Disorder

The Credit Strategist - September 2022

I’ve argued all year that stock prices will retest their lows and I see no reason to change that view now.  The 15-20% drop we’ve seen thus far is insufficient to reflect what is happening in the world economically and geopolitically.  Reducing inflation to 2% without a serious economic downturn was always a fantasy.  And the Fed’s threshold for economic and market pain appears higher than expected.  Stated another way, the Fed put appears to have a lower strike price than markets originally priced and are still pricing in.  The bear market rally, impressive as it was, got far ahead of itself.  I expect to see the S&P 500 hit 3400-3500 again over the six months and that would still leave stocks generously valued.  Next year’s earnings should be in the low $200 range (inflated by all the usual nonsense of course) and a 15-16x multiple is appropriate, bringing the right range for the S&P 500 somewhere in the low 3000s.  That tells me prices need to drop at least another 15-20%. 

Thus far, the economy has suffered limited damage from the tightening cycle that began in March (and many of the most hard-hit areas are the most speculative activities that need to be flushed).  But there is more damage to come as higher interest rates work their way through to consumers and businesses.  Two quarters of slightly negative real growth (but still positive nominal growth) accompanied by strong employment numbers suggest that the economy can handle more tightening.  Job openings rose to a seasonally adjusted 11.2 million in July, up from June, according to the Labor Department, and the August employment report was strong.  This kind of data gives the Fed breathing room to keep hiking and shrinking its balance sheet (it barely started doing the latter but picks up the pace in September).  The point of tightening is to shrink demand; fighting inflation is supposed to be painful.  The delayed effects of tightening will become increasingly apparent in the months ahead.  Those effects will be mitigated (and the effects of policy muted) if there are indications that the Fed is preparing to reverse course in 2023.  That was why it was so important for Mr. Powell to talk tough at Jackson Hole and for his colleagues to reinforce the message afterwards. The bear market rally was decidedly unhelpful to the Fed’s inflation fight and they needed to snuff it out.  For the moment it appears they succeeded.