This bear market rally feels more driven by FOMO than the fundamentals. What is there to get so excited about as to justify this rally off of the June lows?
- Inflation: Is the fact that headline CPI slowed to 8.5% from 9.1% really anything to write home about? Core CPI plus Food was up 1.4% sequentially, 16.8% annualized. Further, real world inflation is far higher than the reported CPI figures. It is these elevated real world prices that have led to the current recession (yes, “recession”, given we have had two consecutive negative Real GDP quarters).
- Earnings: Management teams have less visibility than normal and this is reflected in the muted outlooks and tempered remarks published by many companies during the July/August earnings season. We believe the current recession will worsen as the Fed tightens which will adversely impact revenue, profitability, operating budgets and hiring plans this year as well as in 2023 and 2024.
- Jobs: While the July jobs number was bolstered by part-time summer jobs, the Labor Participation Rate softened and is barely above COVID levels.
- Interest Rates: Sure, investors are free to cheer that the next Fed rate hike looks more like 50 bps than 75 bps. However, it is irrelevant. The Fed can’t afford to truly fight inflation, thus reported CPI will likely persist well above the Fed’s 2% target for years. We don’t believe the Fed will take its Fed Funds Rate beyond 4%. However, the Fed Funds Rate is likely to increase higher and plateau for longer than most investors believe. We don’t see the Fed cutting rates at year-end as Jerome Powell does not want to suffer the same fate as former Fed Chair Arthur Burns who prematurely pivoted and allowed inflation to reaccelerate as a result. Thus, an elevated Fed Funds Rate is likely to remain well into 2023. Further, we expect the Treasury yield curve to continue to invert.
- Valuations: Still too much air in the “everything bubble” the Fed created.
- Housing prices remain too high, although housing inventories are back at Q2 2010 levels.
- Nasdaq Composite: There are still too many companies trading north of 20x Revenue (which was also the case at the June lows). We never experienced investor capitulation in June, so we will test the June 2022 lows as the economy softens. Some of these companies that have lost 70-80% of their value will lose another 70-80% and many more will be out of business. This zombie company purge needs to happen in order to reset valuations and expectations across public and private markets. The Fed needs to allow the detritus to be cleared.
- Rates up, valuations down: We see risk asset valuations shrinking as interest rates move higher.
- Question of the day: Why is it deemed a victory when a fixed income manager beats treasury yields by 1-2%? That is a negative real rate of return with CPI at 8-9% and real world inflation much higher.
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