I’ve had a couple of days to process the extraordinary pivot from Fed Chair Powell earlier this week.
Rarely have I seen such a reversal in sentiment.
In case you missed it – Powell gave stocks a full green light.
Stocks were already partying into the Fed meeting (up ~12% over 6 weeks) – Powell simply turned up the music.
“Rate cuts party people”…
Here’s my thinking:
Powell desperately wants to stick the landing.
After being late to increase rates – the Fed jacked up rates 550 basis points in combination with $1T in quantitative tightening.
We haven’t seen tightening like this in two decades.
But somehow the economy took it all in stride – with unemployment still below 4.0% and GDP slowly expanding.
That was not expected.
Given the cloudy skies Powell had to navigate (without a GPS) – he now wants to finish the job.
To that end, not only does he want to tame inflation – he also wants to make sure we avoid recession.
“Of course” you might say…
“That’s the central bank’s job”
And you would be right.
However, up until a few weeks ago – Powell may have been willing to tolerate a recession if it meant seeing the back of unwanted inflation.
If that was the cost – so be it.
However, now with the finish line in sight, he wants to bring it home.
But obviously that comes with risk…
For example, by pivoting to target the business cycle – he runs the risk of inflation rearing its ugly head.
Inflation has been known to show head fakes previously.
Just ask former Fed Chair Arthur Burns.
He too ran an early victory lap in the late 1970s – only to see inflation resurface.
The Fed was forced to resume rate hikes and it didn’t end well.
Up until recently I said “Powell will not want to be remembered as another Burns – but rather Paul Volcker”
Volcker was resolute in his fight against inflation.
He hiked rates to ~18% in the early 1980’s (n.b., can you imagine mortgage owners paying 18% today – they kick and scream at 8%) – pushing the economy into recession.
However, he tamed the beast.
Well… it turns out Powell is no Volcker.
With the Fed now in the rear-view mirror (at least in the near-term) – stocks look set to make all-time highs this year.
So here’s today’s exam question:
Have we effectively brought forward some (or all) of 2024’s potential gains?
My thinking is yes – but let’s explore with some charts and reasoning.
S&P 500: Party Like It’s 1999
Dec 16th 2023
With stocks clearing the high of July earlier this year – I’ve sketched in a new distribution labelled A-B.
From mine, this is now likely to influence price action and near-term targets.
Regular readers will know I was tracking a distribution from around May last year – which offered resistance around 4600.
I believe that’s now over.
For clarity, that’s not to say stocks may not come back into this range (they could) – but for now – I think we’re likely to see stocks trade between 4100 to 4800.
Previously my target range was between 3600 (where I added to positions last October) and 4600.
For those less familiar, the way I construct distributions is a Fibonacci retracement on the last meaningful pullback after a strong run higher.
For example, in this case, stocks ran from a low of ~3800 in March to 4600 in July (marked “A“)
From there, the market retraced ~6.5% to 4300 through August – labelled “B“.
The Fibonacci retracements of 61.8% to 76.4% outside that pullback (on the high side) is where I think we will find resistance.
That zone is around 4800.
Similarly should stocks fall, the lower side of the retracement is the zone of 4100.
For clarity, these are zones (not specific levels).
Between now and through January – I think it’s quite feasible stocks continue to rally into the zone of 4800 – likely exceeding the all-time high of 4817 (January 2022).
However, from there I think things get more challenging.
~15% Drawdown First Half of 2024
When the S&P 500 fell from ~4600 to ~4100 between July and October this year – the drawdown was ~10%
Since then it’s been straight up to the tune of 15%
Further my preface, stocks were given a green light from Fed Chair Powell this week.
We have hit the Fed’s terminal rate.
And whilst several rate cuts were already priced in for 2024 – Powell confirmed at least three (according to the dot plot).
For the record, stocks are pricing in at least four.
Now you might say that Powell lowered the “wall of worry” stocks had been climbing.
However, my view is it remains highly presumptuous that all risks have magically been waved away by a dovish Fed.
To use the model of Daniel Kahneman – it’s ‘System 1’ thinking (read his book if you haven’t – it will change the way you think)
For example, even if we take recession off the table (and I don’t think we can) – there is still the very high risk of a growth scare.
