The Week Behind

Despite an unexpectedly hot jobs number, the major indices showed resilience, refusing to give up any of the gains made two weeks ago coming out of the FOMC meeting and mega-tech earnings. This week the DOW and S&P 500 couldn’t be bothered: the former losing ~0.1%, the latter gaining ~0.35%. Meanwhile, the NASDAQ found a little more motivation, adding 2.15%. 

Highlights

• On an intraday basis, the NASDAQ entered a new bull market: up 20% trough to peak – June’s intraday low to last week’s intraday high. 
• Oil has returned to pre-invasion levels despite a far less-than-expected increase in OPEC+ production.
• 10-2 Year U.S. Treasury Yield Curve Inversion Deepest Since 2000.  
• The U.S. economy added 528k jobs in July, more than double expectations.  

The NBER and Recession

While the U.S. has entered a “paper” recession, defined as two consecutive quarters of GDP contraction, technically speaking, it is the NBER – the National Bureau of Economic Research – that officially declares the beginning and end of recessions. Typically, the NBER cites unemployment statistics to determine their beginning and end. With unemployment at 3.5%, the probability the NBER declares recession anytime soon is negligible. 

So, why does that matter? Why is the NBER’s determination of any importance?

Oddly enough, recession, albeit mild in nature, is integral to the bull case. The rate cut bulls are advocating for in the 1H23, which is currently priced-in as per the FED Fund Futures, is dependent on a recession. The FED is unlikely to pivot and cut rates without one. In the 1970’s, the FED pivoted too early, and inflation came back with a vengeance. As a result, Volcker responded by bringing short-term rates to 20% in the early 80’s. The FED is aware of that precedent and is unlikely to repeat it. Despite price action since July’s FOMC suggesting a more dovish FED, I believe the FED will continue tightening until something breaks, or at least cracks. Ahead of the jobs print, consensus was hoping for a cool number to advocate for easier financial policy. Instead, this report showcased an economy strong enough to weather incrementally higher rates for a longer period, inviting additional tightening. 

Concisely, if the NBER does not declare recession, then I do not see a catalyst for the FED to cut rates. Until unemployment is higher, do not expect word from the NBER. While it is possible layoffs and hiring freezes have yet to appear in the data, similar to last month’s CPI not reflecting collapsing commodity prices, for now, the recession, a paramount catalyst to the bull case, has been delayed. 

The Week Ahead

Speaking of CPI, it comes out Wednesday ahead of the bell. While we have initial and continuing jobless claims on Thursday as well as UMich consumer sentiment on Friday, I suspect CPI will dominate the conversation and dictate price action this week. While the bulls shrugged off what I classify as a damaging blow courtesy the job’s market, I do not expect continued resilience if CPI lands a similar hit. 

As for the number itself: Headline is projected for 8.7% – MoM decrease; Core is projected for 6.1% – MoM increase. While the expectations appear tepid, stakes are high. A print that fails to satisfy could be enough to thwart the bull case surrounding a rate cut, jeopardizing 3-6% of the rally in the S&P. While a cool print does nothing for the hot jobs number, it could provide the FED some evidence their activities have had the desired effect on inflation. Perhaps, it could fuel another 1-2% uspide in the S&P.  

Overall, I see risk-reward skewed to the downside. Consequently, I foresee selling going into the print, especially into Tuesday’s close. In an uncertain environment, profit-taking and cash-raising is to be expected after such a broad, quick, and aggressive move off the low. I expect the selling to be most prominent where the gains have been most spectacular: the NASDAQ, mega-cap tech, speculative ARKK-type names, etc… 

A Rally With Little Room Left To Run: Valuation Analysis

Currently, the consensus FWD EPS (1-year projected earnings per share) for the S&P 500 is ~$227 per share. As a result, as of Friday’s close at ~4150, the S&P 500’s FWD PE is ~18.25x. At June’s low, using the same FWD estimate and a price level of ~3600, FWD PE is ~15.85x. The 5-year average is 18.6x. The multiple has expanded ~2.5 turns, nearly returning to the 5-year average. Any additional upside implies one or both of the following assumptions:

1. FWD EPS is either correct or will surprise to upside.
2. Multiples will expand beyond their historic average. 

If you are tactically putting money to work at these levels, then this is the bet you are making. 

My Take On The Bull Bet

With respect to forward earnings, I think there is room for further contraction. The FED’s tightening will inevitably slow the economy and dampen inflation. Slowing economy means less consumption means lower profits. Furthermore, it is possible that inflation has actually inflated earnings as companies do not report in inflation-adjusted terms. As inflation comes in, so will its effect on nominal earnings. The recent jobs report suggests FED tightening has yet to affect the broader economy; last month’s CPI suggests a similar lag for inflation and earnings.

With respect to the multiple, until yield curves revert to healthy appearances, I cannot get behind the notion of above-average market multiples. Interest rates and multiples tend to be inversely related. With the 2-year above 3.2%, the 10-year below 2.9%, and imminent balance sheet reduction, I think the 10-year could find itself around 3.5%. Neither rising- nor higher- rate environments are known to foster multiple expansion.  

Clearly, I think markets are a little frothy right now. However, I want to clarify my position: I think we are range-bound. With only 4-months left in the year, I think the lows are in for 2022, especially in the NASDAQ. The lows in June were catalyzed by the worst UMich consumer sentiment in history, oil at $130, FED tightening, historic strength in the dollar, and widespread uncertainty across both geographies and industries. Since then, these issues have either begun to abate or the market has become more comfortable with them. If we see new lows, I suspect it’ll be in the S&P because forward earnings come down more than anticipated. Uncertainty surrounding the FED and path of interest rates is capping the upside. Until we get healthy yield curves and more palatable economic data, I do not see the S&P 500 sustaining a FWD PE exceeding ~18-19x to move significantly higher. Until we get some resolution on that front, I theorize markets will remain range-bound.