In contrast to the stock market’s performance over the past month, actual events were broadly positive from the standpoint of the Market Multiple Table as COVID cases peaked and receded; the Fed met market tapering expectations, and economic data confirmed the “reflation” was once again underway. But the fact that stocks declined anyway simply reinforced the major observation of the MMT in September: Namely that the “best case” scenario for stocks was already priced in and as such the market was vulnerable to a headline driven “air pocket,” which is exactly what happened.
Now, as we look at the October Market Multiple Table, stocks are no longer pricing in a “perfect” scenario, which is a near term positive. However, the “bar” to provide a majorly positive surprise also has risen given we know the Fed tapering schedule, COVID cases have peaked, and the economic recovery is ongoing. So, the major outstanding unknowns (size of tax hikes, pace of increase in yields, whether earnings can remain stable) are more issues of “it won’t be too bad” rather than “it’s a surprise positive”).
Looking at the October Market Multiple Table more specifically, the only major change was “Reflation/Stagflation” being removed as a market influence because for now, the “reflation” is clearly in gear as both growth and inflation remain elevated.
“Reflation/Stagflation” was replaced by “Rising Treasury Yields” as the pace of the rise in yields is now a market influence as it will impact the market multiple. The faster the rise in rates, the more it will pressure the market multiple and that would be a headwind on stocks.
Bottom line, the October MMT largely reflects the reality that the market is no longer priced for perfect and that there’s more fundamental support for stocks at these levels. At the same time, there aren’t a lot of compelling positive catalysts looming, while the current situation assumes “not bad” resolution of: Tax hikes, rising yields and earnings. So, while the market is more fundamentally supported here, downside risks remain.
The current situation now reflects the positive changes to both the COVID outlook (the Delta variant wave is receding) as well as the Fed providing clarity on tapering (starting this year and running at a pace of $15 billion/month). Those two events provide important support for the market around these levels as they confirm neither will be a material negative for stocks. Meanwhile, the focus now turns to Washington and what level of tax increases that will occur, and to expected 2022 earnings and whether they can stay at $220/share for the S&P 500. Right now, the current market valuation assumes that tax increases are relatively small (and that companies bear most of the brunt) and that earnings do not slip from current levels.
Things Get Better If: The Fed Confirms Tapering Will Be More Gradual Than It Implied ($10 billion/month), COVID cases Don’t Start to Rise as it Gets Colder, Treasury Yields Have A Slow/Gradual Rise Higher and Tax Hikes are Minimal.
This is essentially the “best case” scenario for stocks in that an even more gradual tapering timeline is confirmed, COVID essentially “goes away,” yields rise but not at a pace that causes the market multiple to decline and Congress passes minimal tax hikes. This scenario would lift S&P 500 earnings expectations for 2022 to as high as $225 and a combination of the very, very slow taper and extra fiscal stimulus could push the market multiple out above 20X, meaning the best case scenario for the S&P 500 would be in the mid-to-upper 4,000s.
Things Get Worse If: Inflation spikes higher or the Jobs Report Is Strong and the Fed Considers a Faster Taper, COVID Cases Rise as the Weather Cools, Yields Rise Quickly (To New 2021 Highs in the Next Few Weeks) and Tax Hikes Are Higher Than Expected.
Each of these potential negatives would put moderate pressure on stocks, especially given the recent pullback but still generally lofty valuations. One of these events would likely result in at least another 5% decline from here, while two or more of these events would risk a full-blown correction.
Bottom line, the MMT in September revealed that this market was vulnerable to an “air pocket” and that’s exactly what happened. Now, the October MMT reflects the fact that some of the biggest potential negative events are “off the table” for now (Fed tapering too quickly, stagflation and sustained COVID surge). But the MMT also reveals that the list of events that would need to happen to provide a meaningful upside catalyst isn’t very likely (Fed tapering less than 10 billion/month), COVID “going away,” smaller than expected tax hikes and very gradual slide in yields. So, we’re left with a market that largely is “fairly” valued given the current macro set up, until we have more clarity on 1) Tax hikes, 2) Yields and 3) 2022 earnings, all of which we will get before next month.
If you have any question about your portfolio, feel free to use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President