top of page
Market Update Fall 2023
Stocks and bonds sold off again in September reminiscent of last year’s dual sell-off of equities and bonds. Higher bond yields are behind this selloff. Bond supply is overwhelming demand in the markets causing yields to spike. Bond and stock prices are inversely correlated with a rapid rise in yields. The average stock, as measured by the Invesco S&P 500 Equal Weight ETF, is slightly negative year-to-date, and the Barclays Aggregate Bond ETF is minus 2.5% at the end of the third quarter. This is the third weakest start to a bull market since World War II according to Ned Davis research. Bull markets have recovered all losses in preceding Bear markets before entering the next Bear market since 1949 according to CFRA research. This means there is more upside in this Bull market to come. What can end this Bull market? The leading culprit would be an overzealous Federal Reserve engineering a recession by going too far with its rate hikes. What will keep Bull alive? An end to Federal Reserve rate hikes this year.
Hawkish comments by the Federal Reserve Chairman have scared investors. Treasury yields across the yield curve have risen dramatically higher in September. The excess supply of bonds hitting the market is driving down bond prices and up yields. Yardeni research points out that the bond market is doing the job for the Government by jacking up yields causing tighter financial conditions. The 30-Year fixed mortgage rate is close to eight percent. The odds of another rate hike by the Federal Reserve by year end are declining as yields rise. I think the Fed is done hiking. I’m watching for a peaking process in the 2-year Treasury note, highly correlated to Federal Funds Rate expectations. The yield has declined this month from its recent high. If I’m right, yields and rates are peaking at 16-year highs.
The Fed sees inflation moderating but not going away next year so it will continue to apply the brakes on the US economy by keeping rates higher for longer. The higher rate for longer theme threatens the “soft landing” trade in the markets while modestly increasing recession risks. Higher rates for longer are likely to impact all areas of the economy especially housing markets, autos, lending, retail, and gradually reduce overall consumer spending especially if unemployment rises from here.
The difference between last year and this year’s market is the Fed is near the end of its historic tightening. The combination of rate hikes, quantitative tightening, and now the “bond market vigilantes” are sure to slow down the economy and further ease the inflation impulse. The Fed must factor into their monetary policy the magnitude and impact of the Governments deficit spending. The US Government’s fiscal deficits are finally drawing the ire of bond market investors who will act even if the Government fails to do so. US debt has risen to an unprecedented 120% of total gross domestic product according to CNBC. Over time, global bond investors could shy away from US Treasuries, demand a higher yield to hold US Treasuries which would increase the US debt service to more than one-third of its budget. US debt service is a problem for the economy now.
Earnings report estimates for the third quarter are less negative than previous quarters. CFRA research reports that census operating earnings are projected to be positive next quarter for the first time over the last four quarters, and gradually rise over the next twelve months. The lag effect on monetary policy on economic growth could slow acceleration to below average rate but still grow. Current projections for earnings growth are above historical average and too rosy given the economic slowdown.
Stock valuations decline as interest rates rise because future earnings growth is likely to be slower as higher rates break economic growth. Although rates have risen dramatically from a zero Federal Funds rate, historically, today’s interest rates are not at out-of-whack levels. The 10-Year Yield is below its 63-year average suggesting the U.S economy can expand under current rate levels. In fact, interest rates and yields are just normalizing. Over long periods of time, GDP growth has a tight positive relationship with long-term government bond yields. Government bond yields generally have averaged the same rate as nominal growth. Given current Treasury yields and interest rate backdrop, earnings have risen by approximately seven percent annually in the past allowing for expansion type stock valuations. Valuations are not likely to expand from today’s multiples unless earnings estimates meet projections. The Fed would have to cut rates to see valuation expansion.
Stock valuations matter now given Federal Funds rate is no longer zero. Most S&P 500 sectors have corrected in price to adjust for higher rate environment. Utilities, Real Estate, and Staples sectors have adjusted in price the most of all sectors. The forward multiple for the S&P 500 is 17.7 according to Factset. It’s above the 10-year average (17.5). However, Mega-cap stocks are pushing up the S&P 500 index multiple. The forward multiple of the equally weighted S&P 500 index is reasonable at 16 and below its 10-year average. The rest of the market, Mid-caps, Small-caps are selling below their 10-Years average. The bottom line is that most areas of the market can be bought at current valuations.
I see inflation remaining range bound tilting towards the lower end of the Fed’s range because of a slowing economy. The Fed’s 2024 projection for Core CPI is 2.5% - 2.8%. Whereas, The Bureau of Labor Statistics projects the Consumer Price Index, the most common inflation measure, to average 3.13%. Prices are moving in the right direction but could be sticky in 2024. Any drop in inflation below 3% should take the pressure off yields allowing for a more generous market multiple as the economy transitions through a slow growth period. Higher levels of employment support a softer landing scenario. Stocks’ returns have been positive during periods of range bound inflation and declining inflation according to NDR.
The period between the Fed’s last rate hike and first cut was a buying opportunity for stocks and bonds and not the time to load up on Treasury Bills. Capital Group research shows that in the year after the Fed stopped hiking rates across the last four cycles, cash had the lowest returns, significantly underperforming stocks, and bonds.
The S&P 500’s near 8.5% pullback from its high this year has gone a long way towards erasing stretched valuations and excessive optimism. What’s more, Money market fund assets hit a record $5.6 trillion in September, according to the Investment Company Institute. The amount of cash on the sidelines is a classic Bullish indicator. The Capital Group study concludes that levels of cash have tended to peak around market troughs and shortly before market recoveries. My view is the market appears to be setting up for a year-end rally as seasonal weakness ends in October. The S&P 500 gained an average of 5.0% during the fourth quarter of all years since 1990, rising in price 82% of the time according to CFRA. Catalyst for year-end rally is an end to Fed tightening cycle and reasonable valuations in the stock market and in long duration fixed income securities.
bottom of page