The S&P just recorded its best month since November 2020, so it’s worth asking if stocks have bottomed. Bear market rallies are normal, and we do not believe the bottom has been reached for this cycle. If the low was reached in June, then it would be the most expensive valuation (PE) bottom. Furthermore, earnings have yet to be cut meaningfully. Recessions have almost always led to large earnings reductions and we anticipate cuts in the 2H as macro conditions only really tightened in May and June.
Nothing we hear from the Fed suggests that they are ready to cut rates from early 2023, which is what markets are pricing. The rally is on the back of futures market pricing Fed funds rate peaking in December 2022, and rate cuts from early 2023. This is unlikely to be a high probability outcome as we expect sticky core inflation even as headline CPI peaks. We have low confidence in the bond market’s predictive ability. 15-years of QE has dulled bond market participants who, in 2021, repeatedly predicted inflation dropping quickly to the Fed’s 2% target. Markets entirely missed the current inflation surge.
Dispatch #16 on July 29th, 2022, focuses solely on the probability of market bottom already taking place.
Have stocks bottomed?
Valuations are elevated
We believe it’s unlikely for the following reasons. Valuations remain elevated as the long-term chart below illustrates.
The smart analysts at Lykeion have taken the Multpl data and constructed the bar chart below that provides a clearer view of today’s expensive valuation vs. previous market bottoms.
It’s no surprise that the CAPE ratio, one of our preferred valuation yardsticks, remains unattractive. The CAPE ratio has been a good indicator of forward 10-year returns, but it is not a short-term market timing mechanism.
Earnings have yet to be revised lower….
…even though recessions have inevitably led to substantial earnings cuts.
We do not believe that this time will be different. Earnings will be come lower in the coming months as the effects of financial tightening impacts activity. If the real estate market is a guide, conditions only tightened in May/June.
We are fully aware that today’s economy will be unable to function with rates of prior decades due to vastly higher debt levels. Yet, as Fed Chair Powell continues to stress, getting inflation under control is their top priority.
Stock allocations remain elevated
Despite many sentiment indicators reflecting extreme bearish views, wealth management portfolio allocations have not revised exposure lower. This could partly be due to bonds falling just as much as stocks in 1H22. Regardless, equity exposure remains high.
The Fed and bond markets have a terrible forecasting record
Much of the bullish view, then, rests on expectations of the Fed cutting rates in 2023, which futures markets currently predict. The chart from the Atlanta Fed shows the path of interest rates currently predicted (7/27) by futures markets. The bond market sees the Fed funds rate peaking at 3.3% in Dec 2022, and rate cuts starting in early in 2023..
Risk assets are placing their faith in the bond market’s predictive accuracy, when those same bond market participants failed to see the current inflationary surge. The market’s poor predictions of inflation is shown in the chart below. The light grey lines in the chart below are the bond market’s prediction of inflation since 2021.
This is a case of markets staying anchored to Fed guidance and giving up accurate forecasts. The Fed’s inflation predictions have been woeful, and they continue to double down on by claiming that the neutral interest rates is in the 2%-2.5% range.
Downside from poor inflation forecast
The downside is that markets are wrong that the Fed will tame inflation by raising rates just above 3%. In prior bouts of high inflation, the Fed was forced to hike rates to a positive real interest rate. Just to provide a real interest rate based on the Fed’s preferred core PCE index would require rates rising to above 5%. Real interest rate using headline CPI would require rates rising to a range of 7-9%.
Regular readers will remember our prediction back in July 2021 for sharply higher inflation on the back of housing/rents. We have also laid out the stickier core inflation in 2H2022 view here. However, there are many macro analysts we follow and respect that see inflation collapsing alongside growth. Here’s a great tweet thread from Real Vision’s Raoul Pal laying out why growth and inflation will slow sharply. Pal falls into the deflationary camp, whereas we modestly favor the stagflationary (high inflation and low growth) outcome.
Bad news is good news is also making the rounds after the latest employment cost index was worse than expected. That drove the core PCE (personal consumption expenditure) index, the Fed’s preferred inflation gauge, +0.6% MoM in June. This was a sharp acceleration from the +0.3% MoM reported in May. This is the kind of bad news that was deemed “good” this week.
Fed needs financial tightening, not markets rallying
If equity and bond markets continue to rally, expect to see Fed official reiterate that inflation is main focus. That has already started with this NY Times article published today (7/29) that quotes Minneapolis Fed President Neel Kashkari:
The Fed needs tighter financial conditions for monetary policy to cool the real economy. Falling market interest rates and stocks rallying loosen financial conditions they follow. The Fed does NOT want to see these headlines – certainly not when they are behind the curve and struggling to get inflation down.
There is no debate that growth is slowing, but we see risk of QE-drunk markets will miss-forecasting inflation. The last Dispatch explained in more detail. We will continue to test our view against opposing views and data to adjust client portfolios with a long-term view.
We hope you are enjoying the summer. Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
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