Stocks continued to move in almost a spasmatic fashion last week, highlighted by a reversal of close to 1500 points intraday on Thursday after the release of CPI data. Thursday’s huge gain, however, was cut in half Friday, again showing that day traders rather than investors currently dominate the market. Bond yields also moved violently as inflation fears rose once again after the CPI report showed it slowing at a slower pace than hoped for. Bond yields responded by retesting recent highs.
Amid all the volatility, there was some encouraging news. While some leading averages set new lows last week, the move down wasn’t universal. A fairly large number of early cycle stocks remained above their Spring and early Summer lows, an indication that most of the damage to them has already been done. While volatility has remained well above average, the normal flight from risk that usually accompanies rises in volatility hasn’t dominated market action. To be sure, there are some groups, notably within Technology and other high-risk sectors of the market, that continue to move lower, a sign that the bottoming process is uneven. These groups are not only acting in concert with rising interest rates that compress P/E multiples, but they also reflect real fundamental problems. More later on that subject.
Perhaps the most important issue is the evolving answer to the question when will the Fed largely complete its cycle of interest rate increases and step aside? Last week’s CPI data solidified the likelihood that the Fed will raise interest rates another 75-basis points when the FOMC meets again in early November. The odds of such an increase were already high before the CPI report. Fed Fund futures now price that in as a virtual certainty. There will be no more CPI reports before the November meeting and just one employment report. Unless the employment report deviates from recent trends showing a gradual release of strength in the labor market, the jobs data won’t affect the November decision.
According to Fed Funds futures, the odds of another 75-basis point increase in December doubled after the CPI report. However, don’t overread that, even as at least one Fed official over the weekend suggested it was likely. Between now and the December meeting there will be two CPI and two employment reports. It will be what they show that will dictate what the Fed will do in December. Last week’s CPI report showed core inflation rose 6.8% year-over-year and 0.6% in the month of September, higher than expected, but there were some confusing numbers with the report that raise questions. By far the most important component of CPI is shelter costs, particularly rents and owner occupancy imputed rents. Together they rose at a 0.8% pace in the month, over 9% annualized. This is in stark contrast to real world information that shows home prices starting to decline and rent increases beginning to flatten out. The disconnect wasn’t unexpected. The shelter cost component within the CPI is computed in a convoluted way that lags real world reality. There is little question that figure won’t fall in half or more over the coming several months. When it will begin to show slower growth is uncertain, but it could well start to slow before the December FOMC meeting.
Other data within the report were also confusing. The cost for eating food away from home rose sequentially from August to September. At the same time, the inflation rate for eating out in a full-service restaurant fell from 0.8% to 0.4%. Eating at a limited-service restaurant also fell. So why the disconnect? The cost of eating at a school cafeteria or employee lunchroom rose by over 40% sequentially from August to September. We all know that didn’t happen in the real world. Just another quirk that messed with the data.
I am not trying to make a silk purse out of a sow’s ear. The news last week wasn’t good, but it may not have been quite as bad as it seemed. Perhaps that explains in part the huge reversal in stock prices last Thursday. The magnitude of the reversal was accelerated by internal factors, namely short-covering. In a word, it was overdone. That explains Friday’s losses. There were other factors in play. Early earnings reports largely met or exceeded expectations. Britain reversed course and decided not to go forward with a nonsensical economic plan that left economists around the world scratching their collective heads.
So, where do we stand now? Futures are up again this morning, a sign trendless volatility will continue for a while longer. The S&P 500 continues to trade on either side of 3600. Bond yields continue to show volatility but are not breaking above recent highs in a notable way. The consensus expectation about inflation is that the pace is peaking. One can argue how fast it will decline, but few see it rising from recent reported levels. That suggests, as I have noted in recent letters, that the process of finding the right P/E for the market is largely complete.
If I divide 3600 by 16, the P/E currently implied, S&P earnings over the next 6-12 months should be about $225. We can argue about that number. It probably isn’t low, but is it way too high? That depends on the path the economy takes over the next year. I believe it is important to step back and note that the economy today shows resilient strength with pockets of weakness. Those pockets generally relate to a mismatch in supply and demand. In housing, the obvious culprit is a spike in mortgage rates to over 7%. That has crushed demand below what had been limited supply. If mortgage rates stay close to 7%, housing demand will remain subdued. The PC and semiconductor industries reflect the healing of supply chains plus a sharp drop in the demand for PCs. Personal computer sales skyrocketed during the pandemic as so many of us worked from home. Clearly, the pandemic pulled forward demand. More chips became available just as demand started to fall. That isn’t entirely coincidental. PC sales are now falling at an annual rate of close to 20%. Normal is about flat. This year’s decline offsets last year’s bulge.
Unfortunately for the semiconductor industry, there are more problems. The U.S. has restricted the sale of advanced chips and equipment to make them unavailable to China. With tensions rising related to the future status of Taiwan, it is in our interest to do whatever necessary to maintain technological advantage over the Chinese. Easing supply chain shortages will also lead to restocking auto dealer lots at a time when demand growth is fading. When the availability of new cars was restricted during pandemic-related parts shortages, consumers reacted by buying cars coming off lease, pre-ordering new models before they arrived at dealers, or purchasing a late model used car. As with PCs, demand was pulled forward. In coming months, as lots fill up and buyers don’t rush back, prices will fall, bad for the auto industry, good for the battle against inflation.
