2023-09-28 16:55:11 ET
Summary
- According to the Real Yields model, the S&P 500 Forward P/E and its fair value should weaken. Historical Evidence between real yields indicates future decline.
- The greatest deviation between calculated fair value and real yields model has occurred, but such deviations have tended to flatten out over time.
- Despite the hawkish message from the FOMC and Powell, the higher for longer narrative is unsustainable without significant earnings and stock price damage.
- Inflation near target is the Fed's primary objective, but real rates are sufficiently restrictive, as in 2007. FFR is higher than inflation, that is the reason the inflation tiger will likely calm down despite upside risks from oil and wage pressures.
- The probability of policy error is rising. Despite short-term market exhaustion, which could result in a price pullback, the significant deviations indicate that we should prefer a pair trade in this environment.
First, the Fed delivered a completely hawkish message, and FOMC members adopted the narrative of higher for longer. Despite the fact that the Fed's stated objective is price stability, I vehemently disagree that the dot-plot results (rate projections) will be realized. Too restrictive of a monetary policy stance for too long could result in recession. Currently, in my view, I consider real interest rates to be excessively high and restrictive enough. Such a result is unfavorable for the stock market as a whole, and investors should place a strong emphasis on the short-term money market, which not only provides us with protection but also rewards us for our patience. This alternative is preferable. First, if the Fed keeps its word about higher interest rates for longer, it will have a significant negative impact on future earnings because the policy is so restrictive. Below, I discuss the most recent FOMC key message, the current market price, a forward valuation based on PE, and other assumptions.
In conclusion, the narrative of higher for longer is unsustainable in my view. In addition, I am projecting my model based on 20-year real yields, and calculating the S&P 500's fair value based on real yields, which suggests that the S&P 500 is significantly overvalued relative to its forward price-to-earnings ratio and its intrinsic value based on tightening conditions. Based on my model, I observe a large spread between the price of SPY and its intrinsic value, giving us an advantage for the pair trade idea revealed at the conclusion of the analysis.
FOMC breakdown and current rates pricing
In my opinion, the outlook for stocks continues to deteriorate as conditions continue to tighten. This is a fundamental factor that could lead to a decline in EPS, margins, valuations, and ultimately stock prices, as was observed in the previous one to three weeks. It does not change from day to day, despite the fact that I firmly believe that the narrative of higher rates for a longer period of time is unsustainable, otherwise, if it continues, the stock market could suffer much more. However, I observe significant short-term exhaustion conditions, which could result in a short-term bounce. I will explain later why.
Summary of the previous thesis
In my most recent in-depth analysis on ( QQQ ) and (TQQQ) titled Risk-Reward Ratio Unfavorable Based On Historical Evidence , published in mid-July, I provided strong statistical evidence that August and September price declines are highly probable due to the following factors:
- Similar statistical evidence supported by strong stock returns through July in the past almost always resulted in a price decline in late August and September, with a very high probability of a 10% drawdown in QQQ, which could result in a 30% drawdown in TQQQ. However, the narrative for ( SPX ) and ( SPY ) remained the same despite lower outcomes,
- with the combination of extremely strong September seasonality, which has already shown itself (not just influenced by the Fed's message, consider the August pullback), and the Fed's message, after the market has experienced a sharp decline,
- moreover, the CNN Fear & Greed Index indicated significantly high levels of greed, and the percentage of stocks above the 20-day and 50-day moving averages was significantly above neutral areas,
- lastly, worsening macro or, alternatively, the proceeding tightening cycle.
The combination of these four factors led me to be bearish in August and September, when it paid to be neutral or short. Always, some ideas succeed while others fail. Enough with the past. Many macro narratives, such as Fed Funds Pricing, FOMC Dot plot, the generally accepted mantra - higher for longer - and the significant cumulative increase in real rates, which is the most tightening event in Fed policy, have changed, so I decided to update the thesis.
Market pricing via Fed Funds Futures
On the graph below, significant changes in Fed Funds Futures, or market expectations for future interest rates, can be seen between early September and the outcome following the so-called hawkish pause by the Federal Reserve. Compared to the beginning of September and the rate expectations after the FOMC, the market had fully priced in nearly two 25-bps rate cuts. That is the result of Mr. Powell's highly effective and hawkish message. Although FOMC members disclosed that 12 of 19 members are in favor of another rate hike before the end of the year, the market appears to be pricing in a peak rate near 5.45% (according to FFF), or a probability of a rate hike near 50% until December. The market is considerably less optimistic than FOMC participants, of whom 63% anticipated another rate hike until December 2023.
