Evening Brief – 06.27.23

We find ourselves with SP500 valuations above their 5-year, 10-year, and 15-year averages at a period in the interest rate cycle when we are adequately restrictive and gazing down the barrel of a prospective recession.

Consequently, the chances of a selloff in the equity markets are considerable. We’re already seeing signs of this in some of the most recent high-flying, AI-powered technology stocks.

While the concept of an AI-led bull market makes sense, it’s probably more of a long-term outlook, and those investors who got in at rather inflated valuations are looking for that gratification sooner rather than later; however, it’s unlikely to produce those desired results in the next three to six months.

The issue with the current equity market landscape is that earnings do not justify the expansion of many of these businesses’ multiples. Forward profits in many tech businesses, for example, are 30%, 40%, or even 50% higher than their three-year averages. To properly explain these high multiples, we need to hear something constructive about the fundamental backdrop.

To be sure, the underlying picture has not worsened as swiftly as Wall Street analysts predicted, both on a global and company-specific basis. However, if inflation falls, which remains a big if, revenues would fall with it because corporations will be unable to sustain the great pricing power they’ve had for most of this cycle.

At the same time, competition heats up again, and consumers begin to cut down on their spending if they are concerned about a recession.

There is growing uncertainty that revenues will meet their expectations in the third and fourth quarters, putting margins under pressure.

Some analysts will contend that with the Fed near the end of tightening it’s a positive for the market, but that depends where you are in the cycle. We are decidedly in the late-stage cycle right now, much like the inverted yield curve.

The issue is not the inverted curve, but the resteepening. The problem isn’t necessarily the hikes or the pause; it’s the rate cuts, particularly how fast and aggressively they occur.

The Fed, according to the optimistic view, will be able to gradually reduce rates and return to a “normal” level as inflation cools without disrupting the economy. However, with these levels of inversion and severe contraction in Leading Economic Indicators – 14 months and counting – it may be impossible to achieve the required soft landing.