The Outlook: On Watch for SPX 2500 by Q1 2024
But first, a "free lunch" April Fools' Squeeze to SPX 4200 is in process.
Executive Summary
On March 22, Fed Chair Jerome Powell outlined in the most transparent terms to-date that the Fed is actively driving the US economy into a recession of unknown severity.
Bond market pricing strongly suggests the recession will be severe, with the unemployment likely moving above 5% by the end of this year.
With a potentially severe recession as the high probability outlook for the US economy, the outlook for the S&P 500 has become crystal clear. Historically, the SPX tends to bottom in recessionary bear markets between 10x and 15x cycle peak EPS, which for this cycle implies a range of 2000-3000.
More important than valuation is the macro condition set that will identify when the SPX has likely entered a durable bottoming process. Condition number one is a rise in the unemployment rate of at least 1.3%. Number two is a drop in the 3y/10y US Treasury curve to 100%. Once those conditions are met, regardless of its valuation the S&P 500 is likely near a durable low.
But first things first. The S&P 500 is currently in a “free lunch” zone of lower rates in anticipation of Fed rate cuts in 2H23 without an obvious deterioration in economic and earnings data. With sentiment still bearish in the wake of the banking crisis, there is room for the SPX to squeeze higher to around 4200 sometime in April. Call it the April Fools’ Squeeze.
Once economic data turn lower in earnest starting in late April and into May, look for the S&P 500 to work down to 2500 by Q1 2024. If the Fed starts cutting rates aggressively at 2500, that is likely the low. But if they stick with their “anti-Burns reaction function” at 2500, look for a final move to 2000 before all is said and done.
The political reality of the 2024 POTUS election is such that a powerful rally in the equity market can be expected starting in early 2024.
Discussion
With the following exchange at his March 22 press conference, Fed Chair Jerome Powell revealed in perhaps the most transparent terms to-date that the Fed is in the process of driving the US economy into a recession of unknown severity (aka a “hard landing”):
Reporter: “I guess the question is, historically, it’s been hard to contain unemployment. Do you worry about some sort of snowball effect, and how do you factor that into your projections and your thoughts?”
Powell: “Recessions tend to be nonlinear, and so they’re very hard to model. You know, the models all work in a kind of linear way—if you have more of this, you get more of that. But when a recession happens, the reactions tend to be nonlinear - so we don’t know whether that’ll happen this time. We don’t know - if so, we don’t know how significant it will be, and so, you know, we’re very focused on getting inflation down because we know in the longer run that that is the thing that will most benefit the people we serve.”
As outlined in its March SEP, the Fed’s published base case outlook for the US economy and monetary policy by December 2023 is a 4.5% unemployment rate, 3.6% core PCE inflation, and a 5.1% Fed Funds Rate (FFR). Bloomberg’s aggregation of private economic forecasts confirms the private sector has largely taken onboard the Fed’s plan, projecting a 4.3% unemployment rate, 3.5% core PCE inflation, and a 5.1% FFR.
Financial markets, on the other hand, have thrown the Fed’s plan overboard. The Overnight Indexed Swaps (OIS) market currently projects the FFR to peak at 5% in May, rate cuts to start in July, and the FFR to end the year almost 40 basis points below where it currently sits.
Given the Fed’s steadfast commitment to not repeating the “stop and go” policy error of the Burns Fed in the 1970s, and the stickiness of above-target underlying inflation and wage growth, it is extraordinarily unlikely the Fed will begin cutting rates so soon after terminating its hiking cycle unless the economy is currently in a recession that is clearly on track to push the unemployment rate well above the Fed’s 4.5% target by year-end. In other words, if the OIS market is correct that the Fed will begin cutting in July, just two meetings after the final hike, the economy needs to start aggressively shedding jobs probably as soon as April.
Just yesterday, the relatively dovish FRB Richmond President Barkin reiterated the lesson from the 1970s:
“Let me now turn to our most recent meeting. I saw substantial inflationary pressure and a resilient banking system. So, I supported raising rates 25 basis points. I am heavily influenced by the experience of the 70s. If you back off on inflation too soon, inflation comes back stronger, requiring the Fed to do even more, with even more damage. With inflation high, broad-based and persistent, I didn’t want to take that risk.”
