Now that I got that out of my system, let’s move to markets and the economy. Hopefully, I can talk positively about the Eagles again in two weeks.
Stocks continued their rally last week, fueled by hope that the Fed will soon slow down or even stop its string of interest rate increases. Amid Fed watching, this will be the busiest week for earnings reports. So far, earnings season has been relatively uneventful.
Let’s start this morning with a look at earnings. Of the biggest companies, only Microsoft# and Tesla have reported so far. Microsoft delivered OK December quarter results, but its outlook was gloomier than consensus. However, after a brief drop, the stock rallied and closed higher for the week. Did investors already factor in reduced expectations or was Microsoft simply carried higher on a wave of optimism? As for Tesla, Q4 deliveries were worse than expected, but management said recent price cuts led to a surge in demand. The company was typically optimistic, and Wall Street, in a good mood, bought the hype. Now it is up to Tesla to deliver.
We went into earnings season with low expectations as did the rest of Wall Street. December was held back by unusually intense year-end tax selling. So far this year, in just four weeks, the S&P has climbed 6% and the NASDAQ has risen 11%. Clearly, that isn’t because the economy is robust or earnings forecasts are rising. Interest rates have fallen a bit at the long end of the curve. Almost all of the drop happened in the first week of the year. Since then, yields have stayed in a very narrow range. So, if earnings haven’t beaten expectations, and bond yields have been contained, what is driving stock prices higher? Can the gains be sustained?
For that answer, we have to shift focus to the Fed. The FOMC meets tomorrow and Wednesday. The immediate action, a 25-basis point increase in the Federal Funds rate, is a foregone conclusion, but what everyone will be watching is what Chairman Powell will say at his press conference following the meeting. More than likely, he will say that recent inflation trends are moving in the right direction, but that the Fed’s job isn’t done. More rate increases are likely. Whether we see three more increases to bring the rate up over 5% is an open question, but he will dampen hope that Wednesday’s increase is the last one. Moreover, Powell is likely to reiterate that rates will remain elevated until there is clear and convincing evidence that inflation is headed back to its 2% target.
Those will be the words. Will they be believed? Markets will certainly react instinctively to what Powell says. If he pushes the thought that more increases are coming, markets won’t react well to the message. If he suggests in any way that Wednesday’s increase may lead to a March pause, equity investors will celebrate. That is not a message Powell wants to deliver now. He won’t, but that doesn’t mean the Fed will continue raising rates in March. That will depend on economic and inflation data over the next six weeks. There will be a lot of it. At least two employment and CPI reports, plus other real time measures of what is going on. If recent trends continue, the argument to pause in March is compelling. That doesn’t mean Wednesday’s increase is the last one, but it could be. Retail sales are sliding. Consumers, who binged using post-Covid handouts from the government, are starting to become more cautious. While unemployment rates are still low and weekly unemployment claims are actually falling, continuing claims are still rising. Those out of work are finding that it takes longer to get a new job. Employers may not be laying off workers, but they are slower to higher. Signing bonuses are no longer needed. Trends are moving in the right direction.
The Fed is often criticized over the notion that it fails to get policy right. It either does too much or too little the vast majority of the time. That doesn’t mean the Fed is inept. It means the idea that the impact of actions taken today won’t be felt for as long as a year. In mid-2022, the Fed raised rates 75-basis points at six consecutive meetings. Much of that impact on the economy is just beginning to be felt. Does the FOMC wait until the full impact is apparent or does it raise rates further, putting an exclamation point to its battle against inflation? That is the dilemma for policy makers. Look at housing for a moment. We all know demand is falling significantly, but homebuilding activity hasn’t slowed yet, for many builders are still working off backlogs. GDP won’t reflect the declines we know are inevitable until sometime this year.
In weather forecasting, a one- or two-degree difference means rain or snow. In economic forecasting, the difference between recession or soft landing could be a single percentage point. Is a single percentage point even all that meaningful? In a flat economy, and that is essentially what we are talking about for the months ahead, individual corporate actions may matter a lot more than the direction of the overall economy. Matching costs to revenues will be key. Stimulating demand with new or better products will be key. Gaining market share will be critical to success. If demand isn’t growing, the only way an individual company can grow is to gain market share.
Let’s pull all this together. The Fed this week will take a moderately hawkish stance. It doesn’t want to suggest that its path of rate increases is over without additional data. With that said, will one or two more increases make a huge difference? Probably not, especially if they are spread out over the next 4-5 months. Over the past year, the Fed has said one thing post-FOMC meetings and done something different at the very next meeting. No one forecasted six straight 75-basis point rate increases. What we do know is that there will be a small increase Wednesday. That’s all we know. In the meantime, earnings momentum is waning. The only offset is a weakening dollar which will help the translation of overseas earnings. Overall, inventories are elevated. The weaker dollar lessens demand for U.S. goods. The economy is clearly slowing.
Lastly, I turn to valuation. The S&P closed Friday at 4070. Earnings estimates for 2023 are around $220 and falling. That’s a P/E of 18.5. If earnings prove to be only $200, the multiple is over 20. That only makes sense if one expects the Fed to revert to the kind of monetary expansion of the last dozen years. That’s a very bad bet in my opinion. What is more logical, going forward, is 2% (or higher) inflation, a Fed Funds rate of at least 3%, and a 10-year Treasury yield near where it is currently. That suggests a forward P/E for the market closer to 16-17 than 18-20. In a nutshell, stocks today are fully priced, if not overvalued.
Most of the big tech giants report this week. The NASDAQ is already up 11% this year. The companies reporting this week are already up more. The bar has been raised. With that said, there is no question that secular growth at Amazon#, Apple#, Alphabet# and Meta Platforms# is slowing. Cost reductions can protect earnings for a time, but long-term growth is driven by revenues, not cost containment. Digital advertising, cloud deployment, streaming, and internet retailing are all maturing growth businesses. It is easy to say the bounces so far this year in NASDAQ stock prices is unsustainable. At a minimum, some pause is likely. The NASDAQ fell over 30% last year. About half the losses have now been recovered. That seems fair. Further progress will require revenue growth acceleration that will be hard to deliver.
I am not forecasting a return to the October lows. The end to the interest rate hiking cycle is near. Any economic slowdown should be modest, but it is simply too soon to be as enthusiastic as the January rally to date suggests. Perhaps the FOMC meeting this week and earnings reports to come will curb some of that enthusiasm.
Today, Phil Collins is 72. Former VP Dick Cheney is 82. Gene Hackman turns 93.