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The market, interest rates, and the Fed policy. Hang in there as this may be a little long...

May 10, 2022
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I have a lot to share about the market, interest rates, and the Fed policy. Hang in there as this may be a little long. 

At the end of 2021, I set out my projections for the stock market in 2022. At the time, I knew that the profits had slowed and that the markets could not sustain an 18% average return. I projected a gain of 10% this year and beyond for the balance of the secular bull market. Those projections were based on our expectations for both profit growth in 2022 and the yield on the 10-year Treasury note. At that time, given interest rates, the US stock market was still fairly valued. I don’t believe that is the case today even though I am not changing my projections. Read on to see why. 

Given the surge in long-term interest rates this year, the US stock market is now fairly valued for the first time in over a dozen years, dating back to the Panic of 2008. During many of these past twelve years, with the US stock market well under fair value year after year, I often lifted my year-end forecast during the year. Using a 2.5% yield on the ten-year treasury suggested fair value for the S&P 500 was 5,250, which became our forecast for the market at the end of 2022. 

But here we are in early May and a vicious sell-off in the bond market has pushed the 10-year yield to 3.1%, substantially higher than the end of last year and above my 2.5% estimate. This higher yield makes a world of difference in how I see the stock market. Using a yield of 3.13% and fourth-quarter profits suggests we were already at fair value as of Friday, with the S&P 500 closing Friday near 4,100. Again, I am using fourth-quarter earnings, not the first quarter. 

I think the outlook through year-end suggests a larger gain than normal when stocks are at fair value. First, some investors are already pricing in a recession for this year or early 2023. But I am not so sure. As the most pessimistic investors realize they were wrong, that’s an adjustment that should drive equities upward. It’s a classic wall of worry that can help boost stocks, with bad news in the near term already over-priced in. One way to think about this is to look at the yield curve. When the Fed gets too tight, the bond market starts to signal that the Fed will need to reverse course, and short-term rates rise above long-term rates – an inverted yield curve. 

That is not happening today. Long-term rates have been rising faster than short-term rates, and the yield curve has steepened. The reopening of the economy following the pandemic is still underway, and we still expect profits to rise this year as the first quarter indicates…read my assessment at the end of this commentary. 

Second, some investors are concerned about a wider war in Eastern Europe, perhaps triggering NATO’s call for mutual defense, which could lead to World War III. I think the conflict is more likely to be contained to Ukraine and as the weeks and months pass without a widening of the conflict, that’s another wall of worry for stocks to climb. 

Third, I think the stars are aligned for large Republican gains in the House and Senate, even after factoring in what appears to be an overturning of Roe vs Wade. Our best guess is that the GOP ends up with a solid House majority near the post-world War II high-water mark of 247 seats (of 435 total) set in the 2014 mid-term election. In addition, it looks like the GOP is heading toward about 53 Senate seats. This is not to say Republican wins are always good for equities; they’re not, far from it. It is to say that in the current political situation a Republican Congress creates a divided government where the odds of tax hikes would be dead at the same time the Judicial Branch is taking a tougher line on federal regulations. 

Put it all together, and I think there’s a recipe here for an equity rally into year-end with the S&P 500 ending the year at 4,900 and the Dow at 39,000. However, assuming some modest increases in interest rates from here, such a rally would also put the stock market in overvalued territory. So the rally I am projecting would be something for equity investors to enjoy, but not a reason to become complacent. For now, my best guess is that the next recession starts in the Spring or Summer of 2024 if at all.

If so, equity gains from our projected year-end level would be limited and it might be time then to think about a significant, albeit temporary, shift in the investment outlook. I would look at adjusting the asset mix to reflect a temporary downturn in the economy. 

One issue making the current environment even more uncertain is that the Federal Reserve is trying to reverse course for the first time under a brand-new monetary regime. Quantitative easing/tightening, along with the payment of interest to banks on the reserves they hold at the Fed, has never faced a test like it does today. As I reflect on the mistakes of the Fed over the past 50 years, I believe they are guessing that current policy would create a soft landing…we will see. 

Under monetary policy before 2008, interest rates and bank reserves were connected. The Fed operated with a “scarce reserve” model. If they pulled reserves down, the federal funds rate would go up. If they added reserves, the rate would fall. But now, interest rates and bank reserves are decoupled. In other words, the Fed can push rates up without changing the amount of money on its balance sheet. In fact, that is what it has done in recent months. 

The Fed has lifted interest rates twice (by a total of 75 bps) but has not done any quantitative tightening. In other words, the Fed has not become tight, just moderately less loose. We do not know, and neither does the Fed, whether the interest rate it pays banks on reserves will actually slow down the growth of the money supply. The bottom line is that recessions typically happen when the Fed tightens too much. And with inflation well above current interest rate levels, the yield curve positively sloped, and the money supply still expanding, the Fed is not tight. It would take a recession for me to believe that a true bear market, not just a correction, would occur. Right now, I do not expect a recession in 2022.

Here is the news on the first-quarter profits. According to FactSet Research, we have seen 87 percent of the S&P 500 report earnings for the first quarter of 2022. Of the 435 companies that have reported, 79 percent have beaten earnings expectations, 3 percent have met expectations and 19 percent have fallen short of expectations. When looking at revenue expectations, 74 percent of the companies that have reported have either beaten or met expectations while 26 percent have fallen short. The overall blended earnings growth rate for the S&P 500 for Q1 2022 is currently 9.1 percent. While 9.1 percent may seem like a high number, it is actually the lowest quarterly growth rate for the S&P 500 since the fourth quarter of 2020. Forward-looking guidance given by companies that have reported has also been pretty weak with 70 percent of the guidance being negative. This week is the start of the big slowdown for earnings reporting as there are fewer than 200 sizable companies set to report their results. This is not a surprise to me as I have predicted a slowdown in earnings, albeit still strong. 

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