Developments Over the Past Month
July 2022 Market Recap: The month of July was driven by better-than-feared earnings, economic data, and falling inflation expectations. The market spent most of June pricing in an earnings Armageddon that has yet to come to fruition. The market took the most recent Fed meeting as a slight dovish pivot, which led equities higher into the end of the month. This past month was the best July since 1939 and the best month for the overall market since November 2020.
Bear Market Bounce or is the Bottom in? The debate about the future direction of the market is heating up. We’ve now seen 4 bear market rallies this year. One of the observations that we’ve seen in recent months is that bear market rallies grow larger as the bear market grows older. Whether the Fed is close to being finished tightening or they are cutting rates, we imagine that every bear market rally during past bear markets (2000-03, 2007-09) generates the “it’s the bottom” conversation every time – this time is no different.
The Beginning of Quantitative Tightening: We are beginning a new regime as the Fed moves to reduce the size of its balance sheet which has grown to nearly $9 Trillion. Since March 2020, the Fed has made more than $4T in bond purchases. Now, to fight inflation, the Fed will begin to let some of their bonds mature (without replacing them). According to the central bank, roll offs will ramp up to $95 billion in September including a $60 billion reduction in U.S. Treasuries (“UST”) and a $35 billion reduction in Mortgage-Backed Securities (“MBS”). The first three months, however, have begun at half that pace; $47.5 billion, comprised of $30 billion UST and $17.5 billion MBS. That compares to a peak roll off of $50 billion a month when the Fed performed the exercise starting back in 2017. The Fed started this process in June.
Where is The Fed Put? We continue to believe that the Fed Put is much lower right now, as FOMC Chairman Jerome Powell has stated that the Fed is going to keep raising until we have a recession unless inflation meaningfully improves. The cause of the decline is equally important. The Fed has a long history of easing policy in response to earnings drops, but there isn’t much evidence that it responds to multiple compression. The fact that inflation is higher than at any time since the genesis of the Fed Put and that stocks have appreciated a lot over the past two years suggest the strike is well below current prices. Similarly, the recent decline in stock prices owes exclusively to lower multiples; it would take another leg down induced by a drop in earnings to impress the Fed.
Rate Hikes:The Fed raised rates again by 75 basis points in July, as the June CPI reading came in much structurally higher than expected. Now, the market is pricing in a 50 basis point hike in September. But after that the outlook is bit cloudier. The market has fully priced in 11 rates hikes in 2022. In 2023, we believe the market will start to price in rate cuts. We expect Powell’s tone to remain hawkish at future press conferences. Finally, financial conditions have already tightened significantly, for example the pop in mortgage rates is harming housing affordability and with further Fed tightening there will be more casualties to slow the economy further.
“Phantom Earnings” Moving Forward: Overall, 2022 consensus EPS are up modestly, but what is most noteworthy is how this earnings trend has skewed between indexes with small cap and value indexes seeing significantly more positive earnings revisions, while growth and larger cap indexes, more negative. We remain skeptics that the current 2023 earnings expectations for the S&P 500 remain too high. On average, earnings as a whole, tend to fall between 15% – 20, of which, earnings are only 2% off their highs.
Earnings Season So Far: Overall earnings season has shown signs of improvement – much better than anticipated by many economists. Of the companies that have reported, S&P 500 year-over-year earning growth now stands at +7.7%, with revenue growth increasing +12.1%. Energy continues to be the standout sector for profits masking the weakness in important sectors like Technology and Discretionary.
The U.S. Consumer: US consumer confidence dropped in June to the lowest in more than a year as inflation continues to dampen Americans’ economic views. The Consumer Confidence Index – a measure of expectations – which reflects consumers’ six-month outlook – dropped to the lowest in nearly a decade as Americans grew more downbeat about the outlook for the economy, labor market, and incomes. Consumer spending is about 70% of the US economy. If people start spending a lot less, then businesses lay off workers, which leads to even less consumer spending. As a result, unemployment could rise a lot. July saw a slight rebound.
S&P Valuation: The S&P 500 increased, along with the market in July – now trading at 18.1x or 2 turns higher than where it was trading at in the middle of June. This seems hard to justify given the growing concern about earnings. As a result, we continue to believe any near-term rally is nothing more than a bear market bounce with lower lows ahead.
Earnings: 2022 S&P 500 operating earnings = $225. 2023 = $246. 2021 = $204. 2020 = $136. 2019 = $161.
Valuations: S&P 500 Fwd. P/E: 18.1x, EAFE: 12.3x, EM: 10.7x, R1V: 13.9x, R1G: 24.3x, and R2K: 12.2x.
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