Market Update

The S&P 500 climbed 4.7% to close at 3752.75 last week. The Nasdaq rose 5.2%. It is probably a bear market rally, but it could last until year-end. Sentiment is bad and institutional money managers are underweight stock. Fund managers are holding the highest level of cash in 21 years, according to a Bank of America survey. The survey showed that fund managers are 2.6 standard deviations overweight cash. They are 3 standard deviations underweight equities.



The S&P 500 could bounce as high as 4,000 to 4,200 between now and year-end. Institutional investors get nervous when underweight stock during rallies. Panic buying can ensue. A rally back to the 200-day moving average would take the index to 4,140. The upper boundary of the downward-trending trading channel is at 4,200.

A bounce to 4,200 would be a 20% rally. The S&P 500 rose 19% from 16 June until 16 August. Better-than-expected earnings guidance is one possible catalyst. Better-than-expected news on the inflation front is another. The stock market has responded well to the first few weeks of earnings season. Continued good news is needed to offset rising interest rate pressure.

The Federal Reserve is expected to hike rates by 1.5% by year-end. The futures market is pricing in another half-point hike by March 2023. Yields on two- and 10-year Treasury bonds hit the highest levels in almost 15 years last week. The three-month Treasury yield rose to 4.01%. The 3M/10Yr spread is only 20 bps from inversion. The 2/10Yr spread has been inverted since 31 March. The time between inversion of the yield curve and a recession has averaged 12 months over the last 50 years. An inverted yield curve has predicted the ten most recent recessions.

Better-than-expected earnings guidance is also needed if the bear market rally is to continue. The consensus for S&P earnings for 2022 is 222.58 per S&P share, a 6.7% increase from 2021. The consensus for 2023 is 239.80, a 7.7% gain. The World Bank is forecasting global growth of 2.9% in 2022, down from 5.7% in 2021. The 2.9% growth rate is well below the 4.1% forecast last January. The Federal Reserve is forecasting U.S. growth of 0.2% in 2022 and 1.2% in 2023. Both the economic growth forecasts and earnings forecasts are too high. It is unlikely that the U.S. and world economies will grow faster in 2023 than 2022. It is also unlikely that U.S. earnings growth will accelerate in 2023. Higher interest rates don't lead to faster growth. On the contrary, the whole point of higher rates is demand destruction leading to less growth.

All of which means that the current bear market rally is likely to end and the bear market to resume. The question is when will the bear market resume. It is increasingly likely that won’t be until early next year. The extreme pessimism argues for more upside. The post-midterm election period is usually strong as well. Seasonality is also favorable once we clear October. A sideways market into year-end is a reasonable forecast. A test of 3,100-3,200 in the first half of 2023 is also reasonable as the U.S. economy slides into recession. Regardless, there are an increasing number of good companies on sale. A target-rich environment offers many opportunities for stock pickers.

Economic Indicators

Economic indicators last week continued to point to a slowing economy. The Federal Reserve interest rate hikes haven’t had time to impact the economy yet, except for the housing market. Interest rate hikes work with a lag of up to 9 months. The Federal Reserve didn’t start raising interest rates until March. It didn’t start shrinking its balance sheet until September. The economic bite has mostly yet to be felt in other words.

The leading economic indicators (LEI) fell to -0.4% in September from 0.0% the prior month. Building permits rose to 1.56 million in September from 1.54 million in August. Building permits are a leading indicator. Housing starts fell to 1.44 million in September from 1.57 million the prior month. The forecast was for 1.47 million. Existing home sales dropped to 4.71 million in September from 4.78 million the prior month. The NAHB home builders’ index fell to 38 in October from 46. The sentiment indicator fell for a record tenth month in a row. It is the lowest reading since August 2012 excluding the pandemic period. The index fell for 8 months in a row during the housing bubble aftermath in 2006 and 2007.

The Empire State manufacturing index fell to -9.1 in October from -1.5 in September. The Philadelphia Fed manufacturing index improved to -8.7 in October from -9.9 in September. Both the Empire and Philadelphia numbers were weak.

We are on track for a recession in 2023. The real question is how much the stock market has already discounted the hit to earnings.

Translating Intrinsic Value to Stock Valuation

Last week we wrote about how to calculate the intrinsic value of a business. The week prior we wrote that stock prices often diverge from intrinsic value. Now it's time to connect intrinsic value to stock prices. But first, a few more things to know about calculating intrinsic value.

You need to estimate owner’s earnings for an appropriate forecast period. The longer the time the less certainty. Anything past ten years is guessing. The calculation is sensitive to the growth rate you pick. It is sensitive to both the discount rate and terminal value you choose also. Estimating the terminal value of the company is difficult. (The terminal value estimates the value of the company after the forecast period.) All in all, it is not easy to arrive at an accurate intrinsic value. Using a range is a better approach.

Net Income is the accountant’s estimate of owner’s earnings. Sometimes it is close to actual owner’s earnings and sometimes less so. Operating cash flow minus estimated maintenance capex is my preference. There is less opportunity for a company to manipulate the cash flow numbers. Operating cash flow minus all capex is a more conservative estimate of owner’s earnings. The difference between the two is less for mature companies that are growing slowly. It is more important to account for growth capex when analyzing a faster-growing company.

Let’s use earnings yield for owner’s earnings since price-to-earnings is the accepted convention. Earnings yield is the inverse of price-to-earnings. The stock market’s average P/E over the very long run is around 16. Investors are willing to pay $16 for every dollar of stock market earnings they buy. The earnings yield is 6.25% for a stock trading at 16x earnings. An investor will earn 6.25% from a stock bought at 16x earnings before any earnings growth. A company trading at 16x earnings and expected to grow earnings at 3% for the next ten years will return 9.25%. The 9.25% return assumes that the P/E doesn’t change. Low P/E stocks can experience multiple expansion. High P/E stocks can experience contraction. Expansion adds to returns while contraction takes away from returns.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist

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