I wanted to wait until after the CPI report to provide an update to the Market Expectations Table (MET) as it gave us needed context for this market set up going forward.
There was legitimate improvement in the August edition of the Market Multiple Table, and that resulted in an increase in the respective trading ranges for the market. Positively, this impressive rally is based on improving fundamentals, but at these levels, stocks are still aggressively pricing in a lot of additional positives occurring over the next several weeks, and as such this market remains vulnerable to disappointment.
Current Situation: Focus on Relationship Between Falling Inflation and Slowing Growth
First, there was a rearranging of the influences on this market last month. Inflation and Fed policy remain the two major influences on the market. But economic growth now is the next most important market influence and for one clear reason.
If inflation has peaked, then in order for the bulls to get the economic soft landing, inflation will have to decline more rapidly than growth (so we have falling inflation but mostly stable growth).
However, if growth falls faster than inflation, then that’s stagflation—and at 4,200 in the S&P 500, stagflation is not priced into stocks.
Going forward the MET clearly shows that we must watch the relative relationships between growth and inflation. Both are falling, but it’s the pace of one vs. the other that will determine a “soft landing” (and higher stock prices) or stagflation (or lower stock prices).
Looking at the current situation, there was legitimate progress on:
Inflation - CPI report combined with the survey indicators shows that inflation likely has peaked and that's a positive.
Earnings - the fears of a severe drop in 2023 EPS have, for now, been unfounded and expected 2023 EPS bounced back last month, helping to increase the various “fair value” trading ranges.
The other influences listed in the table remain unchanged because they did not improve but they also didn't get any worse.
Bottom line, there was legitimate improvement in some of the macro influences over the past month, and no deterioration. So, some of the gains recently are absolutely justified.
But at these levels, the market is pricing in a lot of further improvement across the various
market influences, and while we hope that happens, it’s left the S&P 500 vulnerable to a 5%ish decline (to start) if news turns negative.
Things Get Better If:
CPI continues to drop quickly
The Fed opens the door to a pause late in 2022
Economic growth remains resilient and falls slower than inflation
China distances itself from “Zero COVID”
Russia/ Ukraine have a ceasefire
Things Get Worse If:
August CPI extends the declines
The Fed reinforces it’s not close to done on rate hikes
Economic data falls faster than inflation raising stagflation worries
China locks down again
Russia/Ukraine war expands
The August MET reflects the fact that there has been legitimate macro-economic improvement since early July, as clearly we’re seeing a lot of evidence of a peak in inflation and earnings season has been better than feared.
But, looking at the fundamental valuations, the MET also reveals that, as many of us suspect, a major driver of this rally has been positioning: Investors jumped out of stocks in June, and are now piling back in and chasing stocks higher. But, at these levels, the S&P 500 isn’t just pricing in the improvement that’s occurred, it’s pricing in a lot more improvement that needs to occur including 1) A formal Fed pivot sooner than later and 2) Inflation that slows much faster than economic growth.
As we are on the cusp of feeling the effects of historic Fed tightening, I think at these levels those assumptions are aggressive and leave room for disappointment (and by disappointment a 5% - 10% pullback if the Fed doesn’t signal a pivot or growth slows faster than expected.
Feel free to reach out to me and use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President