This laser-focus on 1970s is the “anti-Burns reaction function” The WOTE has discussed so extensively, starting with the January 11 post “Framing the “Arthur Burns Risk” to the S&P 500” and most recently in “The Ketchup is Finally Out”. In simple summary, it means the Fed will be dogmatically resistant to cutting interest rates as the unemployment rate rises. Back in January, FRB Minnesota President Neel Kashkari framed it well when he told the New York Times: “If inflation were to fall to 3% with unemployment increasing to 6%, things could get tricky.”
Perhaps the most commonly cited reason for the OIS market to price in rate cuts so soon after the Fed reaches the terminal rate is that “truflation” is falling faster than the official statistics, and therefore once the official statistics catch up to “truflation” the Fed will realize it has tightened too much and can start backing off via rate cuts, especially if concurrent with a fall in YoY measures of inflation the unemployment rate begins to tick up.
The problem is that the key YoY measures of underlying inflation (core, median, trimmed mean, etc) that the Fed is focused on have not improved at all over the last year, let alone to the extent of the fall in the “truflation” gauge from 12% to 4%. It’s just not mathematically possible for the Fed’s dashboard of underlying inflation and wage data to improve enough by July for them to start cutting rates.
So, we are left with one of two possibilities: either the OIS market is wrong, or the economy is currently in a recession that is on track to push the unemployment rate well above the Fed’s 4.5% target by year-end.
The pushback to this binary way of looking at OIS market pricing will be that it’s simply the OIS market probabilistically weighing the chance of the economy slipping into a more severe recession than expected, not necessarily a hard and fast projection. The problem with that pushback is the fact OIS is pricing cuts so soon after the hiking cycle terminates, which in The WOTE’s opinion indicates a very high probability that the Fed finally “cracked” the economy and data should start deteriorating quite quickly in the coming months.
Nonlinearity^2
As referenced in the closing to “The Ketchup is Finally Out”, last November Bridgewater’s Greg Jensen said the following with regard to the Fed tightening to the point of “cracking” the US economy:
“I believe the bigger thing is it’s going to be a crack, and a very hard-to-stimulate crack, and that the crack is actually going to be quite large.”
“I think the Fed, because of inflation, they’re going to lag the real economy on purpose because they don’t want to ease too soon, which is a totally different type of easing than they’ve had over the last 30 years were they always eased when assets went down. So this is I think hugely dangerous that they’re not going to ease, that they’re going to keep looking at inflation, and they’re not going to ease even as the slowdown begins to become entrenched. They actually want that.”
In The WOTE’s opinion, in the absence of obviously deteriorating real-time economic data, the best quantitative evidence that this crack is in place is the extent to which the 6-Month US Treasury Bill yield is trading above the 2-Year Note yield (20%) with the Conference Board Leading Indicator deeply negative on a YoY basis.
The 6M Bill yield trading at a 20% premium to the 2Y Note yield is the bond market waving the white flag to the Fed on behalf of the economy, pleading for monetary policy relief. Historically, the Fed has responded with rate cuts. But as communicated by Powell on March 22, this time the Fed wants an economic contraction in order to bring underlying inflation and wage growth back in line with its 2% target, so by design the Fed is going to be late to ease monetary policy, as discussed by Greg Jensen in the quote above.
In his March 22 press conference Powell mentioned the “nonlinearity” of recessions. Typically the Fed is easing monetary policy in the early stages of recession, yet recessions almost always overshoot in their severity as measured by the unemployment rate (hence, “nonlinear”). For instance, the 2001 recession is widely considered to be mild by many measures, but the unemployment rate still rose a sturdy 250 basis points from 380 to 630.
With the Fed maintaining tight monetary policy into this recession, The WOTE’s thesis is that this economic contraction will see its nonlinearity squared, with the unemployment rate most likely rising to above 5% by year-end.
The WOTE takes in as much evidence from as many different sources as possible, including anonymous market participants on “Finance Twitter”. If you follow folks who document their views and trades in real time for long enough, you can get a pretty good sense of their efficacy, and they end up becoming a valuable and regular piece of broad market puzzle. When it comes to the economy, there is perhaps nobody better than INArteCarloDoss. On March 23 (see below) Carlo outlined a detailed view of how the economy is likely to evolve over the rest of the year, a path that is directionally aligned with The WOTE’s thesis that the unemployment rate is likely to shoot up above 5% by year-end.
