The Fed Is Likely Leading The S&P 500 Into A Crushing Zone

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The S&P 500 (NYSEARCA:SPY) has had an explosive twelvemonth truthful far, rebounding and already up much than 6% YTD. This is successful stark opposition to nan Federal Reserve, which continues to raise liking rates and maintains its hawkish stance.

Fed money futures are already presently assuming a Fed Funds complaint of 5.50% successful November 2023. It besides intends that nan Fed is playing pinch occurrence aliases lighting a occurrence nether what utilized to beryllium "TINA" aliases "there is nary alternative," now that nan 6-month liking complaint has surgery done nan 5% barrier.

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Fed Talk

Last week, nan almanac was afloat of FOMC members speaking retired and giving subtle hints astir nan early of liking rates and wherever they judge ostentation to beryllium going. For example, 1 of nan disturbing trends we noticed was that FOMC members were perpetually drawing comparisons betwixt nan existent inflationary situation and that of the 1970s.

Inflation is simply a pernicious problem. One of nan lessons of nan past 2 years is that everybody feels nan effects of inflation. It's beautiful overmuch crossed nan spectrum. So rich | and poor, young and old, everybody notices. So if we can't get this problem nether power soon, we consequence a replay of nan 1970s. (St. Louis President James Bullard)

He besides said he would not norm retired a 50bp complaint hike astatine nan March meeting, and reportedly advocated that astatine nan erstwhile meeting. Bullard besides said he would for illustration to bring nan Fed's argumentation complaint to 5.375% and reaffirmed his position connected nan long of this inflation:

My wide judgement is it will beryllium a agelong conflict against inflation, and we’ll astir apt person to proceed to show inflation-fighting resoluteness arsenic we spell done 2023.

Bullard is different personnel who has advocated nan "front-loading" of monetary argumentation successful nan past. Worse, nan FOMC personnel opposed monetary argumentation slowdowns, 1 of nan main factors preventing nan Fed from raising liking rates faster:

I person pushed backmost against nan agelong and adaptable lags argument… because I deliberation successful nan modern era nan transmission of monetary argumentation is overmuch faster than it would person been successful nan 50s, 60s and 70s.

Federal Reserve (FRED)

Loretta Mester, different hawkish FOMC member, also saw a "compelling lawsuit for different 50 ground constituent complaint hike" earlier this month. But much importantly, astir what steps to expect astatine consequent meetings, she said successful nan question-and-answer session:

The Fed could accelerate nan gait of complaint increases again if economical conditions warrant. It’s not ever going to be, you know, 25(bp).

A region surely does not look to beryllium connected FOMC personnel Mester's books conscionable yet, for erstwhile asked erstwhile they would pause, she noted that Fed officials are still raising liking rates to levels that are restrictive enough. Finally, she besides noted that ostentation risks are still connected nan upside, and those upside risks reason for "overshooting."

Nothing correct now is starring maine to deliberation that I request to really beryllium focused connected that mobility astatine this point.

Other members, specified arsenic Member Bowman and Member Barkin, affirm their position that it will beryllium a long battle against inflation. Richmond Fed Chairman Thomas Barkin besides raises nan connection not to make nan mistakes made successful nan 1970s.

I deliberation there's a very bully lawsuit for leaving rates higher, for a longer play of clip to let nan tightening to hit. I do deliberation nan instruction of nan 70s was very clear, which is don't springiness up excessively early.

Federal Reserve (FRED)

Remarkably, Barkin besides referred on Bloomberg to that play that "their predecessors did nan correct thing," by which he astir apt meant Paul Volcker and called it a pursuit of him and nan Fed.

To sum up each nan Fed talk: FOMC members don't moreover deliberation aliases see a pivot, immoderate would moreover for illustration to overshoot and for illustration to mention to nan 1970s, fundamentally calling for keeping liking rates higher for longer contempt seeing ostentation already coming down.

Our position is that while nan markets proceed to rally, Fed members still look to want to return nan stance of Volcker. And eventually, thing has to give. In this crippled of chicken, it looks for illustration nan Fed will instrumentality to its crippled scheme to get ostentation backmost to 2%, which seems intolerable astatine nan infinitesimal without causing a recession. Though point seems certain: liking rates are astir apt going obscurity but up this year.

What Recession?

We judge nan Federal Reserve will proceed to raise liking rates until nan system breaks, and besides for illustration to mention to nan Federal Reserve's cognition toward economical maturation successful nan past for that matter. After GDP was antagonistic for 2 consecutive quarters past year, nan Fed's attitude was essentially: recession? What recession?

I do not deliberation nan U.S. is presently successful a recession. And nan logic is, location are conscionable excessively galore areas of nan system that are performing, you know, excessively well, and of people I would constituent to nan labour marketplace successful particular.

