January was one for the record books with the S&P 500 rising almost 7% and the NASDAQ up over 11%. All this while economic growth was slipping toward recessionary levels.
Bond prices rose early in the month but were rangebound after the first week. All eyes are now on today’s conclusion of the Fed’s FOMC meeting. There is little question that the Fed Funds rate will be increased by 25-basis points, but what will get the most attention will be Chairman Powell’s remarks after the meeting ends. Recent inflation data is strong, suggesting that inflation rates are falling. Annualized, they have been hovering around 3% in recent months. The Fed Funds rate, currently in a range of 4.25-4.50% is restrictive. Today’s likely increase will make them more restrictive. If the goal is simply to rein in inflation toward its long term 2% target, no further increases are necessary. However, Fed officials have been signaling that further increases would be necessary. More hawkish committee members have suggested a rate of 5% or higher would be necessary.
Clearly markets disagree. They disagree with the conclusion and they are predicting that not only will the Fed stop soon, but that it will begin to cut rates back later this year. At the same time, the notion that there will be a soft landing without any recession seems to be a growing consensus. Which brings up the question that if a soft landing can be achieved, what pressure will there be for the Fed to cut back rates?
Indeed, at least for the moment, financial markets are riding a Goldilocks bandwagon, one that says interest rates have peaked and the economic skies will clear soon. That’s entirely possible, but the difference between rational investing and euphoria is that valuation matters in a rational environment. A range of earnings estimates this year for the S&P 500 centers around $200-225. The lower end assumes a very mild recession; the higher end says soft landing. For argument’s sake, let’s assume a fairly robust improvement in 2024 to a range of $240-250. At last night’s closing price, the P/E on earnings, almost two years out, would be 16.3-17.0x. That isn’t unreasonable depending how interest rates settle. It also suggests little room for further appreciation according to a rational hypothesis.
How does one make the case for reasonably higher prices from here? Two ways. One is a rapid return to a euphoric state. I’m a better judge of rational behavior than runaway emotions, but there are a few arguments to suggest that isn’t going to happen. First, there isn’t a lot of excess money sloshing around. M2 is down from last year’s peaks. Excess savings are falling. Clearly, some speculative fever has returned. One only has to look at bitcoin prices to see that, but the craziness that embraced the SPAC and IPO markets in 2021 doesn’t seem likely any time soon. Second, a lot of unsavvy investors got badly burned last year. Fool me once, shame on you. Fool me twice, shame on me.
The second way is for interest rates to make a hasty retreat back toward last year’s low. Two- and three-year Treasury yields have slipped back to 4.2% and 3.9% respectively. They suggest Fed Funds may slip back toward 3.5% over the next few years. The 5-year rate of 3.6% suggests little further slippage. As we have noted often, it would make little sense for the Fed to revert back to quantitative easing policies after inflation is contained unless there is a severe recession.
Thus, my conclusion is that while the Fed could start cutting rates before the end of 2023, any cuts would be modest and would be consistent with the yield curve today. Should a recession be averted or the end of one that might occur be in sight by the end of this year, the yield curve should resume its normal upward sloping path. That suggests a long-term Fed Funds rate of close to 3%, with higher yields for longer maturing debt issues. That adds an exclamation point to the idea that a P/E ratio for stocks should be in the 16-17 range versus a number closer to 19x currently.
That brings me back to Mr. Powell’s comments coming this afternoon. A runaway stock market doesn’t make the Fed’s job any easier. Without being overly hawkish, i.e., strongly suggesting the Fed Funds rate is on a path to at least 5%, he will likely point to concerns like wage growth to suggest further tightening is a likely course. Again, I don’t agree with that conclusion, but Mr. Powell’s job this afternoon is to separate rational expectations from euphoric hope. With that said, he will continue to state that policy decisions are data dependent. There will be lots of data between now and mid-March when the FOMC meets again.
Meanwhile the earnings parade continues. Managements collectively have been rather sober in their outlooks with little visibility past the next few months. Markets can ride an emotional wave only so long. It’s time to be careful again.
Today, Harry Styles and Julia Garner are both 29.
James M. Meyer, CFA 610-260-2220