What’s interesting is that The WOTE and Carlo are at odds about the current state of the economy. Carlo believes the economy is stronger than implied by the fact the OIS market is priced for rate cuts in 2H23, and thus the OIS curve should reprice higher. But in The WOTE’s opinion, if Carlo’s path for the economy as outlined above plays out, then the OIS market is more appropriately priced than not.
Regardless, the outlook is crystal clear: The unemployment rate is going substantially higher between now and year-end.
The Mother of All Set-Ups
With the equity market rallying on the perception of a free lunch - that being, Fed rate cuts in 2H23 with no recessionary impact on corporate earnings - the set-up is there for a dramatic and sudden downward repricing of equities once the Fed refuses to cut interest rates in response to obviously deteriorating economic data. Think: ISM Services PMI below 50 with the YoY change in Initial Jobless Claims marching relentlessly higher.
ISM Services is currently 55, solidly above the critical 50 threshold that separates expansion from contraction, but with little market fanfare the YoY change in Claims currently sits at 15%. As evidenced by the 2001 and 2007 recessions, once Claims get going ISM Services is not far behind.
What makes this the Mother of All Set-Ups is two-fold. Number one, because stocks are currently rallying equity market participants are actively scoffing at the notion of a severe recession - as the great Helene Meisler likes to say, “There’s nothing like price to change sentiment.” Just last night Jim Cramer said:
“Maybe the recession’s coming; maybe the credit crunch is right upon us. But until then, I think it’s pretty invisible.”
And this morning, Carl Quintanilla reported that the JPM trading desk said the market chatter is “IF we see recession, it’ll be VERY short lived.”
The complacency about the prospect of not just a recession but a likely severe one at that is mind bending in light of the fact the most powerful financial market participant in the world, Fed Chair Powell, just told us on March 22 that he is actively taking the US economy into recession in order to bring inflation back to 2% and is willing to risk a nonlinear move in the unemployment rate to complete the job of bringing inflation back to 2%. Mind. Bending.
Number two. In the 15 NBER-defined US recessions since 1929, the S&P 500 has troughed at an average P/E of 9.4 times cycle peak as-reported LTM EPS. For easy math The WOTE calls it 10-15x on average. For this cycle, peak EPS was $198 for the LTM ending 3/31/22, which puts the target SPX trough level for this recessionary bear market at 2000-3000, or 2500 at the mid point. At its current 4100, the SPX is staring down a -39% price-only decline before all is said and done.
We will look back at this period with shock and awe. But first, there is more squeeze to come.
The April Fools’ Squeeze to SPX 4200
As outlined above, stocks are rallying on the perception of a free lunch: Fed rate cuts in 2H23 without a recessionary impact on corporate earnings. Until economic data start moving lower, this actually makes sense given how NOT forward-looking the equity market is. Equities wait until negative data hit them in the face, and then they react. It’s that simple. Take 2007, for example.
In August 2007 the S&P 500 corrected -12% as the first tremors of the Great Financial Crisis began to ripple through global financial markets. The SPX promptly rebounded 15% to a new all-time high in October, not two months before a recession kicked off in December. The HY CDX index shot up above 500 bps, but then eased back to less than 350 at the October SPX ATH. At that October ATH there is little to no risk of recession priced into equities and credit.
The WOTE’s thesis is that the SVB-led banking crisis was the first major tremor of what is likely to be a severe economic contraction, as discussed at length above. But given this transitory “free lunch” period, oversold market sentiment, and the Fed's aggressive response to the banking crisis, the S&P 500 has room to run back to or slightly above the February 2 peak of 41951, ala October 2007.
What is interesting about this pre-recession period versus 2007 is that the HY CDX index is more stressed this time around (even adjusting for the fact it will continue to move lower as the SPX rallies to 4200), despite the widely held notion that this economic environment is “nothing like 2008”.
The WOTE made the case for a squeeze to 4200 on Twitter on March 29 when the sentiment index above was below 50, but with the market rallying since then the sentiment composite has since moved above 50 and will likely close today over 60. The rough target is the 70-80 range sometime in April before the SPX ultimately tops out.
Don’t get fooled. SPX 4200 will be 21 times $200 cycle peak EPS, 68% higher than the 12.5x it is likely to trade down to by Q1 2024, +/- 2.5 turns.
