Stocks soared for the second day in a row. Two back-to-back up days resets the playing field positively. That doesn’t mean you have to buy today, but it does put the offense on the field for the first time in months. Just to review, one up day of note within a bear market may be nothing more than a short covering rally, but two days that both end strongly represent real buying. It’s the follow through that suggests a change of sentiment occurring.
So, what is the market’s message? What has suddenly changed? As we have noted in recent letters, what happens in earnings season is the market’s reaction to earnings, not the results themselves. Markets look ahead. After a series of disappointments in the first quarter, stocks fell sharply in April, May and June, anticipating lowered earnings expectations and a possible recession. The Fed reinforced those fears by accelerating the pace of increases in short-term rates. The June increase was 75 basis points. The market had anticipated 50. July will likely be another increase of 75 basis points. Perhaps the real turning point occurred not during the surge of the last two days but how the market and the Fed both reacted to the hotter than expected June CPI report. As you may recall, last week the year-over-year CPI growth surged past 9%. At first market watchers feared the Fed might move the Fed Funds rate by a full percentage point when it meets next week. But by the weekend, it became apparent that wasn’t likely. With commodity prices rolling over and housing demand falling sharply, it appears for the first time in months that the Fed can stay on course raising rates at a pace that will bring the Fed Funds rate to over 3% by the end of the year.
With the Fed’s pending actions now pretty much assumed, the focus turned to earnings. The expectation at the start of earnings season was that managements would tone down forecasts for the rest of the year. Almost everyone assumed 2023 earnings forecasts would have to be reduced, perhaps sharply. Early on, and in recent notes, we suggested watching IBM, the big banks and Netflix, which reported last night, thinking they would offer signs of whether markets might have already discounted bad news coming.
The banks generally reported solid earnings. Loan activity is rising and the consumer is in good shape. There remain concerns of credit quality down the road, but for now it is excellent. Delinquencies are well contained. IBM stumbled a bit, but its problems appear to be self-inflicted, a one-off. Netflix reported a further loss of subscribers, after a disappointing Q1, but the loss was actually below expectations. Without any further news, and with the stock already down over 70%, its shares rallied in the aftermarket last evening. As previously noted, that is exactly what an investor wants to see, a stock rising on bad or mediocre news. That suggests that the worst, at least for Netflix, is already priced into expectations of the future. Of course, there are no guarantees that the worst is over, but it will take further bad news to renew the downtrend. No one is suggesting that last night’s rally was the first step back to $700+ per share, but it does suggest that if Netflix can execute to or past current expectations in the future, a low might have been set.
Thus, for six months stocks reacted to a lot of bad news. The Fed was raising interest rates at an accelerated pace. No one was forecasting 75 basis point increases at any Fed meeting this year, let alone two or three at the start of the year. No one was forecasting recession this year. At the start of this year, there was no war in Ukraine. $100 oil wasn’t in the picture. Supply chain shortages were supposed to disappear by now. The idea that China would be locked down due to Covid wasn’t anticipated either. There may be more negative events to come, but for now those listed above have been priced in.
Thus, today we look ahead. The Fed now has Federal Funds rates at 1.5%, and they could well be 3% by the end of September and 3.5% by the end of the year. It is now unlikely that they will climb much higher in 2023. Simply said, the market may be surmising that the peak has been pulled forward and is within sight, meaning within 6-9 months, the time markets normally look ahead.
Earnings estimates are a bit too high, but markets have already been discounting that even as analyst forecasts are still a bit elevated. If I used junk bond yields as a proxy to determine the equivalent P/E for the market, stocks should be selling at about 17 times forward earnings. That suggests that markets are pricing in earnings for the S&P 500 next year of about $230, perhaps 2% above 2022 levels. It suggests markets are already assuming that analysts will have to moderate 2023 forecasts a bit. It also assumes either a soft landing for the economy or a mild recession that will be over by mid-2023.
Is that realistic or optimistic? This week the market is voting realistic, but it is still early in earnings season and a lot of companies have yet to report. The rally of the past few days is at least a tepid vote of optimism. Breaking through the 3900 technical barrier on the S&P 500 could mean a push toward 4200, depending on earnings reports still to come over the next 10 days or so. However, one should never forget the message, “don’t fight the Fed”. Inflation is far from dead and the war to contain it is far from over. 4200 would be roughly halfway between the recent lows just over 3600 and the former highs of more than 4800. It would be a convenient point to measure whether the war is being won or not. Third quarter earnings will be another time to assess the accuracy of 2023 forecasts. It will also let investors see signs of the success of the inflation battle beyond the fall of commodity prices. Finally, it would be logical that remaining supply chain issues should be on the path to resolution.
