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The writer is president of Yardeni Research
In my opinion, investors have turned too pessimistic about the outlook for the US economy and stock market. I don’t recall so much stock market bearishness in a very long time.
I think it’s mostly because the “Fed put” is kaput. The US Federal Reserve has long been expected to step in to bail out markets whenever things get tricky. But now it can no longer be counted on to do so. That’s because inflation hasn’t been as serious a problem as it is today since the 1970s.
The Fed finally acknowledged as much late last year and has increasingly pivoted away from its dovish stance during 2020 and 2021 and started to tighten monetary policy. It is widely expected to have no choice but to raise the benchmark federal funds rate to higher than 2 per cent to subdue inflation. However, the vigilantes in the bond market have already tightened credit conditions significantly.
The 2-year US Treasury note yield, which tends to lead the federal funds rate, has soared from just 0.16 per cent a year ago to 2.68 per cent on Friday. The 10-year US Treasury bond yield soared from a record low of 0.51 per cent on July 31 last year to 3.13 per cent on Friday. The 30-year mortgage rate jumped from 3.29 per cent at the start of this year to 5.45 per cent last week.
As a result, the Nasdaq fell 24.4 per cent into a bear market from its record high on November 19 to Friday, and the S&P 500 is down 14.0 per cent from its record high on January 3.
Over this same period, the ratio of the price to forecast earnings of the S&P 500 has fallen from 21.5 to 17.5. That reflects the drop in the S&P 500 index as well as the increase in the expected earnings per share of its constituents.
That’s right — while investors are reducing the valuation multiple they are willing to pay for consensus earnings, analysts have been raising those very same earnings projections! To some extent, the downward re-rating of the forward PE ratio makes sense since it tends to be inversely correlated with inflation and bond yields, both of which are rising. But it also indicates that investors are much more concerned than industry analysts are that tighter financial conditions will cause a recession.
I am siding with the analysts even though they are not particularly good at anticipating recessions. On the other hand, investors have been prone to numerous panic attacks since the 2008 financial crisis about imminent recessions that haven’t occurred.
On the positive side of the ledger for the outlook, US consumers are in good shape. They are upset about inflation, but the labour market is tight and many employees are quitting jobs for better pay. And consumers have accumulated lots of savings since the start of the pandemic.
Meanwhile, non-financial corporations have refinanced debts and still have plenty of cash on their balance sheets after raising $2.3tn in the bond market over the past 24 months to the end of March. Past recessions have usually been caused by credit crunches resulting from Fed tightening. I doubt that’s likely now with M2 money supply exceeding its pre-pandemic trend by $3tn currently. I expect inflation will peak this summer between 6-7 per cent and fall to 3-4 per cent next year without a recession. Consumer durable goods inflation has been especially hot over the past year and is likely to cool over the year ahead as pent-up demand has largely been satiated. Supply chain disruptions should also abate.
Most of the drop in the S&P 500’s valuation multiple so far this year has been attributable to eight mega-cap stocks — Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla. Currently, they account for 23 per cent of the market capitalisation of the index. Their collective forward PE ratio soared during the first year of the pandemic to about 35.0, and stayed around there last year. It is now down to 25.
On the other hand, the S&P 500 energy sector has been a significant outperformer this year. There have also been opportunities to make money in “economic reopening” trades as investors reduced their bets on consumer goods and increased their positions in consumer services. Financials, especially insurance-related ones, have also done well. Another winning group of industries are ones related to food production and retailing. There are lots of good opportunities to buy stocks in the sectors that have underperformed so far this year.
The bottom line is that I am in the correction camp for now. I expect to see the S&P 500 in record high territory again next year. Contributing to that bullish outlook is the strong dollar, which suggests that global investors see the US as a haven in our turbulent world.
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