Stocks took off yesterday after Fed Chair Jerome Powell strongly indicated that the Fed would start to reduce the pace of future interest rate increases. He did leave some wiggle room noting that there are at least two key economic data points between now and the next Fed rate decision in two weeks, which are Friday’s November employment report and the CPI report to follow on the morning of the FOMC meeting. After tomorrow’s speech, we won’t hear from Fed officials until after the FOMC meeting. The message pre-meeting must be that the Fed is in this battle to whip inflation, whatever it takes, but the pace of future rate increases will slow to allow the central bank to monitor the impact of higher rates on the pace of economic growth.
The bond market, meanwhile, still says recession looms. The 2–10-year Treasury rate spread is now inverted by about 75 basis points. The 3-month to 10-year spread is almost as inverted. Inversion doesn’t always guarantee a recession but no recession in recent memory has occurred without an inverted yield curve. Economists are not quite as convinced as the bond market. They are evenly split between a soft landing and a recession. As investors, we focus on individual stocks. Some companies can still grow in a shrinking economy provided its decline is measured. In a soft landing environment, more companies can make forward progress.
Against this backdrop, stocks soared as Powell’s speech had a more dovish tone than expected. With that said, Fed Fund futures suggest a 75% chance of a 50-basis point increase in two weeks, exactly the same as a week ago. What did change modestly was the prediction of the peak rate for this cycle.
Despite the sharp rally, one of the high-tech darlings, CrowdStrike, which is a major factor in cyber security, reported results that disappointed traders. Its shares dropped about 15%. Once again, the market screamed that when expectations are unrealistically high, the penalty for coming up short is severe. One can’t blame the bond market or rising rates this time. 10-year Treasury yields are more than 50-basis points below recent highs. This simply once again demonstrates that the high expectations built in a time of euphoria, are destined to be readjusted when cynicism replaces euphoria. That correction is well along, but it isn’t over.
Monday was a bad day for stocks, the worst since post-Election Day when a Republican sweep didn’t happen. There wasn’t much bounce Tuesday but yesterday stocks took off once again as Fed Chair Jerome Powell suggested strongly the pace of future rate increases will slow. As I said Monday and many times before, 17 times 225, in my mind are the right P/E and earnings estimates to use right now, but that doesn’t provide any upside to the stock market, at least until earnings trends start to improve. That’s hard to see in an environment where the Fed is going to keep the cost of money high for an extended period of at least a year.
Obviously, forecasts can change radically and quickly. I have noted that a year ago, the consensus expectation for interest rates today was less than 1%. There is a school of thought within economic circles suggesting that inflation will fall back toward 2% as rapidly as it rose. Certainly, if prices fall quickly, so will wage demands. Wage demands are elevated today to compensate for the rising cost of living. If that reasoning falls apart, if inflation subsides fast, so will the intensity of wage demands. There were two ifs in the last sentence. Obviously, Fed members don’t buy that. Then again, they thought inflation was transient in the first place. Correcting the mistakes of 12 years of super aggressive monetary policy isn’t something that we have experienced many times before. It heightens the guesswork investors face assessing where we go from here. Wide dispersion of forecasts increase both risk and opportunity. Transitional times are always difficult times for investors.
The uncertainty of forecasts strongly suggests we are still in choppy times. Without firm conviction, markets travel through emotional peaks and valleys. After very tough commentary at the Fed’s Jackson Hole conclave in August, stocks got crushed in September. When the Fed softened its tone and suggested the pace of future rate increases would moderate, markets did an about face and rallied sharply. Against that, the economic backdrop has changed at a much more moderate pace. Over the past few months, inflation has begun to moderate. Month-to-month the CPI report has sent mixed messages. The current rally has been extended by a favorable report showing moderation in September. Investors are hoping for a repeat when the next report comes out December 13, but month-to-month, who knows? On the GDP front, business remains rather good. Changes in inventory and trade have obscured a rather consistent modest growth performance over the first nine months of this year. Even housing, where demand has fallen sharply, has done well in GDP terms and builders are still working off their backlog of orders. Interest rates have only started to pinch in the last several months at a time when Americans were still burning through the excess savings accumulated during the pandemic.
Thus, it remains logical to expect the U.S. economy to grow at a slow pace, even possibly slipping into recession next year. Profits will be pinched as sellers lose pricing power. Whether that is fully discounted in markets yet is unknown but probably unlikely. There will be more volatility to come.
One of the tricks of successful investing is the ability to separate pertinent information from the vast amount of nonsense. SPACs were nonsense, for the most part, so is much of the babble emanating from crypto supporters. Besides all the lack of control and safety trading crypto, the notion that anyone can fairly value an asset with no underlying intrinsic value is nonsense. That doesn’t mean bitcoin is worth zero. It’s worth whatever you can sell it for today, but no one can make a logical case why tomorrow it will be worth $5,000 or $50,000. For everyday equity investors, the same ability to focus on the facts is crucial. That is why I keep repeating 17 times 225. Both 17 and 225 may be wrong, but they aren’t likely to be far off. Stocks often overshoot and undershoot fair value. With hindsight, in 2021, euphoria dominated reality. We paid the price this year. We also learned once again that companies cannot grow at 2, 3 or 4 times GDP forever.
Great companies are considered great because they do things better than their competition. I can say the name McDonalds and you know exactly what I am talking about. The company knows its mission and its customers. It is fanatical in its efforts to make the experience better. It doesn’t grow faster than GDP because more people are eating hamburgers, it grows by superior execution, slowly taking market share. Procter & Gamble has been doing the same for decades. In tech circles, staying on top is harder because markets change so fast. PCs took over the computer industry but much of their functionality is now done on tablets and smartphones. That transformation isn’t over. It’s never over. Right now, cloud computing and cyber security are hot buttons. That too won’t last forever. Even if it does last for a long period of time, you can count on the fact that some company not even in existence today will discover a better mousetrap that will allow it to gain share from today’s dominant incumbents.
Great products and great companies aren’t the same. Fads fade. Great companies don’t. They look ahead. They adjust. Great companies are not hard to identify. Capturing great companies at a fair price is what takes investor discipline. The good thing about this year is that all the back and forth movement in stock prices can give you a marker where the downside risk becomes modest compared to the upside reward. Rather than chasing rallies, find the companies you really want to own and set a price where value is really in your favor. Then step in, not necessarily all at once, but build positions on dips.
Today, Bette Midler is 77. Woody Allen turns 87.
James M. Meyer, CFA 610-260-2220