The Fed raises rates another 75 basis points … Powell signals a slowdown, but sounds very hawkish … today’s market from a 30,000-foot perspective … where do we go from here?
Today, in a widely-expected move, the Federal Reserve raised rates by another 75 basis points.The fed funds target range now stands at 3.75% to 4.00%, which is the highest it’s been since 2008.The rate hike itself wasn’t today’s primary focal point. Investors were far more interested in hints of a policy change in the days ahead.Well, they got it…but it wasn’t the answer they wanted.The new policy statement included this hint at a slowdown:
[The Fed] will 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 in his live press conference after the statement’s release, Federal Reserve Chairman Jerome Powell answered the question du jour, saying:
…I’ve said at the last two press conferences that at some point it will be important to slow the pace of increases.So that time is coming, and it may come as soon as the next meeting or the one after that. No decision has been made.
But that was about as dovish as Powell sounded. His overall comments were decidedly hawkish.Here are additional selected comments from Powell’s press conference:
- Data since September suggest the “ultimate” level to which rates will go will be higher than 4.6%, which was the expectation at the Fed’s September meeting.
- “We have some ground to cover” to move interest rates higher.
- “I don’t think we have overtightened.”
- It is “very premature” to think about pausing rate hikes.
- “I don’t see the case for real softening just yet” in the labor market.
- It is “still possible” for the Fed to achieve a soft landing, but the path has “narrowed.”
Overall, while today brought the hint of a slowdown that Wall Street wanted, Powell’s hawkishness was the big story.As I write shortly before the closing bell, all three indices are selling off, with the Nasdaq down the most at -2.9%.
So, where does all of this leave us?
Let’s forget the Fed a moment and step back. We’ll begin our analysis with a 30,000-foot perspective.Below, we look at the S&P 500 over the last 20 years. I’ve added a trendline that attempts to capture the long-term average growth of the index.Take a look before we add commentary.
Based on this chart, was the market surge from the pandemic-low of 2020 through the market-high at the start of this year in line with the long-term trendline?Clearly not.It was an above-trendline, steep sloping bubble, inflated by trillions of dollars of new liquidity.With this long-term perspective, it’s clear that this year’s bear market hasn’t resulted in a historic “deep discount” buying opportunity from a valuation/long-term average perspective.All the bear market has done is bleed off the excess gains from 2020 through January 2022. And let’s not argue that that those gains weren’t excessive.At the height of the bullishness, the S&P’s price-to-earnings ratio (P/E) hit roughly 38. That was the third highest reading ever. 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’s P/E ratio has fallen all the way back to 20.03. Yes, that’s a huge drop. But with a long-term orientation that includes today’s P/E of 20 and the S&P’s multi-decade trendline we just looked at, current S&P prices do not scream “low valuation buying opportunity.”At best, broad market valuations have gone from highly-above average to average (based on the 20-year trendline). At worst, valuations remain 25% overvalued (based on the P/E ratio).So, the idea that “we’re due for a huge bull run because of the double-digit market losses this year” completely misses the point – this year’s losses have simply bled out the price excess, returning us to the multi-decade average trendline.I’m not saying the market can’t go on a new bull run. But if it does, it will be sentiment-based, not fundamentals-based.
“But Jeff, the P/E multiple uses old earnings. That’s ancient history. You should be using forward-looking earnings. That will show our valuation edge.”
Fair enough. Let’s do that.
Are earnings estimates correct, or are they inflated and setting up more stock market pain?
So, what do we know about the S&P’s valuation based on forward earnings estimates?Well, let’s go to FactSet, which is the earnings data analytics company used by the pros. From their most recent update last Friday:
The forward 12-month P/E ratio is 16.3, which is below the 5-year average (18.5) and below the 10-year average (17.1).However, it is above 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 increased while the forward 12-month EPS estimate has decreased since September 30.
So, today’s forward 12-month P/E ratio is below its 5- and 10-year average. The bull party is on!Not so fast. Four issues:One, both the 5- and 10-year averages include many years of major bull market pricing that skew the averages up.Two, even if we ignore that upward skew, a forward P/E of 16 isn’t wildly below the other two averages of 17 and 18.5. So, it’s not as though we’re primed for a roaring bull thanks to a basement valuation.Three, these 12-month forward-looking P/E estimates come from very fallible, historically inaccurate humans. Analyst estimates can be woefully 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 far higher.For example, a paper written in 2016 called An Empirical Study of Financial Analysts Earnings Forecast Accuracy put the overestimation at 25%.Such inaccurate bullish estimates have played out all year long. As just one illustration, here’s Fortune from last month:
On Sept. 23, Goldman Sachs lowered its year-end target on the S&P 500 for the fourth time in 2022.Goldman’s new estimate is 3600, a number that’s 29% below the 5100 mark it was forecasting as late as mid-February.
These are the “experts” getting it wrong four times so far this year.Clearly, whether it’s a price-target for the S&P or a 12-month earnings forecast, we have to take such estimates with an enormous grain of salt.But now, let’s quadruple that salt grain as we turn to our fourth point…
How accurately are forward-looking earnings estimates factoring in the potential for a recession?
Let’s repeat this snippet from FactSet:
[Today’s forward 12-month P/E ratio of 16.3] is above 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 increased while the forward 12-month EPS estimate has decreased since September 30.
Got that?While earnings forecasts have been dropping, the S&P has been climbing.Aren’t stock prices supposed to reflect earnings?Before you answer, let’s throw in the extra monkey wrench of a looming recession.If a recession is coming 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’re not in a recession.So, how are estimates looking?According to FactSet, analysts expect calendar year 2023 earnings for the S&P to be $235.61. For greater context, analysts are suggesting that this year’s final earnings number will be $221.65.So, consensus has it that earnings will grow 6.3% next year.How realistic is that earnings growth if we’re in the middle of a recession?Here’s wealth management group DA Davidson with some historical context:
It is important for investors to know during recessions that economic downturns create challenges for corporate profits, and S&P 500 earnings growth turned negative in each of the past ten recessions. S&P 500 earnings per share (EPS) declines, from peak to trough, ranged from -4.6% in the 1980 recession, to -91.9% during the Global Financial Crisis (GFC) from 2007 to 2009.The average earnings decline across all ten recessions was -29.5%.
Again, consensus calls for earnings growth of 6.3% next year.To be fair, not all analysts are upping their 2023 estimates.From Forbes:
…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 decreased his 2023 forecast recently from $240 to $225, and flat year over year.I suspect other analysts have either decreased their 2023 projections or will do so over the next few months.This will create a headwind for stocks to move higher.
Now, given our skepticism about the accuracy of the analyst community, we don’t want to assign more weight to Kolanovic’s forecast than any other.So, let’s fall back upon logic…What seems more likely to you when we evaluate the broad market?An earnings contraction during a recession? Or earnings growth during a recession?
So, what do we make of all this in terms of market direction?
The answer could depend on which time-frame you’re discussing.Despite selling pressure as I write, I suspect the bulls will regroup soon enough.Powell’s reference to a potential slow-down in December or January will likely be the new rallying cry for bulls after they lick their wounds. Plus, we’re entering a seasonally-strong time of year.If softer 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 come Q1 2023.But…For investors looking further into the future, there’s still 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 into Q1 2023, I can envision a sudden *lightbulb!* realization sometime next year that recessionary earnings are miles beneath then-elevated market prices…If that disconnect is too great, it doesn’t bode well for whatever market advancements the bulls make up until then.Lots of moving parts here. We’ll keep tracking them here in the Digest.Have a good evening,Jeff Remsburg