But if you look at the price action – with the market now at ~20x forward earnings – it is representative of extreme optimism.
That bothers me.
What Would Cause Stocks to Pause?
Well for one thing it’s not going to be the Fed.
That we know (after last week).
For example, unless we see some kind of inflation scare (which I doubt ) – we should expect Powell & Co. to simply observe.
In other words, I think we take out the Fed as the primary driver (for now).
They will still have a role to play – but it will be more in the second half of the year.
What we will turn to early next year will be the health of corporate America.
And here I’m talking about earnings – and specifically the outlook.
This is where I think we will see stocks give pause.
Again, look at what we’ve seen in valuations in just the past 7 weeks.
We have gone up almost “3-turns” with respect to multiples.
And with stocks priced at almost 20x forward earnings – not only do companies need to comfortably exceed earnings – they need to offer strong guidance.
In other words, we need to see a consumer not just spending, but accelerating their spend.
But listen to the language of most retail CEO’s the past quarter – they talked to how cautious their consumer is.
We might see a consumer hanging in there (on the assumption they still have a job) – but they are not growing their spend.
This is why I think there is a case to be made for a ~15% drawdown after a run to the 4800 zone in January.
If true – that could see the market trade close to the 61.8% zone on the lower side of my distribution (i.e., 4100 to 4200)
Let’s Not Forget Bond Yields
Whilst equities may have gotten a little over their skis following Powell – the same could be said with bonds.
As part of my last post – I shared what we saw with the US 10-year – now trading with a 3-handle.
Just 8 weeks ago it was a 5-handle (a level where Bill Ackman covered his short bet on bonds – i.e., expecting yields to fall)… which now appears to be the peak in this cycle.
Savvy traders / investors took advantage of the 5.0% yields – in addition to the capital appreciation made (as these yields plummeted).
However, my suspicion is we see yields rally a little from this zone.
That said, if we do have an economic downturn or ‘growth scare’ – they could fall further.
On the other hand, there has been a distinct change in appetite for fixed income from investors which limits the downside in yields.
Higher yields will likely pressure stocks and valuations.
Put another way, a lot of the rally in the past few weeks is opposite expected cheaper funding (e.g., a much lower 10-year)
Opportunity with H1 ’24 Dip
Personally, I’ll be looking to buy quality on the expected dip in the first half of next year.
For now, with valuations appearing stretched and the tape inching towards overbought territory – I’m happy to maintain my 65% long exposure.
I do not have any short positions or puts.
Now, ideally I had greater long exposure coming into this rally – however I was not comfortable with the risks.
For example, if Powell came out and said the Fed may be forced to hike once more due to easing financial conditions (given the dramatic drop in bond yields) – stocks could have easily plunged.
I was not willing to simply hand back my well-earned ~18% gains for the year.
That said, the Fed has now removed some of that risk by telling us ‘peak rates are in’.
Good to know.
Again, this could change if we see an inflation scare – but I don’t think we see that.
Inflation trend lines are coming in as expected (especially Core PCE – now averaging ~2.0% annualized the past few prints)
However, should earnings guidance come in softer than expected and we see a growth scare, stocks could easily drop 10% to 15%
My thesis is the market is irrationally exuberant.
Below is the specific zone I’m targeting:
Dec 16th 2023
For now, sit tight and enjoy the ride higher.
Stocks are most likely to rally into year’s end and through Jan.
That’s typical for this time of year.
Putting it All Together
Before I close, if there is one signal from the market the Fed would be happy with – it’s inflation breakevens.
For those less familiar, this is the implicit projections of future rate increases that are baked into bond prices.
Today they are anchored firmly around 2.18%
Dec 16th 2023
Here we can see how breakevens spiked above 3.5% last year following the Ukraine invasion.
However, now they have calmed down.
What this suggest is markets have always had confidence the Fed would get inflation back under control.
And whilst that confidence level was tested (when it moved to around 2.5%) – it’s now back around the Fed’s target level.
From mine, this chart is another reason why Powell & Co. feel a little more comfortable pivoting to target the business cycle (i.e. ‘stick the landing’)
With the Fed ‘almost’ out of the picture for a couple of months – investors focus will shift to earnings quality and forward guidance.
Is ~20x forward earnings a good risk/reward bet for your money?
Not for me.