Market Update

The S&P 500 lost 0.7% last week. The Nasdaq fell 1.6%. The S&P held the 100-day moving average Thursday before bouncing. It sits about 85 points below the descending 200-day moving average, which is at 4050. Thanksgiving week should be quiet with light volume. We are entering a seasonally positive time of the year. The Santa Claus rally will start sometime in the middle of December if history is any guide. It’s likely that the bear market won’t resume until after the new year.

Inflation and interest rates will dominate the news flow until the mid-December Fed meeting. There is one more CPI report before the Fed meets. There is also a jobs report in early December. The CME FedWatch tool is pricing in a 0.5% hike. Neither report will likely change the Fed’s decision to raise the fund's rate by 0.5%. A half-point hike will put the fund's rate at 4.25% - 4.50%. Inflation is still running north of 7%, making a 4.25% funds rate accommodative. The 10-year Treasury is yielding 3.84%. The real yield is close to a negative 4%, also accommodative.

Rates will need to move higher if interest rate policy is to become restrictive. The Fed isn’t there yet. They may be closer than the fund's rate indicates though. Quantitative tightening continues apace. The Fed is contracting its balance sheet by $95 billion monthly. The contracting balance sheet is reducing liquidity and pushing interest rates higher. The San Francisco Fed calculates a proxy fed funds rate of 6.24% once QT is taken into account.

The Conference Board believes the economy might already be in recession. The Leading Economic Index (LEI) decreased by 0.8% in October. It fell 0.5% in September. The LEI is down 3.2% between April and October. The LEI has fallen for eight straight months, making it possible the U.S. economy is already in recession. The downturn in the LEI reflects a worsening consumer outlook according to Ataman Ozyildirim, Senior Director, Economics, at the Conference Board. High inflation and rising interest rates are weighing on consumers. So is a declining housing market. The Conference Board is forecasting real GDP growth of 1.8% in 2022. It believes a recession will start around year-end and last through mid-2023.

Earnings estimates are coming down regardless of when the recession starts. The S&P is trading at 17x times 12-month forward earnings, but earnings estimates are likely 10% to 20% too high. The S&P is trading at almost 20x earnings if earnings come in at $200 per share for 2023. The current consensus forecast is for $253 per share. Earnings growth of almost 15% in 2023 is needed for the S&P to achieve $253 per share in earnings. And that assumes 2022 earnings of $221, which is the current consensus. Yardeni Research is forecasting earnings of $215 for 2022. The S&P 500 started 2021 trading at 21x earnings. The S&P isn't meaningfully cheaper at 20x earnings going into 2023, despite falling 17% in 2022.

It is unlikely that earnings will grow 15% in 2023, given high inflation and rising interest rates. An earnings decline is more likely in 2023 if the economy enters a recession. Norwood Economics is forecasting a recession for 2023. Our base forecast is for the S&P 500 to make a final bottom for the bear market sometime in the spring or summer. Bottoming in the 3,000 to 3,200 area is a reasonable base case forecast.

It’s possible that the U.S. avoids recession. Goldman Sachs places the odds of a 2023 recession at only 35%. Goldman is more optimistic than the other big Wall Street firms who are placing the odds of recession above 60%. It’s less likely that the U.S. avoids an earnings recession (earnings fall but the economy doesn’t enter a recession). Expect the S&P to at least test its October lows of 3491.58 sometime before the second half of next year.

Norwood Economics is looking forward to buying good companies on sale in 2023. A continuation of the bear market will lead to a target-rich environment.

Economic Indicators

Economic indicators are continuing to roll over pointing to a weakening economy. The Conference Board’s LEI fell 0.8% and is down eight months in a row. Building permits fell. They are a leading indicator. Housing starts also fell, as did existing home sales. The NAHB home builders’ index declined to 33 in November from 38. The indicator measures homebuilder sentiment. It was the lowest reading since June 2012.

Consumers are taking on debt to maintain their spending. Real household debt rose by 6.9% in Q3 compared to 0.8% in Q2. Real mortgage debt rose by 8.2% compared to 0.3% in Q2. Consumers can continue to take on debt to consume for so long. They will run out of borrowing capacity at some point.

The signs of a slowing economy are multiplying. Meanwhile, inflation expectations are not falling. One-year inflation expectations rose in October to 5.9% from 5.4% prior. Inflation is hard to stamp out once consumer expectations are no longer “anchored”. People expecting inflation leads to inflation in other words. Stagflation is becoming more probable as the economy slows and inflation remains high. The Fed will have a tough decision to make if the economy slips into recession with inflation still above 5%. It will need to decide whether price stability or economic growth is more important.

Investing

I still get questions about Bitcoin. People want to know if I have bought it for myself or my clients. The answer is no. Bitcoin isn’t an investment because it doesn’t produce owner’s earnings. Bitcoin doesn’t produce any revenue let alone owner’s earnings. There is no return on investment. Bitcoin also isn’t money, at least not yet. Money has certain properties. It is used as a medium of exchange. We buy things with money. It is used as a store of value and as a unit of account. The latter means we price things in terms of money. I don’t know anyone pricing a loaf of bread using Bitcoin. Bitcoin is too volatile to make a good store of value.

Yet some people seem tempted to start buying Bitcoin now that it has fallen below $17,000. They see it as cheap. After all, it did trade above $61,000 last fall. Compared to its price last fall Bitcoin looks inexpensive. But how do you value something that doesn’t produce owner's earnings? Bitcoin is only cheap compared to its past price. It has no intrinsic value because it earns nothing for its owners. Don’t buy it as an investment. Buy a good company trading at a low valuation based on owner’s earnings instead.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist