Stocks fell for the second straight session, although a modest late rally lessened the damage yesterday. Pundits suggested that rising recession fears, concerns over China’s zero-Covid policy, or trepidation that the Fed might raise interest rates more than previously expected accounted for the declines. I think it is simpler than that. Since the rally began in early October, any remaining bargains were gone. The upturn simply ran out of steam. It wasn’t about interest rates, Fed expectations or whatever. Stocks simply moved from undervalued at the extreme in late September to overbought last week.
Thus, we are back to a picture of a succession of lower highs and higher lows than has been present throughout all of 2022. The December high was lower than the July high. Hopefully, a subsequent low will break the string and be above the September bottom, but we won’t know that until the current emerging pessimism runs its course.
There are reasons to be cautious. Number one, which I keep coming back to, is valuation. Using 16.5 as a P/E, a rate consistent with current bond rates, and $225 for S&P earnings next year, fair value should be close to 3700, just under 10% from where we are today. That’s logic, but stocks don’t usually follow logic in an orderly way. Emotion makes values over and under shoot fair value all the time. Moreover, if long-term bond rates decline further amid growing economic weakness, or if earnings projections are wrong, fair value will have to be adjusted. With that said, history says that in normal times, moments when central banks are neither pumping the economy nor stepping hard on the brakes, 16.5x is a logical multiple. Thus, the key may be the earnings outlook. On one hand, pressure exerted by higher interest rates will be a headwind, the logical precursor of a recession. On the other hand, higher than normal inflation boosts nominal revenues. In addition, consumers may still have more than $1 trillion in reserves left over from all the pandemic giveaways. Thus, while the odds of recession are increasing, it still is not a foregone conclusion. S&P earnings in 2023 could stay close to the $225 estimate. As we move through 2023, stocks will start to reflect 2024 forecasts. If any recession is short, recovery will begin in earnest in 2024 and stocks will reflect that over the coming months.
If I look back at 2022, most of the damage was done in the first six months of the year. There was a spike down in September after Fed Chairman Jerome Powell issued a harsh warning, but the September losses were reversed in October as inflation started to fade and the Fed hinted it could ease pressure on the brakes over the coming months.
Of course, most of the economic headwinds relate to the battle to control inflation. There are many signs that inflation has peaked, but there were multiple causes of inflation and not all have subsided. Commodities, including oil, have retreated from early 2022 highs. There were spikes associated with Russia’s invasion of Ukraine. Almost all of those have been reversed. In some cases, prices are back below pre-pandemic levels. Lumber and chicken prices are two good examples.
On the goods side, demand has slowed. Collectively, we bought a lot of goods to support us when we were cooped up during Covid. Demand for PCs, TVs, and Lysol have cratered. Hand sanitizer is now a giveaway item. As auto manufacturers finally get production higher and dealer lots start to get replenished, demand for used cars is faltering and so are prices. Thus, overall, prices for goods are either in decline or growing at a much slower pace.
We are even starting to see some positive signs of lower inflation on the services side. With demand withering under the pressure of higher rates, Americans are resisting further price increases at restaurants or at the beauty salon. Housing prices are in decline. That will begin to pressure rents. Shelter costs are the biggest determinant of CPI. So far, reported data shows rapid increases. That will change over the coming months.
That leaves wages. Labor is always a lagging indicator. One hires new workers after business improves. Workers seek higher pay after the cost of living rises. It’s always a response, not a proactive step. But there is a fly in the ointment. Even if the economy weakens, if there are not enough workers to fill jobs needed, then wages will stay high and keep rising. Currently, unemployment is 3.7% amid an economy with few immigrants to fill needed positions and a labor participation rate that remains below pre-pandemic levels. It is likely to remain below simply based on demographics of an aging population.
The solution is rather obvious. The Fed will have to raise interest rates, albeit at a slower pace than it has over the last several months, to the point where the economy slows enough to rebalance supply and demand for workers. Since demand for workers is unlikely to grow in a recession, the supply of available workers can only increase by layoffs. We are seeing a microcosm of that in Silicon Valley now. A combination of huge companies growing their employment base too fast, and emerging companies without a path to positive cash flow starving for capital, is causing layoffs, closed offices, and consternation. When euphoria turns to caution, that is what happens. Silicon Valley may be an extreme example, but the path from euphoria to caution is a path a lot of companies will have to follow over the next several months.
If 3700-3800 in the S&P 500 represents fair value, despite obvious seasonal patterns, this is a time to be cautious. Let me lay out one warning flag that could turn red early in January. 2022 has been a bear market year. Investors took their lumps. Losses were created, but many had large gains going into the year from many years of a bull market. In taxable accounts, they could offset those losses with long-term gains from earlier bull markets. With that said, if you look to the top of the S&P 500, one sees a handful of very big names, all technology-based in some way, where long-term investors still have enormous gains and outsized holdings. It is hard to sell a stock at $100 that you bought at $10. It is particularly hard to do that in December without offsetting losses. But January starts a new year. Logically, gains from sales taken in January can be offset somehow over the next 11 months. The names at the top of the S&P 500 are great companies that still can grow, but all have their issues, and none are likely to grow anywhere near the pace they have grown over the past decade. Each, in some way, needs to realign cost growth to revenue growth. Some are far along in the process; others are just beginning. While some or all of these leaders may have seen their lows, all will be under pressure for some time. If the top of the S&P 500 is under pressure, so is the entire average. The bottom for the bear market may have been set in September, but don’t look for a huge post bear market bounce anytime soon.
Today, Larry Bird turns 66. Johnny Bench is 75. Ellen Burstyn is a robust 90.
James M. Meyer, CFA 610-260-2220