Market Update Fall 2022
Stocks and bonds posted their third consecutive quarter of negative returns, as aggressive monetary tightening has taken a toll on equity and fixed income valuations. The S&P 500 Index is down 24.9% Year-to-date (YTD). The conventional “all weather” 60% Equity/40% Fixed-Income portfolio is down 20.1% YTD according to Morningstar – worst on record. Higher rates have adjusted valuations down for both stocks and bonds closer to normal levels associated with slow economic growth.
Fast tightening cycles have resulted in Bear markets and recessions. The Federal Reserve (Fed) has embarked on one of the fastest rate hiking cycles since the 1980s. CME Fed Funds Futures point to more rate hikes ahead. Moreover, the Fed is likely to keep rates high for an extended period, even if inflation falls, to make sure it does not stage a come-back as it did in the 1970s when the Fed eased policy too early.
In addition to raising short-term interest rates, the Fed is allowing Treasury bonds on its balance sheet to mature and is not issuing new bonds to replace the retired ones. This is called Quantitative Tightening (Q.T.). It reduces the money supply in the economic system so there are fewer dollars available to purchase goods and services. In turn it will lower goods and services prices, raise borrowing cost, and slow the economy. A research paper from the Atlanta Fed suggests that planned Q.T. is the equivalent of thirty basis points of rate hike. Between Q.T. and rate hikes, financial conditions have become extremely tight overnight.
There is growing risk that the Fed through its actions will not only cause a recession but also break something globally – trigger a credit event in off balance sheet assets.
Earnings growth is following the path of economic growth. A decelerating Global Manufacturing PMI has not boded well for earnings growth. The Global Manufacturing PMI tends to lead the trend in earnings growth for the global companies in the MSCI World Index by about three months according to S&P Global. It is indicating lower earnings in 2023. Earnings growth is sill positive for 2022 according to FactSet, but earnings growth among all sectors are quickly losing steam and could turn negative in first half of 2023 as rate hikes choke economic growth. Analysts are aggressively revising down projected earnings estimates. Typically, the stock market will bottom six months before earnings bottom in 2023.
S&P 500 Index valuation has corrected 34% so far. The S&P 500’s average valuation declines 33% in a garden variety recession. Forward earnings for 2023 are presently trading at 15.2 with earnings expected to grow 6.5% according to CFRA. The U.S. economy must evade a recession in 2023 to come anywhere close to current projections. The S&P 500 Index cannot report earnings growth in a recession! It does not happen. In a normal recession earnings decline on average 10% according to Bloomberg. Equity markets are not fully pricing in a recession, however, have priced in most of it with the S&P 500 Index declining to a low point that is 27% off its high. If Fed does not stop hiking after December’s hike, its ultra-restrictive monetary policy could push market into an earnings recession that should cause the S&P 500 Index to decline another 5-10% from current level. Keep in mind that the stock market bottom’s six months before earnings bottom. It will be time to buy stocks in the coming months.
Where does market go from here in the short term? Investors may see a year-end rally given how oversold stocks have becomes, and extreme negative investor sentiment indicators. Every investor expects the stock market to drop further which technically is a good rallying point. Historically in mid-term years, stocks bottomed in October, then proceeded to produce above average returns in the next 12 months according to CFRA. Cyclical stocks outperform defensives after a Bear market bottom.
Beyond a year-end technical rally, markets are waiting for a moderation in inflation. The Fed wants to see inflation peaking over a three-month period before it becomes less hawkish. Historically, when inflation peaks the forward returns for the S&P 500 Index are positive according to Bloomberg research. A steady decline in inflation allows for earnings to meet expectation because consumers will then see their cost-of-living decline allowing for greater consumer spending. Consumer spending is the key to stock market valuations. Furthermore, profit margins should be higher if company input costs are lower. Lastly, lower inflation is key to higher consumer confidence. The path the stock market takes depends on the path of inflation.
Recent market volatility is very characteristic of a market bottoming process. Most Bear markets bottom in October – capitulation month. What is more, the average length of a Bear market, associated with a garden variety recession, is 11 months since 1929 according to S&P Capital IQ. This Bear market is going on its 11 month this November. It is too late to sell even if valuations adjust lower for the next six-months. Instead, gradually invest in cyclical stocks which are in the long-term buy zone. The best values in stocks are created in a Bear market. Forward returns are among the highest from a Bear market low.