Broker Check

Bottom Line—Has the Outlook Really Turned More Negative?

September 25, 2023

Before I start my newsletter, I want to clarify our stance on the markets and economy. We have been conservative in our investing since the beginning of the year because of Fed tightening, earnings slow down and the possibility of a recession. As a result, we have not seen the gains of the S&P 500 or the Nasdaq. I believe much of those gains will be given back in the next several months. So we remain conservative and will enter a more aggressive stance when the markets fall at least 10%. 

Bottom Line—Has the Outlook Really Turned More Negative? 

Stocks dropped last week thanks to rising yields and a more- hawkish-than-expected Fed.

The S&P 500 traded down to the lower end of the fair value range we presented in the September Market Multiple Table (4,320) and given current fundamentals, while that level could be broken on a short-term basis by selling momentum, we think fundamentally it should hold beyond the short term. 

Put differently, the outlook for stocks didn’t get materially worse last week, but it did get a bit worse and that was reflected in prices. Given the current state of affairs, the issue for this market is more that it lacks a viable upside catalyst more than anything else. Here’s why. 

Economic growth is slowing. That’s not really debatable. But what is very debatable is how much it will slow and, for now, that answer appears to be “not that much.” 

Additionally, the Fed is going to keep rates higher for longer. Importantly (and it’s key to understand this distinction) the Fed didn’t get more hawkish last week. For that to happen, the Fed would need to hint at more rate hikes than currently expected and that would be a significant negative. That did not happen. What did happen was the Fed pushed back on the market’s ultimately dovish expectations and emphasized through the dots that it will not be getting less hawkish any time soon. That impacts 1) Investor psychology and 2) Valuations, as structurally higher yields require a lower stock multiple. Essentially, the inflation optimists are counting on “Immaculate Disinflation,” where inflation magically evaporates while growth doesn’t slow. That doesn’t exactly jive with anyone’s understanding of economics, but nonetheless, that’s what’s happened so far in 2023. The question, of course, is whether that can continue, and there are plenty of reasons to be skeptical. 

None of those realities (growth slowing but we don’t know by how much, Fed keeping rates high but not raising them anymore and whether disinflation continues with resilient growth) are directly negative for stocks, because all of them can be resolved positively. However, they also can be resolved negatively, so for stocks to sustainably rally from here, we need more proof each of those three realities will be resolved positively, and we’re just not getting it right now. 

So, I’d expect the S&P 500 to remain rangebound in our “Fair Value” level from the September MMT between 4,320-4,560 until such time as the fundamentals imply that either the positive scenario occurs: The economy isn’t slowing very much (or stops slowing), the Fed truly won’t get any more hawkish, and disinflation continues towards target. Or the negative scenario occurs: The economy begins to slow more quickly than expected, the Fed threatens to get more hawkish or inflation bounces back. 

We will tell you which one is going to occur, as early as we possibly can, because that will be the time to either 1) Seize an opportunity ahead of a breakout or 2) Get seriously defensive in anticipation of a breakdown. 



We have plenty of data reports to go, but, so far, the third quarter is shaping up to be a strong one for the US economy. The Atlanta Fed’s GDP Now model is tracking a Real GDP growth rate of 4.9% for Q3, which would be the fastest quarterly growth rate since the earlier part of the COVID recovery.

Our models aren’t tracking quite so high but are projecting growth at about a 4.0% rate, still strong by the standards of the past couple of decades.

However, we would not get too excited about what’s happening in the third quarter and don’t think one quarter of strong economic growth means a recession is off the table.

The economy is likely feeling the last positive remnants of the surge in the money supply in 2020-21. The lags between monetary policy and the economy have always been long and variable, as Milton Friedman taught us. Beyond the third quarter, the economy is likely to show more of the effects of the drop in the M2 measure of the money supply from mid-2022 through early 2023.

Another reason we think the third quarter is a head-fake is that deficit spending by the federal government is very unlikely to expand in 2024 like it has in 2023. Were it not for President Biden announcing his student loan debt forgiveness plan last year the budget deficit would have been 4.0% of GDP in Fiscal Year 2022, high but not extraordinary.

And if it hadn’t been for the Supreme Court striking down that plan this year, the deficit would have been about 7.8% of GDP for Fiscal Year 2023, well beyond even the highest deficit under President Reagan in the 1980s and all while the unemployment rate is averaging about 3.6%.

The rise in the deficit of almost four percentage points of GDP with the unemployment rate so low is unprecedented. Other prior leaps in the deficit of this magnitude have been during major wars or recessions, not when the US is at peace and the unemployment rate is unusually low.

In particular, the way some of the extra deficit spending is structured looks designed to temporarily and artificially boost economic growth. The CHIPS Act, for example, is encouraging private investment in chip manufacturing facilities in the US. So far this year (through July), private spending to construct manufacturing facilities in the computer, electronic, and electrical sector are up 228% versus the same period in 2022.

But these buildings don’t have to be rebuilt every year. Sometime soon the gains in this sector will dwindle and reverse, with collateral damage to other sectors, like trucking.

To be clear, we do not believe government spending is a positive for long-term growth. In fact, it often distorts and diminishes overall activity. However, in the short-term, as we saw during COVID (and apparently this year as well) it can make the economy look stronger than it really is. A price will be paid, and as all this extra stimulus wears off a recession is highly likely. We don’t see how it is avoided.

The next recession is unlikely to be as devasting as the ones in 2008-09 or 2020. But our view remains that a recession is on the way. 

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