The Fed raises rates another 75bps…Powell signals a slowdown, but seems very hawkish…the current market from a 30,000 foot perspective…where do we go now?
Today, in a widely expected move, the Federal Reserve raised rates another 75 basis points.
The federal funds target range is now between 3.75% and 4.00%, which is the highest since 2008.
The rate hike itself was not the main focal point today. Investors were much more interested in hints of a change in policy in the days ahead.
Well, they got it… but it wasn’t the answer they wanted.
The new policy statement included this slowdown hint:
[The Fed] take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
And during his live press conference following the release of the statement, Federal Reserve Chairman Jerome Powell responded to the question of the day by saying:
…I said at the last two press conferences that at some point it will be important to slow down the rate of increases.
So that time is coming, and it may come as soon as the next meeting or the one after. No decision has been made.
But that was about as accommodating as Powell sounded. His general comments were decidedly warmongering.
Here are other selected comments from Powell’s press conference:
- Data since September suggests that the “ultimate” level at which rates will reach will be above 4.6%, which was expected at the Fed’s September meeting.
- “We have a long way to go” to raise interest rates.
- “I don’t think we’ve tightened too much.”
- It is “very premature” to consider suspending rate hikes.
- “I don’t see a case yet for any real easing” in the labor market.
- It is “still possible” for the Fed to achieve a soft landing, but the path has “narrowed”.
All in all, as today brought the hint of a downturn that Wall Street wanted, Powell’s warmongering was the big story.
As I write shortly before the closing bell, all three indices are selling, with the Nasdaq the most down at -2.9%.
So where does all of this lead us?
Let’s forget about the Fed for a moment and take a step back. We will begin our analysis with a 30,000 foot perspective.
Below we take a look at the S&P 500 over the past 20 years. I have added a trend line which attempts to capture the long term average growth of the index.
Take a look before adding a comment.
Based on this chart, was the market surge from the pandemic low of 2020 to the market high at the start of this year consistent with the long-term trend line?
It was a bubble above the steeply sloping trend line, inflated by trillions of dollars of new liquidity.
With this long-term perspective, it is clear that this year’s bear market has not resulted in a historic “deep discount” buying opportunity from a valuation/long-term average perspective.
All the bear market did was bleed out excess gains from 2020 through January 2022. And let’s not pretend those gains weren’t excessive.
At the peak of the uptrend, the S&P’s price-to-earnings (P/E) ratio hit around 38. This was the third-highest reading on record. For perspective, according to multpl.com, the long-term average P/E ratio for the S&P 500 is 15.98.
Today, the S&P P/E ratio fell back to 20.03. Yes, that’s a huge drop. But with a long-term outlook that includes the current P/E of 20 and the multi-decade S&P trendline we just looked at, current S&P prices aren’t screaming “low valuation buy opportunity.” .
At best, general stock market valuations have moved from well above average to average (based on the 20-year trendline). At worst, valuations remain overvalued by 25% (based on the P/E ratio).
So the idea that “we’re due for a huge bull run due to double-digit market losses this year” completely misses the point – this year’s losses simply bled the excess price, bringing us back to the average over several decades. trend line.
I’m not saying the market can’t start a new bull run. But if so, it will be based on sentiment, not fundamentals.
“But Jeff, the P/E multiple uses old earnings. It’s ancient history. You should use prospective earnings. This will show our valuation advantage.
Fair enough. Let’s do this.
Are the earnings estimates correct or are they inflated and creating more difficulties in the stock markets?
So what do we know about the S&P’s valuation based on earnings forecasts?
Well, let’s go to FactSet, which is the earnings data analytics company used by the pros. From their latest update last Friday:
The 12-month forward price-to-earnings ratio is 16.3, which is below the 5-year average (18.5) and below the 10-year average (17.1).
However, it is higher than the forward P/E ratio of 15.2 recorded at the end of the third quarter (September 30), as the price of the index has risen while the 12-month forward EPS estimate has since declined. September 30.
As such, today’s 12-month forward price-to-earnings ratio is below its 5- and 10-year average. The bullfight is on!
Not so fast. Four problems:
First, the 5- and 10-year averages include many years of significant bull market prices that skew the averages.
