- Don’t be too short-sighted
- The difference between being tactical and strategic
- My 4-point hypothesis on framing this market
“What will the Fed do in December… 50 or 75?”
“Has the market bottomed” and “will we see a rip between now and year end?”
These are the types of short-sighted questions I get regularly.
My take: who cares what the market does in the next “2-3 months”? And what difference does “25 bps” make?
If that’s your lens – this blog probably isn’t for you.
There are plenty of ‘trading sites’ out there who claim to know how the market will move day-to-day.
Yes, we may get to 4100 on the S&P 500 over next two months (as I’ve shown in previous missives).
Sure… why not?
For one, it’s seasonally a very strong time of year and it’s only 5-6% away.
Earnings are behind us and there are few catalysts to send us lower (barring some geopolitical event)
But why try and time it for just a handful of points?
A better way of thinking about is what’s the downside risk from there?
20% or more?
What’s attractive about (potentially) gaining 5% to easily lose 20%?
From my lens – nothing has changed.
For example, inflation is still white-hot (given it still starts with a “7”)
But most importantly – the Fed is not done tightening.
Consider what St. Louis Fed President James Bullard told us today:
“The Fed’s target policy needs to rise to at least a range between 5.00% and 5.25% from the current level of just below 4.00% to be “sufficiently restrictive” to curb inflation, though he would defer to Fed Chair Jerome Powell regarding how much higher to move rates at upcoming policy meetings”
The 2-Year note suggests the Fed funds rate will hit at least 4.75% next year.
My best guess is somewhere between 4.75% and 5.00% – but ideally above the rate of inflation.
That’s how you kill it.
I would be really happy if we saw 5.50%… but I question whether the economy will cope?
And with today’s rate at 3.75% and CPI headline running at 7.7%… there’s work to do.
From my perspective – the equation is this simple:
Until we see the Fed make a definitive shift from monetary tightening to easing – any rally in stocks will likely be short lived.
What’s more, that will be accompanied by a bearish trend with:
- 2-year yields; and the
- US dollar index.
Neither of these conditions (or trends) are in play right now.
Tactical vs Strategic
Question for you:
Is your own personal trading style tactical (e.g., day-to-day or week-to-week) or more strategic?
Personally I am the latter.
But that’s what works for me.
Regular readers will know I don’t get excited by big up or down days.
Equally, I don’t get too excited by one or two data points (e.g., October’s CPI)
I’m play the ‘slow’ game with the 3-year plus lens.
And look – so far this year it has worked reasonably well – with my own portfolio only down ~1.1%
For all intensive purposes – being down ~1% is basically flat.
My portfolio (which is 65% long) will move up and down 1% every day of the week.
But look at what we see with the S&P 500…
It’s been a horrible year by any measure… down ~16%.
Today I choose to remain very defensive.
As I said in June (and often before that) – 2022 will be a year not to lose too much money (vs making money)
The past few years have been absolute gifts (i.e., times to make money) — with returns anywhere from 16% to over 20%
But the last thing you want to do is give that straight back.
Some people have done exactly that this year (hello Cathie Wood!)
To me, the mark of a successful (perhaps wise?) investor is two-fold:
- playing strong defense when times are difficult (this year has been tough); and
- strong offense when it’s time to take on more risk.
What’s critical is you know the difference!
Cathie Wood (and many others like her) have not quite worked that out.
The time to increase our risk profile will come again… perhaps later in 2023 at a guess.
Perhaps that may be the time when the Fed may indicate the time to pump the brakes could be coming?
Again, that is dependent entirely on inflation and employment.
As we know, predicting the timing of these things is impossible (so I don’t try).
But for now – this remains a game of playing great defense.
My Hypothesis in 4 Points
I don’t pretend to some ‘macro wizard’; or have any greater insights than you.
Chances are we read similar things.
What’s more, I certainly don’t pretend to be a great timer of markets.
I wish…
I will never pick the bottom; and nor will I be able to tell you the top.
That said, I can tell what my base case is and go from there.
Obviously as we get more data – the base case can change. It’s fluid.
But at least this will explain my thought process into next year (leading to what will be smarter decisions)
And it’s not complex.
Hypothesis #1: Recession in 2023
First up, I see a recession in the first half of 2023.
Big call right?
Not really.
For example, look no further to what we see with the 10/2 yield curve (you can choose any duration along the curve)
This is the bond market (the smart money) screaming recession dead ahead.
Nov 17 2022
Guess what… I also don’t think this curve is done inverting.
For example, if the growth outlook deteriorates (i.e., the 10-year yield drops) as the Fed hikes the short-end to near 5.0% — this curve will invert further.
Which leads me to my second hypothesis…
Hypothesis #2: Earnings Contraction
Whether or not we have a recession will depend on your macro lens.
For example, there’s every chance we can avoid a recession all together.
I think it’s a lower probability – but who knows – many people are still of that view (e.g. Goldman Sachs this week).
