By: W. Kirk Taylor, CFP®; Chief Investment Officer
January, much to the chagrin of the consensus that was steadfastly calling for tough sledding in the first half of the year, has ushered in all sorts of technical “buy” signals and reviving the markets animal spirits in the process. At a minimum, these buy signals are suggesting more gains lie ahead for investors. They may be pointing to the start of the new bull market, but we are skeptical. We tend to agree with the bullish camp over the short-term but we do so with a few key caveats.
Prognosticators continue to hotly debate whether the Fed will become dovish i.e., they will pause, or they will halt altogether their aggressive rate hike campaign. Some even forecast that the Fed will lower interest rates in the latter part of the year; hardly something to be bullish about in our view as there is only one reason for the Fed to lower interest rates; to prop up a sagging economy.
The bears on the other hand fear that the Fed will keep pumping the brakes of monetary policy far too long, unintentionally sending the economy head-on into the wall of a recession. This is not a risk to take lightly.
Both camps make compelling arguments for their view, but the former “doveish” camp is winning out for now. The market wants the Fed to pause. They believe the Fed can engineer a soft-landing. They may also believe in unicorns.
As Warren Buffet has famously said, “In the short run, the stock market is a voting machine. In the long run, it is a weighing machine.” In other words, sentiment and psychology can dictate the near-term direction of the market but eventually sentiment and psychology will give way to the cold reality of the underlying fundamentals, whether good or bad.
The Technical Take
2023 is off to a good start after a challenging 2022. Stocks are rising broadly with small, mid and large cap companies performing well. Interestingly, growth-oriented stocks are up but value-oriented stocks are up more. Non-US equities are up on the heels of a weakening dollar and bond prices are rising as interest rates fall. Everywhere you look, there’s nothing but “green on the screen” of Bloomberg terminals and in client portfolios. What a relief!
We observe that “breadth” is strong, moving averages are giving “golden cross” buy signals and “sentiment” is improving among individual investors as they believe the worst is behind us. Investors seem to be saying “Keep Calm and Carry On”.
We believe this bout of optimism may prove to be different than the optimism that drove multiple failed rallies in 2022. According to some analysts, we may see double-digit gains for the S&P 500 during the first part of the year given the strength of the technical indicator.
We caution investors however to “not drink the Kool-Aid”.
For investors who lowered their equity allocation in 2022 in a prudent defensive posture, we see a brief window of opportunity to broadly increase their exposure to stocks and bonds on pullbacks. For the time being, it’s safe to “buy the dip”. Just recognize, as we lay out below, that more challenging times likely await investors in the second half of the year.
Don’t Fight the Fed
In 1970, famed investor Marty Zweig coined the phrase “Don’t Fight the Fed.” He observed that both stock and bond market returns are highly correlated with the direction of short-term interest rates i.e., the Federal Funds Rate (FFR) established by the Federal Open Market Committee (FOMC). The FFR serves as a “guide” for overnight lending rates among U.S. banks, which in turn impacts the interest for all borrowers. Notably, for consumers it means less disposable income to spend on non-discretionary and big-ticket items.
In short, when the Fed is raising rates, thereby contracting the supply of money, investors should be cautious given the damaging effects of higher interest rates on all borrowers – corporations, consumers, and the US government.
The opposite is true when the Fed is lowering interest rates and expanding the supply of money, as lower interest rates translate into lower borrowing costs for all borrowers. This in turn translates in to increased discretionary spending by consumers. Given that consumer spending accounts for two-thirds of Gross Domestic Product, this spending naturally leads to an expanding economy, higher corporate profits and of course higher stock prices. As always, stock prices head higher well in advance of the actual rebound.
Looking back over the past two plus decades, there are three shining examples of the powerful impact that lower interest rates can have on the economy: the 2001 recession, the Great Recession and the COVID recession. In each case, the stock market ultimately skyrocketed in anticipation of an economic recovery when the Fed flooded with the economy with cheap money.
