Wall Street Looking Ahead to the Fed’s Inevitable Monetary Policy Pivot


By Victor Sperandeo with the Curmudgeon  

Market Review:

The equity markets are rallying into the consensus for a +25bps rate hike at the end of next week’s FOMC meeting on February 1st.  However, it should be noted that some Fed watchers say there could be a +50bps increase, because the market has rallied too much?

The debt markets were slightly down last week as yields rose while precious metal markets were slightly higher. 

All that was to be expected.

Missing from the Economic Data:

What is not showing up in the reported U.S. economic data is any material weakness in employment (initial jobless claims decreased last week despite huge big tech layoffs) or overall economic weakness that would reflect a recession (real GDP increased at an annual rate of 2.9% in the 4th quarter of 2022 after a 3.2% increase in the 3rd quarter).

For sure, economic growth is slowing. Business investment grew at only 1.4% in the 4th quarter, but that was almost entirely inventory growth. Nonresidential investment, a key driver of future economic growth, was up just 0.7%.

Residential investment fell a steep 26.7% as consumers were unable to afford the combination of high home prices, high interest rates and falling real incomes.  Indeed, real disposable income fell over $1 trillion in 2022.  That’s the second-largest percentage drop in real disposable income ever, behind only 1932, the worst year of the Great Depression. To keep up with inflation, consumers are depleting their savings.

However, corporate earnings are not moving down so the relative strength of stocks continues to move up.

Stocks vs. Gold:

Several months ago, we wrote that stocks perform better than gold during inflationary periods.  That’s because public companies can raise prices and pay dividends, while precious metals do not. I stated that stocks go down when the Fed tightens credit which causes earnings to decline.  Then gold will go up as stocks go down.

To some degree this has occurred, but a big equity bear market --- on the order of a -50% decline (like in 2000-2002 and 2008-2009) --- has not occurred because earnings have NOT YET declined. Indeed, the bigger companies still have “pricing power” and maintained margins by raising prices.  Until now, their stocks have held up reasonably well because of that.

Are Earnings Estimates Too High?

Many analysts believe that corporate earnings estimates are too high. According to Jurrien Timmer, Fidelity’s Director of Global Macro, earnings growth expectations for 2023 have declined from +9.4% last summer to +1.3% now (still positive but falling). The 2024 estimate is RISING and is now at +10.3%.  That is very optimistic!

Some analysts think earnings estimates will come down in a big way.  Morgan Stanley strategist Michael Wilson warned on Monday that plunging forward-looking indicators will translate into an earnings recession and will end up hitting U.S. equity markets. Recent optimism around a less hawkish Federal Reserve, China reopening, and a weaker dollar is already priced into share prices, he wrote in a note.

“The question is when will equity indices price the current weakness in the leading data and the eventual weakness in the hard data?” said the strategist, who ranked No. 1 in last year’s Institutional Investor survey. “We think it’s this calendar quarter.”

JP Morgan Chase & Co. strategist Mislav Matejka says the earnings environment will be particularly challenging this year.  Corporate pricing power is starting to reverse, just as profit margins are near record-high in the U.S. and in Europe.

“Even if companies do not disappoint for the fourth quarter 2022, we do not believe EPS upgrades will come in the first half of this year,” Matejka wrote in a note.

Is the U.S. Stock Market Overvalued?

The current S&P500 10-year P/E Ratio is 29.3. That is 45% above the modern-era market average of 19.6, putting the current P/E at 1.1 standard deviations above the modern-era average. This suggests that the market is currently very overvalued.

According to the Estimite website, the U.S. stock market currently appears to be overvalued by 40%.  It would take a 28% drop to bring the market back to its long-run equilibrium level. At the last all-time high, on November 8, 2021, the market was 82.5% overvalued. In comparison, at the peak of the Dot-com bubble, on March 24, 2000, the market was 91.7% overvalued. When the market bottomed out 2.5 years later, it had dropped 50.2% from its previous all-time high and was undervalued by 18.6%.

“These estimates are based on a model that is inspired by Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE). We find the CAPE measure preferable to the market cap-to-GNP ratio, as it accounts for long-term changes in the ratio of corporate profits to GNP. The model estimates the long-run equilibrium between stock market capitalization and cyclically adjusted corporate earnings.”

The fact that the market currently appears overvalued does not necessarily mean it will correct back any time soon. The forces pulling the market toward the long-run equilibrium are relatively weak and allow the market to stay over- or undervalued for extended periods of time: From 1954 to 1970, the market stayed continuously overvalued for over 15 years, and from 1973 until 1987, it stayed undervalued for about 14 years.

