The one thing you can learn from history is that people don’t learn from history.
– Warren Buffett
There are several major developments we should see unfold in the next few months. One can make parallels to the sticky inflation and stagflation of the 1970s and early 80s and, we can also make parallels to the Dot-Com Crash of 2000. In the mid-70s, Fed Chair Arthur Burns temporarily hiked interest rates and then cut early, thereby allowing inflation to continue festering. It took the 2-Year Treasury to reach 17% (that is not a typo – Fed Chair Paul Volcker raised the Federal Funds rate to nearly 20% by 1981) and a terrible recession to stamp inflation out.1 Jimmy Carter probably lost his re-election bid because of it, but Volker’s bold act set the stage for the longest secular bull market in America history (1982-2022). That bull market has essentially come to an end even though it doesn’t seem like it. If one looks at the stock market today, it may seem that many are punch drunk at the moment, but there are definite headwinds coming.
Don’t Fight The Fed
Time will tell, but it seems that Fed Chair Powell is leaning towards Volcker and away from Burns. The pace of the recent interest rate hikes is the fastest since the 1980s. Traders and investors didn’t fight the Fed while they were cutting rates, but they are fighting the Fed while they are raising them.
We haven’t seen a meaningful decline in equity prices to reflect these hikes, however. Traders and investors on Wall Street have a relatively short-term memory and seem to have forgotten that there is typically a 6-12 month lag to the economy after each interest rate hike, so the largest ones that were done in September, October, November and December, we likely won’t feel until probably middle of 2023.2
Whether these hikes tip the U.S. economy into a recession is less debatable. It seems highly unlikely that we avoid a recession, but we must give at least some credence to Fed actions. They may be late to the party, but they have definitely taken the punch bowl away, and it might – just might – be enough. That said, it is our base case is that we will have at least a noteworthy slowdown or mild recession sometime in 2023 and that is how we plan on managing our clients’ assets. All bets of a mild recession are off, however, if something in the system breaks. If we have a Lehman moment, that would be enough to trigger some serious panic in markets and we would be adjusting our strategy accordingly.
Earnings Revisions And A Recession Are Likely
In the movie Titanic, the ship hits the iceberg, the passengers on the ship feel a rumble and are startled for a minute. And then a few moments afterwards, the folks in first class shrug it off and start drinking their champagne again. Two hours later the ship is sinking into the Atlantic Ocean. You can think of the ship as the economy and the iceberg as interest rate hikes. Now we aren’t saying that the U.S. economy is going to end up at the bottom of the Atlantic Ocean, but it is highly likely the ship is probably going to sustain some damage in the short-term.
There seems to be a similar Titanic effect occurring in the market today. Earnings estimates seem too high for 2023 given the interest rate hikes we have seen so far, and we suspect that there may be some downward revisions to come. The revisions should inevitably affect the broader indices and, if we get them, we are certainly looking at at least another 10-20% on the downside. Can the Fed achieve a “soft landing?” Can the war in Ukraine come to an end? Can China re-open successfully after abandoning its absurd Covid policy? We can only speculate on these contingencies, but in the meantime, given the facts of the current situation, we see more downside risk than upside risk.
S&P 500 Earnings Chart
At the moment, S&P earnings per share are predicted for 2023 at roughly $220 at an 18 multiple, which gives us a price of roughly 4,000. If we get a say 10% downward revision on earnings and a slightly lower multiple of 16, which is more in line with historical averages, then we should be looking at an S&P of 3,200, which would be about 20% lower than what the S&P is trading at today.
On the consumer front, there is evidence that people are continuing to spend money even as inflation stays elevated, however, they are spending less on an inflation-adjusted basis. The housing market has dried up dramatically due to a nearly 2.5 fold increase in interest rates. Household credit balances have reached historic highs while household savings rates are at historic lows.3 4
On the business front, there are hundreds of zombie companies that were unprofitable before the interest rate hikes that were only alive due to ultra-cheap money from the Fed. Those same companies are now teetering on the edge of bankruptcy. Small businesses surveys are incredibly pessimistic for the next 12 months.5 Producer Manufacturing Index data is signaling a contraction for the first time in a very long while.6 Large cap tech companies are laying off huge percentages of their workforce.7
Yield Curve Inversion Chart
The final thing we will say about earnings and recession odds is the yield curve inversion (the 10-Year Treasury yield minus the 2-Year Treasury yield), which is maybe the single best indicator in predicting a recession, is more inverted than the curve has been in the last 40 years. If the Fed can pull off a “soft landing”, it will be the first time they have done that in American history with a yield curve as inverted as it is today. Possible? Yes, but not likely.
Prepare for Pain Around the Corner
If the recession comes, which seems more and more likely with every passing economic report, our counsel to our clients is, as Amazon’s founder recently said, “to batten down the hatches.” Increase your cash reserves and cut down on discretionary expenses. Your ski trip in the Alps can wait for a year or so. Bottom line, we are going to undergo some pain in the near-term and we want you all to be ready for it.
Many of you have significant cash positions ready to go and the strategy has been laid out with the time coming to begin deploying that capital is very soon. Our patience is likely to be rewarded and we should be able to take advantage of the opportunities that should come in any downturn.
If you are not a ConCapper, don’t hesitate to reach out to us to see how we could help in your financial independence journey. Visit our Requirements page to schedule your free initial consultation. We invite you to like and follow our company Facebook page to get real-time access to our new articles and company updates.
Sources:
1 Board of Governors of the Federal Reserve System (US), 2-Year Treasury Constant Maturity Rate [DGS2]. (2018, June 25). FRED, Federal Reserve Bank of St. Louis. Retrieved Janary 16, 2023. https://fred.stlouisfed.org/series/DGS2
2 Levin, M. How long does it take for Fed rate hikes to work? Marketplace. Retrieved Janary 16, 2023. https://www.marketplace.org/2022/10/28/how-long-does-it-take-for-fed-rate-hikes-to-work/
3 Cox, J. Household debt soars at fastest pace in 15 years as credit card use surges, Fed report says. CNBC. Retrieved January 16, 2023. https://www.cnbc.com/2022/11/15/household-debt-soars-at-fastest-pace-in-15-years-as-credit-card-use-surges-fed-report-says.html
4 U.S. Bureau of Economic Analysis, Personal Saving Rate [PSAVERT]. Federal Reserve Bank of St. Louis. Retrieved January 16, 2023. https://fred.stlouisfed.org/series/PSAVERT
5 NFIB. (2022, December). NFIB. Retrieved January 16, 2023. https://www.nfib.com/surveys/small-business-economic-trends/
6 Institute for Supply Management. (2023, January 4). PR Newswire. Retrieved January 16, 2023. https://www.prnewswire.com/news-releases/manufacturing-pmi-at-48-4-december-2022-manufacturing-ism-report-on-business-301712602.html
7 RTTNews. (2023, January 16). Layoffs at Tech Giants continue in 2023. Nasdaq. Retrieved January 16, 2023. https://www.nasdaq.com/articles/layoffs-at-tech-giants-continue-in-2023
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