Stocks went for a wild ride Friday after an employment report that showed the economy was continuing to grow and wage rate increases were still higher than central bankers wanted to see. At the start of Friday’s session, the Dow Industrials rose by more than 600 points, only to give all the gains back by midday. But another burst in the afternoon sent stocks surging again, while many of the highest multiple tech stocks took a beating.
How does one square that circle? First, let’s start with the employment report itself, which showed ongoing economic resilience. That can never be a bad thing. If job growth matched the growth of the working age population, average monthly gains would be about 50,000. For the past three months, it has averaged over 300,000. The unemployment rate in October rose to 3.7%, but only because the labor participation rate fell. To remind all, the male participation rate peaked more than 50 years ago. The female participation rate peaked around 2000. Both are signs of an aging population. Labor participation is not going to go back to pre-pandemic rates simply because close to 2 million Americans retired in the interim. Thus, we continue to be in a situation where there are close to 2 jobs available for everyone seeking to work. If inflation is going to come down, that has to moderate.
Higher interest rates were supposed to moderate demand. They have, particularly in industries like housing, but rates only recently got to a restrictive level. Labor statistics are always viewed as lagging indicators. I expect more moderation in job growth over the coming months. Logically, the pace of employment growth should decelerate.
If labor force growth has been surprisingly strong, why is the Fed talking about slowing the pace of future interest rate increases? Because there is a lag between rate increases and their impact, members of the Fed’s governing committees want to avoid any crisis within financial markets. We have already seen the Bank of England forced to take extraordinary action and Korean debt markets are facing severe issues. Yet the Fed has made it clear that slowing the pace of future rate increases doesn’t mean that rates won’t have to go significantly higher to ensure inflationary pressures are reduced.
As a result, markets rightfully reacted negatively to the FOMC commentary last week which expressed just that point. Bond market yields rose, also a bad omen for stocks, but a particularly bad omen for those tech companies experiencing a measurable moderation in their growth rates.
Let’s look back to the 1990s, the Internet boom. Internet shopping, full-fledged email, and search engines were just getting started. There was no cloud, not even a smartphone. PCs were becoming networked, but most networks were hardwired, confined to certain geographies. PC-related companies were in the peak part of their growth cycles. Investors couldn’t get enough of these companies. As often happens late in a bull market, euphoria spread to blue chip names like GE, Procter & Gamble, and Walmart. Warren Buffett famously said “you don’t know who’s swimming naked until the tide goes out”. Once the Internet bubble burst on Wall Street, investors discovered that growth for the PC-related companies wasn’t infinite. A startup named Google linked thousands of PCs together to create superior search performance. It was death for Yahoo, Lycos, Alta Vista and Ask Jeeves. Microsoft Outlook displaced AOL. The list goes on. Even some of the long-time blue chips failed to meet expectations. The saga of GE will prove that point. Indeed, every bull market ends in similar fashion.
Today, we wonder how much growth is left for social media, digital advertising, or internet shopping. Peer-to-peer cash payments were the rage two years ago. Inevitably, competition increased. The big boys wanted in. Apple Pay and Google Pay grabbed chunks of market share from Venmo and Square. In short, the disruptors of 20 years ago are getting disrupted. The old guard doesn’t die easily, but investing today in Yahoo or Intel isn’t pleasant.
Thus, what is going on in equity markets is a restatement of expectations. Investors now expect less growth from many of yesterday’s leaders. They are repricing the most optimistic stories to reflect lower P/E ratios, but also more rational growth expectations. 20x earnings is a rich valuation in normal markets. 20x sales makes little sense in any market. To be sure, the story is not the same with every former favorite. Many are quite well situated to continue solid growth, but not all.
With euphoria gone, investors have been selling the handful of stocks representing the top 25% of the market, spreading the proceeds among companies they feel can withstand higher interest rates and moderating economic growth. They would rather own McDonalds# than Meta Platforms#. Few are confident that the tens of billions Zuckerberg is spending on whatever the metaverse may be will generate superior investment returns. Meanwhile, no one under the age of 50 is signing up for Facebook anymore.
There is a word for all this. It’s called rotation. Markets do this all the time. Energy was out of favor for more than a decade but is the one segment that is higher this year, not because oil prices are higher today, but because investors now expect them to remain high for several more years. Rotation doesn’t ignore the economy, but it does reposition investments for a more sober investing environment ahead. If there is to be a recession, it won’t happen evenly throughout the economy. High interest rates are bad for borrowers, good for lenders. The Federal government has expanded ObamaCare. Offshore manufacturing is coming back to the States. Oil seems to be in persistent short supply after years of underinvestment. Over $1 trillion has been allocated to infrastructure. Over $50 billion to new semiconductor plants. Tax incentives will lower the real cost of a new electric vehicle. And, of course, faster and faster computer chips will open up more opportunities down the road.
I see no reason why the lows of June and October can’t hold. I also don’t see why stocks should surge through the July/August highs. Health insurance and drug distribution companies are hitting new highs, while many tech stocks fill the new low list. But even there, differences appear. The semiconductor stocks, decimated in recent months, today sit well off their lows. It’s a stock pickers market. If you own a stock setting new lows daily, ask yourself why.
Economically, one should expect 2023 to be a year of no growth. That could mean a mild recession or none at all. Inflation will moderate, although it could take 2-3 years to get back to the Fed’s 2% target. Long-term interest rates could start to recede slowly as growth and inflation both slow. That will help boost stock prices. Short-term rates will remain elevated as long as the Fed avoids any cut to the Fed Funds rate. As for earnings, pricing power will be key. Restaurants can’t raise prices 10-20% per year and expect to keep their customers. Colleges will see resistance to double-digit tuition increases as well. Netflix has found it needs to accept ads in order to keep prices in check. Others will invent similar alternatives to simply raising prices. In the business world raising prices is analogous to the government raising taxes. It gets you more revenue in the short term, but it chases your customers (or residents) away. Raising prices is always a last resort.
In short, markets will remain volatile while economic and inflation data unfold, but the volatility should slowly subside. A real sustainable bull market needs a prospect of growth with moderating inflation. There is a path toward moderating inflation, but growth is likely to decelerate before it accelerates again. Guessing the market will prove less satisfactory than finding bargains within the market.
Today, Lorde is 26. Joni Mitchell, a singer from a very different generation, is 79. Former supermodel Jean Shrimpton turns 80.
James M. Meyer, CFA 610-260-2220