Market Outlook

September 1, 2023

Despite Economy’s Soft Landing, Market Risk Is Rising

John Bonnanzio

A reader took exception to my August 18 Hotline for being overly "optimistic" about the economy. "I think I am being conned on a favorable outlook," he wrote.

In my defense, the purpose of Friday updates is to provide context for the market’s behavior and to detail any portfolio trade recommendations. Nevertheless, our reader touched on an important question: If the economy is so great, why have stocks been under selling pressure? The short answers are rising long-term interest rates and above-average valuations. Let’s discuss both.

Stock Valuations

The first thing to know about valuations is that many investors (institutional and retail) don’t always care much about them — until they care a great deal! With the notable exception of value investors, few on Wall Street lose sleep when stocks trade above historical levels. At the end of July, for example, the trailing price-to-earnings ratio of the S&P 500 was about 23 versus the 33-year average of 24. Moreover, moderately elevated P/Es are rarely reliable predictors of selloffs. Indeed, stocks often trade at a premium when earnings are expected to accelerate. (Of course, the bust, from 2000 - 2003, is the best example of what happens to stocks when earnings don’t materialize!)

S&P P/E Ratio Trailing

With the odds of a recession in the second half fading, P/Es stand to contract in later quarters as stronger economic growth portends higher earnings growth. So the bottom line for now is that modestly high valuations are supportable, though it’s important to keep a close eye on interest rates.

Borrowing Costs Rising

Among the most worrisome issues right now is high interest rates.

Although inflation is down from 8.5% a year ago, at 3.2%, it’s still above the Fed’s 2% target. That delta is why Powell may not be satisfied with rates in the target range of 5.25% to 5.5%. However, he also seems to recognize that the economy’s soft landing may be jeopardized if 500 basis points in hikes jumps too quickly to 525 bps or more.

To our reader’s point, the economy is not without its problems.

Last month, mortgage interest rates breached a 22-year high of 7% (applications fell to a 28-year low). Credit card and auto loan delinquencies are up, credit standards are tighter, Covid-era "savings" are spent, and 44 million Americans are now redirecting paychecks to student loans. The pace of job creation and hiring is slowing; consumer confidence is ebbing.

So far, post-pandemic spending is yet to wane (it actually accelerated this summer!). But the question remains: will stronger GDP growth be enough to fuel earnings growth and, in turn, support stretched stock valuations?

That answer will come. In the meantime, the tug-of-war between optimists and pessimists may result in stepped up volatility (risk). While we never advocate market-timing, it’s a good time to align one’s risk tolerance with actual market exposure. As per our trades, our equity-oriented models are now positioned a bit more defensively.

— John Bonnanzio