iCapital Market Pulse: We have a ways to go, but the next stop is 5%

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As expected, the Fed raised the fed funds rate by another 75 basis points to 4%, indicating  that the time to slow rate hikes “may come as soon as next meeting or the one after that.”¹ Still, what the markets zeroed in on is that there is a great likelihood that the next stop for the fed funds rate is 5% or above.² Clearly,  monetary policy has not yet been sufficiently restrictive, as labor market strength persists. This week, September job openings  surprised to the upside and October ADP payrolls came in strong, both of which must have reinforced the Fed’s view that to be restrictive, rates need to be higher still.³
 
This is not good news for equity investors, as the expected 5% cash rate in the coming months raises the hurdle equity investments need to overcome to be attractive. It solidifies our view that beyond any short-term rallies, it is still a very uncomfortable time to be a stock investor. We explore why that is below, reassess how to think about the levels of the S&P 500 that offer value, and update the playbook for portfolio positioning.
 

An uncomfortable time to be a stock investor right now

On one hand, everyone is so bearish, you want to be bullish. For example, consensus currently expects the S&P 500 to finish 2023 at 4055, below the 4350 target level now estimated for year-end 2022.⁴ And with the labor market remaining incredibly strong (judging by JOLTs and payrolls), maybe we won’t have a true recession. But on the other hand – the catalyst for a sustained bullish re-rating is elusive, but the risks are clearly present.

1. With rates continuing to rise, relative value of equities is the worst since 2007, as measured by the spread between the S&P 500 earnings yield and the U.S. 10-year Treasury yield (we wrote about this here).⁵
2. Recession risks are looming with historical indicators such as the spread between the U.S. 10-year Treasury and U.S. 3-month Treasury – which currently stands at -7bps – currently pointing to a recession in the coming quarters.⁶ Latest recessionary probabilities extrapolated from current economic indicators are 51% vs typical historical probability of 18%.⁷ Even Fed Chair Powell did not push back on the likelihood of a recession. And the few times when a recession didn’t follow probabilities this high was when the central banks pivoted (in 2018, 2015 and 2011), which is not to be expected today.⁸
3. Finally, another concern is this inflationary episode (defined as inflation spiking above 2% and staying above 2%), which is far from over. Betting on peak inflation has been a fool’s errand, and as history suggests, inflation episodes last a while, so a quick resolution should not be the base case. We are approximately 20 months into this inflationary episode, with the median duration historically at 30 months.⁹ And as a result, Fed evolving policy is still likely to keep markets on its toes.

Where is the value in S&P 500?

At current levels around 3800, the S&P 500 is not too cheap and not too expensive. 2023 EPS estimates for the S&P 500 have come down around 3-4% during this earnings season and in fact have dropped from $250 roughly four months ago to $235 most recently.¹⁰ Assuming 2023 EPS for the S&P 500 holds at $235 and a 16x multiple is not too stretched, the level of around 3750-3800 could hold for now.¹¹

But we fully expect that equities will continue to whipsaw around this 3750-3800 level. As they rise above this level and the S&P 500 tries to breach 4100 (the current 200-day moving average), they will likely be knocked down by recessionary fears and/or the prospect of 5% terminal rates.¹² At the same time, at 4100 the implied multiple on the S&P 500 of ~17.5x is too stretched for the current level of rates.¹³

On the other hand, as the S&P 500 declines towards 3600, it will likely be propped up by the hopes of the Fed’s eventual pause as inflation eases.¹⁴ At 3600, the multiple of ~15.5x also becomes more appropriate for the current level of rates (which was also the average during 2004-2006) and the current state of affairs (still not recessionary conditions).¹⁵ However, we would consider the “go all-in” multiple on equities to be ~14x (consistent with prior mild recessions), which would imply roughly 3300 on SPX.¹⁶

Updated portfolio positioning thoughts

With these levels and risks in mind, what’s an investor to do? It’s best to deploy a guarded and balanced portfolio approach. Here are some actions to consider:

1. Use rallies to trim ‘undesired’ positions. We would use this rally to trim unprofitable growth companies who will struggle with revenue growth in a recessionary environment and have been too reliant on multiple expansion. We would also reduce positions in prior big tech leaders that are now experiencing both a cyclical and secular slowdown. We would put both in a category of “broken leaders” and it takes time to regain/fix leadership. For example, the Nasdaq continued to underperform for an additional 2 years after the massive correction in 2000 before regaining its footing. And since unprofitable tech is down – 61% YTD and NYFANG index is down -30% YTD, depending on the point of entry into these positions, clients may also be able to sell these shares for tax loss harvesting.¹⁷

2. If/when we get toward 3600 on SPX, buy the dip in dividend payers, including energy. In a world where the Fed has reset the hurdle rate for return sufficiently higher, and any investment has to have a prospective return of higher than 4%+ expected return on cash to make sense, companies that pay an attractive dividend should be well-positioned. In early October, dividend-paying stocks got washed out with the rest of equities and should that happen again, we would be buyers. Energy remains one of our favorite sectors, as demand for mobility remains robust, but supplies are still constrained. For example, as Russian oil ban/price caps may reduce supply in early December, OPEC seems intent to support the price of oil via production cuts while inventories are depleted. Also, if current oil prices are sustained, oil companies have an economic incentive to grow domestic U.S. production, especially considering the geopolitical needs. Oil-related exports surged in this last quarter’s GDP.¹⁸ And while the sector seems close to overbought in the near-term, low multiple, strong profitability, and shareholder returns via dividend and buybacks are all great reasons to continue to own the sector and add to it on pullbacks.

3. If adding risk, consider doing so with a buffer on the downside, leverage on the upside, or a coupon. The reality is investors need to be positioned for the downside scenarios given current uncertainties and should welcome an opportunity to either earn a coupon or increase otherwise low returns expected from equities. Structured notes offer an attractive way to do this, and pricing on structured notes has historically been attractive in market environments with higher rates, volatility, and credit spreads, as we wrote here.

4. Save some dry powder for later and keep it in cash (and other income alternatives) for now. The opportunity cost of waiting for more clarity is much lower now that cash pays close to 4%, which could soon rise to 5%. And of course, as highlighted last week here, high yield and private credit offer another attractive way to get paid while you wait out the volatility and earn an above inflation yield.