And after

Hello. Twice on Friday, the S&P 500 broke its June lows at 3,666 (technical analysts will note the presence of the beast number). Twice it rebounded and the index closed at 3,693. Old lows held may be reassuring, but the smell of fear is unmistakable. Email us: [email protected] and [email protected].

The Matrix Reloaded

The market rout last Thursday and Friday had many pundits thinking capitulation. Bob Schwartz of Oxford Economics said “financial markets are throwing in the towel”, after finally accepting that the Fed is ready to trigger a recession if necessary. Citigroup’s sentiment indicator has broken into “panic” territory for the first time since early 2020. In the FT, our colleagues Eric Platt and Nicholas Megaw report a rush into put options:

Purchases of put options contracts on stocks and exchange-traded funds surged, with large fund managers spending $34.3 billion on options in the four weeks to September 23, according to data from Options. Clearing Corp analyzed by Sundial Capital Research. . . The total was the largest on record in data dating back to 2009, and four times the average since the start of 2020. Institutional investors spent $9.6 billion in the past week alone. . . In contrast, demand for call options, which can pay off if stocks rally, has waned.

We wrote recently that sentiment indicators and derivatives markets may not be sending clear signals at present, but that said, there is little doubt that anxiety is in the air.

So how bad could things get? In search of answer and humility, we thought back to our last major prognostic effort. Just over three months ago, we presented the matrix below, giving ourselves and readers a chance to do a very simplified scenario analysis of what the next 12 months have in store for us:

It’s hard to imagine that at the start of the summer, the central market projection was for a fed funds rate of just 3%! With the policy rate at 3.25% today and market prices at a peak rate of around 4.7, June is a universe away.

Here’s how Unhedged and readers judged the odds at the time:

Our judgment on the trajectory of rates is proving to be very erroneous. Here is what we wrote about our predictions:

Unhedged tends toward a successful inflation-fighting campaign that plunges us into recession (A). We believe the Federal Reserve is trying to bring inflation down, but growth and inflation are already showing signs of peaking. The Fed can kick down a door that’s opening, hard. Housing inflation will decline as wages continue to moderate, and bloated inventories will prove disinflationary. Unfortunately, that will mean a recession.

Our humiliation at having misjudged the height of the rates and the speed is slightly mitigated by the fact that we still agree with most of the paragraph above. We remain in the recession camp, and our description of the Fed as “trenched” looks good in hindsight. But our belief that slowing growth would bring inflation down quickly was grossly naive. Our readers were smarter, shifting more probability weight to the upper right quadrant.

Before establishing a new matrix, let’s go back to what happened between June and September that changed the outlook so much. Headline inflation peaked in June at 9.1% yoy, a report we called “horror” at the time. Yet we also noted how indifferent the markets seemed:

The S&P 500 completed a touchdown and the Nasdaq was flat. The Treasury market also remained calm. . . The market is still pricing in Federal Reserve cut rates next year.

One possibility is that markets are focusing less on the CPI than on other data that suggests we are at the start of an inflation-killing recession. . . the bullwhip effect reducing spending on manufactured goods, falling commodity prices, a rapidly cooling housing market and decelerating wage growth.

As the weeks passed, weaker economic data left just enough room to hope that inflation would fall quickly. Brent crude is down 29% from June; copper 20 percent. The housing market is in free fall. Manufacturing PMIs fell in June and July. A softer CPI report on August 10 – zero percent month-on-month! – renewed the faith of optimists, giving a final boost to the bear market rally.

The turning point came on August 18 when Fed officials, likely frustrated by markets easing financial conditions at exactly the wrong time, did their best to scare off investors. What they said, that higher rates will come soon and cuts probably won’t, wasn’t new. But the repetition worked. Powell’s Jackson Hole speech bolstered the tough talk, and then August’s searing inflation report, fueled by sticky rents and wages, made it seem prescient. The markets fell. Last week’s economic projections from the Fed provided final confirmation.

Now reload the matrix. This time we’re changing things up a bit by focusing on the stock market rather than general economic conditions. Is there another big step coming? This can happen through declining corporate earnings, compressing price/earnings ratios, or both. The current consensus EPS estimate for 2023 is $231, according to FactSet, and the forward market P/E is 15.4. For context, here’s how earnings have grown since 2008, along with current estimates through 2024:

And here is the S&P P/E ratio, dating back to 2005:

By placing the two variables in a matrix, we obtain:

Of course, in cells A and D, you can imagine an extreme scenario where a huge move in one variable overwhelms a small drop in the other, generating big or terrible returns. But the question before us is: the main threat to returns, earnings, valuation, both or neither? And remember, in recessions and booms, the two tend to travel together.

Now, one could equate the question of whether the P/E will go down with the question of whether rates will get another leg up. P/Es and rates are not in a mechanical relationship valid in all circumstances, but it is quite clear that the recent compression of P/Es and higher rates are related. Similarly, one could equate the question of whether earnings estimates will fall with the recession question, although you can certainly see earnings fall without a recession (Jason De Sena Trennert of Strategas estimates that the median decline in earnings during US recessions is 22 percent). So, although they are not exactly the same, there is a vague sense in which the new matrix is ​​the old rates and recession matrix, but with new labels.

What does Unhedged think? Well, we have no idea where the rates are going, as we proved last time. So let’s take a look and weigh the possibility of a contraction in the P/E ratio to 50/50. But we’re pretty confident that the 2023 estimates will come down from here, because we’re pretty confident that there will be a recession, for the simple reasons that (a) major cycles of tightening usually end in recessions and (b) many important sectors of the economy are rapidly slowing down.

So let’s say we think there’s a 75% chance that the estimates will drop significantly. This gives probabilities of 37% for A and B, and 13% for C and D. This is a picture in which the most likely outcome (50%) is that the market gets confused, but there is a much higher probability than usual. very poor results and a much lower than usual probability of particularly good results.

We’re fine with that, but we’re much more interested in your probability estimates than ours. Please email them to us – or share them on Rob’s Twitter account.

A good read

The Death of the Starter House.