Tech stocks are crushing the broad market … understanding the discount rate and stock valuations … did the Fed’s poker face crack on Wednesday? … a huge Fed/Wall Street disconnect

 

This morning, we learned that the U.S. economy added – wait for it – 517,000 jobs in January.

This is a staggering figure given that the forecast was just 187,000.

Meanwhile, the unemployment rate has now fallen to 3.4%, the lowest level since 1969.

The market’s reaction today has been fascinating…

Stocks were down big before the opening bell, with the Nasdaq off roughly 2%.

But within about an hour into the day, all three major indices had rallied and were in positive territory.

Of course, as I write early-afternoon, they’re down again. The Nasdaq is off 1%.

Frankly, it’s anyone’s guess where we’ll end the day.

Overall, bulls can’t like a data-point like this morning’s jobs report because it strongly suggests the Fed still has lots of work to do as it tries to tighten the labor market.

Yet, this morning’s reaction shows that the party-appetite on Wall Street is still strong – especially for tech stocks.

This is a lopsided bull market to put it mildly

On one end of the spectrum, we have the Dow Jones Industrial Index, up 2.3% so far in 2023 (as I write Friday afternoon).

By historical standards, that’s a great start to the year.

Things look even brighter when we turn to the S&P. It’s up nearly 8% so far.

Well, hold on to your hats.

The tech-heavy Nasdaq has surged more than 15% in 2023.

What’s behind this tech outperformance?

Let’s jump to our technical experts, John Jagerson and Wade Hansen of Strategic Trader. From their Wednesday update:

The Nasdaq Composite, which is heavily weighted in the technology sector, has increased by almost [16]% since Jan. 1, making it the market leader in the first quarter of 2023.

The Technology sector has been boosted by the recovery of mega-cap stocks like Apple, Amazon, and Microsoft.

These stocks have been beaten up for a year as investors have been discounting their earnings as interest rates have gone up.

Now that it looks like interest rates are stabilizing at lower levels and the Fed may be preparing to slow the rate at which it is hiking rates, investors are starting to take another look.

The relationship between interest rates, cash flows, and stock valuations

To make sure we’re all on the same page, let’s provide a bit more color on the connection between interest rates and stock prices.

When analysts estimate a stock’s value, they use what’s called a “discount rate.”

They add up what they believe will be a company’s future cash flows, then use this discount rate to calculate a “net present value” of all those future cash flows.

This net present value is what analysts think is a fair stock price.

If the current market price is much higher than this net present value, then the stock appears to be overvalued. In other words, the price is too expensive relative to the underlying value of all those future cash-flows.

On the other hand, if current stock price is much lower than the net present value of future cash-flows, well, that would appear to be a great buying opportunity.

Given the math involved in this calculation, the higher the discount rate, the lower the net present value of future flows, and vice versa.

So, high discount rates usually aren’t great for stock prices.

What determines whether the discount rate is high or low?

Typically, the discount rate mirrors what’s happening with bond yields and interest rates.

So, climbing bond yields typically result in a climbing discount rate – translation, bad for stock valuations.

But falling bond yields and interest rates take pressure off discount rates – good for stock valuations.

Below, we look at a chart of the 10-year Treasury yield and the S&P 500 since January 1, 2022. It shows the striking inverse correlation between yield and price.

The 10-year Treasury yield is in purple, the S&P’s price is in black.

Tying back to technology stocks, the tech sector is very reliant on expectations of future cash flows. This makes tech valuations even more sensitive to the ups-and-downs of discount rates.

So, in recent months, as bond yields have fallen and Wall Street has grown more confident that the Fed is nearly finished hiking rates, discount rates have fallen. This has been especially beneficial for growth-oriented tech stocks.

To see this, take a look at the tech-heavy Nasdaq (in black) along with the 10-year Treasury yield (in purple), so far this year.

But John and Wade believe there’s plenty of bullishness to spread around beyond tech

Back to their update:

The U.S. economy has performed better than most investors had anticipated.

We found out just last week that gross domestic product (GDP) increased at an annual rate of 2.9% in the fourth quarter.

GDP went up because private inventory investment, consumer spending, federal government spending, state and local government spending, and nonresidential fixed investment all went up.

The manufacturing industry – mostly oil, coal, and chemical products – as well as the mining, utilities, and construction industries were behind most of the rise in private inventory investment.

Consumer spending went up because both services and goods went up in price.

Healthcare, housing, and utilities, as well as “other” services, led the rise in services.

 In terms of goods, motor vehicles and parts were the biggest contributor.

