Stocks dropped sharply last week after stern comments from Fed Chairman Jerome Powell suggesting the fight against inflation was nowhere near complete despite two consecutive CPI reports that were better than expected. While goods inflation has receded and key commodities like oil are in incline, at least for the moment, wage pressures remain high as companies are still hiring.
Yet none of this is new news. Investors knew the Fed would raise short-term interest rates by 50-basis points last week, and the likelihood of another increase of at least 25-basis points was likely the next time the FOMC meets at the start of February. Granted, the dot plots of Fed officials pointed higher than expected, but those longer-term predictions have been so wrong in the past as to be almost meaningless. A week ago, there was talk of an increased likelihood of a soft landing. After the Dow fell well over 1,000 points in three days, the conversation was all centered around the severity of the pending recession. Fundamentally, nothing changed in the interim. Psychologically, the Fed achieved what it wanted, a tempering of enthusiasm that members felt was misplaced.
If I asked you to tell me the weather for April 1st, you could logically predict that it will be warmer than on February 1st. But can you tell me whether the highs will be in the 60s or the 40s? If you did, it would only be a guess. Same as to the likelihood of precipitation. Other than parroting long-term averages, you would simply lack any credible information to make a learned projection. Now let’s turn to inflation. It is pretty clear that it has peaked. It is also clear that the Fed has a goal of bringing it down toward 2% within a reasonable period of time. In so many words, Fed officials have said that to do that some slack must be created in labor markets. How much is a guess. Employment growth has been slowing in recent months. There are signs that the growth rate of the overall economy is starting to slow as well. Beyond this, the picture starts to get hazy. Is the economy going to add any jobs in February or might there be gains close to 200,000? Will GDP still be growing in Q1 of next year? We just don’t have enough data to know. As we look further into 2023, the picture gets even fuzzier.
The bond market and the Fed certainly don’t agree on the outlook as Jim Vogt pointed out on Friday. 10-year bond yields are actually higher this morning than they were a week ago before the FOMC meeting. The 2-year is about the same. In essence, the bond market is saying that actions taken last week are in synch with the market’s prior expectations. The curve remains, an indication that the bond market believes in recession versus a soft landing. The bond market is also messaging that the Fed could well start to lower rates before the end of 2023 in reaction to a recession. The FOMC dot plots predict no recession and no rate cuts until 2024. Of course, one has to assume some bias in the dot plots. Why would a Fed official predict that its own actions would cause a recession?
If the bond market essentially blew off the FOMC meeting as a non-event, why was there such a violent reaction in the stock market?
In a word, valuation.
I have been harping on valuation for weeks. Accepting the S&P earnings estimate for 2023 of $225, a P/E multiple of 17 would equate to an average of 3825, less than 1% below where it closed on Friday. While Treasury yields remained flat (with some volatility) last week, high yield spreads widened as fears of recession grew. Widening spreads make a case for a P/E lower than 17. A 16 P/E would yield a price target of 3600. There is nothing sacrosanct about the $225 earnings estimate or a P/E of 17, but these numbers are a good place to start. Right now, given the outlook for a weakening economy, the odds that earnings next year will be materially higher than $225 aren’t very high. As for the P/E, 17 is on the high side of historic norms.
The bottom line regarding valuation, therefore, is that stocks are fairly valued, at best, and could fall another 10% using more negative assumptions. Conversely, it has been extremely hard to justify the recent move to 4000.
But don’t get overly negative either. Seasonally, the second half of December is normally a positive time for equity markets. Should earnings dip below $225 in a moderate recession, they shouldn’t stay down for very long. This would be a recession manufactured by the Fed and one the Fed could terminate rather quickly if it started to cut rates. Inflation spiked quickly in 2021, but most of the pressures that ignited inflation are gone or dissipating. Wage growth is a lagging indicator. If price trends moderate, wage demand growth will slow.
Thus, the worst I see is another retest of the June and October lows, probably in the first quarter of 2023. Any move below 3600 should wet buyer appetites. On the other hand, despite last week’s sharp drop, I don’t see much near-term upside from here. In tough economic times, January and Q1 can be tough times for equity investors. Look at 2009, a year when the first quarter was down followed by a vigorous rally for the rest of the year. Individually, many stocks have most likely set their bear market lows. Those are buys if they dip towards their June/October bottoms. Beware, however, of stocks that continue to set new lows over the next month or two. They are unlikely to be leaders during the ensuing recovery.
Today, Jake Gyllenhaal is 42. Alyssa Milano turns 50. “Flashdance” star Jennifer Beals turns 59.
James M. Meyer, CFA 610-260-2220