Now based on what we have seen with all other recessions (no exceptions) – we will see earnings decline.
As it stands today, the market now only sees 4% growth in earnings next year.
The ‘good news’ is they have finally brought that down from an expected 8% growth (where it stood last month)
We are getting there… but analysts are slow.
At 4-5% growth – that puts S&P 500 EPS at around $230 per share next year.
I am not buying it.
My thinking is we will see earnings contract between 5% and 10% next year.
If we assume a 10% contraction – that puts S&P 500 EPS at ~$200 per share.
Here’s the thing:
An earnings contraction in the realm of 5-10% is not priced in the market today.
Which brings me to my third hypothesis – what multiple do we apply? 15x? 20x? How much is too much?
Now things are getting interesting…
Hypothesis #3: Multiples
The question of what multiple is a great one.
And look, I don’t have any brilliant answers. But I can offer you some “guard-rails”.
Typically with interest rates north of 4.50% (where I think that’s conservative) – paying more than 16x forward earnings is aggressive.
Put another way, it’s a higher risk bet. Companies have to grow faster.
Now by way of comparison – over the past 100 years – the market has averaged a forward PE of ~15.5x forward.
It goes higher when rates are held at zero (combined with quantitative easing); and it dives lower during times of tightening (as treasuries offer an alternative).
For example, last year the forward PE was around 21x with rates at zero and the Fed printing money as fast as it could.
Now things have changed.
A year ago the 2-year yield was basically zero. Today these same notes offer a risk free 4.50%.
Heck – even my savings account with Goldman Sachs (Marcus) is earning above 3.0%
That’s a very attractive bet in this market… something we have not seen in well over a decade.
(n.b., I’m always a big fan of lenders actually being paid to lend… as there should be a price for money. What’s more – this lowers the risk of capital being mis-priced – which leads to distorted asset bubbles)
So let’s assume a market multiple of say 16x next year (the higher end).
That’s still above the 100-year average and ideally we would aim to buy it lower.
If we plug in $200 EPS for the S&P 500 and multiply that by 16x – we get 3200
And as readers will know – that has been my target (sharing the weekly chart from last week)
Again, this is the S&P 500 from last week. I will update the weekly chart at the end of this week.
Hypothesis #4: Don’t Fight the Fed
Oh how I would love a dollar for every time I have written that line on this blog the past 11 years!!
For example, see this missive from August.
That’s the overarching theme here.
I say that because I don’t pretend to know where:
- inflation will be in 1, 2 or 6 months time;
- what the Fed funds rate will be;
- what the price of crude oil will trade for; or
- how high unemployment levels will be?
But there is no shortage of people (experts?) who like to tell us every day exactly where each of these things will be!
Right?
But if you obey the simple rule of not fighting the Fed — it will serve you well.
Remember:
October’s headline CPI print was 7.7%.
Their objective is 2.0%
The only reason we saw CPI drop just 0.2% was a fall in used-car prices and some goods like apparel.
Now this tiny drop gave (some) market participants reason to conclude a 50 basis point hike in December is somehow “dovish”!
Well that’s just batshit crazy if you ask me…
I’m not buying it.
I go back to Bullard’s comment of the terminal rate hitting 5.00% next year.
Some in the mainstream were criticizing him today saying he’s being way too aggressive… I didn’t think so.
If anything, it was rationale.
Again, CPI for October was 7.7%.
We will be lucky if it falls to 7.5% for November (as things like fuel, energy and airfares all rise)
How is 5.00% being overly aggressive?
I’m of the view that we will see continual tightening.
And whilst it may not be continual monthly 75 bps hikes (that is extreme) – we still have further to go.
And until we see a material trend lower in inflation (i.e., 3 or 4 consecutive months); and more importantly – a deterioration in employment – why would the Fed get dovish (i.e., move to cutting rates vs just pausing)
Note: we got more robust news on the jobs market again today – despite tech layoffs.
Putting it All Together
I might be wrong with all four points.
For example, we may not have a recession next year.
And we could see earnings expand (not decline); and multiples could go back to 18x to 19x (where they are today)
What’s more, maybe trying to precisely time the Fed’s inevitable pivot to rate cuts may work for you.
I am just not that smart to get it right.
We will get more inflation (and employment data) soon – which will shape the course of monetary policy.
For example, Dec 13th we get November CPI.
Here’s my thinking:
If we do see a meaningful reduction (e.g. below 7.5%) – you will most likely see a bounce in equities.
On the flip side, if CPI comes in at 7.7% or above, you could see the opposite.
That will remind readers of the (heavy) lift the Fed has ahead – causing them to be more cautious.
But as I said in my last missive – with services sector inflation still high – I’m leaning towards a 7.5%+ number
What’s the bottom line:
Continue to act with patience.
It can be hard and it’s tempting to think the lows are in.
And they might well be in for 2022…
But my bet is we make new lows in 2023.
And if we see the S&P 500 at 3200… don’t be afraid to step up to the plate with a 3-year lens.