VTI - Tougher For Longer

2023-10-10 15:15:57 ET

Summary

• Optimism for a soft landing in the economy has faded, with interest rates expected to remain higher for longer, leading to declines in the overall market in August and September.
• Importantly, thanks to rising yields and tepid earnings growth, the risk premium between the S&P 500 and Treasuries has essentially shrunk to zero.
• Unfortunately, the most likely way this equity risk premium gets restored is for the S&P 500 to experience a bear market.
• Why investors are likely facing a "tougher for longer" scenario in the months and quarters ahead is discussed in the paragraphs below.

So, we shall let the reader answer this question for himself: who is the happier man, he who has braved the storm of life and lived, or he who has stayed securely on shore and merely existed ?”? Hunter S. Thompson.

Optimism about a " soft landing" that became the main narrative for the overall market in late spring and early summer of this year has faded significantly in recent months. A new narrative has set in calling for interest rates to remain " higher for longer ." The result has been declines in the overall market for both August and September. This also continues to have impacts to stocks and the economy. This week, Goldman Sachs took down its GDP forecast by half of a percent over the next year due to higher interest rates.

My regular readers know I never bought into hopes for a soft landing starting with an article entitled The 'Soft Landing' Fallacy in August. As yields on the 10-Year Treasury (US10Y) have shot up over the past three months, the higher-for-longer thesis has become accepted by many investors.

Today, I want to introduce a new term for what investors are likely to face from equities in the coming months and quarters. Today's moniker is " Tougher For Longer, ' trademark not pending. In previous articles, I have spoken around how today's market and credit conditions remind of a less dire version of the period before the Great Financial Crisis, such as in " Shades Of 2007 ." I have also documented the deteriorating condition of the American consumer class in " The Consumer Is Toast ." Finally, I have discussed the coming debacle in commercial real estate and rising levels of debt throughout the economy and within the Federal Government ad nauseam at this point. Therefore, I will not rehash those worries.

However, one of the primary reasons investors should be concerned that equities will be challenging and " tougher for longer" goes back to Economics 101. This is simply why individuals invest in the stock market in the first place.

People and institutions invest in the stock market because, over time, doing so pays a solid premium over what one can get in a " risk free" investment, such as Federal Treasury instruments. Unfortunately, thanks to rising interest rates and tepid earnings growth from the S&P 500 (SP500), that " premium" has now essentially shrunk to zero. As you can see from the above chart, the inverse P/E yield on the S&P 500 is essentially the same as the yield on the 10-Year Treasury. As one can also see on the chart, the best stock market returns tend to happen historically when there is a significant risk premium between the two.

Let's take Apple ( AAPL ), which has the largest market capitalization of any equity in the U.S. indices, to demonstrate the lack of equity risk premium in the current market. Now, the stock has come down approximately seven percent from its recent highs in early September. However, the shares are up some 43% so far here in 2023. This despite the fact that both earnings and revenues are projected to decline slightly here in FY2023. Now, as a rational investor following the tenets of Economics 101, should I pay nearly 30 times earnings for AAPL that yields just over a half a percent in dividends, or buy " risk-free" short-term treasuries yielding 5.5%? And Apple is far from the only " dilemma" for investors right now using basic economy theory. This is a key reason half of my portfolio is currently in short-term treasuries currently.

Now, S&P earnings growth could accelerate significantly, which would restore some premium compared to risk free assets in the year ahead. However, with Germany in a technical recession due to high energy prices and shrinking industrial demand , China facing its slowest growth prospects in decades , and most financial professionals predicting a recession in the United States in 2024, that seems very unlikely.

In addition, the yield on 10-Year Treasuries could come down substantially, boosting the risk premium for owning stocks. This seems unlikely outside of a recession in the short term, given both July (3.2%) and August (3.7%) CPI readings ticked up from June's levels (3.0%). If a recession does occur, that event would knock earnings down at the S&P 500 significantly, negating any rise from falling treasury yields.

The most likely way an " adequate" risk premium gets restored in the market between the S&P 500 and 10-Year Treasury yields is the S&P falls at least 20% from its peak and enters an official " bear market ."

This is why I built up a solid holding of out of the money, long-dated bear put spreads against the SPDR® S&P 500 ETF Trust ( SPY ) in June and July when the S&P VIX Index ( VIX ) traded in a range of just 12-14 during those months. This move provides significant " portfolio insurance," as they will pay out 8 to 12 to 1 if my prediction of at least a 20% decline in the S&P 500 comes to fruition by next summer.

I believe there is a solid probability that this scenario plays out, and that is why I think investors have several quarters of the " tougher for longer" narrative to navigate through as we head into 2024.

Never was anything great achieved without danger. ”? Niccolo Machiavelli.

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