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So... The S&P 500 to 5k or beyond. Can we make a case for it?
Let's start by saying that we don't think this is the most likely outcome. As Alex Barrow pointed out yesterday:
"You don’t have cyclical bottoms when aggregate median valuations are in the 88th percentile and the Fed is still in the midst of its most aggressive hiking cycle in decades"
But these are just probabilities and numbers. The midst of the hiking cycle is clearing and WTF do we really know about the future? My crystal ball's permanently on the blink and if enough people choose to believe that it's a new cycle, then it's a new cycle.
You can argue with them if you want, I'm just going with the flow.
OK, let's work from the assumption that inflation is soon going to become yesterday's narrative.
It might take a bit of imagination, but in a situation where the economy's slowing and inflation's rapidly falling, the market is likely to start pricing rate cuts again.
Potentially aggressive cuts to mitigate the impact of the aggressive hikes. The idea that the Fed will overcompensate in the opposite direction is enticing.
Now, history doesn't entirely support the view that stocks bottom as soon as the Fed stops hiking...
But history's more of a guide than a fixed set of rules. Averages tend to obscure things too. Such as the three occasions when stocks bottomed within two months of the Fed's last hike.
That's three out of seven... Not a bad strike rate. The caveat is that if things do go wrong, it's often a painful long wait until the bottom is in. All or nothing.
But that's the problem with this type of analysis. The sample size is seven. Across 30 years. That's it. It's either group A (0, 1, or 2 months) or Group B (17, 20, 29 or 33 months). There's an entire chasm in between.
Which is why we need to go further and bring in some out-loud thinking from a locked account (SC) on the Twitters.
First up, breaking down the valuation equation 👇
SC: A rapid path to +5k SPX: *again not saying this happens, keep an open mind* There is a proliferation of pundits on twitter that say: $225eps * 0.9 (discount) * 16x (with rates here) = SPX 3240 so be short stocks I have a lot of sympathy with that, and believe its useful...
This is a great rule of thumb for valuation. In the current situation, you take the eps (earnings per share) of the index, and apply a discount of say 10% (*0.9) to those earnings which allows for deterioration as the economy slows. The equation gives you a rough idea of 'fair value'.
People are willing to pay a higher or lower multiple of those earnings depending on interest rates and/or where we are in the cycle. If we're late cycle with no signs of bottoming out and starting a new cycle, people will generally pay lower multiples.
If we're starting a new cycle, the opposite can be true (more on that in a sec).
Enter the equity risk premium. Basically, the extra returns that stock market investors can expect as reward for taking on equity risk instead of parking their money in 'risk-free' government bonds.
Perceptions of this premium will change depending on the context. Even though the US 10 year currently yields almost 4% now, stocks have typically returned a lot more than 4%...
And, if we subject ourselves to recency bias, they're already 16% discounted since last January's high (not saying this is the best way to think of it, but people are susceptible to recency bias).
Back to SC and where the bear case might run into trouble...
SC: the way it [bear case of SPX 3240] could go badly wrong right now…
If inflation continues its trend lower (jan turns out to be a data blip), oil and commods keep going lower etc the US 10y could quickly trade sub 3% thats great, stocks will rally on it, but will only get you so far…
Call this the 'relief' rally. Markets relieved that rates won't be staying higher for longer after all, but the economy's really going to slow unless we get some rate cuts around here Mr Powell.
New cycle behaviour
This is where things really get fun. As rates fall (especially long rates), the housing market could pick up steam again.
SC: You could see the house builders break out to new highs pretty quickly - then it gets interesting. House builders are early cycle stocks, what if the market starts pricing this as a new cycle starting? Last year was the bear and its over now
SC: All of a sudden you have to have very different pricing assumptions in your little equation. Early cycle means that multiples can really be expanded (you have +8 years of growth ahead of you now) and as we discussed rates are also lower too
SC: Then on top of that we take away the earnings discount as it seems things will pick up now your equation could be: $225eps * 25x (start of cycle valuation) = SPX 5625 anyone ‘short assets’ gets carried out on a stretcher
Sounds INSANE given all of the bearish commentary out there, but let's take a look at the balance of things in current market pricing.
Which is the more attractive bet?
OK. Maybe you can argue that 5625 is a little OTT. None of this is a prediction. Let's dial down the bullishness and simply look for a return to the January 2022 high.
At current pricing we're at the mid-point between the bear case and (reasonable) bull case.
To reiterate, we're definitely late cycle, and there's every chance that things could get worse economically for some time yet while central banks simply can't cut due to high inflation. That's a perfectly good base case for how this is likely to play out.
However, there's zero guarantee that markets will trade that outcome. If markets get a sniff that inflation is falling rapidly and interest rates follow suit, we could easily start trading as if a new cycle is beginning.
Maybe that turns out to be true. Maybe the rug is brutally ripped from beneath us before the theme gets going. Anything can happen. The path matters more than the destination.
(Yes, we're fully aware that this will likely mark the local top and everyone will laugh at us. We don't care)