Will US Equities Revert To Inflation Era Valuations?

September 23, 2022

Sign Up for Weekly Insights

Keep abreast of the latest changes in the markets and the economy as a whole by signing up for the Weekly Insights newsletter. Every week, Chris Belchamber tells you what’s on his mind when he’s thinking about his clients’ investments. Our blogs, emails, and postings on social media provide key insights as well as updates on strategies, backed with cutting edge research explained in terms investors can understand quickly

We have always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging. We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.
Fed Chair Powell

There’s a high probability in my mind that the market, at best, is going to be kind of flat for 10 years, sort of like this ’66 to ’82 time period,
Stan Druckenmiller

What is worrisome in the last 48 hours is an accelerated loss of confidence in policy making
Mohammed El-Erian

The Fed has been very clear that tightening financial conditions is a core component of their fight against inflation and the chart below shows this happening. This week’s Fed statements told us more is coming. So far US equities have held in remarkably well in comparison. Has the correlation broken? Or is this a delayed reaction?

In the Fed meeting this week Fed officials put their interest rate expectations well above prevailing market rates over the next 2 years.

The median forecast among the 19 Fed officials is for unemployment to reach 4.4% next year and stay there through 2024, from the current rate of 3.7%. But even that new level might still be too low. Almost all participants said risks to their new forecasts were weighted to the upside. They projected interest rates reaching 4.4% this year and 4.6% in 2023, before moderating to 3.9% in 2024.

As Powell’s statement above makes clear, Fed officials are prioritizing their inflation objectives even at the cost to economic growth. The market is to some degree doubtful about these projections. At some point weak economic growth will become a bigger problem.

Raising rates into weak, or recessionary economic conditions is very rare because it is likely to make growth even weaker. The chart below shows the high correlation between the YOY change in the Leading Economic Indicator (LEI), and the YOY change in the 2 year Treasury Yield. The collapse in the LEI this year has coincided with one the most substantial rises in the 2 year Treasury Yield.

The Fed can’t keep raising interest rates for long into a recession. Increasingly weak growth will be a constraint on disinflationary interest rate rises. The major test for the central banks is yet to come. In the mean time, this is hardly good news for equities.

In addition to tighter financial conditions, US equities have still not unwound over a decade of rising valuations. US equities are now confronted not only by the highest interest rates for over a decade but also the highest inflation levels for over 40 years.

The chart below shows that inflationary conditions, as seen last in the 1970s, are highly damaging for equity valuations. The average valuation for equities is more than 50% below the current level as measured by average 10 year earnings.

The chart below shows that big cap technology stocks are a large component of this issue, with a comparison to the technology bubble in 2000. The current bubble has been even bigger and potentially has much further to fall.

Big cap stocks have been supported by record levels of buybacks.

However, the coming earnings weakness may limit the extent to which corporations choose to leverage their balance sheet further. Against this QT is coming on stream this month so this would most likely fully offset buybacks as a factor.

Growth Weak in Q3 2022

For the third quarter in a row it looks like GDP will be weak – currently tracking only just above zero.

Weak growth is a global phenomena with inverted yield curves everywhere.

The Fed Focus Is On The Most Lagged Data

The Fed is now heavily focused on the labor market and the CPI for policy decisions. Regretably, both these indicators have very late signals in the economic cycle. The largest component of the CPI is the housing component which peaks around a year after house prices. Then it is not disputed that the labor market is always the last component of the economy to turn, as previous insights have pointed out.

The Fed is raising rates so aggressively at least partially because it has finally realized that it made a clear policy error with the explosion of inflation. The Fed has lost credibility and does not want to miss on getting inflation back under control as soon as possible. With so much to prove and in addition focusing so much on late cycle indicators, the risk is significant that the Fed may go too far and stay tight too long. This raises the stakes on a longer deeper recession than many may be expecting.

Summary

Investors who are used to riding out equity corrections because the market always comes back should consider what correction the market could have in this cycle. The Fed “put” or market support is currently absent, valuations are still near record levels, the Fed has warned it may well cause a recession, and the Fed may well be biased to go too far for too long in its tightening policy in this cycle.

If you’re not already a client of CB Investment Management, schedule a FREE consultation today. Let me use my expertise and multidecade experience to apply Best Investor risk management methods to navigate your portfolio for the uncertain and potentially challenging conditions ahead.

Please note these important disclaimers: Educational use Only. The market update published by CB Investment Management, LLC (“CB Investment”) is intended to be educational in nature and is not intended to be a recommendation for any specific investment product, strategy, plan feature or other purposes. Accordingly, it should not be construed by any consumer and/or prospective client as solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation.Advertising and Marketing. Communications such as this are not impartial and are provided in connection with advertising and marketing. This material is not suggesting a specific course of action or any action at all. Prior to making any investment or financial decisions, an investor should seek individualized advice from a personal financial, insurance, legal or tax professional that takes into account all of the particular facts and circumstances of an investor’s own situation. No person associated with CB Investment is a licensed attorney or tax professional and the information contained herein should not be considered tax or legal advice. Links to Third Party Content. This Market Update contains links to articles or other information maintained by unrelated third parties. You acknowledge and agree to the following: All such information is provided solely for convenience purposes only because we believe that it may provide useful content and all users thereof should be guided accordingly. We disclaim any responsibility for the link’s performance or interaction with your computer, its security and privacy policies and practices, and any consequences that may result from visiting it. We do not control the content published by the third-party; we do not guarantee any claims made on it, nor do we endorse its sponsor or any of the content, policies, activities, products or services offered by any advertiser on the site. CB Investment assumes no liability for any inaccuracies, errors or omissions in or from any data or other information provided by the third party and inclusion or reference by CB Investment to any third party link should not be construed by any consumer and/or prospective client as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation, over the Internet.
Important Information regarding Registration Investment advice is offered through CB Investment Management, LLC (“CB Investment”), 8231 Crestwood Heights Drive, Mclean VA 22102 an investment adviser registered with the states of Virginia and Maryland. Registration with the states of Virginia and Maryland should not be construed to imply that the SEC has approved or endorsed qualifications or the services offered, or that its personnel possess a particular level of skill, expertise or training. Important information and disclosures related to CB Investment are available at https://chrisbelchamber.com.

More Info

Archives

Start Today

Investing like the best can lower your stress and risk levels while bringing you higher, long-term returns. It can provide a stable platform for planning and give you more financial security now and for the rest of your life. Let’s get started.