Rates measured by FFF (Author)
In the Q&A section , there was an intriguing question in which Mr. Powell made it clear that primary stability is more important than goals and soft landing objectives:
HOWARD SCHNEIDER. So just to boil that down for a second, you know, we've gone from a very narrow path to a soft landing to something different. Would you call the soft landing now a baseline expectation?
CHAIR POWELL. No, no. I would not do that. I would just say -- what would I say about that? I've always thought that the soft landing was a plausible outcome, that there was a path, really, to a soft landing. I've thought that and I've said that since we lifted off. We will restore price stability. We know that we have to do that and we know the public depends on us doing that.
The astoundingly high real yields reflect a strong restrictive stance
While another increase is possible, I am convinced that the likelihood of overtightening is much greater. Because long-term real yields are at almost 2007-2008 levels, this indicates that monetary policy is extremely restrictive. Fed Funds Rate and UST are both above inflation and potentially above neutral rates (to be discussed later).
While nominal yields are comprised of real yields and breakeven (annualized inflation expectations of market participants), the current increase in nominal yields is merely driven by real yields and not by the market's measured inflation rate. However, there are additional reasons why real interest rates rise, some of which are monetary and some of which are not, such as a high supply of U.S. Treasury securities, rising debt, the fiscal side's reluctance to reduce spending, and structural changes as suggested by the legendary Bill Ackman, which I agree with in part and disagree with in part.
Nick Timiraos from Wall Street asked one question at the most recent press conference, and Powell led the real rates discussion:
NICK TIMIRAOS. Chair Powell, both you and Vice Chair Williams have indicated that sufficiently restrictive will be judged on a real rather than nominal basis, implying some scope for nominal rate cuts next year provided further compelling evidence that price pressures will continue to subside. Is the FOMC focused on targeting a real level of policy restriction?
CHAIR POWELL. I mean, yes, we understand that it's a real rate that will matter and that needs to be sufficiently restrictive. And, again, I would say you know sufficiently restrictive only when you see it. It's not something you can arrive at with confidence in a model or in various estimates, you know.
The estimated fair value based on a model of real yields indicates an overvaluation
My research also establishes a connection between S&P Forward PE (valuation) and real yields, confirming the existence of a common relationship. I estimated the intrinsic or fair value of the S&P 500 based on its real yields. Frequently, such deviations necessitate an opportunity or, alternatively, a cautious call, which is always dependent on the estimated value and outcomes. While the model indicated a clear opportunity in 2011, when model-based fair value was significantly higher than price, the spread narrowed from 2013 to 2019, indicating that the S&P 500 traded close to its fair value. Since the beginning of the COVID-19 crisis in 2020-'21, the deviation between fair value and price has been significant, but the trend indicates that the stock price is on an upward trajectory. The price then returned to its fair value in 2022. Presently, there is a significant deviation between the projected value and price of the S&P 500 index. Historically speaking, despite the fact that the difference has begun to narrow over the past week, it is still astronomically large.
S&P 500 Price vs. Estimated Value Based on Real Yields (Author)
While I'm not suggesting that this is the correct model, as much depends on estimated earnings and future growth, fiscal spending, etc., this did provide a fairly solid and clear idea of where the price could be if real yields are considered. However, concentrating on real yields and forward PE yields a wealth of information. I calculated that based on the real yields, so from this perspective, the real yield curve also conceals the changes behind the development of nominal yields, such as supply, fiscal spending, and market expectations, along with the monetary policy. On the other hand, using forward PE reflects Wall Street's valuation of future earnings. Maybe someone is asking why I used 20y real yields and not 10y or 30y. It is due to the solid results (best fit) over the past two decades. However, fair value is primarily determined by the relationship between real yields and forward price-to-earnings, and I estimated fair value for the S&P 500 based on this relationship.
The disparity between forward P/E and estimated forward P/E
Focusing on real yields and forward PE valuation provided me with one of my most valuable market insights. It eliminates the psychological factor. The psychology is based on the AI boom we witnessed in the preceding months and its impact on the price of the S&P 500, as well as the very unconventional movements and boom in 2021. Nonetheless, AI could objectively cause faster growth and productivity, which could influence the forward PE positively due to the potential for higher growth. However, the psychological factor is strong here.
Currently, the model implies a fair Forward PE of 14, not 18. Nobody is claiming we will get there, as there has always been a deviation between S&P and modeled values, but this gives us a clear picture, as this is the largest deviation ever (with the exception of the 2011-2012 reversal).
