March 2023 Market Update

Federal Reserve policy works with long and variable lags. The economy will likely not feel the full effect of the Feds rate hikes until six to nine months after the last hike. This leaves the market with great uncertainty regarding the strength of future economic data and earnings growth. As of now the markets are ignoring economic and earnings risk and are priced for economic and earnings perfection, and in our opinion, represents the peak area of the trough, expansion, peak, contraction business cycle.

For the month of February, the ISM Manufacturing index posted a reading of 47.4, its fourth consecutive month of contraction below 50. This suggests a deterioration in the strength of the economic cycle. Chicago PMI for February was reported at 43.6, a touch lower than Januarys reading of 44.3, demonstrating further weakness to come for S&P 500 earnings estimates.

Since mid-October, the global economy has bounced. Led by surprisingly warm weather throughout Europe, reducing concern for a European energy shortage developing from the fallout of the Russia/Ukraine war and China economic reopening from zero covid policy. This caused global M2 money supply to rise in the short term, sending the Eurodollar higher, the US dollar weaker, mortgage yields lower and creating a tougher environment for the Fed to reduce inflation. Especially in the core services ex shelter area of the economy. Which means sticky inflation is resulting from strong employment. Meanwhile, U.S. domestic M2 money supply has reported a negative year over year reading for the first time in U.S. history. We do not expect global M2 to continue rising as that typically results in a negative feedback loop for other countries while the Fed is tightening. To us the choice is clear. Either investors believe in China and Europe moving the global economy without the United States or investors believe the Federal Reserve is still the most powerful central bank in the world. A world in which the United States leads in hegemony. We choose the ladder and respect the effect of long and variable lags from Federal Reserve policy.

As labor market data continues to be resilient so far in 2023, we have witnessed the fed funds terminal rate rise from 4.8% to 5.6% from the end of 2022 to the beginning of March 2023. We are seeing softer earnings estimates and softer cash flows in reported earnings. Weaker earnings combined with higher fed funds rates suggests stocks will likely break new lows in the coming months as new risks appear. We believe the Fed will be successful in creating 4.5% unemployment rate they mentioned in their economic outlook for 2023. If the labor market data for some reason becomes stronger then the fed funds terminal rate will just climb higher. The labor market is trapped in our view, not the Fed.

These factors lead to a risk off market until a higher fed funds rate and lower growth in earnings result in PE multiple compression, like the 1999-2003 period and the mid 2004 - 2009 period. What are we looking for? We are looking for S&P 500 earnings to mean revert to long-term trend growth. Let’s do some math. In 2022 the S&P 500 reported $223 in earnings. Based on the mean red line on the first chart below, mean S&P 500 earnings are around $180. Now let’s move to the second chart below and look at the long-term median PE. The long-term median PE is 19.64. If we assume no multiple compression from higher rates and lower earnings, then a 19.64 PE multiplied by $180 in mean reverted earnings would produce an S&P 500 valuation of 3,535.

Now let’s look at the third chart below and view how much PE multiples compressed as the fed funds rate began to climb higher in the 1999-2003 and 2004-2009 periods. Both of these periods resulted in lower projected economic growth. In 1999 the fed funds rate was 4.5% and as it began to climb to 6.5% by 2001 the S&P 500 PE dropped from 29 down to 22 at the beginning of 2001. The Fed then began cutting rates after 9/11 and as you can see the PE climbed higher until 2002, but due to declining growth the PE dropped to 18 by 2003. In 2004 the fed funds rate was 1.25% and by 2006 it was 5%. During that period the S&P 500 multiple dropped from 19.5 in 2004 down to 13.8 in 2008 and ultimately 11.8 in 2009, after realizing once again a lower economic growth trajectory.

We expect the market to trade at or below a 15 PE down from 19.64 which “could” value the S&P 500 with mean earnings of $180 at 2,700.

The real risk in the market at this time, given these factors, is based on which area of the business cycle the economy is in. Since we believe that we are at the peak area of the business cycle, with rising fed funds rates, deteriorating earnings and record low unemployment, the downside risk to market valuations simply reverting to the mean while entering the contraction area of the business cycle from the peak is very high. As we have just demonstrated the S&P 500 valued at mean earnings of $180 and median PE of 19.64 assuming no PE multiple compression is 3,535 versus the S&P 500 valued at mean earnings of $180 and a multiple compressed PE of 15 from higher rates is 2,700. This is a -23.6% difference in value and a -32.5% difference from where the S&P 500 currently trades at 4000.

We want to emphasize that these numbers are not projecting some major bearish, economic catastrophe. These numbers simply represent a reversion back to the long term average or mean. In other words, when investors claim the importance of being in the market for the long term, it is always important to remember that when in a contraction or recession that the market will eventually return higher, back up to the long term mean or average. The economy is coming out of a substantial boom whereas market valuations along with S&P 500 earnings are way above the long-term average or mean. We are looking for the business cycle to shift from peak to contraction. A recession. As higher interest rates reduce the value of net present cash flows.

The 6-month, 1-year and 2-year U.S. treasury notes are now paying at or above 5% interest. Money market funds are paying > 4% interest. The S&P 500 earnings yield is at 5.1%. It does not make sense to take market and earnings risk to earn 5% while risk-free rates are near or at 5%. This is the highest opportunity cost of capital in 17 years. U.S. savers have not been paid this much interest on savings, risk-free in almost two decades. After 14 years, the longest business cycle in US history, financed by cheap money, it’s no mistake that the average market participant doesn’t believe in risk management and has zero fear about potential recession and valuation risk.

We believe investors will continue to be rewarded by being positioned risk off and in cash, short term interest rates, money market funds, 10-year minus 2-year yield curve re steepening and select low duration equities.

We will know a recession is likely to begin when the 10-2’s yield curve is no longer becoming further inverted and begins re steepening along with the unemployment rate beginning to rise.

Disclosure: Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.

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