Once a month, on the fourth Wednesday of the month, I will put up a long term view of the market. This is provided for investors who don’t want to trade secondary swings in the market, but would like to exit the stock market relatively soon after a bear market begins, or enter the market after a new bull market begins (change in the primary trend). In the blog, they will always have a title called “Long Term (month) (year)”, so you can use your browser “Find” function and easily find them.
GDP – The second estimate of 2022 Q2 GDP released in late August was -0.6%. Two consecutive quarters of negative GDP is a common definition of a recession, so here we are in a recession. There are more complicated definitions of what a recession is, buy I don’t think my readers are interested in an academic discussion, so we’ll stick with the common definition.
I looked up the Atlanta Fed GDPNow forecast, which gets close to the real number late in the quarter, and their forecast for Q3 GDP is +.3%. There is a good chance the real number will be plus or minus 1%, so from -.7% to +1.3%. That is from mild contraction to tepid growth range.
This is bearish for the stock market.
Fed interest rates – The Fed raised the Fed Funds rate by .75% in late Sept., as expected. That brought the Fed Funds rate to 3.25%, up from zero in February. The Fed indicated that 2.5% is presumed to be the “neutral rate” for the economy, which is neither accommodative nor restrictive. Unfortunately with inflation running at 8% on the CPI, we need a restrictive rate to slow the economy in order to bring down inflation, so now the Fed says the rate is restrictive.
The impact on mortgage rates has been more dramatic taking the rate on a 30 year fixed mortgage from 3% to 6%, and housing is seeing a slowdown. That will dampen inflation going forward.
The other thing the Fed is doing is Quantitative Tightening (QT), which means they are not buying bonds to replace those that they hold when they mature, and outright selling bonds into the secondary market. This will force private companies and individuals to buy the bonds, and then those dollars are not available to buy TV’s, boats, or other big ticket items. Private investors may demand a higher interest rate, especially with inflation running at 8%, and higher interest rates would tend to slow economic activity.
Fed policy is restrictive for the economy, and bearish for the stock market.
|Date||Fed Funds Rate||5 Year Treasury||10 Year Treasury||30 Year Treasury|
|2020 Year||0.4||0.6||0.9||1.6 – Covid|
|2018 Year||1.8||2.8||2.9||3.1 – Tax Cut|
S&P 500 earnings – Factset shows that for Q3 of 2022 earnings are projected to be up 3.2% above Q3 of last year, which is down from their projection last month of +6% earnings increase.
Lesson to be learned, projections of the future can be wrong, then you just change the number.
For CY 2022, Factset analysts are projecting earnings growth of 7.7%, down 2.3% from the projection in July.
The forward PE for the S&P is 15.8 compared to the ten year average of 17.
The 12 month forward earnings estimate on the S&P 500 from the Standard and Poor’s company is $229, down $3 from last month.
The outlook for earnings is bullish, but the earnings outlook is being trimmed.
PE on S&P 500 – The current 12-month trailing GAAP PE on the S&P 500 is 19.7, down from 21.0 last month and down from 31 a year ago. I used 4 quarters of earnings with the most recent being Q2 2022. We had a big rally in stock prices into mid-August that took the PE up, and we have a selloff in process that has taken the valuation back down.
This metric is fairly valued relative to my trimmed 30 year average of 19. I trimmed out the quarters during recessions for my 30 year average, since the P/E behaves very abnormally during those times. I go in 5 point increments for my terminology, so 20 – 25 would be moderately overvalued, while 25 – 30 would be significantly overvalued. Above 30 would be dangerously overvalued.
Here is the risk with PE ratio. With a peak in the 30’s, and an average of 19, what does that tell you? The hard truth is for that to be true, it is also true that the PE ratio MUST spend some time below 19, well below in fact. During bull times, the market overshoots to the upside, and in bear times, the market overshoots to the downside. In bad bear markets, the PE has fallen to single digits, but an average bear market may only see PE’s go down to the 10 – 14 range, but that is much lower than today.
This indicator is neutral.
Age of primary move, bull or bear market – This bear market is 9 months old. This is neither bullish nor bearish, but it is worthwhile to keep it in mind.
COVID-19: Covid has moderated in most countries. Newer variants like Omicron are more transmissible but less lethal. The Omicron BA.5 variant has been spreading and China is imposing lockdowns in various cities again.
Liquidity: Central banks globally are withdrawing emergency accommodation for Covid. QE has ended and interest rates are rising. We can expect a few rough spots in the transition back to normal monetary policy.
US Trade Relations: The US trade delegation has met with the Chinese to begin discussions on a reset of the US – China trade agreements. No progress has been made by July 2022. At some point one has to wonder if that in fact is the way one or both countries want it, no concessions from China, and the US taking a tougher stance toward them on trade. It appears to me that the US and China are engaged in a tug of war to see who is the world’s economic leader. China has advantages in low cost labor and some natural resources such as rare earth metals, but they lack oil and natural gas. The US has long been a technology leader and we have sophisticated financial markets that are usually well regulated.
