Wall Street Looking Ahead to the Fed’s Inevitable Monetary
Policy Pivot
By Victor
Sperandeo with the Curmudgeon
Market Review:
The equity markets are rallying into the consensus
for a +25bps rate hike at the end of next week’s FOMC meeting on February 1st. However, it should be noted that some Fed
watchers say there could be a +50bps increase, because the market has rallied
too much?
The debt markets were slightly down last week as
yields rose while precious metal markets were slightly higher.
All that was to be expected.
Missing from the Economic Data:
What is not showing up in the reported U.S. economic
data is any material weakness in employment (initial jobless claims decreased
last week despite huge big tech layoffs) or overall economic
weakness that would reflect a recession (real GDP increased at an annual rate
of 2.9% in the 4th quarter of 2022 after a 3.2% increase in the 3rd
quarter).
For sure, economic growth is slowing. Business
investment grew at only 1.4% in the 4th quarter, but that was almost
entirely inventory growth. Nonresidential investment, a key driver of future
economic growth, was up just 0.7%.
Residential investment fell a steep 26.7% as consumers
were unable to afford the combination of high home prices, high interest
rates and falling real incomes. Indeed,
real disposable income fell over $1 trillion in 2022. That’s the second-largest percentage drop in
real disposable income ever, behind only 1932, the worst year of the Great
Depression. To keep up with inflation, consumers are depleting their savings.
However, corporate earnings are not moving down so
the relative strength of stocks continues to move up.
Stocks vs. Gold:
Several months ago, we
wrote that stocks perform better than gold during inflationary
periods. That’s because public companies
can raise prices and pay dividends, while precious metals do not. I stated that
stocks go down when the Fed tightens credit which causes earnings to
decline. Then gold will go up as stocks
go down.
To some degree this has occurred, but a big equity
bear market --- on the order of a -50% decline (like in 2000-2002 and
2008-2009) --- has not occurred because earnings have NOT YET declined. Indeed,
the bigger companies still have “pricing power” and maintained margins by
raising prices. Until now, their stocks
have held up reasonably well because of that.
Are Earnings Estimates Too High?
Many analysts believe that corporate earnings
estimates are too high. According to Jurrien Timmer, Fidelity’s Director of Global Macro,
earnings growth expectations for 2023 have declined from +9.4% last summer to
+1.3% now (still positive but falling). The 2024 estimate is RISING and is now
at +10.3%. That is very optimistic!
Some analysts think earnings estimates will come down
in a big way. Morgan Stanley
strategist Michael Wilson warned on Monday that plunging forward-looking
indicators will translate into an earnings recession and will end up
hitting U.S. equity markets. Recent optimism around a less hawkish Federal
Reserve, China reopening, and a weaker dollar is already priced into share
prices, he wrote in a note.
“The question is when will equity indices price the
current weakness in the leading data and the eventual weakness in the hard data?”
said the strategist, who ranked No. 1 in last year’s Institutional Investor
survey. “We think it’s this calendar quarter.”
JP Morgan Chase & Co. strategist Mislav Matejka says the earnings environment will be particularly challenging
this year. Corporate pricing power is
starting to reverse, just as profit margins are near record-high in the U.S.
and in Europe.
“Even if companies do not disappoint for the fourth
quarter 2022, we do not believe EPS upgrades will come in the first half of
this year,” Matejka wrote in a note.
Is the U.S. Stock Market Overvalued?
The current S&P500 10-year P/E Ratio is 29.3.
That is 45% above the modern-era market average of 19.6, putting the current
P/E at 1.1 standard deviations above the modern-era average. This suggests that
the market is currently very overvalued.
According to the Estimite website, the U.S. stock market
currently appears to be overvalued by 40%. It would take a 28% drop to bring the market
back to its long-run equilibrium level. At the last all-time high, on November
8, 2021, the market was 82.5% overvalued. In comparison, at the peak of the
Dot-com bubble, on March 24, 2000, the market was 91.7% overvalued. When the
market bottomed out 2.5 years later, it had dropped 50.2% from its previous
all-time high and was undervalued by 18.6%.
“These estimates are based on a model that is
inspired by Robert Shiller’s cyclically adjusted price-to-earnings ratio
(CAPE). We find the CAPE measure preferable to the market cap-to-GNP ratio, as
it accounts for long-term changes in the ratio of corporate profits to GNP. The
model estimates the long-run equilibrium between stock market capitalization
and cyclically adjusted corporate earnings.”
