- Investors hoping for “Fed treats” this Halloween
- Morgan Stanley offers near-term target of 4150
- Don’t be tempted to chase this bear market rally too far
It’s Halloween in the US…
Trick or treat?
Maybe some treats in the near-term…
For example, later this week the Fed might treat investors with less hawkish tones…
Let’s hope so… as the market is ‘fed up’ with tricks!
Morgan Stanley’s Mike Wilson sees some near-term treats ahead… offering targets of 4150 for the S&P 500… but also offers caution:
From Marketwatch today
“Bottom line, inflation has peaked and is likely to fall faster than most expect, based on M2 growth. This could provide some relief to stocks in the short term as rates fall in anticipation of the change. Combining this with the compelling technicals, we think the current rally in the S&P 500 has legs to 4000-4150 before reality sets in on how far 2023 EPS estimates need to come down”
Spooky don’t you think?
For example, in July I talked about the decline in M2 money growth and likely impact on inflation (more on this below)
And just last week I offered S&P 500 targets of around 4100; whilst warning of downside revisions to 2023 earnings.
Someone is reading the blog?
Let’s break it down…
Falling M2 Growth -> Lower Inflation
Let’s start with Wilson’s belief that inflation has peaked and will fall due to declining growth in M2.
July 14th I shared this post – specifically calling out the correlation between CPI and the rate of money (M2) supply growth:
July 14 2022
In short, I showed the rapid decline in M2 money supply growth (purple line).
It was the fastest pace we have seen in decades.
Now the orange line is what we see with CPI.
At the time, it was still moving higher, however I said we can expect this to peak soon.
Repeating my language from July:
“We should see inflation really start to drop in Q1 2023. And this is precisely what the bond market has been suggesting. For example, last week I highlighted how 5-Year TIPS now have inflation averaging just 2.5% the next 5 years (down from 3.60%)”
Whilst I didn’t pretend to know precisely when inflation would peak… we were getting closer.
Fast forward almost 4 months and inflation is rolling over.
And when you look at how closely these two datasets map each other – it should not be surprising to see inflation starting to come down.
Relief Rally…
The second part of Wilson’s note calls for the S&P 500 to potentially rally as high as 4150 – implying around 6% upside from here.
Last Friday I updated the weekly S&P 500 chart with forecast:
October 28 2022
Wilson’s target is less than 1% above the 35-week EMA – pretty much inline with my purple ellipse.
And whilst 6% upside is not unreasonable — further gains feel capped.
Today the market paused – waiting on two things:
(a) sentiment from the Fed later this week; and
(b) the all-important October jobs data.
For example, any more than 250,000 jobs added in October could send the market sharply lower.
Why?
For the simple reason it gives the Fed more ammunition to continue its aggressive hikes.
2023 Earnings Estimates to Come Down
The third part of Wilson’s note talks to earnings estimates for next year still being too high.
I agree… they are.
But as I was saying last week, so far earnings for Q3 have largely been inline with expectations (Facebook’s Metacurse aside)
However, the bar was extremely low.
For example, at the end of June the market lowered expectations to just 3% growth for Q3 – down from 11% growth only a few months ago.
That’s why earnings have been “better than expected”
73% have beaten low bars.
That said, if the bar was not lowered from June, most would have missed.
So whether it’s a case of “earnings beat” or “earning miss” — it’s entirely a function of where you set the bar.
Set it low enough (e.g. 3% in this case) – the more beats you get.
However, what I see is a declining trend… and that should be the focus:
Source: Schwab
But here’s something else…
If companies missed a lower bar – their stocks are hammered. And those who met expectations – most barely moved.
Source: Schwab
Last week I cited JP Morgan’s Chief Equity strategist lowering his 2023 EPS estimates for the S&P 500 to only $220 (from $240)
$240 has assumed growth of 8% – which I felt was ambitious – especially heading into a likely recession.
$220 assumes growth will be flat on 2022.
My expectation is more bearish – with earnings more likely to fall as much as 5-10%.
That could see EPS closer to $210 than $220.
From there, if we plug in a level of 4100 for the S&P 500 at just $210 per share – the market is trading at something like 19.5x forward multiple.
This is what Mike Wilson is effectively saying (without offering a target)
My preference is to consider adding exposure closer to 15x to 16x forward (i.e 3200 to 2400)… not 19.5x.
Finally Some Perspective…
When people ask where the market is likely this time next year – my answer is always the same.
I have no idea and nor do I care.
But what I can tell you is over the past 50+ years, the S&P 500 has offered investors an average total annualized return of around 10.5%
Some years it shoots sharply higher (e.g., from 2016 to 2021) – and some years it gives some back (e.g. recessions)
Now when I look at what we have seen from the end of 2016 to the start of this year – that CAGR was 16.3% exclusive of dividends.
That’s unsustainable.
With dividends – that equates to around 8% per year above the average for 6 years!
Therefore, the retracement of 20-25% is simply a reversion to the mean.
Let me illustrate with back of the envelope math:
For example, let’s say we finish the year at around 3600 on the S&P 500.
From 2016, that would equate to a 6-year CAGR of 8.24% plus ~2.0% dividends – for a total return of ~10.24%
Put another way, things have reverted to the mean.
Now we can talk about guessing what earnings will be next year; the forward multiple to apply; what the Fed funds rate may be; 10-year yields; and when inflation is likely to peak.
And I can waste “millions of pixels” writing about it.
However, if you simply apply long term CAGRs over “5, 10, 20, 30 or 50” years – you will find that buying the market between the zone of 3200 and 3600 offers a strong long-term risk reward.
Sure, the market may produce negative returns this year and next.
That’s more than fine.
Again, for the past 5 years we were averaging something in the realm of 16% + dividends.
But you can be sure that when the Fed cuts (vs simply pausing)… stocks will likely take off.
In between now and then — we need to see:
(a) inflation move a lot lower over several consecutive months; and
(b) unemployment start to rise to levels of closer to 5.0% (vs just 3.5% today)
And that’s when you can start to think the bottom is getting closer.
Putting it All Together
We can expect stocks to post more gains heading into year end – barring any “tricks” from the Fed.
My feeling is we will receive more (near-term) “treats than tricks”
However, don’t get too carried away if we see the S&P 500 trading around 4100.
That’s only another 6% from here.
But more importantly, buying the market at 4100 does not offer a strong risk / reward for subsequent years.
Remember: the key is not only what we buy – but to buy well.
Three S&P 500 levels I have offered readers (as a guide):
- 3600 is not a bad level to start nibbling;
- 3400 looks more attractive; and
- 3200 is time to ‘pin your ears back’ and buy with confidence
When the market trades at 4100+ later this year — it will feel like these price levels are not going to present again.
And you will be tempted to chase the market. That’s what bear market rallies do.
Don’t do it.
Bear markets trick you.
I think there is a very good chance you will get another good bite at the cherry.
Happy Halloween!