Market Update - March 2023 | |
We are used to rapid travel and modern electronics, but the normal evolution of markets is much slower. Even as the Fed faces higher inflation and pressure to raise rates, talk of market bottoms and rate cuts permeates Wall Street research. We are not "there", yet, in our view. | |
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During February, stock and bond markets fell as January inflation came in higher than expected along with hints of higher interest rates from the Federal Reserve.
- Economic data continues to be mixed. The service economy is doing great, the consumer is spending, but manufacturing is slowing down.
- Our view is that stock market just finished another bear market rally. The Fed is still raising rates, inflation is high, employment is strong and bad news is coming out slowly. Conversely, the slowing of the economy is pulling down inflation which should be bullish for bonds.
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Table 1: Market performance estimate as of 2/28/2023 (LIMW) | |
During February, all major markets fell to one degree or another. Emerging markets, international debt, and gold fell the most as the US Dollar rallied. The US Dollar itself is reacting to rising expectations of higher interest rates. The market is saying that if inflation is not falling as rapidly as late 2022, then the pain required to slow down our service economy will be more severe. | |
January's inflation reading was disappointing | |
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Without going into all the details, January's inflation reading was very disappointing for those predicting a rapid fall in inflation, an imminent halt to Fed rate increases and hopes of a soft landing.
Not only was January's reading high, but November and December readings were also adjusted up. Now to be fair, there were a lot of statistical adjustments made by the government, so these numbers have to used carefully.
In the year-over-year chart I like to show, you can barely see the January reading, but you can see that inflation did not falling as fast as in late 2022. There is a tendency for markets to take the latest reading and extrapolate it out forever. Our view is that we need to wait for more data to confirm a change in the inflation trajectory.
Figure 1: Headline CPI, 10-year yields, and Federal Funds interest rates (LIWM)
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Some sectors have been inflating rapidly for decades | |
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Most of us who pay the bills are aware of the ridiculous cost of health-care and education. These parts of the economy are typical of the service industries that have been inflating strongly for the last 20 years. Coincidentally, this overlaps with 2 periods, 2003-2007 and 2010-2020, when the Fed was having trouble with low inflation.
The powerful inflation impulse from the pandemic stimulus has created a major inflation issue for the country. For the first time since the 1970s, the Federal Reserve has an inflation problem on their hands. The cost of fixing this problem is still unknown, but it certainly involves higher interest rates and a recession.
Remember, the Fed has a dual mandate: maximum employment, stable prices, and moderate long-term interest rates. Today, they are completely focused on suppressing inflation.
Figure 2: Inflation of key consumer spending items (BLS, AEI)
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Economic indicators are slowing, but do not indicate a deep recession (yet) | |
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During the 2000 and 2008 recessions, there were sharp declines in all economic indicators. One of our favorite data points is the Purchasing Managers Index. The reason we like this indicator is because it comes out monthly and is very timely. Many government economic statistics come out months after the measurement period or are revised frequently.
Down below we have the broad Purchasing Manager Index (PMI) reported by the Institute for Supply Management (ISM). Additionally, we have the Non-manufacturing PMI from the same group. What we are trying to measure is the manufacturing and service economy strength over time.
We've annotated two major recessions (2009 and 2020) over the last 15 years along with the current slowdown. You can see the service economy in RED is very resilient which is why inflation is not falling faster.
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Figure 3: Purchasing manager indexes - Broad and Non-manufacturing (LIWM) | |
Large companies are starting to announce layoffs | |
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Most states require companies to publicly announce large layoffs. Even though the employment situation seems very tight now, companies are getting ready to cut back on labor. Additionally, employment data is frequently revised; the headline data points are preliminary, but they frequently move the market. There are some indications that more complete data sets of the employment situation are significantly weaker than initially thought.
This wave of layoff announcements indicate we are following the recessionary script as companies cut costs to maintain earnings. We expect more of this as we progress through the year.
Table 2: Large company layoff announcements in 2023 (Intellizence)
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Stocks are still expensive by almost every objective measure | |
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In the following table, we can see how current valuation metrics (the bars "|") compared to those of January 2022 (the "X's") when plotted against the normal historical range for each valuation metric. While valuations have fallen in general, many are still at the extreme high end of the historical range.
What that means is that investors should consider that high valuation, slowing growth and high interest rates may be significant headwinds for equity investors as we move forward.
