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Monday, August 8, 2022

Is the stock market “cheap enough” yet?

Is the stock market “cheap enough” yet? What does that even mean? Never mind, too hard a question – it’s very cheap if you’re holding til 2050 or later. It might not be all that cheap if you’re a seller this fall to start paying your kid’s college tuition off.

Valuation doesn’t provide you with any usable signal over the near term so, by all means, be aware of it, but don’t rely upon it to deliver something it can’t. Expensive stock markets can continue to go up in price for years. Cheap stock markets may remain cheap (or get cheaper) for decades.

So what should we be focused on today? I think the paradigm of the current moment is fairly simple. It’s a binary situation that’s been set up for us. Technicals, valuations, economics, toss it all into the cauldron. Stir. Here’s what you get:

Scenario One: Soft Landing

As prices cool and possibly roll over for durable goods, the inflation begins to leave that segment of the economy and work its way into the services side (this is underway now). It’s painful for a few months as rents and wages rise and these increases become sticky. But the rate of acceleration in these costs slows as tightening financial conditions (rising rates, falling stocks, decreased credit availability) work their magic. The Fed sees progress in these prices slowing (or even reversing) and softens its rhetoric. There are 1.9 jobs for every 1 person currently seeking a job (11.5 million job vacancies and 5.9 million unemployed workers) – so we avoid the recession as the labor market stays strong and consumer spending wobbles without completely falling off the tracks.

Takeaway: If we have a soft landing into 2023 rather than a recession, stocks are way oversold and about half the S&P 500 is way too cheap to be ignored. The good news your stocks will go higher in this scenario as relief washes over everyone and the risks of inflation abate. This will feel good, for awhile at least.

Scenario Two: Recession

It’s already too late. Higher wages and higher prices are locked in a spiral where one goes up which means the other has to follow, and these two things feed off of each other until employers and consumers are both miserable. “Yes, I’m making fifteen percent more money but my cost of living is rising almost twice as fast,”  says the faithful employee. “Yes my revenues are up nominally but my cost of doing business is up even more and I cannot expand because there aren’t any workers in the salary range I am able to offer,” says the boss. Sooner or later, something (many things) start to break – the banks stop lending, businesses stop borrowing, unemployment ticks up, the labor force participation rate is thrown into reverse as people give up on finding the work situation they want. Consumer spending falls and falls some more as pessimism takes hold. The investor class de-leverages and a big financial institution (or two) blows up.

Takeaway: If we have a recession into 2023 rather than a soft landing, stocks may not be down enough to account for the earnings hit companies will take and a large amount of public companies will turn out to have had unsustainable business models and fold. many companies will find themselves unable to finance and refinance their way to profitability due to declining investor interest. The electric vehicle space, for example, is full of these situations. It’s hard to imagine we’ll get through a recession at 18 times forward earnings, so the S&P 500 would have to experience both a contraction in earnings per share (happens in every downturn) coupled with a simultaneous contraction in the price-earnings multiple. So far this year we’ve had the multiple contraction but earnings growth has been (partially) offsetting it. In a recession, that’s not going to be the case – companies will earn less and investors will decide to pay less for those earnings.

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So which way will it go? My forecast will be as useless as yours. But I’ll tell you which scenario I believe would be the least harmful, and you might be surprised…

Personally, I would root for recession here.

I think stocks are already paying the piper as it is, why not complete the process? If we manage to avoid a 2023 recession, we’d only be forestalling the inevitable: Recessions are a normal and natural part of the economic cycle and the longer we go without one, the worse the imbalances will be when we get there. Recessions are a correction of imbalances that are unsustainable. The current imbalances are glaring and obvious to everyone: Record high valuations for unprofitable technology startups, a labor market where people have gotten accustomed to being paid to do nothing, home prices that cannot be paid by first-time buyers without rich parents putting down cash, a supply chain debacle that’s laid bare the vulnerability of our economy and very way of life for all to see – I could go on, but you get the idea. All of it unsustainable. There should be no desire to maintain the status quo now that market forces are already hard at work dismantling these imbalances right before our eyes.

Given the damage already done to the stock market, with 50% of Nasdaq stocks down 50% or more and only three sectors (Staples, Utilities, Energy) trading above their 200-day moving averages, we might as well just have the economic downturn and get it over with. We’re already paying for it anyway. Trillions of dollars have been wiped out of the stock market thanks to the crash of 2022 but there are thousands of stocks that have been trending down since February of 2021 – a year and change of investor pain that ought not go to waste.

Several current and former Federal Reserve officials have been openly saying that the Fed cannot achieve its objective of price stability without causing a recession. Former New York Federal Reserve President and FOMC vice chair Bill Dudley’s recent opinion piece best represents this “rip off the band-aid” view:

So if not this year, then when? That will depend on how the Fed responds to economic developments. Consider, for example, the real possibility that year-over-year inflation readings decline quickly from the 8.5% peak they reached in March — as the prices of oil, gasoline and cars come back down, supply chains untangle and demand reverts back to services from goods. Will this good news be enough to keep the Fed from making monetary policy tight?

Such a delay would probably have two main consequences. First, the near-term risk of a recession would decrease. Second, the labor market would remain very tight and this would prevent inflation from falling back to the Fed’s 2% objective. Underlying inflation would actually keep rising, driven by higher wages and expectations of more persistent inflation. Ultimately, the Fed would eventually have to step in with even tighter monetary policy than initially contemplated, precipitating a deeper recession.

So, you want a shallow recession now or a bigger one later?

I would also point out that we have never, ever, as an economy and a consumer class, been better positioned for a recession. All of the companies that matter have locked in super-low rates on their debt for years to come. Cash is everywhere. Companies, households, you name it. Liquidity is not an issue. Even if home prices and stock prices fall, Americans will enjoy an increased average (or median) net worth relative to the prior trend for years to come. Even a large uptick in layoffs (no sign of this in sight, it’s way early) would be easily absorbed into a labor market with headline unemployment of just 3.6%, the lowest of our lifetime. Corporate and household balance sheets, combined with the current demographic setup, should ensure that a garden variety recession could come and go without a full-blown financial crisis arriving as a package deal.

Stocks will have priced in the full extent of a recession long in advance of when the recession is actually at its worse. The data will continue deteriorating as the stock market begins its rise from the lows. This is how it’s always happened, it won’t be different this time. The bears will stay bearish, citing the data. The bulls will stay bullish citing the pessimism of the bears and the opportunities created in the wreckage. Not everybody makes it to the next cycle. It’s not supposed to be easy. That’s why the winners are able to win. “In bear markets,” we are told by J. Pierpont Morgan, “stocks return to their rightful owners.” And in recessions, we find out who those rightful owners really are.

Free advice: Keep your leverage low, your emotions in check, do a lot less than you did during the rally, no heroics, no style points and don’t try to overthink things. Watch long-term moving averages and monthly closing prices – ignore the daily drama and the nightly noise. And don’t hesitate to ask for help.

You’ll be okay.

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