Finally, retail sales are tepid. Again, the culprits are a function of higher interest rates that impact credit card rates, and some pull forward of demand related to the pandemic. Demand for bicycles, outdoor grills and leisure apparel are all in decline. With these notable exceptions, consumers are still spending. Instead of buying PCs or bikes, they are traveling. They are also spending on necessary services. Your accountant is charging you more. So is your hairdresser, your landscaper, and your supermarket. This is the core of the Fed’s battle against inflation. Today, if your barber says it will cost you another $5 for a haircut, you pay it. But if money is tight, either you go an extra week without a haircut or you switch to a less expensive barber. When that happens, the battle against inflation will be won, at least for the short-term.
To get to that point takes time. That is why it generally takes 6-12 months for the economy to fully digest higher interest costs and tighter economic conditions. Whether the Fed raises rates 50 or 75 basis points in December isn’t all that important. Right now, the markets say 75 with another 25-50 coming early next year. That could all change with the coming October and November inflation and employment data. But what I can conclude is the following:
1. Barring a sudden and unexpected acceleration in the pace of inflation, interest rates, both long and short term, are finally at a point that will restrict economic growth. The process of reintroducing slack needed to slow inflation has begun. There is no apparent need for rates to move materially beyond what the market has already priced in.
2. Markets are pricing in flat earnings over the next 12-18 months. Flat doesn’t mean flat for all. There will be growth in some sectors, and weakness in others. Those operating in interest sensitive parts of the economy will be challenged. There will also be a period of adjustment for companies whose demand was pulled forward by the pandemic now operating in weak conditions. Those will normalize over the next year.
3. The dollar strength will moderate. The U.S. started the fight against inflation and raised rates first. Others will catch up. As they do, currency markets will recalibrate. With that said, U.S. tourists will still find bargains overseas for a while.
4. Britain will remain a mess, the outcome of the war in Ukraine remains uncertain as we head to Winter, and China continues to face its own economic problems as Xi gets reelected to a third 5-year term. The old saw says Japan got rich before poor demographics kicked in. But for China, bad demographics are kicking in before it gets rich. China has bad demographic and real estate related problems that won’t be fixed easily. How both Russia and China react to their current sets of problems is uncertain and worrisome.
5. I don’t know whether stocks have hit bottom or not. The concern today is more related to earnings than P/E. But if the Fed is nearing the end of its cycle of rate increases, the likelihood of a severe recession lessens.
If 16 is the right P/E and S&P earnings for 2023 are near $225, stocks today are fairly valued. If either 16 or $225 are wrong, they are more likely to be too high than too low. That suggests that, while stocks are fishing for a bottom, the risk remains to the downside, at least for now.
So far, this bear market has left few sectors unharmed. Those that outperformed initially, such as utilities and other defensive sectors, have gotten hurt more than others over the Summer and early Fall. That’s typical, but the investment process is forward looking. What we see looking ahead is vastly different than what got left behind. Netflix reports tonight. I have no insight as to what its numbers will be or what management will say. We know the company is pivoting to offer a new ad-supported service soon that will sell for under $7 per month. How many existing subscribers shift and how many new subscribers are added is speculative. What isn’t speculative is that streaming video is now a very crowded industry, one that is expensive for participants, and probably one with too many players. I am highlighting streaming to make a point. Streaming was an exciting growth opportunity a decade ago. It isn’t as exciting today. Most participants are losing money, and many will never make money. Consolidation is inevitable. I could make similar comments about social media. Facebook users are declining. TikTok is disruptive. In a simple phrase, whether I am talking about streaming, social media, or digital advertising, the disruptors are now getting disrupted.
That’s the problem with technology. It moves so fast and changes so rapidly all because new and faster chips allow for more innovation. In 2007, when Apple introduced the iPhone, it was a telephone that improved your ability to receive and send emails and texts. It wasn’t your navigation system. It wasn’t your video game machine. It wasn’t meant to open your hotel room door. Apple CarPlay came more than a decade later. In technology, staying relevant and ahead is an enormous challenge. Digital Equipment, Radio Shack, and Blackberry, just to name a few, didn’t survive. Why bring this all up? Because the top of the S&P is filled with tech disruptors of the past. Some are showing signs suggesting they may not sustain leadership positions. Others will stay atop for a while, but growth rates will fade, just as Cisco# and Intel did two decades ago. I can’t tell you tomorrow’s leadership. What I can tell you is that few of today’s leaders, especially within the tech world, will still be king of the mountain tomorrow.
Embedded within the S&P 500 are new leaders of tomorrow. Some of tomorrow’s future leaders are just being born now and aren’t even public yet. Some will experience a rebirth. Look at Microsoft# which rotated from a PC-centric company to one totally focused on enterprise and cloud computing. Not all future leaders will come from within the tech sector, but virtually all will get there because they can use technology effectively.
Innovation has been the secret sauce of the U.S. economy throughout its history. Whether it be the steam engine, the phone, car, or plane, all these transformative inventions started here. Some of our greatest companies were born in recession. Great times still lie ahead.
Today Ernie Els is 53. Country singer Alan Jackson is 64.
James M. Meyer, CFA 610-260-2220