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The Depth Report – One Way or Another, We’re Going to End Up in the Same Place

Overview:

The stock market, market analysts, and all of us here at Deep Knowledge Investing have been closely watching Jerome Powell and the Federal Reserve for signs regarding future interest rate hikes.  After keeping rates at zero and calling inflation “transitory” for far too long, he now seems focused on aggressively increasing interest rates to get inflation back under control.  Those rate hikes, and indications of more 50 basis point to 75 basis point raises to come have been the primary reason for the decline this year in the S&P 500 and the larger decrease in the NASDAQ 100.  It’s also the reason we’ve held short position in those market indexes all year.

As a result, the P/E on the S&P 500 (how much you pay for each dollar of earnings in the index) has fallen from around 21x to the current 16x.  That’s an almost 25 percent decrease in what you’re paying to own the earnings stream from these companies.  It seems like a pretty large discount, but we’re skeptical about one thing.  Let’s explain:

Powell’s Rate Hikes Are Going to Work:

One reason we’ve had such strong equity returns over the last decade has been the loose policies of the Federal Reserve.  They kept the Fed Funds rate around zero for the last decade and currently have $9 trillion in assets on their balance sheet which reflects additional stimulus currency they’ve put into circulation.  Running this action in reverse will have (and is having) the opposite effect.  It’s worth noting that we’ve had this large decline in the market multiple and the Fed has only raised rates to 1.50%, and still has a $9 trillion balance sheet.

The place we’re seeing the results of Fed actions the most quickly is in the real estate market.  As mortgage rates have risen in a few months from under 3% to around 6%, the low and middle parts of the housing market have locked up and transactions have decreased.  When the market clears and transactions begin again, it’s going to be at lower prices (but not at better affordability due to the higher interest rates on mortgages).  We’re also seeing retail stores overstocked with inventory they’ll have to mark down to sell.  The Fed rate hikes are going to bring down prices and reduce inflation.

During recent public comments, Chairman Powell has made it clear he’s going to keep raising rates until inflation is under control.  The market has risen during the past few days on hopes that if the Fed raises interest rates fast enough, inflation will come under control quickly, and we can get back to more of the zero interest rates and quantitative easing the stock market loves.  Basically, it amounts to an attitude of “let’s take our medicine fast, and then get the party started again right away”.

 

This Seems Pretty Straightforward So What’s This Other Path?

As the Fed raises rates, one of two things is likely to happen.  Currently, the Fed is targeting a Fed Funds rate of 3.40% by year end which would represent a very large increase in 2022, but still be low by historical standards.  If the rate hikes are ineffective or partially effective, and inflation remains high, the Fed is going to have to keep raising faster and longer than people hope and that will further compress the market multiple.  Stocks will fall.

We think the more likely scenario is that interest rate increases are effective in reducing headline inflation and throws the economy into a recession.  DKI is on record as saying that once you adjust for inventory restocking and the undercounting of inflation, GDP growth has been negative in the last two quarters meaning we think we’re already in a recession.  The large banks and establishment economists have just started to talk about the possibility of a recession in the last two weeks, a point we’ve made in a prior post.

The issue as we see it is that earnings estimates haven’t come down.  Almost three months ago, the estimate for 2022 earnings for the S&P 500 was $227.  A couple of weeks ago, that estimate was at $229.  While we’re seeing very high profits for the energy sector due to large increases in the price of oil, that sector only makes up around 3% of the index and is an additional cost for much of the rest of the index.  So, depending on who’s research you’re reading, we’re either in a recession, or about to enter one, and earnings estimates are about the same / up slightly.

This is not a sustainable situation.  If the Fed succeeds in taming inflation through interest rate hikes, it’s going to take a cut out of economic activity, and that’s going to mean lower earnings for the S&P 500.  These estimates haven’t adjusted to this coming reality yet.

 

Conclusion:

One path sees the Fed raising rates more than the market expects to get inflation under control which is going to take the market down from here.  The other path sees Fed rate hikes working and causing people to finally realize we’ve entered a recession.  At that point, earnings estimates will come down (lowering the E in the P/E calculation).  When that happens, the implied market multiple will be higher than current levels meaning that to get back to the current 16x multiple, stock prices need to come down.  As we said in the title, one way or another, we’re going to end up in the same place.

 

 

Information contained in this report is believed by Deep Knowledge Investing (“DKI”) to be accurate and/or derived from sources which it believes to be reliable; however, such information is presented without warranty of any kind, whether express or implied and DKI makes no representation as to the completeness, timeliness or accuracy of the information contained therein or with regard to the results to be obtained from its use.  The provision of the information contained in the Services shall not be deemed to obligate DKI to provide updated or similar information in the future except to the extent it may be required to do so. 

The information we provide is publicly available; our reports are neither an offer nor a solicitation to buy or sell securities. All expressions of opinion are precisely that and are subject to change. DKI , affiliates of DKI or its principal or others associated with DKI may have, take or sell positions in securities of companies about which we write. 

Our opinions are not advice that investment in a company’s securities is suitable for any particular investor. Each investor should consult with and rely on his or its own investigation, due diligence and the recommendations of investment professionals whom the investor has engaged for that purpose. 

 

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