Friday’s much stronger than expected employment report had an outsized impact on the bond market…as the yield on the U.S. 10yr Treasury note jumped from 2.68% to 2.83%. However, it did not have much of an impact on the stock market. After a relatively deep drop at the opening…and another one late in the morning…the S&P 500 finished the day with only a very slight decline. Therefore, the stock market remained very resilient last week. Not only did it hold up in the face of a generous dose of hawkish “Fed speak,” it also held steady to a very strong economic report……The futures are trading higher this morning and they’re more than making up for the mild losses we had on Friday…so it looks like the line of least resistance will continue to be higher for the time being.
However, we remain cautious. The primary reason for this is that we believe the Fed will continue to raise interest rates for longer than the market is pricing-in right now. However, a second (and just as important) reason is due to the fact that they are going to start shrinking their balance sheet much more aggressively going forward. (They’ve BARELY begun that process up until now. They have not been shrinking it at the $37.5bn average they said they would during the summer months.)
We believe that investors are making the mistake of thinking that interest rates and the stock market were at their natural levels at the beginning of the year. Therefore, the rise in rates that we’ve seen so far…and the decline in the stock market we’ve seen so far…are enough to account for the negative impact that higher inflation is having on our economy. They believe that as long as we’ve reached “peak inflation,” the markets can look past this issue and see for further gains over the next 6-12 months. We believe that they don’t realize that the natural level has still not been achieved…now that inflation has become (and will continue to be) a problem
This is a long-winded way of saying that we believe that the Fed has had two goals with their tightening policy. The first one is the goal of taking interest rates back to their natural level. The second one is to tame inflation. However, that second one has become much harder one than it was at the beginning of the year…due to the war in Ukraine.
Sure, the Fed has used the inflation excuse as the only excuse for almost a year now. However, the real (initial) reason they said they would start to tighten policy by raising rates and shrinking their balance sheet was to move the markets back closer to their natural levels…ones that could be justified by their underlying fundamentals. They HAD to do this because they if they kept interest rates artificially low forever…and they kept pumping liquidity into the system…it would have created the kind of bubble that we could not have recovered from…once that bubble inevitably burst.
However, with the war in Ukraine creating a much higher (AND SUSTAINABLE) level of inflation. This made the “inflation” fight more important that it was in January. This, in turn, has made the new “natural level” of interest rates is now even higher. This, in turn, means that the natural level for the stock market is lower than what we were looking at in January (before the invasion).
We just don’t believe that 18.2x forward earnings and 2.5x sales is the natural level for the stock market. History tells us that we can only maintain these kinds of readings when there is a significant level of artificial stimulus in the system. (In the late 1990s, it was the behind-the-scenes stimulus that was needed for us to get through the Y2K crisis.) Therefore, even if the Fed stops raising interest rates, they’re still going to shrink their balance sheet (and unless there is another crisis, they’re not going to engage in a new QE program). Therefore, we believe the stock market has further to fall to reach its “natural” level.
Matthew J. Maley
Chief Market Strategist
Miller Tabak + Co., LLC
Founder, The Maley Report
275 Grove St. Suite 2-400
Newton, MA 02466
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