Stocks were mixed on Friday in a shortened holiday session. Bond yields continued to fall. Indeed, probably the biggest economic story over the past month has been the decline of over 50-basis points in yield on the 10-year Treasury in the face of stronger than expected economic data.
Third quarter GDP grew by over 2.5%, and as of now is on track to grow over 4% in the fourth quarter. On the surface, this is not what seemingly should be expected of the economy in the face of rapid increases in short-term interest rates. The decline in the 20-year yield alone accounts for about 125 points of the increase in the S&P 500 since early October, but that alone doesn’t account for the entire gain of close to 15%. The rest is due to increased optimism that a recession, or at least a severe recession, can be avoided as the Fed slows the future pace of interest rate increases.
As already noted, the pace of the economy has actually accelerated over the past few months. Supply chains have moved a lot smoother, pushing inventory from the open seas of the Pacific to store shelves. At the same time, commodity price inflation has almost stopped. Key food and energy commodities are well below peak levels. Finally, Americans are still living off of the $2-3 trillion in incremental savings built up during the pandemic quarantine period. That could be coming to an end given the rapid decline in accumulated savings back toward normal levels.
The primary reason the economy has remained so strong is that job security today is enormously high. Furthermore, the impact of higher short-term rates is only beginning to be felt. Even industries most affected by higher rates, such as housing, have been living off of order backlogs to date. The actual decline in economic activity is still in the future. That is a primary reason that there is such a time lag between the institution of higher interest rates and their economic impact.
It remains uncertain whether there will be a recession or simply an economic slowdown. But if it is to be the latter, it must be accompanied by a slower pace of wage increases. Prior to the pandemic, wages were rising at a moderate pace. That accelerated after inflation began to spike and continued upward as inflation proved to be more than just “transient”. Monthly job increases have begun to recede over the past few months, but they remain at a pace suggesting solid economic growth. If the economy were simply moving sideways, the monthly gains would be close to 50,000. They were 5 times that number in October. The labor market is too strong to support the case that inflation will get back to 2% anytime soon. That doesn’t mean that inflation isn’t moving in the right direction. The October CPI report sparked a further rally in stocks, and justifiably so, but the number was still way too high to cry “victory”. Goods inflation is back within or even below targeted ranges for the most part, aided by a strong dollar, but the cost of services is still rising at an unacceptable rate. That will decline more slowly. All this supports the notion that the Fed will have to raise short-term rates to somewhere close to 5% and keep them there a bit longer than previously anticipated. When I say 5%, I can’t be too precise. Perhaps 4.5% is the top. More important is where rates will settle once the Fed takes its foot off the brakes. The economic problems we face today are 100% related to the policy of central banks around the world to make money free for most of the past dozen years, supporting a growth rate that was simply unsustainable without central bank support. The proper goal would be to regain supply/demand balance and then let markets take over from there without central bank intervention. Easier said than done.
As for markets themselves, I repeat the math I display persistently. 17 times 225 equals 3825. That’s price/earnings multiple of 17 times expected 2023 earnings of $225 for the S&P 500. To me, that’s the center point of fair value today, assuming I apply those targets to a mid-year run rate looking ahead. Stocks discount reality by 6-9 months. Because the Fed did such a good job of advertising its game plan starting in the fall of 2021, markets may have looked beyond 6-9 months, thus anticipating a recession much earlier than normal, but also anticipating a recovery sooner than one would expect.
History is a guide to the future. Instinct suggests that most recent history is the dominant guide. After bear markets in 2000-2002, the Great Recession, and the brief but sharp drop during the pandemic, stocks rallied sharply, rising more than 30% within the first year. But that isn’t true of all past bear markets. Ultimately, rising markets need fundamental support. That takes me back to 17 times 225. The “problem” this time around is that the post bear market recovery is starting at an elevated P/E ratio, while earnings have yet to fall. In 2013, four years into the 2009-2021 extended bull market, stocks were still selling at only 13 times earnings. Starting a new bull market at 17x leaves little room for upside. As for the earnings themselves, if there is a downturn coming, $225 may be an optimistic earnings estimate. If there is a soft landing, it won’t be far off. Either way, fundamentally stocks are fully valued. Seasonal momentum could still carry values higher, but if it does, they won’t stay there very long.
All this doesn’t mean the bear market isn’t over. Without either a serious recession or stronger than expected inflation, there is little reason to expect a retreat back toward 3400. On the other hand, with 1% (or less) population growth, and very low expected improvement in productivity, there is little reason to expect annual GDP growth in good times to exceed 2% plus the rate of inflation. If we return to a normal world, with a cost to money, we face a world of slow growth. Obviously, well managed growth companies are not constrained by a slow economy. With that said, visions of future growth have been adjusted in 2022 to a new reality in many cases. The euphoria of 2021, which happens roughly once a decade, is over. It will reappear, but not real soon.
Today, Jon Stewart is 60. Berry Gordy turns 93.
James M. Meyer, CFA 610-260-2220