In each instance, once the Fed opened the monetary spigot and figuratively dropped money from a helicopter, the mantra of “Don’t Fight the Fed.” was plastered over every news outlet and media publication in the land as justification for spurring an economic recovery and importantly, a rebound in stock prices.
During a 60 Minutes interview with Scott Pelley in 2009, then Fed Chairman Ben Bernanke, tacitly admitted that by dropping the FFR to nearly zero, the FOMC was hoping to prop up the economy, and thus the stock market, via the ”wealth effect”; a theory in which consumers increase their spending more than they might otherwise have because their stock portfolio and home values are appreciating. They “feel” wealthier than before, thus they spend more. How simple is that?!?!.
During the COVID crisis, the Fed once again lowered the FFR to near zero. This policy soon became known as ZIRP – Zero Interest Rate Policy. ZIRP was followed by TINA – There is No Alternative to stocks and finally FOMO – Fear of Missing Out. Low and behold it worked. From mid-March 2009, (the depths of The Great Recession) when the S&P 500 closed at 666, through December 2021, the S&P 500 gained 4,100 points or a whopping 615% in less than 12 years.
To put the magnitude of this stunning gain into context, at the end of 2021, the 3-year, 5-year and 10-year average annualized return for the S&P 500 was plus 15%. For perspective, the average annualized return for the S&P 500 since 1926 is approximately 10%. In other words, and rather remarkably, the S&P 500 gained FIFTY PERCENT MORE than the nearly 100-year average over the preceding 3, 5, and 10-year periods. That’s a rare occurrence.
It’s easy to see how impactful lower interest rates can be on spurring an economic recovery and boosting stock prices. I guess you could say that Marty Zweig was spot on when he said, “Don’t Fight the Fed.”
The Slope of Hope
Not to be cynical, but one has to wonder if lowering interest rates to zero and keeping them at zero for a prolonged period of time can have such a profound impact on the economy and stock prices, shouldn’t the opposite be true?
In other words, can a prolonged period of high interest rates also be the catalyst for the next bull market? We think not, and we think investors may be sorely underestimating the impact of higher interest rates on the overall health of the economy and equity valuations.
Therein lies the great conundrum for investors in 2023. As we pointed out in our Feb 2022 commentary, “The Winds of Change?” in 2021, investors looked past a bevy of risk factors, including the prospects for higher interest rates, as the S&P 500 rose nearly 26%, driven by ZIRP.
In 2022 that changed. Investors could no longer look the other way as the Fed was removing the proverbial punch bowl from the party in the form of five rate hikes that totaled 350 basis points in one year. This was simply a steady campaign of interest rate hikes, designed to combat a 40-year high in inflation. The result, much as we suggested one year ago in our “Are You Prepared for the Great Rotation”, commentary, was that growth stocks were pummeled (the NASDAQ fell over 30%) while the S&P 500 narrowly avoided a formal bear market, defined as a 20% loss, by declining 18%. Yet again, “Don’t Fight the Fed” proved to be more than just cute saying.
At the start of 2023, investors are back at it once again. They’ve hung their hats on the fact that inflation, at least as measured by goods inflation seems to have peaked, leading the Fed to soon pause its aggressive rate hike campaign. As mentioned previously, some even expect the Fed to lower the FFR later in the year, as economy meanders toward a recession in 2023. Again, there is only one reason for the Fed to lower interest rates, and that is because the economy is in trouble.
As my colleague, Dr. Mark D. Troutman, CFP®, detailed in our recent accompanying Economic Commentary titled “Inflation: Maybe Not Dead Yet”, the other side of the inflation coin, which is comprised largely of labor and services inflation, shows little sign of abating anytime soon. Unlike goods inflation, wage inflation is quite “sticky”, especially with unemployment at an all-time low of ~3.5%.
There are simply too few workers (at the moment) to meet demand despite puny layoffs from Big Tech giants like Meta and Alphabet. At the same time and given the supply and demand imbalances in the labor market, employees are emboldened to not only ask for pay increases but without reservation they are demanding other benefits and perks e.g., working remotely full-time.