Inverted Yield Curve and LEI Screaming RECESSION:

We’ve stated for months that the U.S. Treasury yield curve has been the most inverted since at least 1982.  Yield curve inversions that last longer tend to have more predictive power of a recession.  And this one has lasted for many months!

Equally important is the Conference Board’s Leading Economic Index (LEI) which has declined for 12 consecutive months and that decline has accelerated recently.  The U.S. LEI decreased by 1.0% in December 2022 to 110.5 (2016=100), following a decline of 1.1% in November. The LEI is now down 4.2% over the six-month period between June and December 2022—a much steeper rate of decline than its 1.9% contraction over the previous six-month period (December 2021–June 2022).

“The US LEI fell sharply again in December—continuing to signal recession for the US economy in the near term,” said Ataman Ozyildirim, Senior Director, Economics, at The Conference Board.

Chart, line chart

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Source: Conference Board

“There was widespread weakness among leading indicators in December, indicating deteriorating conditions for labor markets, manufacturing, housing construction, and financial markets in the months ahead. Meanwhile, the coincident economic index (CEI) has not weakened in the same fashion as the LEI because labor market related indicators (employment and personal income) remain robust. Nonetheless, industrial production— also a component of the CEI—fell for the third straight month. Overall economic activity is likely to turn negative in the coming quarters before picking up again in the final quarter of 2023.”

What Might Change Fed Monetary Policy?

BofA’s U.S. economist Mike Gapen expects the Fed to hike rates by 25bps three more times and believes the market is pricing in rate cuts too early.

In order for the Fed to pivot (i.e., to stop raising rates and then lower them), we need far more economic weakness, or a crisis event, such as an expansion of “credit spreads” on BBB and CCC rated corporate debt. I believe we will get that.

Normally, when the Fed raises or lowers rates it takes 9 to 12 months to have an economic consequence. Since rates were first raised in March 2022, the negative economic impact will start hitting the economy now, with greater effects in four months.

It’s a virtual guarantee the U.S. will be in a recession from a monetary view as M2 has declined year over year!

A clearly evident recession will cause the Fed to pivot, while the U.S. budget deficit will be much larger than now forecast. 

The U.S. national debt could grow to $36 trillion by 2025!  Pundits say debt doesn’t matter till it does.  When is a question of psychology. The tipping point will be a loss of confidence in the U.S. dollar, as we’ve stated for the last 10 years in these Sperandeo/Curmudgeon blog posts. 

Critical Note on the War in Ukraine:

The most important thing for all of us now is not what the Fed does or how markets react.  It is the escalation of the war in Ukraine.  On Wednesday, the U.S. and Germany said they will send contingents of tanks to Ukraine, reversing their longstanding trepidation at providing Kyiv with offensive armored vehicles and unleashing powerful new tools in Ukraine’s efforts to retake territory seized by Russia.

German Chancellor Olaf Scholz’s announcement that he will send Leopard 2 tanks was coupled with U.S. stating it would provide 31 M1 Abrams tanks to Ukraine, reversing the administration’s longstanding resistance to requests from Kyiv for the highly sophisticated but maintenance-heavy vehicles.

“As of today, numerous countries have officially confirmed their agreement to deliver 321 heavy tanks to Ukraine,” said Vadym Omelchenko, Kyiv’s ambassador to France on Friday.

Russia responded with a warning to the West.  Dmitry Peskov, Russian President Vladimir Putin’s spokesperson, said in the state-owned outlet Tass: “Moscow perceives everything that both the alliance and the capitals I mentioned have been doing as direct involvement in the conflict. We see that it is growing.”


Victor’s Conclusions:

The widening of the conflict in Ukraine could lead to World War III, which would be the end of all markets!  Biden said that in March when he chose not to send jets and tanks to Ukraine because doing so would be a dangerous escalation.

“The idea that we’re going to send in offensive equipment and have planes and tanks and trains going in with American pilots and American crews — just understand, don’t kid yourself, no matter what y’all say, that’s called World War III,” Biden said on March 11, 2022, while speaking at a gathering of House Democrats in Philadelphia.

The contradictions and provocation effects are not talked about in the mainstream media. Where is the outrage?

Cartoon of the Week:


Be well, stay healthy, warm, and dry. Till next time…...


The Curmudgeon

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies, and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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