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Market Update Spring 2023
The S&P 500 Index returned 7% for the first quarter and the SPDR Aggregate Bond ETF 3.23%. Semis conductor stocks are leading the market. Historically, when semis lead it is a bullish sign for investors. Historically, when the S&P 500 ended a quarter up so much it also ended the year higher but not without more volatility according to BIG research. Markets are anticipating the end to rate hikes this year. Interest rates are the key to markets. Higher rates depress valuations across all types of assets, not just stocks and bonds affecting wealth, and consumption.
The market is trading at levels suggesting any recession ahead should be a mild one and inflation is heading lower. Despite risks of igniting a credit crunch, the Fed hiked the Fed Funds rate again in March, while hinting its hawkish tightening policy may be ending soon. Solvency and liquidity risks in Regional Banks appear to be easing for the moment, the Bank Term Funding Program has provided a stop gap liquidity to any Bank that needs it. However, there may be other regional banks that could have solvency issues by year-end if the Federal Reserve (Fed) does not stop its hiking regime. The Fed intends to hike by twenty-five basis points at its May meeting and hopefully stop. Fed officials see Fed Funds Rate unchanged from next month’s hike for the remainder of the year. Let us hope the Fed does not repeat its past mistakes of hiking until “Regional Banking” sector totally breaks creating a credit crisis. U.S. banks are sitting on sizeable unrealized losses from bonds due to Fed rate hikes and the Fed will not stop hiking making the situation worse and driving economy into a recession. Bank tighter lending standards could replace any rate hikes. Tighter financial conditions will stall economic growth and ease inflationary pressure.
Analysts project earnings decline to bottom in the first half of year, and earnings to return to growth in the second half of 2023. Analysts are forecasting an earnings recession, two quarters of consecutive for earnings decline from Q1 to Q2. For all of CY 2023, analysts predict earnings growth of -1.1%. according to CFRA. There is reason to believe that earnings may drop less than in past recessions this time because of structural employment reasons. Equity markets bottom before the real economy and six months before earnings, which are the last to bottom. And historically equity markets have bottomed out before any economic indicators turned. If this is the case, then October 2022 low may be the bottom of Bear market given Fed stops hiking after May’s meeting. A re-test of October’s bottom could happen based on further tightening by the Fed and on lagging effect of tightening finally hitting economy. I think any re-test would be short lived and bought by investors.
The Fed Funds rate level is just as important as earnings for equity valuations. Interest rates change the value of all assets and are brakes on economic growth. If interest rates peak this May, then forward valuations will rise in the future as the market anticipates a bottom in earnings and re-acceleration as the Fed cuts rates to end recession. It is all about interest rates now. Historically, valuations start rising at about mid-point in recession even as earnings decline due to tighter financial conditions. By then interest rates will have long peaked and yields historically fall allowing for future earnings to accelerate. Lower interest rates support higher consumption, higher earnings, and in turn higher valuations. Restrictive monetary policy is a headwind for stock earnings until the Fed is finished hiking Fed Funds Rate. Forward equity returns following recessions are positive according to Blackrock research.
A case for moderate decline in earnings depends on a mild recession. Alliance Bernstein research says a mild recession would require the Fed hikes to end at the median magnitude of 4.8% and shorter tightening cycle than the median of 23 months. Both conditions for milder earnings decline are met about now. Also, when the 2 Year Treasury Note falls below the Fed Federal Funds rate signals the end to Fed tightening cycle. That happened in March. That may mean yields either stay close to their current levels or fall given a recession happens.
On the other hand, earnings projections for 2023 are too optimistic given the economy enters a recession this year. Revenue growth is projected to slow in the second quarter to the lowest rate since 2020. Manufacturing and Service ISM Indexes also point towards lower earnings at best earnings may be negative by a few percentage points for the S&P 500 companies. CFRA research projects earning to be bottom by Q3. Those estimates require a “softer landing” in the economy and below average rise in unemployment associated with a recession. If a garden variety recession happens earnings typically decline about 15%! Corporate profits have declined a lot less during recessions in times of high inflation based on Fidelity research. While earnings may drop, it may not necessarily mean lower equity prices according to a January 2023 study by Evercore ISI Research. S&P 500 index returns have been positive after inflation peaks says 22V Research reported by Bloomberg.
The forward 12-month P/E ratio for the S&P 500 is 19.1 according to CFRA. This P/E ratio is above the 10-year average of 17.3. Historically, with inflation of 3-4% the S&P 500 Index trades at about 17.2. The market is trading on the assumption that inflation is heading lower and peak interest rates come in May. The overall stock market trades at a higher valuation when inflation declines except for deflation environment. And trades at a lower valuation when inflation is above 5% because the Fed hits the breaks on economic growth. The Fed's FRED 1 Year Expected Inflation Index projects inflation to be 2.6% a year from now.
U.S. broad stock market indexes are expensive, and earnings are coming down. Even so the stock market could rally six months after interest rates peak and earnings bottom. It is all about the level of interest rates. Higher rates less liquidity, lower earnings, lower valuations in security prices and other assets and vice versa. When interest rates peak forward valuations start to expand anticipating bottoming in earnings then a re-acceleration in earnings as rates cuts follow. I think that's the cycle ahead for investors over the next twelve months.
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