S&P Forward P/E vs. Estimated Based on Real Yields (Author)
From a historical perspective, such large deviations indicate that the S&P is overvalued relative to its fair value (model based approach), and such deviations have frequently returned to neutral territory, such as in 2007, 2017, and 2021-2022. However, this model predicted extremely high returns when the price was below its fair value. It can also be observed in 2012, 2018 and 2020. However, this gap can be reduced in two ways. When real yields decline, this could have a positive impact on forward PE because of a direct impact on forward EPS expectations. Based on the extremely large difference between the current price and the model's estimated fair value, I see the following options as potential neutralization options:
- First, I do not believe that higher yields can be sustained for an extended period of time; thus, a decline in real yields is one possibility,
- secondly, the S&P's downward price pressure can bring the deviation down as well,
- thirdly, when Wall Street Consensus increase the Forward EPS.
I believe the combination of the first two possible outcomes is the most likely.
Deviation from fair value based on model RY20 (Author.)
According to my assessment, this deviation is also highly significant due to the ongoing AI boom, which has already been fully priced in - the psychological effect on the markets. My real yield model used to exclude this factor, focusing solely on fundamentals; however, as previously stated, it is prone to error; there is no holy grail.
I'm not suggesting that the S&P 500 will drop to its fair value, but it will almost certainly get much closer to its fair value, as we see today, or real yields will fall, causing the spread to narrow. In the medium term, I see a combination of these alternatives. I do not believe that such high real yields are sustainable over the long term, where a softening could result in a rise in EPS, and fair value could be more reliable. But not when real rates stay higher for longer, just the opposite. This option would also result in the flattening of the deviation. This chart was created the previous week, but this spread had already decreased by 70 basis points (bps) due to the further decline in SPY or S&P 500, which was partially offset by the increase in real yields.
Forward EPS
In the table below, you will find EPS projections from Yardeni Research , estimates from the research group, and the market consensus. I consider the market consensus for growth in 2024 at 12.1% and in 2025 at 12.2% to be excessively high and I tend to agree with Yardeni's projections, but I believe the actual results will be even lower. I detect a robust sense of optimism, which I believe will diminish as a result of the substantial increase in yields alone. The declining estimates may reduce "earnings" in the PE formula, so the ratio may increase if it is not followed by a price decline. Here is complete information from Yardeni's most recent research report:
Yardeni Research | Analysts' Consensus | |||
Level | YOY % | Level | YOY % | |
2019 | 162.93a | 0.6 | 162.93a | 0.6 |
2020 | 139.72a | -14.2 | 139.72a | -14.2 |
2021 | 208.12a | 49.0 | 208.12a | 49.0 |
2022 | 218.09a | 4.8 | 218.09a | 4.8 |
2023 | 225.00e | 3.2 | 220.65e | 1.2 |
2024 | 250.00e | 11.1 | 247.29e | 12.1 |
2025 | 270.00e | 8.0 | 277.49e | 12.2 |
Multiple times during press conferences, Mr. Powell emphasized that price stability is the primary objective. Inflation, in my opinion, is on a solid trajectory; however, there are upside risks from oil prices and wage pressures, which could cause the CPI to rise in the coming months and additionally to core inflation via the secondary effects. Despite all of these risks, I believe that whether or not the Fed tightens, the policy is already extremely restrictive and will result in a decline in inflation. Except for commodity prices, which have begun to rise, and as a leading indicator it could endanger Fed's policy.
Summary and Risks
Inflation, FOMC projections and the neutral rate
One of the greatest risks is that inflation will not decrease. As Powell strongly indicated, the primary objective is to return inflation to the target. Additionally, he remarked that a stronger economy is associated with upside risks and, indirectly, that the economy can halt significantly more than in prior cycles. Because when you examine the most recent dot-plot or summary of economic projections and look beyond the median projection of Fed Funds Rates, you can observe that the Fed has raised the neutral rate projection.
Summary of Economic Projections, FOMC (FOMC)
The green line below stands for the anticipated neutral rate over the long term. As a result of so-called top estimates of Central Tendency (where the lowest and highest values are ignored), it began to deviate from the median projection. FOMC members increased the range from 2,5-2,8 to 2,5-3,3 in the most recent SEP. It indicates that some FOMC participants see a higher neutral rate, i.e., that the economy can withstand higher Fed Funds Rates and that they must be raised to tame inflation.
Below, you can see it via a chart with other relevant inputs:
Possible change of neutral rate by FOMC participants (Author. FRED.)
