For those of you who remember life before the creation of President’s Day, today, the anniversary of George Washington’s birthday, would have been a national holiday. Maybe we need that after yesterday’s pounding. Home Depot’s tepid earnings outlook was partly to blame. So were higher long-term interest rates, but I continue to harp on valuation as the primary headwind for stocks.
Walmart# and Home Depot# both reported earnings yesterday. These are two of the largest retailers in the world, and both are very well run. When both offer essentially the same somber outlook for the economy, investors should listen. Yesterday, it appeared they did. In both cases, implied forecasts from company managements were lower than what had been expected. Translate that out further, it is likely that earnings estimates for the entire S&P 500 for 2023 are too high. Optimistically, using $225 for 2023 earnings, about level with 2022 results, the forward P/E was 17.8. But if you just haircut the earnings number to $210, which may still be optimistic, the P/E rises to 19x.
Some will argue that valuation should not be based on one year’s depressed results. OK, I buy that. Let’s look to 2024. Let’s further assume a broad recovery with earnings rising all the way to $250. That is about as optimistic as I can see it. Then the P/E, based on 2024 earnings, would be 16, about in line with historic norms.
What does “historic norms” mean? It has to relate to some alternative interest rate history to make sense. I have noted before that from 1965 to 2000 the Fed Funds rate was only below 3% for one month. Most of the time it was between 3.0% and 4.5%. If we look at longer rates, the picture is much less clear. Starting near 4% in 1965, the 10-year Treasury yield climbed to about 15% in 1981 before receding to near zero during the Covid pandemic. There isn’t any nice compact range, but clearly long-term averages for the past 50 years are well over 4%. Professor Jeremy Siegel gained fame looking at long-term equity returns. He shows that stocks appreciate at an annualized rate of about 6% plus the rate of inflation. Right now, inflation is projected to average about 2.3% long term. An 8-9% return would be in line with history, but only if your starting point (today) is at a neutral point. I would argue it is not, that valuations today are above average implying at least for the next several years that equity returns will average below an 8-9% norm.
For months the bond and stock markets were giving mixed messages. Longer-term bond yields shot up to about 4.25% last fall, fearful that inflation would stay higher for longer. By early this year, however, the mood had changed. Inflation for a few months appeared to be coming down sharply, encouraging investors to believe the battle to whip inflation would be won quickly. I had thought the February 1 Fed Funds rate increase might be the last one, but that appears to be wrong. Inflation is more persistent. It is coming down, particularly in commodity related areas. Softer demand is igniting more sales, increasing pricing pressure. Cars today can once again be bought below list price. But labor markets are still way too tight. After all the interest rate increases, significant parts of our economy are surging, especially travel, leisure, and entertainment. The bond market reads this and responds by pushing long-term yields higher, not back to October 2022 levels, but uncomfortably close.
Meanwhile, at least until the last couple of weeks, equity markets were behaving like everything was rosy. Money poured back into the most speculative areas, from Tech names focused on artificial intelligence, to Bitcoin. Traders raced away from safety (e.g., Consumer Staples, Drugs and Utilities) and ran towards Growth and Cyclicals. It was a belief that recession could be avoided and inflation whipped simultaneously. That bubble has now been deflated.
Equity investors also have short-term memories. The most vivid is of the 2010-2020 decade pre-Covid, when growth was moderate, and the cost of money, in real terms, was negative. In fact, around the world, most sovereign interest rates in developed nations were negative in nominal terms. There was no limit to the amount of borrowing if debt service costs were near zero. Of course, the inflation of 2022, an inevitable result of too much money sloshing around, burst that dream.
Free money led to foolish investments. It led to excess capacity. For a while that kept inflation down. It also created inefficiencies. And, of course, it seeded today’s inflation.
The Fed isn’t about to go back to a world of free money anytime soon. If it were to do that, inflation would repeat the path of the 1970s. Tomorrow’s world is going to see Fed Funds rates above 3% and long-term bond yields higher. Demographic evidence suggests real growth as high as 2% is likely unsustainable without significant improvements in productivity. This outlook is not what equity investors want to hear. They want a return to 2010-2020 when annualized returns were greater than 15%.
If future growth is going to be less, and the cost of money normalizes to levels that fit within norms of the last fifty years, one has to accept that expectations need to moderate. Earnings projections have to come down. So do P/E multiples.
I still am not forecasting a recession, nor am I saying one will be avoided. It is going to be a close call. The headwind for stocks isn’t likely to be the need to drastically cut earnings forecasts. Nor do I see interest rates as a major headwind going forward. They have been a headwind for the past couple of weeks as the 10-year Treasury yield jumped from about 3.4% to 3.9%, but that is all within a range set since October. The real headwind is valuation. That can be corrected by a quick decline in stock prices, or it can be corrected over time by volatile sideways movement.
Within a few years, S&P 500 earnings will rise toward $300 and then move beyond. Stock prices will respond and move higher. A relatively short-term correction or sideways movement doesn’t negate the long-term attractiveness of owning stocks. Inflation is an enemy of stocks, but it is even a bigger enemy of bonds since the lender will be repaid ultimately in dollars depreciated by inflation. Inflation depletes the value of your savings. That can be somewhat offset by interest payments, but not while rates are rising. The good news today is that we are over the hump. Inflation is falling. It will continue to fall. Getting it back to target may take a bit longer than optimists might have hoped for, but it will get there.
I suspect that by the end of 2023 we will be looking at a brighter sky on the horizon. We may or may not be in a recession, but if we are, it should be shallow and it should be the needed ingredient to break the back of inflation. When wage demands fall and the number of new hires moderates to under 50,000 for a number of months, peaks of blue sky will appear on the horizon. Stocks will respond positively.
In simple terms, last October may have been too soon for the bear market to end. That doesn’t mean those lows have to be revisited, but it does mean that the all-clear siren that blared in January was misguided. In 2008-2009, markets touched a double-bottom in October and November of 2008, rallied into year-end, and then fell back to a final climax in March. History doesn’t have to repeat itself, but it does offer lessons that getting too excited too quickly has a price.
For now, I would offer that a trading range defined by the October lows and the recent highs is appropriate until there are real signals that labor markets are easing and that inflation will get back to well under 3% and stay there. Whether that takes a few months or many is too early to call, but it is also worth nothing that high interest rates can distress markets. Today, for instance, default rates on car loans to those with low credit scores has spiked to levels not seen since the Great Recession. Americans took on a record amount of new debt in the fourth quarter of 2022. Expensive debt. The savings cushion created with government handouts during Covid is being dissipated. Savings rates are down. There are signs that the stubbornly strong economy may not be so strong for long. Indeed, that is exactly what Walmart and Home Depot told us yesterday. Obviously, investors heard the message.
Today, Drew Barrymore is 48. Dr. J, Julius Erving, turns 73.
James M. Meyer, CFA 610-260-2220