Housing weakness, high valuations, depleted consumer savings and a collapse in spending. What could go wrong?
In today’s newsletter we provide our read of the sell-off, our worries around the consumer, why Tech stocks won’t save the day and how an easing Fed would be a negative for the market.
Rising Rates Test the Market’s Bullish Structure
The recent rise in interest rates has put a stop on this year’s market rally. Price has been testing the key channel support that held up even during March’s banking panic. That’s a big concern.
A full-blown financial crisis was prevented by the Fed and FDIC in March. However, the Fed doesn’t have much control over long-term rates. And these have been rising lately, causing stocks to fall.
Following the shock from the financial crisis, inflation was low. So, any rise in rates was a positive for stocks because it meant growth was picking up, while inflation wasn’t a threat.
Modest economic growth with low inflation is a very favorable backdrop for the stock market.
You should know that today’s inflation has changed the rules of the game. Now when interest rates rise, it’s a negative for stocks. That’s like what we saw in the 1970s through the 1990s.
After Covid, stocks and rates began moving in opposite direction (negative correlation). That’s because when inflation is high, the Fed raises rates to tame it. That hurts the economy and stocks.
Investors are worried that we may be in this new regime of rising rates/falling stocks for a long time. That will ultimately depend on whether inflation returns to low levels.
The Latest Sell-Off Signals a Rate-Sensitive Consumer
Since the end-July, Consumer Discretionary stocks have underperformed the rest of the market.
We looked at the performance of Consumer Discretionary stocks on an equally-weighted basis to ensure that Tesla, a massive stock in that sector, isn’t distorting the results.
The underperformance of Consumer Discretionary stocks tells us that the market is worried about spending. With the labor market cooling off, consumers are sensitive to rising rates.
Credit card spending dropped in September. It’s now only marginally stronger than was the case pre-pandemic. The slump happened when student loan payments started again.
Spending had also slumped back in March when the banking crisis unfolded. However, the regulators rescued the system from a potential catastrophe, and consumer confidence returned.
In 2022 the consumer stayed strong even though the Fed was raising rates aggressively. Part of that was due to hundreds of billions of fiscal stimulus-driven savings that insulated against the shock.
We expect consumer spending to weaken. The big savings from the fiscal stimulus have been depleted, making the consumer more vulnerable.
The starting point was already poor, with wages as a share of the economy falling for decades as the middle class was hollowed out amid globalization.
Could Tech Stocks Rescue the Market? Unlikely
A weakening consumer is a negative for S&P 500 earnings. The latter is mainly driven by household spending on goods. Could Tech firms’ typically-fast earnings growth come in and save the day?
Tech stocks comprise close to 30% of the S&P 500’s value, the largest of all sectors. So, they have major influence in the returns of the broader S&P 500.
One big problem with Tech stocks you need to be aware of is their expensive valuations. Owning Tech stocks now earns less than just owning cash, like Treasury Bills.
Back in 2013, Tech stocks were very attractive to own compared to cash, as they offered an 8% expected return. That was a very favorable starting point for their bout of outperformance.
So why take such big risk with owning Tech stocks today considering these 2 major headwinds:
- The revenue growth has been slower than that of the rest of the market
- The stocks are expensive
It’s possible that high expectations around AI come true, and big revenue growth is realized. But that’s just a bet like any other. It’s not helpful when high valuations leave little room for error.
With Tech being less attractive than cash, the sector is a tough buy. The same is true for the S&P 500 itself. Tech is simply the poster child of an overvalued market.
Given the challenges that Tech is facing, we see it less likely to carry the market higher. In fact, its huge share of the market creates more of a vulnerability than an advantage.
Higher-for-Longer Interest Rates is a Negative for Stocks
With the consumer weakening, and Tech stocks unable to propel the market higher, the market is in limbo. Even if rates were to stabilize, their high level would still prove detrimental to earnings.
30-year mortgage rates at 7.8%, for example, are a huge headwind for the housing market. There’s one key concept you should know: the housing cycle drives the business cycle.
When people buy houses, they also buy a lot of durable goods that come with it, like refrigerators, furniture, TVs, etc. If that market is stagnating, durable goods spending is as well.
If we don’t see a recovery in the housing market, it’s hard to see how we avoid a recession. Without a recovery in housing, it’s unlikely we’ll see earnings rebounding in coming quarters.
The Fed’s rate hikes has increased the probability of recession in the next 12 months to 55%.
Probability of recession is based on the yield curve being very inverted. It’s a great tool to see how tight monetary policy is at any given moment. [2]
The yield curve has an excellent track record in predicting recessions, but it’s not perfect. The inversion of 1965, for instance, didn’t lead to a recession.
We believe that a recession will materialize by the 1st-half of ’24.
With inflation high, it’s unlikely the Fed will consider easing in the near term. That increases the exposure of the economy to higher interest rates for longer. The probability of recession goes up.
We believe that the Fed reversing course and cutting rates to avert the downturn will be a negative for stocks. The high probability of recession informs our view.
Episodes when the Fed cuts rates into a recession tend to see the S&P 500 down over the following 6 months. Treasury bonds outperform significantly, while gold posts modest returns.
Conclusion: The Stock Market is in Limbo, Risk-Reward is Poor
The bullish structure in the S&P 500 is being tested. Consumers are weakening, threatening earnings. Tech is expensive, a ball-and-chain for the market given their big share of the market.
The probability of recession in the next 12 months is high, and we think it’ll go higher. That will force the Fed to cut rates eventually. Unfortunately, that’ll come too late for stocks.
In coming reports we’ll be looking at the yield curve steepening of late. We’ll also explore how big of a threat the commercial real estate market is. Please stay tuned.
Are you worried about the consumer? Could AI lift the market here? What research would you like to see us work on? Let us know your thoughts below the article!
Footnotes
[1] The expected return is proxied by the 12-month forward earnings yield. That’s the earnings-per-share expected over the next 12 months divided by the share price.
[2] The yield curve used here is the 10-year/3-month spread.