However, I strongly believe that the service sector will start to weaken as long-term nominal yields and especially the 20y real yields increased in the previous month by more than 30 bps and more than 55 bps in the latest three to four months. This is the risk that is developing in real time, while businesses respond with a lag. My opinion is that it will be sufficient to weaken the economy, or the robust and resilient services sector, but it can devastate the manufacturing sector even further, which is more rate sensitive.
Short-term indicators suggest the exhaustion
CNN Greed & Fear Index
Despite all the bearish thoughts, I see a potential for a short-term bullish reversal due to the first signs of market exhaustion, given the extremely high levels of fear ( CNN Greed & Fear Index ).
CNN Greed and Fear Index (CNN)
Put/Call Ratio
Second, because of the higher 9-day moving average of the Put/call ratio, which indicates a short-term reversal when elevated and vice versa when decreased (near local bottoms). However, nobody knows when the market will peak; however, we are near levels where a short-term rebound has previously occurred.
Put/Call Ratio and Its Moving Average and SPY (Author via Tradingview)
Long-term and short-term extremes
The final item on my short-term watchlist is the outlook for the percentage of stocks above the 200-day (blue) and 50-day (orange) moving averages. While the blue indicator indicates that there is no long-term extreme, which is a sign that the bearish rally could continue, the orange indicator indicates that there is only a limited short-term move to the downside based on the past evidence. From this point of view, I firmly believe, there could be short-term pullback, but next followed by continuing downward bearish rally, which should last until fundamentals change. Lastly, there is still the possibility that real yields could increase, which would result in greater downward pressure on stock prices, dropping the fair value based on my model, and the spread could widen. However, this would not be a desirable outcome, but a realistic one.
Percent of Stocks Above 200 and 50 Days (Author via Tradingview)
Final Pair Trade Idea
I do not believe the S&P 500 or SPY will fall to a fair value, as this would imply extremely strong downward pressures. On the other hand, I believe that the spread between fair value and the price will narrow from nearly one thousand points to somewhere between six hundred and seven hundred, as a result of the lower yield in TIPs and the further decline in the S&P 500. However, this does not imply that the S&P 500 will fall by 300–400 points (the index is already down 70 points). This is my medium-term strategy because, according to the fair value model based on real yield, valuations should have historically been pulled down much more aggressively.
Therefore, the trade idea is a pair trade based on the narrowing of the spread, and the optimal way to implement it is by longing TIPS ETF medium and long-term ETF via (TIP), (LTPZ), or ( SPIP ) and shorting S&P 500 via ((SPY)). However, the rationale and optimal scenario are contingent upon your risk profile, risk management, and personal assumptions. As the market is extremely exhausted in the short term, the optimal strategy is to wait for an SPY price pullback. Here are the effective maturities of the following TIPs and ETFs:
- ((LTPZ)) is a long-term ETF TIPS based, making it the most vulnerable to a rise in real yields. I believe it is currently advantageous with an effective duration of 19.3 years,
- ((TIP)) with effective duration of 6.46 years,
- and ((SPIP)) with the similar duration of 6.71 years.
I highly prefer being long of long-term piece such as ((LTPZ)) and being out of market or betting on a lowering a spread via short in ((SPY)), but as I said, it's better to wait for some kind of pullback.
Feel free to refer to my previous bearish thesis on ((TQQQ)) and medium-term bond ETF analysis of ( AGG ) and (TLT), where I also see great opportunity, but where I warned 3 to 4 weeks ago of a short-term increase in yields by an additional 10 to 20 basis points that could bring a solid long-term opportunity:
Imagine the following long-term yields: 4.24 percent for 10 years, 4.55 percent for 20 years, and 4.33 percent for 30 years. These are the levels that investors and many analysts believed would never be reached again. Levels last seen in 2009. Nonetheless, this threat persists. From a timing perspective I believe, there could be a little bit spark up by 10-20 bps from current yields, which could pull down the AGG and TLT down. This could be solid opportunity.
Now we can observe that the US 20-year yield is close to 4.90 percent, which is a result of both the rise in real yields (driven by monetary and non-monetary factors) and the rise in inflation expectations (driven by oil prices). I have also been preliminary bullish on lithium producers , which are down 20% from the thesis, but deep value and discounts can still be found, now with even greater margin of safety. I was twice bullish on Tesla in early 2023 and turned bearish on Tesla near its peak in July, which has already paid off.
Keep in mind that the current and previous analyses represent only my thoughts and perspective, while your decision should be based solely on your own research and sense of responsibility. I would appreciate any thoughtful comment that could lead to a respectful discussion or a different viewpoint to help improve my next analysis.
For further details see:
Historical Evidence Between Real Yields Suggests Further Slump For SPY