After a miserable September, stocks have limped sideways for the last two sessions waiting for today’s employment report. The focus will not only be on the top line number, which has averaged about 150,000 net new jobs over the past three months, but also on the pace of wage growth and the labor participation rates. Data this week for weekly unemployment claims and new job postings suggest the labor market remains robust. Investors will be looking for some signs of easing. The best way to see that is via the trend in wages. When demand outstrips supply, wage pressure increases and visa versa. Any number suggesting increased wage pressure would be received badly. Before earnings season starts at the end of next week, there will also be an eagerly awaited CPI report, one that will also be market moving. Stripping away the impact of higher oil prices (which have moderated significantly over the past two weeks), hopefully the CPI report will show some moderation in the pace of inflation.
The market’s mood has changed noticeably since the FOMC meeting in mid-September. At that meeting, Fed officials made two basic conclusions. First, it saw a path to a soft landing, one that could let inflation subside toward its 2% goal over 2-3 years without incurring a recession. Second, to accomplish that, it would have to keep interest rates higher for a longer period of time. The reaction to that in the bond market was immediate. Higher for longer meant rates had to adjust higher all along the yield curve. While short-term rates rose only slightly, yields on the important 10-year Treasury rose by more than 50 basis points before pausing a bit the last two sessions. Rising interest rates mean lower P/Es for the stock market. Simple math suggests the following. The consensus earnings per share estimate for the S&P 500 is about $220 for this year. A one-point drop in the P/E ratio means the S&P 500 must drop 220 points or roughly 5%. A two-point drop would result in a 10% correction. It’s really that simple.
But when a decline in stock prices starts to accelerate, fears start to rise. Is the 50-basis point rise in 10-year rates going to flip the economy into recession? Given how close a call the recession/soft landing argument is, that’s possible. But we’re playing with numbers. Is there really a huge difference between 0.2% growth and -0.2% growth? One of the important points to note is that the impact of higher rates has been muted by steps both consumers and businesses took before rates started to rise. Before the Great Recession, homeowners were used to a lot of variants of adjustable-rate mortgages. Today, over 90% of mortgage are fixed rate. The reason there are so few existing homes for sale is that no one wants to give up a 3% mortgage for one over 7%. Car buyers too have been taking fixed rate loans. Corporations used a low-rate environment to lock in low rates for an extended period. They couldn’t tie up money for 30 years, but they could do it for 5. Eventually, much of that debt will have to be refinanced. But it will take years, not months.
The other worry bubbling to the surface is one we have discussed numerous times over the past many months, the meteoric increase in Federal debt and the deficits. That ties in to the House leadership debacle. I wish I could argue that Matt Goetz and his Trumpettes had any idea of how to reduce the debt or deficits. If they do, beyond pontificating that we spend too much, I haven’t heard a solution offered. I am not about to offer one, but I will lay out some facts.
Social Security, Medicare and other health programs (e.g., Medicaid) account for almost half of Federal outlays. For now, everyone deems them to be off the table. Interest is 11%. Defense 13%. If I add what we spend supporting all the other cabinet departments except Defense and Health and Human Services (this includes everything from embassies, Congress, national parks, courts, roads and infrastructure, agriculture, you name it) that accounts for just over 5%. When Congress talks of cutting, they mean taking whatever they can find out of the 5%. The increased focus on spending heightens the focus on what we are spending to support Ukraine. Over 18 months, that has amounted to about $113 billion. That doesn’t even equal the annual increases this year and next in debt service costs. I am not in a position to argue for or against Ukraine support. Rather, the point I am making is that taking the support costs to zero would stop our deficits from rising this year or next.
The reality is simple. Until Congress wants to fix Social Security (it’s all actuarial), or control the increases in Medicare and Medicaid, it won’t make a serious dent in the deficit. When will that happen? When the bond market says so. These are problems that don’t matter until they matter. Obviously, 2024 is an election year and no one will address these issues directly in a campaign. If the price for U.S. debt continues to fall, and rates keep rising, the odds of recession rise. If one ensues, the Fed will cut short-term rates materially and long-term rates will come down as well. But deficits will rise even further and so will Federal debt levels. If there is a soft-landing and rates stay high, Republicans will blame Democrats for reckless spending, people like Matt Goetz will preen for the cameras, but nothing will change. Voters will decide who can best solve the problems (or who is less likely to make them worse!).
If the economy is softening amid rising interest rates and lower P/Es, it would be logical that high P/E stocks take a hit. They have. But the real losers the past two months have been companies with large dividends, and those who have debt-laden balance sheets. The latter is understandable but why do the Procter & Gambles or Con Eds suffer? Again, it is all about the math. When bond yields were low and term premiums were near zero or lower, a competitive dividend yield might have been about 2%. With an economy slowing, and the dollar rising along with higher rates, the earnings outlook for these companies has worsened slightly. If the bond market’s term premium rises from below zero to over 2%, where it is today, a conservative stock like Procter & Gamble has to be repriced to offer a competitive return. If the growth rate falls just one percentage point, the offset requirement is a higher dividend yield. Just moving from a 2.3% yield to a 2.6% yield will send the stock down 10%. For stocks more dependent on dividend return than earnings growth (think utilities and REITS), the impact has been especially harsh.
If there is a silver lining, it is that there is little fundamental reason to expect 10-year Treasury yields to go above 5% and stay there amid a weakening economy and slower inflation unless one expects the term premium to rise. There are some suddenly shouting that the U.S. is in dire straits with all this debt. But the dollar has been super strong while rates are rising. That wouldn’t happen if the dollar was about to lose its place as the reserve currency. After all, what could take its place? The euro would be the next best choice but it has its own set of flaws and the EU countries have the same set of fiscal and monetary problems that we have. Japan is too small. China’s currency doesn’t even float freely. Anyone want rubles?
Short-term technicians all argue that markets are oversold and set for a bounce. Maybe so, but it is hard to get very bullish until the bond market settles down, or until there is greater clarity about the paths of inflation and the economy. The most likely good news is noticeable moderation in inflation, especially with oil prices settling back. Gasoline prices should decline meaningfully over the next month.
The real key is valuation. If I use a range of $220-240 for S&P earnings next year, and simply apply a 17x multiple to those numbers, I get a fair value for the S&P of about 3900. The top end of the range still gets me below 4100. And 17x is high historically. Maybe the “Magnificent Seven” can substantiate a 17x multiple but all seven are going to grow at a slower pace over the next five years than they have over the past five years. Apple#, number one in terms of valuation, is likely to have four declining year-over-year revenue quarters for the first time since 2001. Thus, even if markets settle down, there is NO reason for a runaway rally. If I use the top end of the 2024 earnings range and can somehow justify a 19x multiple, the target would be 4560. If I use the low end and use a long-term average of 15.5x, I get 3410. Meanwhile, I can lock in a ladder of 5-10 years simply using Treasuries that will guarantee me a 5% return in a world when 10-year inflation expectations are less than 2.5%.
Against this backdrop, there will be individual companies that can do spectacularly well. They will grow at extraordinary rates because they create new worlds. Look at Tesla, or Nvidia# or, for that matter, Apple, as past examples. AI, a new world of weight loss regiments, you name it. It doesn’t have to be that fancy technologically. Look at the success of a company like Lululemon. So, there will be big successes within a tough market environment. But I am suggesting that a world where easy money inflates valuations and raises all boats is likely over. Returning to an old world where there is a real cost to money ultimately will lead to a more efficient world with higher real returns for successful leadership companies. It will just take time.
One final point. If the Republicans in the House insist that just one member can force a vote to vacate, in today’s Congress, less than 3% of Republicans can force the next speaker out. It doesn’t have to be a member of the fringe right. It could be any Representative who is ticked off and finds just four others to agree. That’s no way to govern. There should be enough angry Republicans right now that the present situation can be fixed.
Today, actress Elizabeth Shue is 60. Gerry Adams, co-founder of Sinn Fein, and certainly one of the key figures of Northern Ireland’s “troubles” turns 75.
James M. Meyer, CFA 610-260-2220