This unexpectedly strong GDP performance has boosted the entire stock market.

So, the question now is “will this bullishness continue?”

Well, that points us back to the Fed.

Did the Fed finally show its cards on Wednesday?

Regular Digest readers know that we’ve been chronicling the ongoing “poker match” between Wall Street and the Fed.

On one hand, the Fed has been claiming that rates will head “higher for longer” to make sure we win the fight against inflation.

For example, in his press conference on Wednesday, Federal Reserve Chairman Jerome Powell said:

Given our outlook, I don’t see us cutting rates this year, if our outlook comes true.

On the other hand, Wall Street has looked at cooling inflationary and economic data and responded, “you’re bluffing. You’re going to be cutting rates later this year.”

Well, after Wednesday’s press conference with Powell, the edge has to go to Wall Street.

Despite sticking to some hawkish talking points, Powell sounded more dovish than usual. He even acknowledged that the Fed would factor in the speed of disinflation into its policy plans.

This resulted in the months-long disconnect between the Fed and Wall Street becoming even more glaring.

From Bloomberg:

Traders in the interest rate swaps market have concluded after the Federal Reserve rate decision that policy direction is set for a deeper dovish pivot from the middle of this year. 

Swap contracts tied to this year’s Fed meetings show approximately 50 basis points of rate cuts are now firmly priced between the June policy peak of 4.90% to the 4.40% overnight lending rate tied to the December policy meeting. 

To make this point crystal clear, the Fed has signaled its eventual terminal rate will be 5.1%, reached sometime in the next few months, and there will be zero rate cuts in 2023.

But Wall Street is pricing the market to reflect its belief that rates will fall to 4.40% by December.

Investors are forced to pick a side, with the prosect of major portfolio gains or losses if you pick wrong.

Did Powell mean to sound more dovish than usual on Wednesday?

Back to Bloomberg:

Behind closed doors, Federal Reserve policy makers worry rallying markets are impeding their efforts to control inflation. But every time Jerome Powell goes out in public, he gives them more room to run…

Powell may have intended to deliver a stern message that the Fed still had a lot of work to do to tame inflation [at his press conference on Wednesday], but that’s not what investors heard.

Instead, they heard a chairman who indicated he was seeing clear evidence of slowing consumer price increases and who didn’t seem particularly bothered by the January rally in markets…

None of the market action is likely what the central bank wants to see as it looks to continue to rein in inflation, said Adam Phillips, managing director of portfolio strategy at EP Wealth Advisors.

“I’m surprised Chairman Powell didn’t use this opportunity to deliver a wakeup call to those investors who seem to have gotten ahead of themselves,” he said.

“There are ways to acknowledge the progress that’s been made on inflation while still talking tough on the work that needs to be done.”

But then again, what if Powell has just been bluffing the entire time? What if we finally got a peek at his cards?

John and Wade suggest the edge goes to Wall Street

In their update, John and Wade referenced the Fed’s policy statement, calling out the line “The Committee anticipates that ongoing increases in the target range will be appropriate…”

Here’s their related commentary:

As you can see, there are no hints suggesting that the FOMC is close to being done raising rates this year. Instead, the FOMC emphasized “ongoing increases in the target range will be appropriate…”

However, the FOMC said it would also be monitoring economic data moving forward and is open to adjusting its monetary policy.

This tells us that Wall Street has a green light to continue buying if earnings data remains positive and economic indicators – like those that monitor inflation – continue to improve.

Regular Digest readers know that I’ve leaned bearish for months. But if Powell’s hawkishness is cracking, it’s time to reevaluate.

It will be interesting to hear whether Powell walks-back any dovish-interpreted comments and/or talks-down the market rally in his upcoming speaking engagements.

If not, then bears should take note.

I’ll end with the take of Josh Brown, CEO of Ritholtz Wealth Management:

Now listen up and listen good. 

Last May 4th, Fed Chairman Jay Powell told a press conference that “A 75 basis point increase is not something that the committee is actively considering.”

Five weeks later, the Fed hiked rates by 75 basis points. Then he did another 75 basis points, then another 75 basis points, then another 75 basis points. Four in a row.

So today, when Powell goes out of his way to tell you how high rates are going to go and for how long they’ll stay there, remember that he doesn’t even know what they’re going to be doing next month, let alone by the end of the year.

The Fed’s forecasts are as worthless as anyone else’s. That’s why they say they are “data dependent.”

Invest like an adult, not a child who believes in clairvoyance.

Have a good evening,

Jeff Remsburg