Second, even if we ignore this uptrend, a forward P/E of 16 is not much lower than the other two averages of 17 and 18.5. So it’s not like we’re ready for a roaring bull thanks to a basement appraisal.
Third, these 12-month forward P/E estimates come from highly fallible and historically inaccurate humans. Analyst estimates can be horribly wrong…in fact, they’re usually wrong.
Investopedia reports that, on average, forward earnings estimates are about 10% higher than where earnings come in.
Some studies put the number much higher.
For example, a 2016 paper titled An Empirical Study of Financial Analysts Earnings Forecast Accuracy estimated the overstatement at 25%.
These inaccurate bullish estimates have played out throughout the year. As an example, here’s Fortune from last month:
On September 23, Goldman Sachs lowered its year-end target on the S&P 500 for the fourth time in 2022.
Goldman’s new estimate is 3,600, a number 29% lower than the 5,100 mark it forecast in mid-February.
It’s the “experts” who have been wrong four times so far this year.
Obviously, whether it’s a price target for the S&P or a 12-month earnings forecast, we have to take these estimates with a huge grain of salt.
But now, let’s quadruple that grain of salt as we move on to our fourth point…
How accurately do forward-looking earnings estimates account for recession potential?
Let’s repeat this excerpt from FactSet:
[Today’s forward 12-month P/E ratio of 16.3] is above the forward C/E ratio of 15.2 recorded at the end of the third quarter (September 30), as the price of the index has risen while the 12-month forward EPS estimate has fallen since September 30.
As earnings forecasts fell, the S&P rose.
Aren’t stock prices supposed to reflect earnings?
Before I answer, let’s add the additional wrench of an impending recession.
If a recession comes next year, which many experts are predicting (Bloomberg just put the odds at 100%), then it seems fair to say that earnings during that recession will be lower than earnings today, when we are not in a recession. .
So how do the estimates look like?
According to FactSet, analysts expect calendar year 2023 earnings for the S&P to be $235.61. For more context, analysts suggest that the end result for this year will be $221.65.
Thus, the consensus is that profits will increase by 6.3% next year.
How realistic is this earnings growth if we are in the middle of a recession?
Here is the DA Davidson Wealth Management Group with historical context:
It’s important for investors to know during recessions that economic downturns create challenges for corporate earnings and that S&P 500 earnings growth has turned negative in each of the past ten recessions.
S&P 500 earnings per share (PES) declines, from peak to trough, ranged from -4.6% during the 1980 recession to -91.9% during the Global Financial Crisis (GFC) from 2007 to 2009.
The average decline in income over the ten recessions was -29.5%.
Once again, the consensus is for earnings growth of 6.3% next year.
To be fair, not all analysts are raising their estimates for 2023.
… At least one market strategist, Marko Kolanovic, JP Morgan’s chief global markets strategist, has his 2022 earnings estimate at $225, slightly above consensus, but recently cut his 2023 forecast by $240 at $225, and flat year-over-year.
I suspect other analysts have either cut their projections for 2023 or will do so in the coming months.
This will create a headwind for stocks to rise.
Now, given our skepticism about the accuracy of the analyst community, we don’t want to attribute more weight to Kolanovic’s predictions than any other.
So, back to logic…
What do you think is most likely when we assess the broader market?
A contraction in profits during a recession? Or earnings growth in a recession?
So what do we think of all this in terms of market direction?
The answer might depend on the time period you are talking about.
Despite selling pressure as I write, I suspect the bulls will regroup soon enough.
Powell’s reference to a potential slowdown in December or January will likely be the bulls’ new rallying cry after licking their wounds. Moreover, we are entering a period of the year with strong seasonality.
If weaker inflation numbers arrive in the coming weeks, it could lead to a Fed slowdown in December, which invigorates the bulls, leading to a 20%-25% rally in Q1 2023.
For investors looking further into the future, there remains a huge looming problem: earnings estimates are likely too high in light of a 2023 recession.
So if the bulls regain control in the coming weeks and push the market higher in Q1 2023, I can imagine a sudden realization *lightbulb!* next year that recession earnings are miles away. below then high market prices…
If this disconnect is too big, it doesn’t bode well for the market progress the bulls have made so far.
Lots of moving parts here. We will continue to follow them here in the Digest.
Have a good evening,