Our risk signals flipped negative last week for the first time since February of 2020. For our non-institutional clients, we have decreased our exposure to the equity markets by 50% or more. The bears currently have control of the market and preservation of capital is crucial to long-term performance.
The S&P 500 is just above the 200 day-moving-average. We do expect a rally for a few days, but then we expect the sellers to show back up.
We want to be very careful of these rallies, because as long as our risk signals are negative, they are most likely bear traps. There are a lot of things to be monitored, such as very high inflation, and rising rates, but one in particular that needs to be monitored is the standoff between Russia and Ukraine.
Are we headed for a bear market or is this just a nasty correction? Only time will tell, but for now the trend is down and fighting the trend can be very expensive and painful. We will let the market stabilize and when our signals turn positive, we will re-enter.
Next, let's move on to this month's market expectations table.
In looking at the changes in the Market Multiple Table between January and February, it’s really no wonder why stocks dropped. I say that, because over the past 30 days we’ve seen the “Gets Worse If” scenarios come true for two of the market influences from last month’s Market Multiple Table: Fed Tightening and Inflation.
Last month, I wrote the macro outlook would deteriorate if: “The Fed reinforces at least three hikes are coming (if not four)” and “Omicron extends supply chain issues and inflation remains well above the Fed’s target (> 4%).” Well, that’s exactly what’s happened, and stocks have dropped as a result.
Looking at this month’s Market Multiple Table, one of the bigger changes is that Omicron is no longer a market influence. Not only are cases declining, but as a WSJ article yesterday reported the U.S. and most of the world (ex-China) is simply learning to “live” with COVID and as such cases won’t cause the type of economic slowdowns previously encountered. Stated differently, COVID isn’t a threat to close the economy anymore.
That means this month gives us the smallest number of market influences since the Market Multiple Table was started more than two years ago: Fed Tightening and Inflation. Those are the two influences over stocks that will determine whether markets can extend this rebound, or if we test the recent lows.
Notably, I did not include economic growth as a market influence. The short-term economic noise from Omicron essentially will give bad data a “pass” for the next few weeks. If data turns bad and stays that way through March, then economic growth will become a market influence as investors will get very nervous about stagflation. But we can address that in next month’s MMT. Point being, even if data is bad in February, it will be “blamed” on Omicron and won’t impact the Fed or expectations for the economic recovery. Bottom line, the February MMT reflects this market reality: It’s all about the Fed and inflation, and whether we see the Fed get more hawkish (bearish) or less hawkish (short-term bullish).
Current Situation. As mentioned, both Fed Tightening and Inflation saw the “Gets Worse If” scenarios become reality over the past 30 days, and that’s the main reason stocks dropped in January. The good news from that is now markets view the Fed as very hawkish, pricing in at least four rate hikes in 2022 and summer balance sheet reduction. That’s likely an appropriate view of Fed policy given what we now know (and if anything it’s slightly more hawkish than the Fed might end up being), so for now stocks have gone through the painful process of pricing in the more-hawkish Fed.
On the inflation front, Omicron has once again resulted in worker shortages and global production disruptions, and while they aren’t as bad as at the start of the pandemic, they will continue to impact the supply of goods and services. And since the global economic recovery remains strong and demand is robust, that equals high demand and low supply, which will continue to put pressure on inflation.
So, the events of the last 30 days (hawkish Fed, stubbornly high inflation) have compressed the market multiple—just as they should have. And we’ve gone from a “Current Situation” multiple above 20X in January to one between a more historically normal 19.0X-19.5X.
Point being, the macroeconomic outlook has deteriorated over the past 30 days, but that is now reflected in the market valuation, and while stocks still aren’t “cheap” on a historical basis, they are much more appropriately valued for the current situation.
Things Get Better If: The Fed Hints It Won’t Hike More than Four Times in 2022, Inflation Peaks Not Just Statistically but Also As a Focus of Washington.
This outcome could put more fuel into the ongoing relief rally, as expectations for the Fed have become so hawkish that there is now room for a “dovish” surprise. But given the intense rally of the past two days, stocks have largely priced in this outcome from a fundamental standpoint, although momentum could carry the S&P 500 higher towards 4,600 or slightly higher. But from a fundamental standpoint that’d be aggressive, as the new reality of multiple Fed rate hikes this year has lowered the “Best Case” market multiple to 20X.
Meanwhile, earnings season hasn’t been bad, but it’s been disappointing enough to erase hopes of positive earnings revisions. Point being, we do not see 2022 S&P 500 EPS going any higher than the current $226. That also removes a potential positive catalyst that was in place for previous “Best Case” scenarios. Bottom line, there’s room for some positive, dovish surprises in the markets, but that doesn’t change the fact that the Fed is hiking multiple times in 2022 and reducing the balance sheet, so the upside on those surprises is limited from here.
Things Get Worse If: The Fed Hints There Could Be More Than Four Rate Hikes in 2022, Inflation Stays High Both Statistically and as a Focus of Washington.
The good news is that it’s unlikely the Fed gets materially more hawkish than it currently is, and hints at five rate hikes or more aggressive balance sheet reduction. The bad news is that if that unlikely event occurs, it’s a long way down to fundamental support in the markets (if the January lows are broken). To that point, a 19.0X-19.5X multiple (the current situation) is not pricing in a very aggressive Fed (just a moderately aggressive Fed) so if the Fed does get even more aggressive, we will see the multiple come down at least another “turn,” (meaning one full point) and the declines from here would be painful.
Bottom Line
The macro outlook has deteriorated and stocks have dropped accordingly as the market multiple fell as investors priced in future higher rates. But while the drop in January was not enjoyable, the side effect is that stocks are much more appropriately priced for the current environment. Looking forward, there is upside in this market if the Fed provides a dovish surprise, but with the rally of the past two days that upside is limited. Conversely, while it is more unlikely, we do need to be aware that if the Fed hints at five hikes or aggressive balance sheet reduction, then it’s still a long way down towards fundamental support for a very aggressive Fed.
Bottom line, the market is much more fairly valued for the macro reality than it has been in months, but there’s not much additional upside and a lot of downside if we get another hawkish surprise, and that’s one of the reasons we continue to expect continued volatility (and think rallies like this one should be used to get defensive tactical exposure).
If you have any questions, feel free to use me as a sounding board CLICK HERE.
Best regards,
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Direct: 952.828.5336
Email: kurt@ivoryhill.com
—Written 02.01.2022.
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