Stocks ended mixed yesterday in a very volatile session where the Dow Industrial Average moved back and forth by more than 1000 points. News was rather sparse. A brief afternoon plunge occurred after the Bank of England signaled it would halt its planned intervention to support the pound Friday as originally planned. Stock, bond, and currency markets all had brief spasms but settled down. The important 10-year Treasury bond fell in price for the day, but yields remained below the important 4.0% level.
Today producer price numbers for September will be announced. Unless they are far off consensus, they should be much less market moving than tomorrow’s CPI report. Tomorrow’s inflation report could be followed by volatile stock movement, in either direction. It is unlikely, by itself, to change the likelihood of a 75-basis point move by the Federal Reserve next month. The Fed needs to see some persistence to move lower and it won’t get it from one month’s data no matter how favorable it might be. But you can’t start a trend without a good month, so, it’s important.
Once the CPI report is out, the focus will turn to earnings. In both the first and second quarters, earnings beat expectations. In July particularly, the beat came against sour investment sentiment and fed a sizeable rally. It lasted less than a month, overtaken by the persistence of inflation, borne out in the August CPI report, and higher interest rates.
In some ways, this time is different, and in some ways it’s the same. What’s similar is the awful sentiment. September was an awful month for equities but most of the negativity related to persistent inflation and the need for further forceful Fed action. Parts of the economy showed increased downward momentum including housing, semiconductor manufacturing, and auto sales. In all three cases either higher costs or increased inventories arrived just as demand waned, a nasty combination. But for most of the rest of the economy, demand remains strong. In fact, demand has remained strong enough to encourage further price increases in many cases. That signals we remain in the early innings of the fight against inflation, a reality that has been bad for stocks all summer amid more aggressive increases in interest rates.
But back to earnings, we once again expect most companies to meet or exceed forecasts with one major caveat, the impact of a stronger dollar on earnings. The dollar strength will be a weight on results as earnings generated overseas get translated back into fewer dollars. Investors and analysts tend to pay less attention to currency translation losses than they do to general operating results, but the impact on reported numbers is the same.
Pepsi# kicked off earnings season this morning with a strong quarter, one that beat forecasts. Its shares, premarket, are up 1-2%. Not a bad way to start. On Friday a trio of large banks will report. Results should be mixed but close to expectations. International banks, like JP Morgan Chase# will face more headwinds, but investors know that. Last quarter, it was the ability of the large tech names that dominate the top of the S&P 500 to beat estimates that sparked the market’s July rally. Since then, only Amazon has held even some of its gains. Slower demand for chips, PCs, and less growth in digital advertising threatens to weigh on most of the big names. If they disappoint, it will be hard for the overall market to push higher, but if they surprise by beating muted forecasts, a bear market relief rally is possible.
October is often the time for market bottoms. It is possible again this time. In early October, markets face headwinds of mutual fund window dressing and the fact that most companies cannot buy their own stock in the interim between quarter’s end and the time they report results. If tomorrow’s CPI report sparks some optimism and the tone of future expectations from managements are encouraging, there could be a bottom or a significant bear market rally to come.
The other focus will be on the 10-year Treasury yield. Logically, slower growth going forward, and lower inflation combined should begin to move the rate lower. On the other hand, rising yields overseas could put upward pressure on rates, and if the Fed continues its effort to reduce assets on its balance sheet (mostly via roll off of maturing bonds), then Federal deficits will start to rise again as the growth of Treasury receipts slows and spending rises. If long-term yields can stabilize, markets could as well, assuming future earnings and expectations match.
But therein lies the rub. It is very rare for stock markets to bottom before an economic downturn begins. The latest forecast from the Atlanta Fed is that third quarter GDP grew 2.9%, the best performance of the year. Last night President Biden suggested we face a very mild or no recession, but since when does a President predict gloom on his watch? Most economists now believe the odds of a recession in 2023 are over 50% and it hasn’t begun yet.
On the other hand, it is rare for stock markets to fall 25% before a recession begins. The famed economist Paul Samuelson famously noted that markets had predicted 9 of the last 5 recessions. Markets aren’t always right. That’s the hope here. Can inflation be licked with such a tight labor market as we have today? Probably not.
To me, the more natural scenario would be for managements to tone down future expectations as they report third quarter results. While companies beat second quarter expectations as noted above, when the results were reported, analysts took down Q3 forecasts by almost 7%. I would expect similar adjustments this quarter with several high-profile adjustments of a much larger amount. It may take one more quarter to complete the task, to align expectations to future reality. January would be a logical time for that to happen. This is the time everyone uniformly focuses on 2023. The Fed should be near the end of its interest rate raising cycle. The impact of rate increases since last March should begin to impact demand and growth rates. Managements will want to set up 2023 in a way that allows them to match expectations in a weak economy, recession or not.
The average bear market, post WWII shows a decline of 25-30%. If interest rates stabilize and the recession is no worse than average, perhaps we can stay within that range. The bottom could be close at hand. The last 4 bear markets have all shown declines of over 30%. They include the valuation adjustment in 1987 and the bursting of the Internet bubble in 2000. The most pain was in the high multiple stocks. We are seeing replication today. I am not sure the speculation purge is yet complete even as many of the most popular stocks of 2020-2021 are now down well over 50%. It still seems much easier to construct a portfolio of solid growing companies selling for less than 15x earnings than to rebuild using a basket of stocks selling for 20-30 times earnings or more. The temptation to race back and buy yesterday’s superstars simply because they have fallen so far ignores the fact that many of those names that have fallen were overhyped companies that may never live up to expectations. In the 1973-74 bear market, one that massacred the so-called “Nifty Fifty”, some came back quickly once the bear market ended, but some never came back. Think Polaroid, Kodak, Avon, and Xerox. In 1987, the market punctuated its decline with a one-day drop of 22%. It bounced from there, but Digital Equipment and other mini-computer names never recovered. They are all gone today. After 2000, names like Yahoo never came back. Cisco# and Intel still sell well below their 2000 highs. Some do come back. Amazon# and Microsoft# are notable examples. But they are the exceptions, not the rule.
Bottom line, the ingredients exist for a good rally if long-term rates stabilize near here, the CPI number tomorrow is in line or better than expectations, and earnings once again beat forecasts. It’s hard to think this is the real bottom before an economic slowdown even begins. A true sign of a bottom is when companies report worse than expected news and markets shrug off the disappointment. We aren’t there yet. A more logical time for a bottom is early in 2023 as the Fed completes its cycle of rising rates. Jamie Dimon, CEO of JP Morgan Chase, said in an interview this week, that another 20% decline wouldn’t surprise him. That wasn’t a prediction. One can get to 2800 on the S&P using a 14 P/E and $200 for earnings. But a 16x multiple, where the market is now, and a more modest decline in profits, perhaps to $215, suggest a possible bottom of 3440, a further decline of less that 4%. There is a lot of space in between. A conclusion might be that there remains a bit more risk than reward at the moment and this isn’t the time to try and be a hero. Guessing a bottom before it happens is hazardous, especially when bonds are now offering positive returns adjusted for inflation. Indeed, the attractiveness of bonds will temper the pace of future equity recovery.
Today Hugh Jackman is 54.
James M. Meyer, CFA 610-260-2220