The Outlook: The Bear is Just Waking Up
SPX 4000 is the new peak. The Fed is currently raising rates in a recession with an anti-Arthur Burns reaction function, and at 4000 SPX is 22x normalized peak EPS. -43% downside lies ahead.
Discussion
As discussed in the “It’s the Yield Curve, Stupid”, the S&P 500 is at a fork in the road. Fork #1 is a new bull market as indicated by improving credit conditions, breadth thrust signals, and a breakout in cyclical sectors and factors. Fork #2 is a resumption of the bear market, driven by the Fed re-tightening financial conditions to ensure enough economic restraint remains in place to bring inflation back to 2%. A deep and persistent 3y/10y US Treasury curve inversion breaks the tie, suggesting market participants should be on watch and positioned for a resumption of the bear market. But those are rather short-term tactical “trees” well-covered by the mainstream market conversation. It’s time to zoom out and focus on the strategic “forest” that is the likelihood this bear market is just getting started.
For three reasons, the “forest” is quite large:
Recession. The equity market consensus is rapidly coalescing around a “soft landing” scenario as base case, with perhaps a mild downturn in 2H23 mentioned here and there out of begrudging respect for the downside. But the weight of the evidence strongly suggests a recession of potentially large magnitude is already underway.
Arthur Burns. As discussed in “Framing the Arthur Burns Risk to the S&P 500”, the Powell Fed is dogmatically focused on not repeating the “stop and go” policy error of the Burns Fed in the 1970s. So by design, the Fed will be “late” in responding to the recession with easier monetary policy, if at all.
Valuation. Above all, the S&P 500 is overvalued by approximately 1/3 on a normalized, mid-cycle basis. Were the SPX trading at fair value, it would still need to go lower to account for the impact of recession and the Fed’s anti-Burns reaction function. As such, the current SPX multiple of 22x normalized peak EPS has double-dip downside potential through 17.5x fair value to the 10-15x recessionary bear market trough range.
Recession: Mind the Data, Please
The Overnight Indexed Swaps (OIS) market currently has the Fed hiking the Fed Funds Rate (FFR) to 489 bps by June (another 50 bps of hikes) and then cutting to 436 by December (right back to current levels of around 433 bps).
Given the Fed’s steadfast commitment to not repeat the “stop and go” policy error of the Burns Fed in the 1970s, it is highly unlikely the Fed will cut rates so soon after terminating the hiking cycle and risk fatally wounding its 5-10 year inflation-fighting credibility. The Weight of the Evidence (WOTE) thesis is that these cuts imply something more sinister is at work, that being: The economy is much weaker than the Fed believes and the data will force them to terminate the hiking cycle after a 25 bps hike on February 1 (to a 458 FFR), with an outside chance financial conditions tighten enough between now and February 1 to allow the Fed forgo hiking by 25 bps February 1 (leaving the FFR at 433). The WOTE outlined this “something more sinister” thesis on January 15 in “It’s the Yield Curve, Stupid”, but subsequent analysis has only bolstered the conclusion.
On January 13 the Economic Cycle Research Institute (ECRI) penned an opinion piece for CNN titled “Don’t Be Fooled, A Recession Really Is Coming”. The money quote from the piece was on the labor market:
“Employment, in particular, can hold up longer than expected in a recessionary scenario. That was true in the inflationary era around the 1970s. Most notably, employment didn't peak until eight months after the start of the severe 1973-1975 recession.”
You never know how a thesis will ultimately come together, but after reading the ECRI piece the Conference Board lead/lag ratio that Jeff Weniger highlighted on January 15 came to mind. At last click on November 30, the YoY change in the Conference Board Leading index was -4.5% while the YoY change in the Lagging index was +6.9%. Going back to the 1960s the only time the Leading index was negative YoY with the Lagging above +5% YoY was in the Great Inflation period of the 1970s and 1980s. To ECRI’s point, in high inflation environments lagging data skews the real-time view of the economy.
The weight of the following evidence strongly suggests the National Bureau of Economic Research will ultimately declare that a US recession began in 4Q22: a deep and persistent inversion of the 3y/10y US Treasury curve, the OIS market’s refusal to price out 2H23 rate cuts despite the Fed’s insistence it will not repeat the Burns Fed “stop and go” policy error, and Great Inflation-like divergence between the Conference Board Leading and Lagging indices.