A alternatively unusual statement, arsenic astir group and nan Fed itself knows that the labour market is seen arsenic a lagging indicator. In nan past, whenever nan labour marketplace began to deteriorate, it was already excessively precocious to return action because nan recession was already underway.

Take moreover caller data, from 2000 and 2008, wherever nan Fed trim liking rates, and nan labour marketplace conscionable kept deteriorating pinch a slowing effect until nan extremity of nan recession.

Federal Reserve (FRED)

There are very fewer reasons to judge that immoderate benignant of "soft landing" is successful nan books, arsenic nan Fed has single-handedly collapsed nan system successful nan past each clip it raised liking rates. The conception "the Fed raises liking rates until thing breaks" has proven existent passim history.

Returning to nan Fed's earlier speech, it is successful truth what FOMC members person besides indicated, pinch personnel Mester, for example, indicating that they for illustration to "overshoot." Will it beryllium different this time? The yield curve tells america a story.

Federal Reserve (FRED)

The Fed and nan National Bureau for Economic Research (NBER) do not want to explanation existent economical conditions arsenic a recession yet. But funnily enough, by nan clip a play is defined arsenic a recession, employment is already successful nan gutter and nan S&P 500 is down by much than 30% successful caller history.

Fighting An Asset Bubble?

When we talk about CPI, we are often amazed really small nan various components of that ostentation are mentioned. If we look astatine nan CPI index, it is still up 6.34% year-on-year, good supra nan 2% target.

But if we return nan shelter constituent retired of nan equation, we spot that ostentation has been perfectly level successful caller months. When we perceive "sticky inflation," we perceive small astir nan lodging market.

Federal Reserve (FRED)

The shelter constituent consists of some rent and 'owners' balanced rent'. When we crippled some elements of nan shelter component, we spot thing remarkable.

Owner-equivalent rent and rent itself person still gone wholly vertical successful caller months, contempt reports from nan lodging marketplace showing a notable slowdown owed to higher owe rates, which nearly reached 7% past November.

Federal Reserve (FRED)

Both of these are known arsenic lagging indicators, and yet marketplace participants look to place them completely. Because if we look astatine existent data, from sources that person real-time data, specified arsenic Redfin and nan National Association of Realtors, we spot that nan median income value of a location is much than 11% little than astatine its peak.

Data by YCharts

Every measurement of nan lodging marketplace showed cracks past year, pinch nan median income value falling importantly from its highest constituent ever.

Data by YCharts

And truthful it should be, arsenic liking rates person risen astatine nan fastest gait since nan 1980s, and mortgages person go overmuch much expensive, pinch 30-year owe rates good supra 6%.

Yet nan Federal Reserve's website shows that lodging indicators are still resilient and stagnant astir existent levels. On nan Fed's website, nan median income value of a location sold successful nan United States roseate from $329K successful early 2020 to $468K today. That's a 45.34% summation complete 3 years.

Federal Reserve (FRED)

Rents, according to real-time data from astir sources, besides constituent to a decline, successful opposition to nan Federal Reserve's lagging data, which indicates that nan immense inflationary pressures successful that marketplace are still being felt.

This discrepancy betwixt nan Federal Reserve and galore economists looking astatine lagging information raises galore questions for america arsenic to whether, erstwhile they talk astir sticky inflation, they are looking astatine each components of nan CPI.

Rent.com

To put that successful perspective, we person seen precisely nan aforesaid summation successful location prices complete nan past 3 years that we saw betwixt Q4 2004 and 2020. So we ask: is nan Fed fighting inflation, aliases an plus bubble?

In our view, if nan Fed wants to get liking rates beneath 2%, they are either waiting for nan year-over-year equations successful nan lodging marketplace to fall, which is simply a lagging indicator, aliases person profound deflation successful different parts of nan economy. And correct now we don't spot those different parts showing beardown deflation. On nan different hand, if nan lodging marketplace cracks, aliases nan equations driblet from twelvemonth to year, we could extremity up pinch ostentation good beneath target.

And if that happens, we extremity up arsenic accustomed successful a recession pinch a important driblet successful nan S&P 500 and possibly moreover deflation connected a YoY basis. This could beryllium nan script arsenic nan Fed is keen to support liking rates higher for longer.

Federal Reserve (FRED)

And that besides raises nan mobility of what would hap erstwhile we yet felt nan effect of these liking rates. As immoderate FOMC members pointed out, they person travel to judge that "long and adaptable lags" successful this modern system whitethorn not beryllium that agelong aliases variable.

Whereas investigation shows that it takes 12 months for monetary argumentation changes, specified arsenic liking complaint changes, to return effect and 18 months for nan afloat effect to beryllium felt. To put that into context, we person already knowledgeable profound deflationary forces recently, while according to nan research, nary liking complaint hike has been felt yet.

These changes should not beryllium felt until nan extremity of this twelvemonth and return afloat effect successful 2024. Therefore, we still spot a recession by nan extremity of this twelvemonth aliases astatine nan commencement of 2024.

