Both the economy and financial markets are reacting to a mixture of forces, some of which are visible and others are not. As the effects of Federal Reserve policy lag the policy implementation, the Fed continues to be careful but is starting to think that their actions may be enough to gradually slow inflation. The markets however, as always, suffer from hyperactivity disorder and react quickly to every economic data point and nuance in the Fed’s commentary.

The Economy

The most recent GDP report for the third quarter showed robust 4.9% annual growth. However, more recent data has suggested there may be some slowing. The Atlanta Fed’s real-time estimate is reporting 2.3% growth currently, and the Federal Reserve recent survey of member banks reports that economic activity had slowed between October and November’s reports. The Conference Board’s Leading Economic Indicators posted its 20th consecutive monthly decline. Of the ten components that make up the indicators, the stock market was the only positive measure.

Mortgage rates have begun to decline since peaking at the end of October. Housing affordability at that time was hitting a new recent low and house sales were 13.2% lower than last year, while prices still increased by 3.5%, which was slightly less than inflation. In the most recent report, payrolls increased, and the unemployment rate dropped slightly to 3.7%. For its part, the Federal Reserve continues to keep its foot on the economic brake, holding the Federal Funds rate at 5.33% while also working off some of the excess money that was created while responding to the COVID pandemic.

The Markets

This was the year of the Magnificent 7. This small group of stocks* contributed 67% of the entire gain of the S&P500. Their value increased by an average of 90%, led by Nvidia’s 248% gain. The remainder of the S&P500 spent the year bouncing around in a channel that was essentially flat. The non-magnificent 493 group did pick up some steam after the Fed held off raising interest rates for the second time in September and is now approaching break-even with its prior high set in January 2022. While the average large cap stock has barely recovered its losses from the last two years, small cap stocks are still lagging by about 6%, and the total return of 10-year treasury bonds is 20% below its peak.

The Magnificent 7 remains an important group, because these stocks are the primary holdings in mutual funds and retirement plans. They are felt by most analysts to be quality, leading companies that will continue to exhibit strong growth. According to Reuters, their ratio of current price to estimated future earnings is 33.6. This compares to 19.8 for the S&P500 as a whole. Because of their higher valuation and S&P500 concentration, if they should stumble, they would have an outsized impact on the market indexes and the retirement plans that are based on indexed investments.

Threading The Needle

Over the last 10 years, the markets learned that the Federal Reserve reverses restrictive policies ("pivots") on the first sign of economic weakness. This occurred in spades after the COVID pandemic. Investors took these lessons to heart and the stock market has continuously expected an early end to the anti-inflation policy, largely ignoring the Fed's "rates higher for longer" guidance. Most recently, the market took off when the Fed began to slow the rate increases by holding the target steady in June. After a downdraft, the rally started again after the September meeting ended without an increase. The markets still do not believe the Fed. Holders of futures contracts are betting on seven consecutive rate cuts beginning in March and ending in December at 3.8%. In contrast, the Fed members that set the rates expect only three decreases to 4.6% by the end of 2024. The markets may be ahead of their skis, which could precipitate a tumble.

Neither avoiding nor encountering a recession is a sure thing. The Conference Board's Leading Economic Indicators has fallen for 22 straight months. The restrictive financial condition, where short-term rates are higher than long-term rates (an inverted yield curve), is still in place. This anomaly has always led to a recession from this level, so there is by no means an all-clear signal on the economic front. The market seems to be rallying on the expectation of returning to the good old days of low rates and Fed supported economic growth, but there may be an inconsistency here. The only reason that the Fed would lower rates at the speed envisioned by the markets would be due to a recession. Recessions limit economic growth as well as stock market gains. Otherwise, if rates were cut aggressively and economic growth continued, inflation could become an issue again, and the Fed would need to restart the rate increases.

The problem and confusion likely stem from the fact that the effect of Fed policy takes time to bite. Rates can be increased today, but an increase in mortgage rates will only affect a long-term fixed rate mortgage when a person decides to move and buys a new home. Likewise for business financing, rate changes occur when business loans rollover or floating rates reset. Fed chair Jerome Powell referred to this lag effect when he mentioned that the Fed was "navigating by the stars under cloudy skies." Should they wait too long to ease policy there is a risk of deeper recession. Should they stop too early, there is the risk of rekindling inflation.

In theory, fundamental equity values should be based upon economic growth and prevailing interest rates. The higher the growth rate, the higher the equity value. The lower the prevailing interest rate, the higher the equity value becomes. If the Fed has re-learned that keeping interest rates too low for too long can engender inflation, they will not likely go back to their previous zero interest rate policy. Maintaining higher, but historically normal rates would reduce the theoretical market excess valuations from the levels seen in the last decade, whether or not a recession occurs.

In practice though, psychology also influences market prices. The re-emergence of a the speculative Fear-Of-Missing-Out (FOMO) psychology that is driving the current market rally, (also illustrated by the resurgence of Bitcoin) may be misplaced. The question is whether the market can maintain its over-valuation without speculative fervor, or whether today’s valuation can eventually normalize. Returning to a normal valuation level would require either a bear market period, like the early 2000s, or allowing earnings time to catch-up to price in a longer consolidation, like the 1970s.

At this point, there are a number of possible outcomes. The future is heavily dependent on how Fed and government fiscal policy is executed. It is hard to imagine the Fed intending to go back to the "lower for longer" rate policy that created the recent "everything bubble". It is likely safe to say, however, that without a recession-prompted pivot, the financial environment will not be what we became accustomed to under the previous Fed policy regime. At this point, there may be enough excess liquidity in the financial system to support another speculative blow-off.

Another element at work is the calendar. Typically in the last year of a presidential election cycle, looser fiscal and monetary policy works its magic to produce better economic conditions and market values in time for the election. On average this effect produces a flat–to-lower first half, followed by a strong third quarter.

If the Fed is successful, they may be able to thread the needle between recession and inflation and keep the economy and market values growing in concert. In any case, flat or decreasing interest rates can be expected next year. That implies that today’s high money market rates will melt away while the return of longer-term bonds returns improves. Although yields could rise again if inflation data causes the Fed to maintain their currently restrictive policy, this is likely a good time to rebalance portfolio stock/bond allocations to assure that bonds or bond funds are appropriately represented. It could also make sense to consider locking in today’s bond yields buy buying a fixed-rate treasury bond.

As is often the case, this is an unpredictable time. For people who have plenty of time before retirement, it can be said that a long-term risk tolerant approach remains a good strategy. For others, who have less time before retirement and are not yet well-prepared, it could be better to take a shorter-term more risk averse approach until clarity improves and a solid trend materializes again.

 

*Nvidia (NVDA), Meta Platforms (META), Amazon.com (AMZN), Microsoft (MSFT), Apple (AAPL), Alphabet (GOOGL) and Tesla (TSLA)