Arthur Burns: “Don’t Do This”
The Fed communicates its thinking through a number of channels, but the real important stuff they can’t say out loud themselves is done through former Fed officials. Last July, in the early stages of the first major “Fed Pivot” rally that ultimately terminated in mid-August, former Fed Vice Chair for Supervision Randal Quarles was deployed to reiterate the Powell Fed’s anti-Burns reaction function. He did so with the following story:
“…this young security guard was something of an art aficionado as well, and so he then was interested in the art that was on the walls of the office. And the Fed gives the governors a choice of art to decorate your office. It's not a valuable collection. It's a nice enough collection, but it's not from the Smithsonian. But one of the things that I had chosen to put on my walls was actually painted by Arthur Burns. It was an abstract painting. For policy folks who have turned to painting, George W. Bush is a much better painter than Arthur Burns. But I had it on my wall as sort of a memento mori of, ‘Don't do this.’ Not the painting, but what Arthur Burns stood for at the Fed.
“So as we're going around, and I'm explaining, ‘Well, this painting, this is a chalk portrait of Marriner Eccles, and this is a chalk portrait of Carter Glass,’ and explaining to the young security guard the history and so forth, we get to Arthur Burns. And I say, ‘Now, this was painted by Arthur Burns,’ and I'm getting ready to explain to him who Arthur Burns was and why it's on the wall, and kind of bringing this young, new member of the Fed family under the tent. But before I can explain any of that, all I say is that this is by Arthur Burns, and the security guard says, ‘Oh, my gosh, that's the guy that let inflation get out of control.’
“…it's a story that I sometimes tell to sort of give an indication of the commitment of the institution to controlling inflation, when people say, "Will this Federal Reserve really have the stomach to control inflation and see the unemployment rate rise and the economy be reined in?" And the answer is, the one great sin at the Federal Reserve that is on everyone's mind, from Jay Powell's to the brand-new security guard, is that you don't let inflation get out of control. My young colleague had no idea what the unemployment rate was in 1972, had no idea what the oil price was in 1972, had no idea what the political situation was in 1972, but he knew that Arthur Burns let inflation get out of control, and was a hiss and a byword in the building half a century later. This FOMC is not going to become those people.”
It is clear that equity market participants do not appreciate what the Fed’s anti-Burns reaction function means in reality, as to a person, everyone thinks the Fed will ultimately cut rates in response to an economic downturn. This is an incredibly dangerous game of chicken that the Fed is openly saying it will win. Here’s Minneapolis Fed President Neel Kashkari in a New York Times interview released on January 10:
“But the markets were pricing in cuts starting in its second half. ‘I’ve spent enough time around Wall Street to know that they are culturally, institutionally, optimistic,’ Kashkari replied. I said it seemed almost as if the markets were playing chicken with the Fed. Kashkari laughed. ‘They are going to lose the game of chicken, I can tell you that,’ he said.”
“Kashkari said that this solidarity might become harder to maintain the longer the inflation battle drags on, especially if — or when — the labor market cools. If inflation were to fall to 3 percent with unemployment increasing to 6 percent, things could get tricky. He personally wouldn’t flinch…”
Fast forward 12 months and imagine Core Services Inflation ex. Shelter is at 3% (currently running at 6% YoY) with the unemployment rate at 6% and the Fed is debating whether it should loosen monetary policy. Where should the S&P 500 trade as a multiple of normalized peak EPS of $181?
Valuation: Dope Sick
“Dope sick” is slang for opiate withdrawal symptoms, and it is an exquisitely appropriate descriptor for the equity market’s behavior since the Fed launched its tightening program in late 2021. For decades the Fed came running to the rescue of financial markets after an uncomfortable tightening of financial conditions, a process commonly referred to as the “Fed Put”. The market is addicted to the Fed. It needs the Fed, and it is willing to pay any price for even the hint of a softening in its aggressive rhetoric.
Do this thought experiment. Try to forget everything that has transpired over the last 12 months and consider the current set of conditions: The Fed’s preferred inflation metric (Core Services ex. Shelter) is running at 6% YoY; the Fed is committed to not “prematurely easing” monetary policy as the Burns Fed did in the 1970s; the Fed is still raising interest rates with the US economy very likely already in a recession; and at its recent 4000 level the S&P 500 P/E was 22 times normalized peak EPS of $181 (see spreadsheet below).
22 times.
At its 2000 and 2007 peaks the SPX P/E was 27.7x and 19.6x.
On a longer-term fair value basis the SPX is likely worth 17.5 times normalized mid-cycle EPS of $174, or circa 3045. But from the standpoint of recessionary bear market history, going back to 1929 the SPX doesn’t bottom until somewhere between 10 and 15 times peak EPS, or call it 12.5x.
12.5 times normalized peak EPS of $181 puts the target trough level for the S&P 500 around 2263, -43% lower than the recent 4000 level, which seems perfectly appropriate for an historically toxic set of market conditions.
The bear is just waking up.
love these , great job