Stocks were mixed once again with the Dow Industrials rising while the NASDAQ continued to get thumped. New 52-week highs were set by Merck and Caterpillar. New lows were set by Tesla and Apple#. I don’t have to say much more. At the start of the bear market, I noted two primary influences. First, the expectation of higher interest rates was likely to weigh on stocks. They have. Second, the excessive speculation fed by easy money for more than a decade had to be eradicated. That process is ongoing. I wish I could say it’s over.
Let’s start with Tesla. We have all seen the hype. For a while, Elon Musk was the richest man in the world, at least on paper. His inflated offer to buy Twitter soiled his reputation and hurt his pocketbook, but Twitter isn’t the only reason Tesla’s stock is falling. I have been saying for months that a huge problem for the companies at the top of the S&P 500 is that all were maturing to some degree. But Tesla? After all, the transformation of the auto industry from gasoline powered to electric is just beginning, isn’t it? All true, but Tesla says it will increase production 50% per year, even as every current traditional auto manufacturer introduces electric vehicles and other newbies like Rivian and Lucid join the fray. Volumes will rise but profit margins will fall as demand growth slows and competition intensifies. Tesla’s stock just a few months ago was priced to perfection. Now as the warts appear (everybody has blemishes), its stock price is adjusting. It’s simply one more example of the purging of euphoria. The process is well underway, but it isn’t over. Unlike some of the recent startups that only have limited market opportunity and may never make money, Tesla as a company has a bright future, but its stock is another story. Even after falling over 70%, it still sells at over 25 times next year’s estimated earnings. General Motors sells for less than 5 times.
As noted, the purging of 2021’s excesses is well underway, much closer to the end than the beginning. The point, looking ahead, is that it is simply too soon to presume that the speculative and high growth ends of the market are ready, once again, to lead the market forward, at least not for a while. All the biggest names, including Apple, have been underperformers year-to-date. Some, eventually, will outperform once again. Others may not. Look as the histories of Cisco# and Intel as lessons.
This being my last note of the year, I now want to look ahead to next year. To start, I want to move the clock back a year. A year ago, the Fed was winding down its bond purchasing program, preparing to start raising interest rates in March to begin the anti-inflation battle. At the time, no one understood how fierce the fight would be. Rates in 2022 rose much faster and higher than expected, but directionally, everyone knew that in 2022 rates would rise. That was the major influence on stock prices this year, the primary cause of the bear market, along with the purging of speculation.
To everyone’s surprise, the economy did pretty well. Excluding the quarterly impact of changes in inventory and trade, growth averaged close to 1%, perhaps even a bit higher. While higher rates had a predictable impact on housing and the demand for discretionary consumer goods, Americans had built up savings during the pandemic. When the doors opened, they spent freely enough to offset the headwinds of higher rates.
Remembering that stocks look ahead, at the start of 2022 the outlook was for higher rates and slower growth. That’s about as bad a combination for stocks as one could ask for.
Now let’s move to the present. Rates are still rising, but the Fed is nearing the end of its rate hiking cycle. Maybe there are 1-3 25-basis point increases left. Perhaps none, depending on data between now and February 1, the date of the next FOMC meeting. Inflation has already peaked. We have seen it in the data. We will see more once the CPI calculation reflects a slowing pace of rent increases. One can argue how fast inflation will recede, but few will argue that the peak is still ahead.
As for economic growth, so far it has been stubbornly resistant to the impact of higher rates. As rates continue to rise, and excess savings get dissipated, it is likely that growth will slow further. Whether the cycle bottom is just above zero or somewhat below is an open question.
Unless the Fed way overdoes it with rate increases and a shrinking balance sheet, we are unlikely to face a severe recession. Parts of the economy will shrink markedly. Housing activity is way below peak levels already. Prices are starting to fall. The outlook for auto sales and retail spending is weak. Tech spending growth has slowed but is still rising as is spending for health care and education. If there is a recession, look for the pace of inflation to continue receding. A combination of rapid deceleration in the pace of inflation and economic growth almost certainly will cause a change in Fed policy. First, it will stop raising rates. There is no reason it must raise rates, even by 25 basis points, at each FOMC meeting. If conditions deteriorate enough, it might even cut rates before the end of 2023.
What brings me to my conclusion is a year ago, investors expected a deteriorating inflation, interest rate, and earnings outlook. Stocks fell. This year, there are still a lot of storm clouds present. Likely, a recession has not even begun. However, by the end of 2023, the outlook is likely to be much different. Inflation will be much lower than today and moving in the right direction. Monetary policy won’t be tighter than it is today. Short-term interest rates may begin to fall. The outlook for 2024 will be for a normalization of monetary conditions. If there is a recession, the worst should be this coming year or, perhaps, early in 2024. A year from now investors will look past that abyss.
Thus, a year from now, the investment outlook will be much brighter, lower inflation, a path to normalizing monetary policy, and, hopefully, a vision of stable growth ahead.
The issue is getting from here to there. Here means inflation is still too high, and a slower economy lies ahead amid peak interest rates. There is slowing inflation, lower rates, and visions of better times ahead. In 2009, at the tail end of the Great Recession, stocks fell almost 20% in the first 75 days before rallying close to 50% over the balance of the year. Between now and the next FOMC meeting in February, there will be a lot of data supporting the thesis of lower inflation and slower growth. The focus over the next two months will be on the labor market. How fast is it growing? What is the pace of rising wages? There will only be one more monthly labor report before the February 1 meeting, maybe not enough to stop the pattern of interest rate hikes. But a slower increase, one of just 25 basis points, may be in the cards. The following meeting concludes March 22. It will include expanded data and revised projections. That could well be the crucial meeting of 2023, perhaps even the turning point when the Fed suggests the end of the rate hiking cycle is near. In addition, don’t forget that the Fed is currently liquidating its balance sheet to the tune of close to $100 billion per month. Expect that pace to slow next year. A new path forward should be set by mid-year if there is evidence of a slowing economy and further progress on the inflation front.
When investors conclude that a turning point is near, stocks will stop going down. Is that day February 1, March 22 or some other date? It’s too soon to call, but it is likely to be well before mid-year. Bear markets don’t last all that long compared to bull markets. The bear market associated with the Great Recession lasted 16 months. The bear market associated with the Covid lockdown lasted less than two. The current one is about to enter its 13th month.
Losses at the end of a bear market can be steep, but they get reversed quickly as psychology changes virtually 180 degrees. That is why V-bottoms are often associated with bear markets. Thus, I expect a bumpy ride for the next couple of months but then breaks in the clouds. By year end, there will be more sun than clouds. With that said, stocks still are not cheap. They are near fair value. I don’t think markets will return to the 2021 euphoric peak for some time.
Today, John Legend is 44. Seth Myers turns 49. Linus Torvalds, the developer of the Linux operating system, is 53. Denzel Washington is 68 while Maggie Smith turns 88.
James M. Meyer, CFA 610-260-2220