As we ponder what is ahead for investors in the form of risks and opportunities, our primary concern is that the Fed is likely to disappoint investors regarding the highly anticipated pause in rate hikes. The Fed may indeed pause after the March rate hike but unless wage inflation falls, which it is currently not doing, the Fed may once again be forced to increase the FFR, not lower the FFR later in the year as the unicorn believers are hoping for.
While Mark describes in detail why “sticky” inflation has a long way to go before approaching the Fed’s 2% target, he also details the destructive nature of higher interest rates on corporate profits and discretionary income for individuals. Remember, “Don’t Fight the Fed.” was coined at a time when inflation was front-of-mind for investors and decimating their standard of living.
Our fundamental outlook on inflation, interest rates and thus the economy, leads us to a somewhat sanguine view for the market for the latter part of 2023. Moreover, when it comes to engineering the soft-landing that so many investors are expecting, there is scant evidence of the Fed’s ability to do so.
Remember, this is the same Fed that kept interest rates far too low, for far too long. Their rather poor forecasting skills played a definitive role in creating a 40-year high in inflation; inflation they are now steadfastly committed to returning to their longstanding target of 2%.
Although the reasonably strong start to the year likely has more upside before rolling over, the advance in stock prices feels more like the “The Slope of Hope” than it does the start of a new bull market.
Having said that, and unlike the conventional wisdom coming into the beginning of the year, we suspect the first portion of the year may surprise investors in terms of its upside. It is the back portion of the year that worries us. Investors may unknowingly be standing on a trap door as the expectations of a soft-landing fade.
Valuations Matter
The forecast for corporate earnings for the full year of 2023 for the S&P 500 is currently in a range of $195 to $225. The S&P 500 closed at ~ 4,195 on February 2nd, the peak so far for the year.
Earnings forecasts are backloaded as analysts are looking for a moderate decline in the economy and earnings in the first half of 2023, and then a notable increase in both indicators in the second half. The softness in the first half is the “soft landing” that virtually everyone is expecting. We have come to learn over the years that it’s often wise to be skeptical of the consensus. And we are.
For context, and per J.P. Morgan, the long-run median forward P/E multiple is 16.5. At 4,195 the S&P 500 is trading relatively close to the peak P/E multiple of 21 in 2021. It’s hard to imagine that there’s a tremendous amount of sustainable upside in the market at current levels.
If anything, and even though the S&P 500 was down nearly 20% in 2022, one could argue that the S&P 500 seems priced for perfection. Previous bear market lows have occurred when the S&P 500 traded in the 12-14 P/E range, not in the 18-20 P/E range. Consequently, we think there are tremendous risks in market in the back half of the year.
Outlier Risks
Not to complicate an already complicated and complex set of forces impacting the outlook for the economy and the market, investors should pay close attention to a few outliers that may create more uncertainty in the coming months.
Notably, China, in a stark turnaround driven by social unrest, has moved away from its strict “Zero COVID” policy. While deaths have and will continue to rise, perhaps the bigger risk is that pent up demand in China may spur already high inflationary pressures as their economy reopens. Should this prove to be the case, the Fed’s job will only get harder and more complicated.
Outside of China, geopolitical risks loom large given the ongoing Russian invasion of Ukraine, and the potential for a Chinese invasion of Tiawan. A further risk surrounds the unfolding struggle over raising the debt ceiling. Many will remember the summer of 2011, when the last incident of debt ceiling brinkmanship eroded consumer confidence and sparked a 17% decline in the S&P 500.
Play The Long Game
We certainly have concerns about the myriad of risk factors facing investors later in the year, and as a consequence, we see limited upside for equity investors beyond the first half of the year.
Having said that, we strongly suspect that a great buying opportunity lies ahead for patient investors who created some dry powder in 2022. We would like to see a soft landing for the economy as much as anyone else, but our decades of experience tell us that the Fed is unlikely to pull that rabbit out of its hat. As always be patient and stay disciplined while looking for opportunities in the second half of the year. They’ll be here before you know it.
