The Market Rally
Equity markets have begun the year on an uptrend, driven by various factors, including lower inflation data and growing expectations that the Federal Reserve may end its interest rate hikes soon. Some speculate that the Fed may even lower rates later in the year. The S&P 500 finished the week at 4070, surpassing key technical indicators such as the 50-day, 100-day, and 200-day simple moving averages and breaking a long-standing trendline. This is considered to be a bullish signal, indicating that the market could continue to rise in the near term. It's worth noting that the S&P 500 recently reached this level on November 30th and September 12th, indicating that there may also be resistance at this price point.
S&P 500 Fair Value
One method to determine a fair value for the S&P 500 is to use a multiple of earnings estimate. This involves taking earnings estimates for the companies in the index and applying a multiple, such as a price-to-earnings ratio (P/E ratio), that reflects the price investors are willing to pay for expected earnings. This method can give an idea of where the index should be trading based on the anticipated earnings of its component companies.
The Rule of 20 is a method for arriving at a fair P/E multiple, which is used to estimate the intrinsic value of a stock or index. The Rule of 20 states that the fair P/E ratio is equal to 20 minus the inflation rate. The idea is that when inflation is high, investors will pay less for future earnings, and when inflation is low, investors will pay more for future earnings. This Rule is based on the assumption that a P/E ratio of 20 is fair when inflation is zero and that the fair P/E ratio should be adjusted based on the current inflation rate.
Earnings estimates for 2023 have been revised downward over the past year, with initial projections starting at $252. The current 2023 S&P 500 earnings estimate, according to S&P Dow Jones Indices, is $223. The P/E ratio, calculated using today's closing level of the S&P 500, is 18. 4070 would be fair value for the S&P 500 if the inflation rate fell to 2% and the current earnings estimates for 2023 are not revised downward any further.
Let's wait until next week
I want to be completely transparent. Our portfolio models remain defensively positioned and have underperformed their benchmarks in January. We are in earnings season, when companies announce their earnings for the previous quarter and give guidance for the following year. About a fifth of the S&P 500 have reported their earnings so far, and they have been okay but not impressive. Next week we will hear from some of the largest companies in the S&P 500 and the Technology sector, which has been the main driving force behind the recent market rally. Wednesday, the Federal Reserve will conclude its two-day meeting with a rate decision and a press conference, and on Friday, the monthly jobs report will be released. The market rally seems premature ahead of so many unknowns.
Outside the U.S.
The ongoing war in Ukraine continues to be a significant geopolitical risk. On February 5th, Europe will impose additional restrictions on Russian petroleum distillates, which could lead to increased price pressures on diesel and gasoline. While China's reopening is expected to be positive for the global economy, the increased economic activity will also lead to a rise in energy demand, further adding to the price pressure on oil. As a result, I anticipate that U.S. gasoline prices may rise in the coming weeks and months, contributing to inflation and inflation expectations.
Recession Risks
The 10-Year to 3-Month Treasury Yield Spread, a reliable recession indicator, remains inverted by -1.22%. The consumer remains resilient though we are beginning to see a slide in consumer spending. As long as the unemployment rate remains below the Feds' projected 4.5%, I would expect any recession to be mild unless you're one of the 4.5%. The Fed Funds Futures market implies the Fed will cut interest rates later this year, which would also suggest anticipation of a weakening economy and rising unemployment.