The fact that the market currently appears overvalued
does not necessarily mean it will correct back any time soon. The forces
pulling the market toward the long-run equilibrium are relatively weak and
allow the market to stay over- or undervalued for extended periods of time:
From 1954 to 1970, the market stayed continuously overvalued for over 15 years,
and from 1973 until 1987, it stayed undervalued for about 14 years.
Inverted Yield Curve and LEI Screaming RECESSION:
We’ve stated for months that the U.S. Treasury yield
curve has been the most inverted since at least 1982. Yield curve inversions that last longer tend
to have more predictive power of a recession.
And this one has lasted for many months!
Equally important is the Conference Board’s
Leading Economic Index (LEI) which has declined for 12 consecutive months
and that decline has accelerated recently.
The U.S. LEI decreased by 1.0% in December 2022 to 110.5 (2016=100),
following a decline of 1.1% in November. The LEI is now down 4.2% over the
six-month period between June and December 2022—a much steeper rate of decline
than its 1.9% contraction over the previous six-month period (December
2021–June 2022).
“The US LEI fell sharply again in December—continuing
to signal recession for the US economy in the near term,” said Ataman
Ozyildirim, Senior Director, Economics, at The Conference Board.
Source: Conference Board
“There was widespread weakness among leading
indicators in December, indicating deteriorating conditions for labor markets,
manufacturing, housing construction, and financial markets in the months ahead.
Meanwhile, the coincident economic index (CEI) has not weakened in the same
fashion as the LEI because labor market related indicators (employment and
personal income) remain robust. Nonetheless, industrial production— also a
component of the CEI—fell for the third straight month. Overall economic
activity is likely to turn negative in the coming quarters before picking up
again in the final quarter of 2023.”
What Might Change Fed Monetary Policy?
BofA’s U.S. economist Mike Gapen expects
the Fed to hike rates by 25bps three more times and believes the market is pricing
in rate cuts too early.
In order for the Fed to pivot (i.e., to stop raising rates and then lower
them), we need far more economic weakness, or a crisis event, such as an
expansion of “credit spreads” on BBB and CCC rated corporate debt. I believe
we will get that.
Normally, when the Fed raises or lowers rates it
takes 9 to 12 months to have an economic consequence. Since rates were first
raised in March 2022, the negative economic impact will start hitting the
economy now, with greater effects in four months.
It’s a virtual guarantee the U.S. will be in a
recession from a monetary view as M2 has declined year over year!
A clearly evident recession will cause the Fed to pivot, while the U.S.
budget deficit will be much larger than now forecast.
The U.S. national debt could grow to $36
trillion by 2025! Pundits say debt
doesn’t matter till it does. When is a
question of psychology. The tipping point will be a loss of confidence in the
U.S. dollar, as we’ve stated for the last 10 years in these Sperandeo/Curmudgeon
blog posts.
Critical Note on the War in Ukraine:
The most important thing for all of us now is not
what the Fed does or how markets react.
It is the escalation of the war in Ukraine. On Wednesday, the U.S. and Germany said
they will send contingents of tanks to Ukraine, reversing their longstanding
trepidation at providing Kyiv with offensive armored vehicles and unleashing
powerful new tools in Ukraine’s efforts to retake territory seized by Russia.
German Chancellor Olaf Scholz’s announcement that he
will send Leopard 2 tanks was coupled with U.S. stating it would provide 31 M1
Abrams tanks to Ukraine, reversing the administration’s longstanding resistance
to requests from Kyiv for the highly sophisticated but maintenance-heavy vehicles.
“As of today, numerous countries have officially
confirmed their agreement to deliver 321 heavy tanks to Ukraine,” said
Vadym Omelchenko, Kyiv’s ambassador to France on Friday.
Russia responded with a warning to the West. Dmitry Peskov, Russian President Vladimir
Putin’s spokesperson, said in the state-owned outlet Tass:
“Moscow perceives everything that both the alliance and the capitals I
mentioned have been doing as direct involvement in the conflict. We see
that it is growing.”
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Victor’s Conclusions:
The widening of the conflict in Ukraine could lead to
World War III, which would be the end of all markets! Biden said that in March when he chose not
to send jets and tanks to Ukraine because doing so would be a dangerous
escalation.
“The idea that we’re going to send in offensive
equipment and have planes and tanks and trains going in with American pilots
and American crews — just understand, don’t kid yourself, no matter what y’all
say, that’s called World War III,” Biden said on March 11, 2022, while
speaking at a gathering of House Democrats in Philadelphia.
The contradictions and provocation effects are not
talked about in the mainstream media. Where is the outrage?
Cartoon of the Week:
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Be well, stay healthy, warm, and dry. Till next
time…...
The Curmudgeon
ajwdct@gmail.com
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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