Federal Reserve (FRED)

But what was nan Fed focusing connected this week? The main focus seems to beryllium connected retail sales, which came successful basking and indicated that user spending remains strong. This raises nan likelihood of nan Fed raising liking rates.

And for us, it increases nan likelihood that nan Fed will proceed to raise liking rates to a overmuch excessively tight level, and that nan Fed will make specified argumentation correction worse if conscionable a mates of bad ostentation prints show up. We impulse investors to inquire nan question: erstwhile was nan past clip nan Fed made nan correct decision? And let's look it: we don't cognize wherever nan Fed will spell pinch liking rates, we can't foretell nan future. But correct now, looking astatine nan Fed's past actions and their comments, it doesn't look good.

One point we tin return distant from each gathering that is simply a fixed is that nether nary circumstances will nan Fed see a 2% ostentation target increase. And it seems that definite marketplace participants don't understand why that should be, and conscionable tolerate a 3% aliases 4% target.

Federal Reserve (FRED)

Wages are not keeping up pinch inflation, and personal savings astatine its lowest constituent successful decades. For example, much than half of Americans cannot screen $1,000 for emergencies pinch savings.

If ostentation continues astatine these levels, nan mean American will beryllium crushed by it. This clip nan Fed will rally down nan mean American, who does not ain nan assets that person been inflated, and nan Fed will support going, astir apt until those assets are crushed.

The Fed has reiterated, clip and again, that difficult markets are not arsenic bad arsenic vastly accrued ostentation for nan mean household. Also from a method standpoint, we deliberation nan 2022 lows will beryllium tested again this year.

TradingView, Author

Finally, different facet is really this higher liking complaint whitethorn impact nan move we person had complete nan past 20 years aliases truthful of "TINA," aliases deficiency of bully alternatives to stocks.

As you tin spot successful nan floor plan below, we took Federal Reserve data and plotted nan net output of nan S&P 500 complete nan past 60 years and compared it to nan output investors get from 10-year Treasuries. We chose 10-year Treasuries because this is often utilized arsenic nan discount complaint successful discounted rate travel models, looking 10 years ahead. The 10-year output collapsed 4% past twelvemonth and presently stands astatine 3.82% successful an upward trend.

This compares pinch an earnings yield for nan S&P 500, which is only 4.59%. For example, if that 10-year output approaches nan net output of nan S&P 500, investors are fundamentally only getting net maturation arsenic a premium. In short, nan 10-year output could put terrible unit connected nan S&P 500 aggregate if it keeps going higher.

Author's Visualization, Federal Reserve Data

The past clip nan 10-year output was astir 4%, successful nan early to mid-2000s, nan net output was person to 6%, aliases a humanities mean valuation of astir 16x nan P/E ratio. And that does not see immoderate net deterioration that usually occurs successful a recession.

Currently, stocks conscionable aren't cheap astatine 22x earnings, we think, pinch a Federal Reserve that wants to support liking rates supra 5% for a agelong time, possibly until thing breaks.

The Bottom Line

While nan Fed focuses connected lagging indicators specified arsenic nan labour marketplace aliases prefers not to return excessively overmuch relationship of what is going connected successful nan lodging marketplace and its effect connected nan CPI, we judge these questions should beryllium raised and made a existent concern.

We deliberation that nan Federal Reserve, arsenic ever successful history, will raise liking rates until thing breaks. The deflationary forces we are seeing, on pinch nan Fed's cognition that it thinks it is fighting ostentation arsenic it did successful nan 1970s, lead america to judge that nan Fed will massively overshoot and support liking rates precocious until nan jobs marketplace breaks and nan S&P 500 is erstwhile again down much than 30% than ever before. Since it looks to america for illustration nan Fed is successful rod position to clang nan economy, we counsel investors to beryllium cautious astir equity rallies based connected nan presumption that nan Federal Reserve will pivot soon.

Data by YCharts

We are cautious astir long-duration, specified arsenic axenic maturation stocks, and for illustration short-term t-bills pinch yields astir 5%, cash, and a concentrated portfolio of stocks that already person beardown free rate flow. Or ones who person nan imaginable to make said rate soon to bargain backmost shares aliases salary dividends.

Long-term, Equity & Macro Research. Providing independent investigation pinch a unsocial position connected publically traded equities and different securities. Our thesis is short: if we tin find exorbitant worth successful it, pinch an ample separator of safety, it becomes portion of our portfolio. Wright's Research prefers a fundamentally driven finance exemplary based connected logical reasoning and quantitative measures, besides incorporating nan accelerated gait of invention by considering factors specified arsenic costs declines and take rates, to supply vulnerability to maturation and invention astatine a adjacent price. We adopt a bottom-up strategy and see changes successful nan macroeconomic situation successful our finance strategies.