The stock market has gone back into sell mode, but there’s still reason to believe it’s close to finding a floor—and moving higher again.
down more than 2% from Tuesday’s close. That was the last day of trading before the Federal Reserve announced its decision to raise the federal funds rate by a quarter of a percentage point.
The Fed’s announcement also revealed that a majority of committee members see the Fed funds peak rate higher than the market expected.
The Fed is trying to end inflation by reducing economic demand, which hurts the stock market. Now, the S&P 500 is in further decline, down more than 12% from the summer rally peak.
Part of the problem is that higher short-term rates are pushing up longer-term bond yields.
Currently, that has caused the “real yield” on the 10-Year Treasury bond to rise to about 1.3 percentage points. That means the simple return is significantly higher than the average annual inflation expectations for the next 10 years of 2.38%.
A higher inflation-adjusted rate of return on a safe government bond makes the stock market risk less attractive. It reduces the multiple of expected near-term earnings that investors are willing to pay. The S&P 500’s aggregate forward price/earnings multiple fell to around 16 times from just over 20 times at the start of the year. The index is just below 3800 now.
The good news is that the worst may be almost over now.
“We see lower inflation, the 10-year TIPS yield [real yield] pulling back and 4,400 for the S&P 500 by the fourth quarter, 20022/first quarter, 2023,” wrote Barry Bannister,
key equity strategies.
His thesis begins with a declining rate of inflation. The year-over-year gain of the consumer price index has declined for two consecutive months. To be sure, inflation is declining more slowly than the market expected, but it is falling nonetheless. For three-month windows, namely June to August, the annual inflation rate has been cut in half, Bannister notes.
That means the 10-year yield could decline as investors bid the price up, driving its interest rate down.
And that is precisely Bannister’s second point. The real 10-year yield may peak here. That’s also because Bannister sees the Fed’s expected peak fed funds rate not going any higher from here — and the Fed’s projections even showed the strong possibility of a rate cut in early 2024. The real 10-year yield is correlated significantly with forecasts for the fed funds rate in the future, Stifel data shows.
And a lower 10-year real yield would raise the price/earnings multiple of the S&P 500. Bannister’s year-end price target of 4400 for the index represents a multiple of just over 18 times analysts’ expected 2023 aggregate earnings per share of $240 for S&P 500 companies, according to FactSet. There is a rationale for that multiple—he hit 18 times in August when the real result was a little lower.
There is only one main risk. With the possible destruction of economic demand, earnings estimates may decline slightly. But even if next year’s EPS forecast fell – say 5% – by the end of the year, the index would still post a gain from the current level.
Accordingly, if the inflation rate is truly falling, the Fed will be under less pressure to raise rates beyond current expectations. That could save the economy from a severe recession, and the market could handle a softer market.
Whatever level the S&P 500 may reach in the coming months, it’s more justified to start buying a little now.
Write to Jacob Sonenshine at firstname.lastname@example.org