Stocks fell sharply on Friday, capping the worst week for equities since December. A core PCE inflation number, the one allegedly followed most closely by the Fed, rose 4.7% year-over-year, higher than the 4.4% expectation. Personal spending in January rose by 1.8%, a huge number. Coupled with the recently reported sharp gains in retail sales and jobs, January was a far more robust month than central bankers wanted to see. Higher interest rates are having an impact, but not as large or as quick as hoped for.
During the sharp January rally, it was hoped that the rapid decline in the pace of inflation reported near the end of 2022 would continue. Some, including myself, hoped that the February 1 increase in the Fed Funds rate would be the last one for this cycle. Fed Chair Jerome Powell has said repeatedly that he wanted to see an enduring trend toward the 2% goal before he stopped tightening. We learned in January’s data that licking inflation won’t be as easy as some had thought.
The inflation we have been enduring came from two sources, both contributing to an imbalance of supply and demand. The first was pandemic-related supply chain disruptions. The second was simply a case of demand rising faster than supply at a time when excess capacity, built up during the Great Recession, had largely been absorbed. By now, most of the supply chain issues have been resolved. Indeed, there are pockets of excess in some economic segments, but with unemployment at 3.4% and capacity utilization pressing 80%, price pressures continue. There are signs, however, that the economy is growing more slowly. While demand for new houses turned down before mid-2022, builders still were working off backlogs. Those are dissipating and the inventory of unsold new homes is rising. As auto lots refill, prices for used cars are falling. Default rates for low-credit buyers are spiking. Retailers are more promotional than they were for over a year. Demand for electronics and appliances is notably weak. Indeed, the Fed is on the right course. It may take a couple of extra rate increases and a few more months to accelerate movement in the right direction, but it will happen.
10-year Treasury yields have risen back to 3.95% from a low near 3.4% in January. That is still below the 4.25% level seen last Fall. The rise is more impacted by the apparent need to raise short-term rates to over 5% than by any increase in long-term inflation expectations which are still anchored below 2.5%. Right now, the inversion spread between 2-year and 10-year Treasury yields is the widest since 1982, when both inflation and short-term Treasury yields were at double-digit levels. We don’t expect that spread to rise appreciably. In fact, if there is to be a recession sometime this year, it is more likely that the spread will narrow or even reverse as a recession begins.
While interest rates, the economy, and earnings expectations are all factors leading stock prices lower, we continue to argue that valuation is the biggest villain. Stock prices don’t exist in a vacuum. We all have choices where to invest. To be absurd, if you could get 10% in a money-market fund indefinitely, there would be no good reason to hold a higher risk class like equities that have returned 8-9% per year for the last century or more. Of course, you can’t get 10% today, but you can get 4-5% versus next to nothing a year ago. Corporate bond yields of over 5% are fairly common today. Relatively, stocks are less attractive. You see that as retail investors sell and move to fixed income, notably money market funds. Whether that is a permanent move or simply waiting out the storm is speculative, but the point to be made is that higher rates make equities less appealing. The balancing factor is price. Make stock prices low enough and they will be attractive again. For decades, stocks were considered expensive when the dividend yield on the S&P 500 fell below 3%. Today it is 1.7%. Today corporations increasingly use excess cash to buy back stock, another way to increase value for those who hold for the long term. Every time a company buys back stock, the remaining holders each own a bigger fraction of the pie while doing nothing. Thus, the 3% rule may not apply any longer.
P/E ratios do matter. Today, they are still well over 17. We calculate an equilibrium P/E at under 16. I can’t fuss too much about one or two multiple points as a long-term investor, but it is fair to say that even after the February decline, stocks simply aren’t cheap. If you want to see all that money stored in money market funds return to the market, lower prices will be the enticement.
There are ways besides falling stock prices to restore balance. Lower interest rates would be one way, but the Fed is signaling that more increases are coming. So, at least in the short-run, significant drops in rates don’t seem likely. Just as January economic numbers were shockingly strong, that could reverse anytime. The impact of last year’s rate increases isn’t fully felt, but clearly, pockets of strength endure that have to wane before the inflation battle ends. Travel is still surging despite record airfare and hotel prices. Consumers have taken on a record amount of new debt in recent months, a trend that can’t endure. There are no signs it will end tomorrow, but it will end.
It all comes down to time. We are likely to get three more Fed Funds increases according to the futures market. That process should end by mid-year. The number of added jobs per month will slow. It already has for large corporations. Over time, inflation will recede. The Fed isn’t going to lose this battle. The optimism of January was clearly overdone. As interest rates rise and P/Es move back down, it’s the growth names that led the January rally that reverse course the fastest. Note, however, that the defensive Consumer Staples, Utilities and Drug stocks have not bounced, a sign that the bear market may finally be winding down.
Last year posited that the first half of 2023 would be more difficult than the second half. That looked like a foolish outlook just a few weeks ago, but appears less foolish now. The Dow is actually down year-to-date for the first time. We don’t have to revisit the October lows, but the possibility that might happen isn’t out of the question. Ideally, should stocks once again sell below 16 times forecasted earnings, that would be a very enticing buy point for long-term investors. Right now, even with last week’s decline, an entry point of 17.5-18.0x doesn’t leave a lot of upside potential. I would still rather park excess cash in a money market fund, but that will change, either by lower prices or a rosier outlook. As I said last year, by the second half of 2023 markets will be looking beyond any economic downturn toward a renewal of earnings growth. Inflation will be lower and interest rates will be on their way to normalizing at a lower rate. I haven’t changed my outlook for the second half of this year, we simply have to get through some bumpy times first.
Today, Josh Groban is 42. Ralph Nader turns 89.
James M. Meyer, CFA 610-260-2220