The Path Ahead
It’s always dangerous to try to anticipate the path of the market, but now that Powell has officially declared that the Fed is driving the economy into recession, the windshield has cleared up quite nicely. Once the SPX squeezes everyone into the market sometime in April, the market should work lower for the rest of Q2 in anticipation of the economy going off the cliff in Q3. The speed of the decline in May and June will be determined by the speed of the downturn in economic data. Assuming a steady move lower in the data, a reasonable June 30 price target for the SPX is the October 2022 low of 3490. There will likely be some demand for stocks there given it will be a widely watched “retest”, but as long as the Fed does not start cutting rates or put its QT program on pause, any bounce from there is likely to be short-lived.
The real move lower will be in Q3 when economic data speeds up to the downside and the Fed refuses to cut rates. A move down to the upper end of the SPX 2000-3000 trough target range by September 30 can be expected. The first move by the Fed in response to the economic contraction will likely be to put QT on hold, which they could very well do with the SPX at 3000 by September 30. Pausing QT is likely good for a sturdy bear market rally, but the bear market will then resume into Q1 2024 alongside further data deterioration and hesitancy by the Fed to cut rates. Once the SPX moves down to 2500, where the market moves from there is highly Fed-dependent. Even The WOTE thinks the Fed will succumb to rate cut pressure with the SPX at 2500, but if they don’t start easing at that point, then a move down to 2000 is very much in the cards.
Q1 2024 is a good spot for a bear market trough given the timing of the unemployment rate moving higher, the Fed’s unwillingness to cut rates, and, most importantly, the strong likelihood the Biden administration will do everything it can to stimulate the economy and asset prices heading into the November 2024 POTUS election.
Far more important than the timing of the bear market low is having a robust condition set for identifying a durable low. The WOTE has long viewed the Great Inflation period as the most pertinent period for analyzing the likely conditions seen at a bear market trough, and the conviction in that view has only grown with time. The key reason for this is the yield curve. In a high inflation environment, when the SPX bottoms in a recession the yield curve is never as steep as it is in a low inflation environment. So, if one waits for a dramatically steep yield curve to give the all-clear signal for stocks in the middle of a recession in a high inflation environment, one is likely to get left behind in a new bull market.
With the market rallying and equity bulls scoffing at the notion of an oncoming recession, it is very easy to get trapped into thinking the October 2022 SPX low of 3490 was THE low for this “bear market”. But two things: 1) the yield curve was nowhere close to parity, as it was at all four bear market lows in the Great Inflation period, and 2) the unemployment rate had not yet risen. 2022 was not the real bear market. The real bear market began on February 2, 2023.
The 1970 and 1974 bear market lows are most pertinent to today, as the 1980 and 1982 lows were deep into the Great Inflation with the unemployment rate running persistently high as Volcker sought to quash inflation once and for all. And for what it’s worth, 1970 is probably the single best comp. Regardless, here is the condition set at the 1970 and 1974 SPX bear market low:
1970: unemployment rate 4.8%, 1.4% higher than the 3.4% cycle trough; and the 3y/10y curve at 100%.
1974: unemployment rate 5.9%, 1.3% higher than the 4.6% cycle trough; and the 3y/10y curve at 100%.
At present, the 3y/10y UST curve is 110% and the unemployment rate is 3.6%, just .2% above the 3.4% cycle low.
The ideal scenario for a bear market low is the SPX trading at 12.5 times $200 cycle peak EPS with the 3y/10y UST curve at 100% and the unemployment rate above the Fed’s 4.5% target. But obviously there are going to be puts and takes. The bottom may come at 15x (SPX 3000) with the 3y/10y curve at 100% and the unemployment rate at 4.5%, or it may come at 10x (SPX 2000) with the curve at 100% and the unemployment rate at 6%.
At minimum, it’s mission critical that the unemployment rate rises to at least 4.5% before we declare the S&P 500 has entered the zone of a durable bottom.
The WOTE considers the February 2 SPX peak of 4195 as the adjusted peak for this bear market. Given the number of breadth thrust signals that fired over the course of 2022, a dynamic that is just not typical of a normal recessionary bear market, it’s The WOTE’s thesis that 2022 was more of a valuation reset in response to Fed tightening.