Market Update

The S&P 500 rose 1.5% in a holiday-shortened week. The Nasdaq was up 0.7%. The S&P is down 15.5% on the year. The Nasdaq is off 28%. The S&P is challenging the 200-day moving average but hasn’t been able to rise above it. The index stalled below it on Tuesday 15 November before backing off. It spent Wednesday and Friday last week pushing against it. Investors were unable to breach the 200-day either day. The 200-day is at 4,035. The coming week will bring another opportunity to restart the bear market rally.

The bear market rally should be about over though. The 15% bounce off the October low is typical for bear market rallies. The prior bear market rally that ended on 16 August peaked at the descending 200-day after a 19% gain. We’ll see in the coming weeks if the current bear market rally can do better. Regardless it is unlikely that the bear market is over. The Fed is still raising interest rates. It is likely to raise the fed-funds rate by 0.5% in mid-December. It will also probably raise rates by at least another 1.0% to 1.5% during the next few quarters. Additionally, it is shrinking its balance sheet by $95 billion monthly. Pulling liquidity out of the economy will impact economic growth and corporate earnings. The question is by how much?

Financial conditions are tightening. Earnings estimates are falling. The consensus for 2023 S&P earnings has fallen from around $253 to $231 in the last few weeks. The S&P 500 is trading at 17.4 times lowered consensus earnings estimates. It is trading at 20 times if earnings come in at $200 next year. Earnings of $200 would be a decline of 9%-10%. We are more likely to experience an earnings decline next year of 9% to 10% than the 4.9% increase currently forecast. Bear markets don’t end with price-to-earnings above the long-term average of 15.5x. They certainly don’t end with a 12-month forward P/E of 20. Actual 2023 earnings will go a long way in determining whether the S&P is higher or lower by next summer.

The monetary policy conditions index is one measure of financial conditions. The index includes the 2-year Treasury rate, which impacts short-term loans. It includes the 10-year rate which impacts longer-term loans. It also includes measures of inflation and the dollar. The former affects consumers while the latter affects exports and imports. A high and rising monetary policy conditions index precedes economic downturns and bear markets. The monetary policy conditions index has surged higher over the last year. It is higher than it’s been in decades. The index is likely to continue still higher with the Fed raising rates and the dollar strengthening. Tighter monetary conditions will reduce profit margins and corporate earnings.

The bear market should resume early next year as investors start to price in recession. Tightening financial conditions makes a resumption of the bear market our base case. Bear markets make wonderful buying opportunities. Norwood Economics is looking forward to buying good companies at steep discounts in 2023.

Economic Indicators

It was a light week for economic data. The data that did come out showed mostly weakness. The Chicago Fed national activity index (CFNAI) was negative 0.05 in October. A negative number indicates below-trend economic growth. The CFNAI is composed of 85 separate indicators. Durable goods orders were up 1.0% in October, a small positive. Initial jobless claims rose to 240,000 in November from 223,000 the month prior. As well, both the S&P U.S. manufacturing PMI and services PMI showed contraction. The UMich consumer sentiment index remains in recessionary territory.

Meanwhile, consumer inflation expectations are rising. The NY Fed's 3-year consumer inflation expectations index has increased to 3.11% from 2.76% in August. The University of Michigan’s 5 and 10-year inflation expectations outlook has climbed to 3% from 2.7% in September. The Federal Reserve cannot be happy about rising consumer inflation expectations because it knows that expectations can become reality with inflation.

Continued Tightening Likely

One of the best know axioms about investing is “Don’t Fight the Fed”. Everyone seems to have heard “Don’t Fight the Fed” yet a surprising number of investors do anyway. The Fed is still raising rates. Sure, it will likely only raise rates by 0.5% in December, but 0.25% used to be the norm. A 0.5% rate hike was once considered aggressive. The expected half-point hike follows four 0.75% hikes in a row, unheard of before this tightening cycle. It's been a mere eight months since the Fed funds rate was 0.0%. The rate hikes haven’t even had time to impact the economy yet. Rate hikes work with a two to three-quarter lag.

The Fed is also shrinking its balance sheet. Pulling $1.14 trillion out of the financial system annually has no precedence. No one knows what taking that much monetary base out of the economy will do to the economy. Given that everyone knows not to fight the Fed, investors must be running for the hills… except they aren’t. Instead, investors have been buying stocks aggressively since the market bottomed on 13 October. They are doing so in the belief that the Fed is close to ending the tightening cycle. A 0.5% hike in December followed by a 0.25% in February or March 2023 and they are done, or so the narrative goes. The narrative is likely wrong.

Credit is growing rapidly as banks meet strong demand from businesses and consumers. Loans to businesses, consumers, and real estate have accelerated to the fastest pace since 2008, according to Barron’s. As well, there is still more than $4 trillion in excess monetary base in the system courtesy of the Fed’s pandemic QE. Rapid credit growth and an excessive amount of monetary base means the Fed must do more to restrain inflation. Investors may learn why “don’t fight the Fed” is a truism on Wall Street sometime in 2023.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist