Stocks fell sharply amid a series of negative events. Bad momentum, an extended auto strike, the likelihood of a partial government shutdown, higher interest rates, you name it. The news was all bad and the stock market reflected it. Meanwhile 10-year Treasuries traded over 4.5% and threatened to move ever higher.
With all this said, this is not a repeat of September 2008. The economy is still growing, there is no Lehman-like failure on the horizon, and financial markets are still functioning properly. Thus, let’s look at today’s market through a proper lens. The economy is weakening. Consumers are running through excess savings. Higher oil and gasoline prices are hurting confidence. As for Washington, it’s pure absurd theater. On the far right, members of the so-called Freedom Caucus are trying to make a point no one really understands. They are doing what they can to grab headlines, tear down government procedures without a constructive plan to move forward. They choose to debate and vote on appropriation bills individually but then vote “no” on all without any constructive alternative. They want to cut spending, certainly an admirable focus given the huge deficits the Biden administration is racking up. But how and where, we have no clue. The reality today is that debt service, Medicare, and Social Security are growing together by about $500 billion annually. All are untouchable, even to members of the Freedom Caucus. The simple truth is if anyone’s real goal is to attack the deficit, it cannot be done without dealing with Social Security and Medicare. But 2024 is an election year and no one is going to do a thing about it.
As for the Biden team, with the nation near a government shutdown this weekend, they were off to Michigan to join the striking auto workers picket line. Biden becomes the first sitting president to do that. He and other progressives want the auto workers to achieve a living wage. The union is asking for a package that will raise wage rates well above the current average of about $65 per hour. The full package of demands would bring that to over $100 per hour. Multiply that times an average work schedule of 2000 hours per year and the “living wage” being asked for is about $200,000. If anyone thinks auto company managements are about to change their stances because President Biden wants a photo-op along the picket line, I have a bridge to sell them. His trip won’t help matters nor hurt them. It is simply a photo-op to show voters that he continues to move further toward the progressive left. No wonder voters don’t want a Trump-Biden rematch.
Yet the economy runs along. In fact, the word for this morning is normal. Growth continues in the 2-3% range adjusted for inflation. That is likely to weaken a bit. But even if it slips into recession for 2-3 quarters next year, it will still be well within a range of normal. Demographics rule. While the nation’s birth rate is falling, immigration is rising. Together, they support long-term growth close to 2%. Normal. Today, the bond market yield curve is not yet normal. Short-term rates still exceed long-term rates. But the spread is starting to narrow. If there is a recession, short-term rates will come down as the Fed makes policy adjustments. Once that rate returns to inflation plus some sort of real cost, the Fed Funds rate should settle in a 3-4% range. If there is a looming recession, it will come down quicker once the Fed moves to end its tight money policy. If we are headed for a soft landing, it will take longer, but it will happen. According to the dot-plots of the recent FOMC meeting, in a soft-landing environment, it could take up to three years to fully normalize. As for the 10-year bond, yields have now risen to 4.5% and threaten to go a bit higher. Compared to just a year or two ago, that’s a big jump, one that is impacting markets. But 4-5% is right in the middle of the 100-year trading range. Normal.
Thus, growth is relatively normal, and so are long-term bond yields. Earnings are flat. That isn’t normal but certainly not cause for long-term concern. The Fed is still working to bring down inflation and that will only happen if some economic slack is restored. We have all been talking about a soft-landing or modest inflation for almost two years. Nothing has happened to change that outlook.
So, what isn’t normal? The answer is equity prices. More specifically large-cap equity prices. Stocks still sell for 18+ times forward earnings. That isn’t normal. In a world where short-term money returns 5% perfectly safe, and long-term bond returns are fast approaching 5%, buying stocks valued at a 10% premium to normal simply doesn’t make sense. It has taken investors a while to see that. But now the adjustment process is underway. For months, we have been warning that stocks were out of line with bonds. If you can earn 5% risk-free, what do you need to get paid to take on the additional risk of equities? Growth at any price works in euphoric times, but not when investors become risk-averse.
A P/E correction can happen suddenly or it can happen over time. There is no magic answer. As noted above, it’s large-cap stocks that are overvalued. Mid-cap and small-cap stocks already trade within a range of normal. Indeed, there are many stocks, large and small, trading well below average historic multiples. It is quite possible that a correction overshoots. If so, real bargains will appear. Build a shopping list, apply a normal multiple, and start to nibble if stock prices fall to your buy point.
A lot has been said about market seasonality. August and September are historically weak months. The fourth quarter, conversely is historically strong. But October isn’t typical. Crashes in 1929, 1987, and 2008 all ended with a bang in October. The first 2-3 weeks of October are often messy, particularly on the heels of a weak September. This is a perfect time to follow my silly 2-day rule. Sharp one-day rallies happen in bear markets. Most often they are amplified by short covering. A real rally has to last longer than a day. Thus, my two-day rule suggests markets need to rise solidly for at least two consecutive sessions to mean more than short covering. Be patient. You don’t need to catch the exact bottom. Pundits will tell you the market is oversold already. True. But it isn’t so oversold that it screams capitulation. The VIX is still below 20. A level of 30 grabs my attention. Fear is starting to bubble, but there is no panic. Markets are still down less than 10% from recent peaks. We aren’t even in correction territory yet. And remember, this is primarily a valuation correction, not a response to a collapsing economy.
If at least part of the market’s message is that the odds of a recession in 2024 are rising, that spells real bad news for the Biden administration. No president since Roosevelt has won reelection during a recession.
With that said, let me end with some hope. If this market is going to bottom sometime later in October, there is a fundamental logic to that happening. Hopefully, in 3-4 weeks, the auto strike and the actors’ strikes will be settled. Should there be a government shutdown, it should also be over or near conclusion by then. I wish I could say the border crisis will be settled by then but that’s a real stretch. However, the current situation of open borders without any serious effort to contain the flood of immigrants can’t go on indefinitely. Maybe by then there will be a response as well. Simply said, a lot of what’s overhanging markets today may be resolved or on the way to resolution in just a few weeks. The key is that long-term values remain unchanged although stock prices still need a bit of adjustment.
Today, Gwyneth Paltrow is 51. Phillies great Mike Schmidt turns 74. Speaking of the Phillies, great win last night! On to the post-season.
James M. Meyer, CFA 610-260-2220