It was a tough week for equities as the Fed hiked 75bps and signaled that “no
pivot” in policy is coming. Such disappointed the markets in desperate need
of some “encouraging news,” but none
was to be had. Furthermore, the Fed slashed economic growth drastically, upped
their unemployment projections, and kept inflation expectations elevated through
Markets broke through support and tested this year’s lows on Friday as selling
was broad-based. As we will discuss momentarily, the market is now figuring out
the rising risk of a policy mistake. On Friday, Goldman Sachs slashed their
year-end price targets for the S&P 500 index. The “hard
landing” scenario was most important.
In a recession, we forecast earnings
will fall and the yield gap will widen, pushing the index to a trough of
3150. Our economists
assign a 35% probability of recession in the next 12 months and note that
any recession would likely be mild given the lack of major financial
imbalances in the economy. As we previously outlined, in the event of a
moderate recession, our top-down model indicates EPS would fall by 11% to
For context, a
34% peak-to-trough decline in the S&P 500 index during a recession would
only be slightly worse than the historical average of 30%. We see
two risks that would create a more dramatic sell-off in equities during a
if inflation concerns were to limit the degree of monetary or fiscal policy
support and interest rates did not fall, it could lead to even lower
valuations or even larger economic and earnings growth declines than we
model. Second, concentrated sector weakness, such as Information
Technology in 2001 and Financials in 2008, could lead to an even sharper
earnings and price decline.
While Goldman is finally coming to grips with economic and fundamental
realities, its expectations for only modest earnings and margin decline are
still optimistic. As
we discussed recently, earnings will likely revert to below
$200/share just to reach the median long-term growth trend.
“More importantly, despite the recent
downward revisions, the current estimates still exceed the historical 6%
exponential growth trend, which contained earnings growth since 1950, by
one of the most significant deviations ever.“
Such leaves the markets in a very tenuous position. However, in the short-term,
markets are testing this year’s lows and are sufficiently oversold to provide a
relief rally. However, there is little to get excited about until the Fed stops
hiking rates aggressively and reducing its balance sheet. We will cut equity
exposure levels on the next rally and raise cash levels further. Keep a watch on
the MACD signal (top of the chart), as
it will provide the best guidance for a sellable rally near term. There is a lot
of congestion at the 3900-4000 level, which will provide sufficient resistance
to cap a reflexive rally. Those levels provide a reasonable “sell” target
Worst Economic Forecasters
The 75bps hike on Wednesday was priced into the market. However, the Fed’s “Dot
Plot,” showing no “pivot” in
policy anytime soon, sent markets lower. There was a 10-9 majority in favor of
hiking above 4.25% this year, suggesting
a fourth 75 basis-point increase in November is possible.(Chart
courtesy of Zerohege)
As noted by Zerohedge:
“Remember, until Powell’s Jackson Hole
speech, the Fed discussed a soft landing scenario with the economic
projections at the June meeting reflecting that thinking.”
Furthermore, the market was also pricing a “pivot” in
monetary policy by May of 2023. The problem is that the Fed’s new economic
projections dashed those hopes, with growth estimates slashed and inflation
substantially revised GDP forecasts lower, with the median estimate
for growth this year at just 0.2%.
rate forecasts are up, with the median now at 4.4% for both 2023
The Fed doesn’t
see inflation returning to its 2% target until 2025.
The problem is that while these statements clearly show that “no
pivot” in policy is coming, they are also likely very wrong.
As we have discussed, the Federal Reserve is the worst economic forecaster ever.
We have been tracking the median point of their projections since 2007, and they
have yet to be accurate. The table and chart show the Fed is always inherently
overly optimistic in its forecasts.
The corner graph shows the sharp drop in economic growth expectations since the
July meeting. If they were this wrong just a few months ago, how wrong will they
be in 2023?
While the Fed is currently pushing a “no
pivot” stance, there is good reason to expect a pivot in 2023.
The September rate hike pushed the Fed funds rate to the highest since January
If you don’t remember what happened then, let me remind you.
In January 2008, the Fed was aggressively hiking interest rates amid a massive
real estate bubble under the Chairmanship of Ben Bernanke. At that time, there
was “no recession” in sight, “subprime
mortgages were contained,” and it was a “Goldilocks
Eight months later, the market fell sharply, banks were on the brink of
bankruptcy, and the economy was entrenched in a massive recession as Lehman
Brothers filed for bankruptcy.
The Federal Reserve never predicted a recession and believed it could navigate a
soft landing in the economy. They were wrong on multiple counts. As we showed
previously, there are ZERO times in history when the Fed was hiking rates that
outcomes were not bad to awful. After rates peaked and yield curves UN-inverted,
recessions, bear markets, and crisis events occurred.
I don’t like market analogs. However, the current Fed policy of hiking rates and
reducing their balance sheet is the most aggressive policy shift since that
period. Every market environment is different, but the similarity of market
action this year is interesting.
We are NOT
suggesting another “Lehman Moment” is
imminent. However, as noted above, a weaker economic environment,
namely a recession, impacts asset prices as earnings and profit margins
Valuations are still not cheap, by any measure.
Most Hated Asset
last week why “bonds” are
likely to be the next “buy” of the
decade. Interestingly enough, with bonds in the most significant bear market on
record, no one wants to buy them. Such is the case historically, as investor
psychology always contradicts investing realities.
As I quoted then:
action of the credit market is consistent with economic weakness and stock
market trouble. I think you have to start becoming more bearish on stocks.Buy
long-term Treasuries. Although the narrative today is exactly the
deflation risk is much higher today than it’s been for the past two years. I’m
not talking about next month. I’m talking about sometime later next year,
certainly in 2023.” – Jeff Gundlach, DoubleLine
I am reiterating this commentary because the recent actions by the Fed almost
guarantee a recession, economic event, or worse. In such an event, the demand
for “safety” will become a primary
Such is because money flows from risk assets into Treasury bonds for safety when
a recession occurs. We see this clearly in the chart below of corporate bond and
Treasuries yields. While it hasn’t happened yet, corporate yields rise during a
bear market or economic event as money rotates into Treasuries’ safety, causing
long-dated yields to fall.
While the Fed’s “no pivot” policy
stance is driving up Treasury yields short-term, the reality is that each
increase puts the Fed one step closer to a policy mistake. It is quite likely
the Fed has already tightened more than the economy can withstand. However,
given the lag time of policy changes to show up in the data, we won’t know for
certain for several more months.
With the Fed removing liquidity from the markets at the most aggressive pace
ever, the risk of a policy mistake is higher than most appreciate. Such is shown
in the annotated chart from Chartr below.
While buying bonds today may still have some “pain” in
them, we are likely closer to a significant buying opportunity than not.
More importantly, if we are correct, the coming bull market in bonds will likely
outperform stocks and inflation-related trades over the next 12 to 24 months.
Such an outcome would not be the first time that happened.
Of course, buying bonds when no one else wants them is a tough thing to do.
The views expressed by Lance Roberts are not
necessarily those of RetireEarlyLifestyle.com