Current major issues facing the market that will determine the next move are: 1) Banking crisis (is it or isn’t it?) 2) Fed policy. Will they raise rates or cut rates? 3) Inflation. If it’s going to resume or decline and how much will banking stress impact it? 4) Economic growth. Will we have a painful recession? 5) Earnings: Can $225 S&P 500 EPS hold through Q1 earnings season?
These are the questions that will determine the next 10%-20% in this market, and so I want to cover the bull and bear opinions below.
If you’re a bull in this market, you must believe: 1) There is no further banking crisis. The Fed’s programs have ring fenced the crisis and Silicon Valley Bank is not the next Northern Rock or Countrywide. 2) The Fed will either stop raising rates or cut rates by year- end. 3) Inflation will continue to decline. Realistically, it’s not going to get to 2%, but the banking crisis will put enough pressure on the economy to cool inflation and it’ll get “close enough” to stop further rate increases. 4) Economic growth will stay resilient. With the Fed finally pivoting, the economy still strong and labor market still tight, the Fed will pull off a soft landing. 5) Earnings slow but not significantly. This quarter will be the last one where analysts focus on 2023 expected S&P 500 EPS (it’ll switch to 2024 expected EPS in July, which is around $240) so if 2023 expected earnings can stay around $225, then the market can maintain somewhat reasonable valuations of 17.9X next year’s earnings.
If you’re a bear in this market, you must believe: 1) There is a banking crisis. SVB is Northern Rock or Countrywide, and the fallout from this will be felt in the coming months. And that will only put additional pressure on an economy that was already going to hit a wall via rate hikes. 2) The Fed will continue to raise rates through the third quarter. 3) Inflation will not continue to decline (or decline very slowly). As we said Monday, inflation is the key. If it does not fall, then the Fed is majorly in a bind, because it can’t help growth with >5% CPI (consumer price index)! 4) Economic growth will not stay resilient. The full impact of the Fed’s rate hikes is just now being felt, and long-ago announced layoffs are just now actually occurring. The labor market will soften and the economy will hit a proverbial brick wall. 5) Earnings will slide further than expected and accelerate down. The resilience of corporate America must be respected, but these companies aren’t operating in a recessionary environment yet. As the economy slows, earnings will drop.
For a guide to what would outperform here, I wanted to look at market internals from immediately following the January jobs report (out February 4th) till March 7th (when the banking crisis took over the market narrative). That was a period defined by higher yields, sticky inflation and rising recession worries, and what outperformed during that period should offer a constructive guide to what works in that environment.
Not surprisingly, virtually everything except short-term bonds registered a negative return over this period, and the sectors that lost the “least” were 1) Energy (XLE) - 0.4%, 2) Industrials (XLI) -1.20% and 3) Consumer Staples (XLP) -2.3%. Sector laggards over this period were driven more by rising yields than anything else, as REITs got hammered (XLRE -10%) but so did tech/growth, utilities and corporate bonds. This makes sense, because in a stagflationary environment, the playbook is inflation- linked assets that people have to pay for; Energy/ commodities, value ETFs, industrials (they have some pricing power) and consumer staples. Again, the key here appears to be yields: Own things that appreciate as yields rise and avoid those that fall as yields rise.
Which One Do I Think Is More Likely?
I feel the bull case is more likely. There are two periods that some say looks like this period of time (early 2000 and 2007). I don’t believe that either one compares even closely. Both were driven by an extreme negative: 2000 markets dramatically overvalued, 2007 a collapse in the real estate and mortgage business. Today there are no major negatives other than the Fed raising interest rates. Inflation does not cause a market downturn, the Fed does. As a result, we must wait and see what happens after the Fed is done for the year. I don’t expect the Fed to lower rates but just stopping the incessant interest rate increase will likely result in a celebration for the markets.
My bullish attitude is based on a few considerations: 1) If inflation has peaked, 2) The banking crisis truly is contained and 3) If the Fed is likely to stop raising rates within the next three months.
All that said, I am a proponent of protecting at the same time that you are preparing for the positive shift. This is why I prefer a defensive approach with stocks that do well in a slow down. That would mean defensive stocks such as dividend stocks and small cap stocks that do not get as hit from a slowdown and international that appears to be poised to outperform.
Bottom line, I hope the markets and the economy can emerge from this rate hike campaign unscathed. It’s not impossible. But every ounce of experience I’ve had in in the past 4 decades tells me that this market is poised for a major move to the upside as soon as the Fed gets out of the way. Continue to read these commentaries as I follow all the numbers to determine when and how much that move will be. For now, we are wait, hold, and do not panic.
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