Bear market rally or off to the races?
Phew, I haven’t had a ride like that since my kids took me on a rollercoaster at Disneyworld. After dropping 12.5% year to date and 4.7% in March at the lows, the equity market leapt 8.6% from the bottom to finish up 3.6% in March and -5% YTD.
Equity Roller Coaster Ride
The bounce was driven by 3 factors. First, short-term sentiment bottomed. The constant barrage of bad news regarding war in Ukraine, inflation, and rising interest rates had run its course (for now). Sentiment was so bad it was hard to get any more negative. When this occurs, equities often snap back in a relief rally.
Second, hope for a path toward resolving the war in Ukraine began to emerge. Unfortunately, it was not fast enough to prevent further bloodshed. But markets are forward looking and see a path toward resolution.
Third, post the March 16 Fed meeting markets started to believe the Fed hiking cycle was fully reflected in the forward rates curve. In laymen’s terms: Rates won’t get much worse so it’s OK to buy.
As the Fed Funds Futures curve in Exhibit 2 shows, markets have priced in nearly 3% Fed Funds out 2 years, up from 1.5% at the beginning of the year. Fed Funds topped out at 2.5% in 2018-2019, the last “normal” economic period, before Fed Chair Powell was forced to ease again. Traders are betting that it is unlikely rates will move much higher during this hiking cycle before the Fed needs to reverse course.
Futures Market Pricing in 3% Fed Funds in 2024
If that is the case—it’s a big if—markets are pricing in the top in rates with the belief inflation will be tamed and the Fed will eventually return to an accommodative stance so economic growth can resume. That’s a lot of “ifs”. But there is still a lot of excess liquidity in the US that needs a place to invest. With inflation potentially peaking soon and earnings news seemingly OK for at least the first quarter, investors are willing to take a shot that the Fed will thread the needle, and all will be well.
Is this the correct interpretation?
Post the equity run-up, markets are at an impasse until more data arrives. From Stableford’s perspective it looks like all the good news is baked in unless earnings can move materially higher. That seems unlikely as government fiscal stimulus rolls off, inflation reduces consumer purchasing power, and higher labor costs cut into corporate profits.
In addition, equity valuations at ~20x 2022 EPS are very high relative to interest rates. After spiking 51 basis points in March, 10 Year US Treasury Yields hit 2.34% (Exhibit 3), a level not seen since mid-2019. With rates this high a fair equity market PE would be closer to 16-18x, or 10-20% lower. Add on top of that the risk of earnings falling as fiscal stimulus wanes and the run up seems overdone.
Bond Yields Increase to Levels Last Seen in Mid-2019
Where can we look for clues about the future?
The ISM Manufacturing survey is a data series we have been focused on as a tell-tale. Historically the S&P 500 tracks the ISM Manufacturing. Within the ISM, the orders component is a good measure of where the overall survey is heading.
Last week, ISM orders fell below inventories for the first time in the current business cycle. Think of this as a book to bill ratio for the economy (if orders are growing slower than inventories you eventually need to slow orders and production, lest you get stuck with too much inventory). We view this as critical, given all the double ordering companies have done to ensure they can continue production (think semi-conductors). This implies further downside for the headline ISM. And as the charts below indicate, this is an ominous sign for the equities market should ISM continue lower.
ISM New Orders – Inventories Bodes Poorly for ISM Manufacturing Headline Index…
ISM Manufacturing PMI May Be Ominous for S&P 500
April brings…tax season and financial planning
Tax season often brings thoughts of updated financial plans. Please let us know how we may be of assistance in any of your financial planning needs.
Are you interested in making portfolio changes or getting a more in-depth analysis? Contact Stableford today by calling 480.493.2300 or simply request a copy of our Market Blast.
This market commentary was written and produced by Stableford Capital, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 INDEX: The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.