Figure 4: Common Valuation Metrics for the S&P 500 (Schwab, Leuthold Group)
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For reference when looking at the heat map above, we've compiled a list of definitions for each metric:
Forward P/E: Divides the current S&P 500 price by 12-month forward expected operating earnings per share.
Trailing P/E: Divides the current S&P 500 price by 12-month trailing operating earnings per share.
5-year normalized P/E: Uses four years of historic earnings, two quarters of forward earnings; taking the midpoint between reported and operating earnings (a take on Shiller's CAPE, but with a shorter time span, and with an adjusted earnings calculation).
Price/book: Divides the S&P 500 price by the book value of its components per share.
Price/cash: Measures the value of the S&P 500 relative to its operating cash flow per share.
Dividend yield: Compares the current dividend yield on the S&P 500 with both historic averages and the 10-year U.S. Treasury yield. At near-equivalent yields, the market is seen as fairly valued.
Shiller's Cyclically Adjusted P/E (CAPE): Uses an inflation-adjusted price for the S&P 500 and divides by reported earnings over the prior 10 years.
Rule of 20: Stocks are considered fairly valued when the sum of the S&P 500 forward P/E ratio and the year-over-year change in the consumer price index (CPI) is equal to 20 (or inexpensive when it's below 20).
Equity risk premiums: Subtracts either the forward 10-year U.S. Treasury bond yield or the forward Baa corporate bond yield from the forward S&P 500's earnings yield (E/P). Positive readings suggest stocks are undervalued relative to bonds.
Fed model: Compares the S&P 500's earnings yield (which is the inverse of the P/E—or E/P) to the yield on long-term U.S. government bonds. Negative readings suggest favoring stocks over bonds.
Tobin's Q: Developed by Nobel Laureate James Tobin, it's a fairly simple concept, but laborious to calculate (calculations are done by the U.S. government and the ratio's readings are provided by the Fed). It's often called the Q Ratio and is the total price of the U.S. stock market divided by the replacement cost of all its companies. A high Q (greater than .85) implies overvaluation.
Market cap/GDP: Considered Warren Buffett's "favorite valuation indicator," it's the ratio of total U.S. market capitalization to gross domestic product (GDP).
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Earnings estimates continue to fall | |
One way to evaluate economic health and the trend in general growth is to look at broad measurements of earnings. One data point is the aggregate earnings of the S&P 500. In other words, we add up all the profits and losses of the S&P 500 companies and weight them by the company's weight in the index to generate a view of how corporate America is doing.
Earnings estimates for the S&P 500 are a lagging indicator, but they give you a sense for the progression of economic contractions or expansions. So far, the data indicates the peak in earnings occurred last year and now we are in the process of regular downgrades. In most recessions, broad earnings fall 20-40%. So far, 2023 estimates have fallen 12% from their high.
Notice that 2023 estimates are equal to 2022 estimates, so there is no anticipated earnings growth this year.
Figure 5: Earnings estimates by year (Schwab, Refinitiv)
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Current market commentary | |
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Equities remain in a bear market that began in January 2022. It is our view that the bear market will continue until four key factors are aligned:
- Falling inflation
- Falling employment
- Falling earnings
- Falling interest rates
So far, we have only seen modest weakness in inflation and an earnings decline of 12% from the peak in 2022. Employment and interest rates are still rising.
Figure 6: Current equity market situation (LIWM)
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Bonds are also in a bear market, but this one began in 2020, almost three years ago. Additionally, its decline from peak to trough was a record-breaking decline for bonds.
Bond investors focus on two things: inflation and defaults. With record low defaults, we can conclude that the weakness in bonds is all about the Federal Reserve's policy to let inflation run hot. It is our view that inflation peaked in June 2022 and that the bond market bottomed in October 2022 for this cycle.
Figure 7: Current bond market situation (LIWM)
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We are in the midst of a difficult bear market in stocks and bonds. The Fed is still raising rates, inflation is high but falling, earnings are weakening, and employment remains strong. We expect the Fed to continue raising rates to 5.5%, which will continue to cause problems for the stock market and economy. Conversely, this may be positive for the investment grade bond market if inflation falls as the economy slows.
We remain underweight equities as we journey into 2023 and are overweight investment grade bonds. The current bear market rally is getting stale and the Fed is unlikely to back off their tightening policy in coming months.
If you are concerned about your situation and would like to speak with us, please reach out to us at the phone numbers below.
We look forward to hearing from you!
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Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
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