HUGE INSIGHTS: The Big Picture - Issue #8
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A Major Top Formation Has Developed
In our year ahead outlook, published on December 31st, we discussed many of the bearish warning signs that had developed in the back half of 2021. They included a structural momentum divergence, a historical valuation extreme, a weakening growth outlook, building inflation pressures, and an epic build-up of total worldwide debt. Yet, we noted a downturn in the growth rate of margin debt, suggesting that there was a subtle de-grossing of positions evident within the leveraged speculating community. We also pointed out that 2022 was a "Shmita" year, the final year in the 7-year cycle, and that markets have tended to experience significant drawdowns during said year.
Four days later, the S&P 500 posted its all-time record high of SPX 4818, followed by an impulsive 14.6% decline over the subsequent 51 trading days to post a YTD low of SPX 4114 on February 24th. The S&P 500 then rallied in three discernable waves (characteristic of a countertrend move) to SPX 4637 on March 29th, just 14 points shy of a perfect Fibonacci 76.4% retracement of the decline. The market has since rolled-over decisively, and has traded hard down over the last four weeks. Historically, April is a seasonally strong month, but the S&P 500 is now poised to deliver its worst monthly performance since COVID tanked the market in March of 2020.
The chart above illustrates the weekly price action of the S&P 500 over the past 3-years. Since January 4th, price has breach trend support as defined by both the 30-week SMA and the 20-week EMA. Price has also breached chart support as defined by the October 4th low at SPX 4278. Indeed, following the countertrend rally, which quickly recovered these heretofore unbroken trend and support measures, we were willing to give the market the benefit of the doubt as long as it held up above the new measure of trendline support that was established off the March 2020 and March 2022 weekly closing lows.
That new trendline has since been breached as well, leaving evident a developing classic patterned top formation of the "Head and Shoulders" variety. A bearish inflection and weekly close below SPX 4114 would confirm the pattern and project a measured move lower to at least SPX 3600.
A Re-Rating Underway
Rates are now rising aggressively. The 10-year Treasury yield has already reached 2.95% -- that's a 9-fold increase from its 2020 low. The reason for this is simple -- inflation has been running red hot for months, and Fed is now behind the curve. How far behind the curve? Well, based upon the nine different core inflation studies published by the Fed, approximately 500 bps. Yes, you read that correctly, five hundred! The Fed funds rate is currently in a range between 0.25% and 0.50%. Yet, core inflation is running at an estimated 5.25% based upon the average of those nine Fed studies, and probably a lot higher now. That basically means that if you buy a 90-day Treasury Bill today, you are guaranteed to earn a negative 5.0% annualized rate of return.
If inflation remains sticky, as many top economists now believe, then the Fed will be forced to continue raising its funds rate until it reaches a breakeven level, or risk stoking the flames of inflation even further. The Treasury market knows this and has been selling-off all year in anticipation of the impending future rate hikes. The only question that remains in the minds of investors now relates to the schedule of these rate hikes. Will it be a gradual, drawn-out affair, or will the Fed just rip off the band-aid as they probably should? One clear hurdle for the Fed is that while they know that they must take aggressive action, they don't want to shock the economy, which is already showing signs of a weakness, as evidenced by -1.4% real GDP growth just reported for 1Q22.
Regardless of the rate hike schedule, it is unlikely that we will see sub-2.0% inflation rates again anytime soon. This is because the inflation that we are seeing is not just transitory as the Fed initially posited. Supply chains are normalizing and demand is moderating, but wage increases are permanent, rents are very sticky, and commodities are in short supply, due to production shut-downs and the war in Eastern Europe. While commodity production will eventually ramp-up in due course (probably measured best in years), the expected duration of the war is unclear and could last much longer than most believe.
In addition, the U.S. has likely entered a new cold-war with Russia and China. Both countries have made aggressive overtures toward the West in recent months, and it's possible that they may be working together to undermine Western Democratic civilization at a structural level. Watch this interview with Pippa Malmgren for more insights on the matter (Warning: You will have trouble sleeping afterwards). If so, we may be embarking upon a new era of de-globalization and natural resource independence, leading to higher structural inflation worldwide. It is for these reasons that we believe long-term interest rates could reverse their four-decades long downtrend this year, and eventually embark upon a path that takes the 10-year Treasury yield to at least 6.0% over the next few years.
Valuation Matters and The Rule of 20
There is a very simple, yet effective valuation methodology that has stood the test of time. It’s called the “Rule of 20.” It states that the stock market is fairly valued when the sum of the forward 12-month (FTM) P/E multiple and the rate of inflation is equal to 20. Historically, the risk-free rate has been an accurate guide for the forward inflation rate, but with the Core PCE at 5.2%, and the 2-year Treasury yield around 2.6%, there is an obvious disconnect evident. As illustrated in the chart below, the FTM P/E multiple on the S&P 500 index has exhibited a fairly tight negative correlation to the 2-year Treasury yield (shown inverted). Since 2015, as 2-year yields have risen, the FTM P/E has compressed proportionately. Based upon the current 2-year Treasury yield of 2.6%, the FTM P/E should be at 14.5x. Instead, it’s over 18.5x today. Four points of multiple compression, assuming FTM op-EPS of $240, translates to about a 20% valuation haircut which, consequently, corresponds closely to fair value as implied by the Rule of 20.
Conclusion
A new bear phase in equities likely began on January 4th. If our analysis proves correct, then the January 4th high in the S&P 500 index may remain the high for some time to come. So what can you do about it?
If you are a professional investor or asset allocator, you may want to consider reducing your equity allocation to the lowest level possible, at least until the FTM P/E reaches 14.5x, or about SPX 3500 based upon current consensus estimates.
However, if you're an individual investor, under the age of forty, then you should continue to dollar-cost-average as much as you can afford each month into the stock market in a systematic manner. Do that consistently for the next 30 years and you will retire wealthy. The power of compounding is extraordinary. Albert Einstein once referred to it as the "eighth wonder of the world." Consider that since 1928 through 2021, the S&P 500 has generated an average compound annual growth rate (CAGR) of 10.49% with all dividends reinvested. Assuming that the long-term CAGR for stocks holds steady for the next 40 years, a thirty-year old investor who dollar-cost-averages just $10,000/year into a low-cost S&P 500 index fund could reasonably expect to have about $6.6 million at age 70, the first year in which you are currently required to take a the minimum distribution from an IRA or 401 (k) retirement account.
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