Valuation Update: Don't Fight the Fed
"If stocks don't fall, the Fed will need to force them."
Brutal Subtitle, eh?
“If stocks don’t fall, the Fed will need to force them. In contrast to many other countries, the US economy doesn’t respond directly to the level of short-term interest rates … financial conditions need to tighten. If this doesn’t happen on its own, the Fed will have to shock markets to achieve the desired response.”
— Bill Dudley, ex-Chief Economist at Goldman Sachs
As you all know, I host livestreams every week with my Founding Members — these are folks who wholly support my work over here on Substack. I was trying to figure out exactly what I wanted to talk about during this stream, then it hit me.
This article shared by Bloomberg on April 6th.
I think the title of the article really got me thinking about a general theme I’m expecting in Q2 — stocks falling. In this post, we’re going to explore a few variables that would catalyze such a fall and what stocks I’m excited to pour money into.
Anatomy of an Earnings Report:
Before we dive into valuation updates — be sure to to check out Public.com’s live event today!
I’ll be chatting with media personality & writer Kinsey Grant about how I analyze stocks and best practices for identifying key metrics.
The most obvious (and arguably the most impactful) would be broad-stroke negative earnings revisions. As you may have read in this post, banks have been kicking off earnings season by sharing their Q1 reports this week. Before the end of April, we’ll see earnings reports from the five companies sitting atop the S&P 500.
So, why would Wall Street analysts issue negative revisions?
Well, the bar for growth during Q1 isn’t exactly demanding. From a GDP perspective, slowing down to only +1.5% is the expectation. What’s concerning (and what causes stocks to sell-off violently) are the forward growth projections.
As of Monday, 55% of the institutions Goldman Sachs surveyed believe the US will enter a recession between now and the end of 2023.
Those are just opinions, however. The economists tell us the GDP will grow by about +3% throughout 2022, and +2% in 2023.
Personally, I can see both sides to the story — but the logical person in me is screaming “recession!” given our heightened inflation, geopolitical uncertainty, Chinese lockdowns, and incoming 5+ rate hikes in the near term.
For me, I’ll be listening very closely during these earnings calls trying to decipher how the management teams of the world’s largest companies are feeling about demand, the supply chain, inflationary pressure, and geopolitical distribution (or lack thereof).
Historically speaking, the S&P 500 forward price-to-earnings ratio is still elevated, despite being out of bubble territory. Remember, as a company’s stock price trades lower (due to bad earnings, bad guidance, lower revisions, etc.) their price-to-earnings ratio comes down as well.
We might begin to see this ratio approach ~16X before we can begin to say “the bottom is in, let’s pile in.”
Inflation, Of Course
I’m not here to exactly blame anyone for the inflation we’re experiencing right now — it’s just really frustrating to see the spending power of people close to me dwindle away as the government continues to print more and more money.
As we all saw, the White House shared a statement pretty much telling us to brace for impact.
“We expect March headline inflation to be extraordinarily elevated.”
Well, it was.
The Consumer Price Index (CPI) came in at an increase of +8.5% year-over-year. The worse part? The Chief Technology Officer of Coinbase encouraged folks on Twitter to build a real inflation calculator — no adjustments to make things look better.
Truflation, the company that spawned from this idea, reported an increase of +13.5% year-over-year. Here’s a link to the details.
As we know, the Fed is going to do all they can to reduce inflation. Remember, inflation is driven higher as the demand for those goods increase, while the supply remains the same. If the Fed can decrease demand, then theoretically speaking inflation comes back down to reality.
How do you decrease demand?
By discouraging people to borrow money — money they’d spend on goods. This is one of the reasons they’re raising interest rates several more times in the near term.
The Fed has clearly conveyed their intentions to tighten financial conditions, slowing down the economy, which will eventually lower inflation. So far, we haven’t exactly seen tighter financial conditions. Bond yields are still reasonably low considering inflation, and the markets are -7% off their highs.
Right now, the markets aren’t reflective of what I think is coming. To me, the markets think the Fed bumps rates, the economy slows, the Fed eases policy in 2025 or so, then things go back to normal. These “back to normal” outcomes have happened in the past, but every time they’ve happened the unemployment rate kept trending lower because the economy didn’t slow enough to push up the unemployment rate.
Today, the unemployment rate hovers around 3.6% — and inflation is hotter than ever. In my opinion, the Fed will need to really slow down the economy to make any sort of dent in inflation. This will more than likely force the unemployment rate higher — and every time the Fed has done exactly that in the past, we experience a recession. Every single time.
How Do We Make Money?
Good question, and a few things come to mind.
The first, glaringly obvious answer is — wait. Yes, you’re right. I cannot predict the future. I have no idea what the stock market will do tomorrow, next month, or next year. However, we can look back in history and try our best to make some assumptions around comparable circumstances.
While browsing Twitter, I found this comparison between the performance of the Nasdaq Composite during 2008 and where it stands today.
The author claims the Nasdaq dropped -24% in 2008 during the initial leg down. Then it retraced about +62% higher in relation to the total delta in the initial drop in value. Then, as we can see from the image on the left, it traded lower.
The similarities are scary.
Now the question is — if we’re on this path and we continue to drop lower throughout the coming 12-18 months, how low would we go?
You all know I’m not a technical analysis person, but I’m a sucker for well explained charts. Below is a chart that illustrates the price of the Nasdaq over the last several years — specifically it’s use of the 200-week EMA as a level of support. However, during the Dot Com Bubble in 2000 and the Great Recession in 2008 we sold-off right through it.
By the way, if you’re into technical analysis I cannot recommend following Katie Stockton enough. She’s a rockstar with this stuff and quite accurately predicted the market “top” in December on a livestream we hosted.
Jumping back now to the “make money” side of the aisle.
We wait until either the markets trade at or below this moving average, or the companies we’re planning to invest in trade below long-standing historical valuation multiples.
Companies on my watchlist — I’m excited to buy lower:
Analog Devices (ADI)
Palo Alto Networks (PANW)
Unity Software (U)
How else I plan to make money:
Fundrise.com shared an incredibly insightful update to their investor specifically pertaining to inflation and the 1970s — I plan to invest a lot more money into real estate through both their website and the stock Tricon Residential (TCN).
I have an affiliate link that pays for my lunch ($25) if you use it — click here.
Quite honestly, I’m piling cash right now. Besides dollar cost averaging every week into my Roth IRA — I really think preparing to buy lower is the best move. I’m doing this specifically because I think we’re going to see heightened volatility during Q2 and I want to be ready to act.
Disclaimer: This is not financial advice or recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.