by Franklin J. Parker, CFA
The Summary
- This week we see some important fundamental economic data. Today, Durable Goods orders post—a gauge of sentiment for business investment. On Wednesday, we get GDP growth figures for the first quarter. Economists are expecting 1.1% GDP growth, down considerably from last quarter’s 6.9%. Obviously this figure will be important as investors try to understand what affects inflation and slowing consumer spending will have on the economy. Also posting this week is personal consumption expenditures—another gauge of inflation—and manufacturing data. This is a busy week for basic economic data!
- Last week’s comments from Federal Reserve officials appear to indicate a preference for a 0.50% rate hike at the next meeting. This was more hawkish than markets expected, and that sent risk prices reeling. I have talked about how the Fed has few tools to fight inflation this time around and that the main weapon in their arsenal is moving rates upward quickly. With that thesis, this “pivot” is not particularly surprising to me, though it does appear that markets may be over-reacting (again). At any rate, this is well within the investment outlook I set for the year, and it is still my view that markets will return to growth in the back half of the year (barring a recession, of course).
- It seems increasingly improbable that the Fed can engineer a “soft landing” for the economy. Much more likely is a “hard landing” that ends in high unemployment, a recession, and—very likely—lingering inflation. History shows us that we get 18 to 24 months of rate hikes before the next recession hits. Based on that alone, we should expect to see a recession in late 2023, an expectation other other indicators seem to confirm. In my view, a recession is likely in 2023, but unlikely this year.
The Details / Chart of the Week
Valuation is a word thrown around a lot, but what does it mean?
Very simply, valuation is the number of dollars an investor is willing to pay for $1 in company earnings. Of course, there are many different methods of measuring this. A method popularized by Nobel laureate Robert Shiller is the cyclically-adjusted price-to-earnings ratio, or CAPE ratio for short. While not as straightforward a measure (like the simple price-to-earnings ratio), it does a better job of showing the longer-term trends in valuation.
This week’s chart shows the historical valuation of the S&P 500. After reaching valuations that were more expensive than 98% of its history, the S&P 500 has begun to retreat a little (though it is still above its 95th percentile). Some of that is from recent price falls, but some is also from earnings growth. While I would expect this reduction in valuation to continue due to the Fed’s change in policy, we did see a similar retreat in 2018-2020, only to move to still newer highs.
In the end, it is important to note valuations (and the risks thereto), but they are also not a useful short-term trading tool. That is, valuations give us very little information about how markets will behave over the coming months or next few years, as our second plot demonstrates. One-year returns for markets are fairly random. However, longer-term returns tend to inversely correlate to valuations (high valuations tend to yield lower returns and vice versa).
As always, we are forced to assess and balance risks that you can afford to take. And, as we have talked about ad nauseum, flexibility is key in this environment.
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