The economist Paul Samuelson is famously quoted as saying that markets have discounted nine of the past five recessions. Maybe markets are saying that today. I have noted all year that a recession was too close to call, and I stand with that same level of hesitation. The economy’s underpinnings today are solid. Consumers, banks and businesses are in good shape. We remain near full employment. Beating 9% inflation won’t be trivial, nor is it likely to end overnight. The issue ahead is centered on the battle to defeat inflation. Right now, markets are betting on success. Forward five- and ten-year inflation expectations are back below 3%. Housing inventories are rising, and prices are starting to fall. Hopefully, that means rents will stabilize soon. Pressure to raise wages remains, but the pace of increase may have already peaked. There are still more than twice as many job postings as there are unemployed workers, but that is likely to change by year end. Things are starting to move in the right direction and the market senses that.
As for new investment opportunities, what worked yesterday is not guaranteed to work tomorrow. The instinct during explosive rallies is to jump back into what led the market in the past, but our world has changed. Covid will no longer be a dominating influence. We don’t know whether white collar workers will come back to the office five days a week or not. Probably not. Video conferencing is a new fact of life. PC demand boomed as workers from home needed to be better equipped. These sudden lifestyle changes created supply chain issues that are still being resolved. But other trends require our notice. The top of the S&P 500 is still heavily skewed to big tech companies that achieved extraordinary growth over the past quarter century. But buyer beware. The laws of large numbers are inescapable. Just as GM, Exxon, Intel and Cisco matured over time and morphed from growth favorites to slow-growing value stocks, the same could happen to the current list of S&P leaders. Amazon’s# retail business is seeing moderating growth. We already noted Netflix. Smartphone demand is increasing at low single digit rates. Digital advertising market share growth is moderating. Competition is increasing.
At the other end of the spectrum, the concept stocks long on story and short of earnings were undressed over the past year. These stocks might bounce early on in a market recovery, but reality will send many into oblivion. Being in the right place is nice, but it isn’t enough. Telemedicine has a bright future, but the true leaders of tomorrow might not even be born yet.
The top of the S&P 500 during the next bull market may not even be in the S&P today. Some of those at the top will be afterthoughts a decade from now. There are major trends that will change our world in the decade ahead. Electric cars should dominate. While Tesla is likely to be among the leaders, we don’t know who else will be at the top of the leaderboard. Millennials will be in their prime years. What they and their children want will differ from the past. Some new trend with the impact of digital advertising, social media and smartphones will emerge. Artificial intelligence will encroach on everything we do. Smarter machines will continue to replace human labor. That part of the labor force won’t be jobless; new opportunities will evolve just as coding did in the last decade. Yet some parts won’t change much. We will still brush our teeth, have most of our dinners at home, go to school, and enjoy the beaches in the summertime. Yesterday’s disruptors will be the disrupted companies of tomorrow. Just look at Tik Tok’s impact on social media or the problems Netflix has been facing. Thus, look ahead, not back.
Some things never change. In the stock market, valuation always matters. We forget that sometimes amid late bull market euphoria, but it always brings us back to center. Valuation cannot be precisely measured. P/E ratios are a function of interest rates, which in turn are keyed off of the sustained pace of inflation. Over the past six months, markets have reset valuations. Hopefully, they are properly resetting earnings expectations. It doesn’t happen in one or two days. The rally so far this week could be the real deal, but also remember the old saw that markets take the escalator up and the elevator down. We face a future of very slow real growth dictated by population and tepid improvements in productivity. Should Congress and the Fed revert to an overly aggressive monetary stance, inflation will reemerge with a vengeance. We learned that lesson 50 years ago. Amid a very slow growing economy there will be companies and businesses that will grow very rapidly. There will be some that fade away. The printed newspaper may be such an example. If the end of the bear market is near, sharpen your pencil and look ahead. Don’t start by simply buying last year’s winners. Always look ahead.
Today, Ben Simmons is 26. Sandra Oh turns 51.
James M. Meyer, CFA 610-260-2220