Month in Review
Three main forces are competing to impact stocks. Increases in money are pushing stocks higher, while future earnings and higher interest rates are pulling them down. Our forecast was that future earnings and higher interest rates were likely to win. The S&P500 has moved below its 200-day average. Despite the decline, our analysis shows stocks remain overvalued.
As for the economy, most economic indicators continue to show both demand and inflation rising rapidly. The increase in demand has the economy growing at a 3%-4% annual rate in the first quarter.
Monetary policy remains highly expansive and is likely to be so for most of this year. As a result, spending will remain strong and inflation will remain close to the 7% vicinity. Although real growth has remained strong, part of the strength is due to growth catching up from the lockdown. This quarter the catch up should end. Future real growth is likely to slow.
The combination of strong demand and weaker growth will keep inflation rates elevated. Although the Fed will be moving interest rates higher, the moves are unlikely at first to lead to any monetary restraint. As such, interest rates should continue to rise in anticipation of further moves by the Fed to contain inflation.
Monetary policy remained highly expansive. In January, the Fed purchased $109 billion in securities. Banks reduced their holdings of deposits at the Fed by $318 billion. Together these two moves increased the raw ingredients of the money supply by $427 billion.+
The Fed intends to continue slowing its security purchases, to $30 billion from mid-February to mid-March. At its mid-March meeting, the Fed anticipates ending its purchases of securities.
The last time the Fed stopped purchasing securities was from 2014-18. This move to monetary restraint had little impact on the economy. Banks made up for the Fed’s restraint by shifting their deposits with the Fed into the economy.
Early signs this year show banks again finding it desirable to shift deposits from the Fed into the economy. As a result, their deposits at the Fed declined from just over $4 trillion to slightly below $4 trillion.
Other monetary indicators confirm a rapid increase in money. The recent sharp rise in interest rates has increased yield spreads above their averages from 1996 to 2021. Other monetary indicators also continue to grow at double-digit rates.
There is tendency for money to impact the economy six-to-nine months after entering the economy. As a result, current dollar spending (GDP) should increase at double-digit rates well into the latter half of this year.
If banks find it attractive to continue to shift their deposits from the Fed into the economy, the surge in spending would continue well into 2023.
The net effect has been an increase in liquidity. Liquidity (Fed holdings less bank reserves) is up 25% from a year ago.
Impact on Economic Growth
In the preliminary estimate for the fourth quarter real growth was close to a 7% annual rate.
Monthly data through January indicate growth likely continued at a 3% to 4% rate despite supply-chain problems.
Real growth has averaged 2.7% over the past two years. The economy has now recovered completely from the disruption associated with the Covid lockdown.
Demand is likely to continue to grow close to double-digit annual rates. Despite continued strong demand, barriers to growth and capacity constraints will likely slow real growth to 2% or less late this year.
If Congress approves additional federal spending and taxes, growth is likely to slow to less than a 2% annual rate.
Sensitive short-term indicators point to a further economic expansion. January ISM surveys remained strong. Readings for new orders are in the vicinity of 60, pointing to further strength in the coming months.
Housing sales are well off their recent peaks because of the combination of low inventories along with sharp increases in home prices. Even so, the February Homebuilders’ Survey was 82, signaling a strong market for new homes.
Coincident indicators show the economy continues to recover. In an encouraging sign, January vehicle sales registered a significant improvement.
The Fed’s index of manufacturing output finally moved above its prior peak. It is now more consistent with the upturn in manufacturing shown in other indicators.
The sharp upturn in inflation continues. Demand is continuing at a rapid rate. By the spring of this year, the 2-year change in current dollar spending will approach 13% annualized.
Our forecast shows it will remain in double digits through the remainder of this year. Inflation is the difference between current dollar spending and the economy’s ability to increase real output. Since the economy’s growth has made up for lost output during the lockdown, real growth going forward is likely to be less than 3% a year.
Subtracting real growth from double-digit increases in spending leaves an underlying inflation rate in the vicinity of 7%. Inflation rates anywhere near this area would encourage the Fed to move interest rates sooner and higher than they have indicated.
As the Fed prepares its first moves to combat inflation, markets anticipate a ¼% to ½% increase in the fed funds rate in mid-March. Financial markets already responded with higher interest rates.
Financial markets erroneously continue to assume the Fed will be able to contain inflation with only gradual, relatively modest increases in short-term interest rates. This is what happened following the 2008 financial crisis, when the economy remained weak and short-term interest rates remained low.
The major difference between then and now is monetary policy. Currently, money is far more expansive than it was following 2008. The current period is more like the late 1970s, which saw much higher inflation and much higher interest rates than almost everyone expected.
With the S&P500 at 4350, stocks are overvalued by 29%. This overvaluation is based on using the fundamental interest rate for bonds in valuing earnings. The fundamental interest rate is where rates would be if the Fed were not holding them at artificially low levers.
An alternative valuation of the S&P500 using current bond rates shows the S&P500 overvalued by 10%.
If interest rates on bonds increase, as most forecasts indicate, the two models will eventually show the similar overvaluation.
Zach’s estimate for fourth quarter S&P500 operating earnings is for $53 a share. This is up 30% from a year ago and up from $52 in the third quarter. Using a similar pattern would put reported profits at $50 a share ($200 at an annual rate).
While most analysts are projecting earning to rise by 9% to 10% in 2022 and 2023, our analysis assumes the earning trend is more likely to return to its longer-term trend. While the upcoming earnings trend is highly speculative, we assume the combination of higher interest rates and rising costs are more likely to produce no increase in earnings or even a decline.
While it is possible earnings will rise in line with analysts’ predictions, we also believe they could just as easily drop quickly back to their longer term trend. The gradual decline is a compromise between the two extremes.
While flat to down earnings would create headwinds for stock prices, the sharp increases in money will work to push stock prices higher. The battle between these two forces is likely to continue.
With the mistakes the Fed has made so far in underestimating inflation, the potential for future policy mistakes cannot be ruled out. The only certainty is investors should remain cautious in facing what is will continue to be a difficult financial environment in the year ahead.
Robert Genetski, Ph.D., one of the nation’s leading economists and financial advisors, has spent more than 35 years promoting the use of classical economic and investment principles for sound financial decisions. He heads ClassicalPrinciples.