ACTV - The Next Chapter Of The Bear Market Has Arrived

2023-03-24 12:28:04 ET

Summary

• The market is finished playing games with the Fed.
• The Fed is focused on inflation, and keeping rates high.
• The market is looking for the Fed to cut rates, as the yield curve steepens.

The market is currently indicating that it's no longer accepting the Federal Reserve's planned path for monetary policy. Instead, it's clamoring for rate cuts by June. This is a significant shift, as just a short while ago, the market was worried about the Fed hiking rates above 5.5% by the fall of 2023. However, that shifted as banks currently deal with losses on their balance sheets due to the aggressive rate-hiking cycle and out-of-saving deposits into money market accounts instead.

Unfortunately, stocks have ignored all the risks and are highly overpriced, given the forecast for no earnings growth in 2023. If the economy heads into a recession, which appears to be the case based on market expectations, the earnings estimates will need to be adjusted lower. The financial sector has already seen a significant drop in earnings forecasts, likely impacting the S&P 500 earnings forecast as credit conditions tighten.

The financial sector accounts for approximately 10% of the S&P 500, so if earnings estimates for this sector continue to drop, broader sector estimates will likely follow suit over time.

Furthermore, this means that stocks are currently trading at an expensive PE ratio of 17.5 times 1-year blended earnings per share of $225.31, while earnings are expected to decrease by 2.5% versus 2022. The index is not only overpriced, considering the projected lack of earnings growth in 2023, but also due to the very high likelihood of further earnings deterioration as the year progresses.

A simple return to the PE ratio of 15.5, seen in June and October of 2022, would push the S&P 500 back to 3,492, assuming the PE contracts and earnings do not contract further. But earnings are likely to contract further because profit margins are forecast to decline in 2023.

The issue is that if the 10-year minus 2-year spread 18 months forward is correct, the steepening of the yield curve continues at its current pace, which usually happens at the onset of a recession. Earnings estimates will likely start to decline very soon. This, in turn, will put pressure on PE ratios, leading to a lower valuation of stocks.

Although the market anticipates a recession and lower earnings growth, the Federal Reserve focuses on inflation. The Fed intends to address the stresses in the financial sector by using its balance sheet rather than by implementing rate cuts. The recent FOMC meeting on Wednesday made it clear that there would be no rate cuts in 2023. However, the Fed acknowledged the two-tiered approach to handling the current challenges during the press conference.

The market's calls for rate cuts may need to become more persistent before the Fed alters its current rate-hiking cycle. However, with inflation persisting as a significant issue, the Fed may be much slower to respond to the market than in the past, which means more pain lies ahead.

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