It is quite clear that Chairman Powell regrets his slightly dovish comments at July’s meeting which helped drive a 25% Nasdaq rally. Since then, every Fed official has been pounding the table leading up to his Jackson Hole brief speech where he basically said getting inflation back towards 2% is more important than jobs, stocks, home prices and GDP. In fact, they fully expect (want?) to damage all four.
Stocks took it on the chin following Wednesday’s Fed meeting, with 1.5%+ losses across the board. They dropped again yesterday. Futures are pointing to even more losses. Markets get it now. Pain is coming, which is already reflected as the Dow Jones, S&P 500 and Nasdaq are down 19%, 22% and 32% respectively from recent highs. A lot of bad news is priced in here, but more pain is coming if the Fed keeps pressing harder than this already overtly hawkish stance.
Take housing for example. Home related stocks are down 30% – 50%. Home prices just witnessed their largest monthly drop in a decade. With respect to the housing market, Powell noted, “we probably, in the housing market, have to go through a correction to get back to that place (so that people can afford houses again).” In simple terms, they expect (want?) home prices to come down substantially. Much of that pain has been priced in, but it will take time to recover from here, meaning near-term upside is limited but long-term investors can start to look at attractive entry points.
As we have noted in prior updates, the Fed can only do so much with their blunt tools. Yes, raising interest rates will crimp loan demand, halt business expansion and slow spending. However, it will not create an environment where companies will produce more oil & gas. Higher interest rates will not improve the semiconductor supply chain, nor will it help auto manufacturers make up the 20 million fewer cars being produced today relative to pre-pandemic. So on and so forth from industry to industry. Higher interest rates will crimp factory and industrial expansion, which could actually add to inflationary pressures in the form of lower supplies.
Further, with inflation elevated, the lower income class is already suffering at an increasing pace. A Fed focused on producing job losses and lower wages will hurt them even more. If you want the Fed to stop tightening market conditions, root for more pain in jobs and economic growth. Not a fun time to say the least. This viscous cycle has followed the Fed ever since its creation in 1913.
Again, a lot of bad news is already priced in. Markets are forward looking. Downside action from here means inflation stays high (unlikely when looking at leading indicators) or the Fed has already made a mistake while inverting the yield curve more than necessary, yielding a very hard landing. A recession is already priced in, the question becomes how deep it will become.
Long-term equity returns are heavily dependent upon entry points. Successful investors buy low and sell high. Going overweight equities when the P/E ratio is at 10x or below historically produces 15%+ long-term returns. On the other hand, paying 20x earnings results in low-single digit returns at best. Today, the S&P is trading at 16x forward estimates, which are likely to be lower than current expectations.
However, that P/E ratio is heavily influenced by mega-cap stocks which are still huge weightings in the Index. Backing them out, the P/E ratio drops to almost 12x forward earnings after hitting nearly 30x almost two years ago. Forward -looking investors could do well to focus on some of the other, undervalued aspects of this economy. Similar to Y2K and the Great Financial Crisis, picking up future leaders which have collapsed by 75% or more will prove beneficial. Recessions yield new bull markets. The key is to not leave at the wrong time.
Source: Alpine Macro, The Daily Shot
What About Earnings:
This leads to the next big question…what will earnings actually be next year? About the only thing we can guarantee is that estimates will change from here throughout 2023, mostly to the downside. Just as analysts and company guidance coming out of a recession miss the impending upside from expanding margins, the exact opposite occurs when entering a slowdown. Unemployment is near historic lows, meaning corporations have elevated labor expenses. Companies continue to hold onto their workforce during an initial downturn. This is even more likely today as finding talented individuals has been difficult coming out of Covid. However, if the Fed wins in their battle to slow this economy, sales will slow and margins will be negatively impacted more than most expect as costs stay elevated from the expanded labor force already in place.
Goldman Sachs currently expects ~$234 in S&P earnings for 2023, putting the benchmark at 16.5x forward estimates. As you can see from the table below, the optimistic scenarios are asking for multiple expansion and a soft landing, both of which could be tough to come by. In fact, if the Fed’s updated dot plots are fortuitous, a hard landing is the more likely scenario, resulting in lower earnings and P/E multiples.
Benefits of Higher Interest Rates:
Clearly, stocks have suffered while interest rates rose this year. The cost of doing business has risen rapidly, which will collectively start hampering margins over the coming quarters. Even the U.S. Government will start breaching $1T in interest expenses soon. Mortgage rates are approaching 7% as well, severely crimping home sales and discretionary spending. While stocks are down ~20%+ across the board, fixed-income investors are having their worst year in a century too. All of this adds up to a very difficult 2022 following massive gains in the prior three years where stocks basically doubled.
However, there are clear beneficiaries in the form of savers and income investors. For over a decade, savings accounts offered minimal returns, 0% for many. Bonds were offering little to no help. This forced a lot of income dependents into the stock market where dividends could help keep cash flows consistent. That elevated risk profiles and increased volatility. TINA, There Is No Alternative, ruled the day.
Today, that story has finally changed for the better, assuming one has cash to invest. For the first time since 2009, it pays to purchase fixed-income instruments. Bonds will now act as a deterrent to investing in stocks. When one can lock in 6% returns in investment grade corporate bonds, why risk buying equities if that return is acceptable? Yet another headwind for stocks today.
Source: Morgan Stanley Research
At the end of the day, much of the bad news coming down the pipeline with respect to earnings, GDP, jobs, wages and home values is priced in. We are only ~3% from July’s lows. A retest is upon us. Many stocks are already down 50% – 75% from their highs, mimicking previous bear market drops. Even though the market-cap weighted S&P at a 16 P/E is considered fair value, much of the market is below that level and offers solid 5+ year risk/reward profiles. Surprisingly, major averages are only ~10% from their pre-pandemic highs. Have companies really made that little progress in the past three years?
Deterrents from here would include inflation holding steady. Increased chaos from Putin, who is elevating geopolitical risks even further, is not to be ignored. A clear Fed mistake is possible where the jobs market quickly reverses trend and starts creating massive layoffs. Lastly, a strong U.S. Dollar, coupled with rising input costs and lower demand, could seriously crimp margins immediately, causing earnings to collapse as opposed to a slight slowdown. With Q3 coming to a close next week, we will start to hear what corporations are experiencing. At the end of the day, earnings will drive stock prices.
Today, Bruce Springsteen (“the Boss”) celebrates his 72nd birthday. Jason Alexander from Seinfeld is 62, and movie actor Anthony Mackie turns 43.
James Vogt, 610-260-2214