The Fed is trying to stamp out inflation by reducing economic demand, which is hurting the stock market.
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The stock market has once again gone into selloff mode, but there is still reason to believe it is close to finding a floor—and moving higher again.
The S&P 500 is down more than 2% since Tuesday’s close. That was the last day of trading before the Federal Reserve announced its decision to lift the federal-funds rate by three quarters of a percentage point.
The Fed’s announcement also showed that the majority of committee members see a higher peak fed-funds rate than what the market had expected.
The Fed is trying to stamp out inflation by reducing economic demand, which is hurting the stock market. Now, the S&P 500 is resuming a larger decline, down more than 12% since the peak of a summer rally.
Part of the problem is that the higher short-term rates are pushing longer-term bond yields upward.
Right now, that is causing the “real yield” on the 10-Year Treasury bond to rise to about 1.3 percentage points. That means the simple yield is that much higher than average annual inflation expectations for the next 10 years of 2.38%.
A higher inflation-adjusted rate of return on a safe government bond makes the riskier stock market slightly less attractive. It lowers the multiple of expected near-term earnings that investors are willing to pay. The S&P 500’s aggregate forward price/earnings multiple has dropped to about 16 times from just over 20 times at the start of the year. The index is now just below 3800.
The good news is that the worst may be almost over now.
“We see lower inflation, the 10 year TIPS yield [real yield] pulling back and 4,400 for S&P 500 by fourth quarter, 20022/first quarter, 2023,” wrote Barry Bannister, Stifel ’s chief equity strategist.
His thesis starts with a declining rate of inflation. The consumer price index’s year over year gain has declined for two consecutive months. To be sure, inflation is declining more slowly than the market had anticipated, but it is dropping nonetheless. For three-month windows, namely June through August, the annualized rate of inflation has been cut in half, Bannister notes.
That means the 10-year yield could decline as investors bid up the price, sending its interest rate downward.
And that is precisely Bannister’s second point. The 10-year real yield could very well be peaking here. That is also because Bannister sees the Fed’s expected peak fed-funds rate as going no higher from here—and the Fed’s projections even showed the strong possibility of a rate cut by early 2024. The 10-year real yield is highly correlated with forecasts for the future fed-funds rate, Stifel’s data show.
And a lower real 10-year yield would lift the S&P 500’s price/earnings multiple. Bannister’s 4400 year-end price target for the index would represent a just above 18 times multiple on analysts’ expected aggregate 2023 earnings per share of $240 for S&P 500 companies, according to FactSet. There is a rationale for that multiple—it did hit 18 times in August when the real yield was a bit lower.
There is just one key risk. With the potential destruction to economic demand, earnings estimates could decline a bit. But even if next year’s EPS forecast drops—say 5%—by year end, the index would still post a gain from its current level.
Consistent with that, if the inflation rate is truly on the decline, the Fed will feel less pressure to lift rates beyond current expectations. That could save the economy from a severe recession, while the market could handle a more mild one.
Whatever level the S&P 500 could hit in the next few months, starting to buy a little bit now is more than defensible.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