Talks on the US getting back in the Iran nuclear deal are ongoing, but currently they are stalled. With oil at over $80 a barrel, I suspect Iran thinks it gives them a negotiating chip if a deal was signed and Iranian crude was back on the market, which would lower oil prices. Iran wants a guarantee from the US that they will honor the deal and not just decide to opt out like Trump did. He could do that because the original Iran deal was never ratified by Congress. Would Congress ratify a deal now? Iran also wants the US to agree to end inspections of their facilities (which do not occur today, but would resume if a new deal is signed), and the US has said that is not acceptable. If Iran wants a deal, they must accept inspections.
Ukraine: Thewar in Ukraine drags on. Ukraine is having more success on the battlefield than most expected, with the help of western weapons. Russia is destroying much of eastern Ukraine’s cities and rebuilding will be difficult. Sanctions against Russia are disrupting commodity markets since Russia was such a large exporter or oil, natural gas, and metals. Ukraine was a large exporter of wheat and other foods and that export is hindered by the war.
Geo-politics is currently bearish, mainly due to the war in Ukraine.
Technically the chart below is negative near term (months), but still positive longer term (year).
RSI at the top of the chart is neutral at 43, but it is falling. Momentum shown by MACD at the bottom of the chart is negative and falling. The price action is negative for the medium term, but still positive longer term. We are in a bear market.
One might observe that the stock prices have just recently fallen back into the 10 year up channel and are near the middle of the channel. That begs the question, why do I say we are now in a bear market. My answer is that the economy is large and complex and influenced by many different factors. The pandemic, easy money from Congress, and zero interest rates from the Fed came together and allowed stock prices to rise far above the top of the 10 year up channel. That is not normal behavior, so my view of the chart is not normal either. If artificial events had not merged and allowed such a surge in stock prices and they had remained inside the channel, this correction would be much closer to the bottom of the channel. I guess unusual economic events can result in an unusual looking chart.
Emergency accommodation is being removed from the monetary system. The Fed ended Quantitative Easing (bond buying). They have begun a series of rate hikes and they have begun shrinking their balance sheet. All of the Fed’s actions reflect a tighter monetary policy to combat inflation. This will slow the economy, it is INTENDED to slow the economy. The question is can they slow the economy enough to get inflation down, and not so much that they drop the economy into a serious recession? It is not easy to do with a large complex economy when your only tool is adjusting the Fed Funds rate. If we go into a recession and the lower line of the ten year growth channel is pierced to the downside, then we would be in a bad bear market.
If you believe the stock market is a forecasting machine looking months ahead, that is what each of us must do to make our investment decisions for 2022. You have to make your forecast, and then decide what to do about it. Will things get better, stay about the same, or get worse? Do you want to hold what you have through a recession, sell now, or wait until things get worse and sell at lower levels from here? Where would you put your money, gold, bonds, stocks, money market?
This is bearish in the short run, but remains bullish longer term.
- GDP growth is slowing with Q2 GDP shrinking by 0.6% following the negative print in Q1, so that is bearish.
- The Fed has short term rates at 3.25%. That is restrictive and bearish, and they are expected to continue tightening.
- S&P earnings for Q2 are projected to be 3.2% above Q3 2021, with S&P projecting 7.7% improvement for calendar year 2022, keeping this factor bullish.
- The PE valuation of the S&P based on the 12 month trailing GAAP number is 19.7, which is fairly valued and neutral.
- The geo-political factors are bearish.
- Technically the chart looks bearish short term, but bullish longer term.
By that way of looking at it, the market is bearish, with one factor bullish, one neutral and four bearish.
Long Term Issues to Keep in Mind:
Federal Deficit: (Updated March 2020) – Well this is going to get a lot worse. Looks like the politicians are going to be printing money and dropping it from helicopters. But all the other major economies will do the same thing, so relatively, the dollar may not drop much (which would be bad for inflation).
(Negative – Noted Jan. 2018) The deficit will go up despite the republicans saying that if the tax cut bill is “dynamically scored” using “possible” increases in economic activity, it will hold down the deficit by increasing tax receipts. This has not been shown to work in the past. The US added $980 billion to the national debt in fiscal 2019 (ended 9/30/2019), a tragedy in good financial times.
The total national debt exceeds $26 Trillion (late 2020), and as interest rates rise, the component of the annual budget allocated to “interest on the debt” will increase, putting pressure on existing programs, or increasing the deficit. If the deficit is allowed to rise too much in good economic times, the value of the dollar will fall and that is inflationary which is usually bad. The thing saving us today is how poorly all the other nations are managing their economies, so the dollar continues to hold up.
Rich Comeau, Rich Investing