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  • Writer's pictureJonathan V. Bever

Outlook 2023: Valuation Pendulum

Our Prediction On The S&P 500 for 2023

"If something cannot go on forever, it will stop," Herbert Stein.

It has been so long since we have seen normal we don't recognize it, but there is a paradigm shift from a deflation period to inflation.

Our outlook for the expected return on the S&P 500 for 2023 is a modest return of 5.7 percent. While earnings growth currently is forecasted to be 9.66 percent, the growth is declining year over year and could be guided lower as the economy softens. However, we do not expect earnings growth to be negative. The market should continue to discount the earnings growth as capital expenditure continues to be cut. Therefore, the price-to-earnings multiple should contract rather than expand. Interest rates, while not exceptionally high, are not likely to go much lower and will probably trend modestly higher. Investing in common stocks is usually one of the best ways of keeping up with and beating inflation. In the new environment, stock selection should be essential.

The History of Economic Cycles

Historical averages are a good measure of what normal looks like.

Let's step back and see what we can learn from the history of economic cycles.

The Great Depression 1929 The Great Depression lasted from 1929 to 1939 for about 11 years. Investors were over-levered, and the stock market crash began one of the most difficult economic periods in the history of the USA. One painful characteristic of the Depression was massive deflation. During the Depression, the Fed maintained a tight monetary policy (considered a mistake by most) despite no inflation, and the economic consequences were tragic. WW2 began in 1939 and pulled us out of the deflation cycle.

Great Financial Crisis 2008 In 2008 the Great Financial Crisis started. The banking system in the USA was overleveraged with bad loans. Many banks were on the verge of bankruptcy. The potential for another great depression was looming. At that time, the Federal Reserve Chairman was Ben Bernanke. The tight monetary policy of the Fed during the Depression was the kind of monetary policy that the current Fed Governor, a student of The Great Depression, was not going to make. During our Great Financial Crisis, the Fed kept the economy going with money printing which would ultimately be called Quantitative Easing and low-interest rates. Since the Great Financial crisis, the fight has been against massive deflation. About 11 years later, in 2018, it seemed the Fed was trying to end the emergency low Fed rates and QE; however, our economy was too fragile and had to pivot. So in 2019, it began cutting rates. Then we had the covid crisis, and money printing looked like it would never end.

Finally, in 2021 we had high inflation that was thought to be in a transitory cycle and not going to last. In 2022 it was clear the inflation was not transitory. The Fed began one of the most aggressive rate hikes in history and began to reduce its balance sheet called Quantitative Tightening (QT). The stock market corrected, the bond market corrected, and the economy slowed.

The Great Financial Crisis of 2008/2009 would have long-term economic consequences. The Fed's biggest fight would be deflation, and it maintained a monetary policy to fight it for the next 13 years. An economic policy of artificially low-interest rates and Quantitative Easing was introduced and was a new concept to most people. Money printing and expansion of the Fed balance sheet; was a paradigm shift. The Fed would increase its balance sheet by buying debt assets and lowering treasury and bond yields. Many anomalies followed. How can a country's debt levels rise while paying lower interest rates? This policy was undoubtedly met with skepticism and seemed to contradict common sense.

Nonetheless, it worked from the perspective of fighting deflation. The objective: fight deflation, create liquidity and expand credit to stimulate the economy. The result: a bull stock market, a bull bond market, historically low-yielding debt, a bull real estate market, a growing economy, and modest inflation. It all sounds a little too good to be true. Yet, it was true. But, of course, it would not last forever; after all, it was built on unconventional economic policy.

Between 2008 and 2020, the Consumer Price Index averaged around 2%.

Please see the chart: The top line is the PCE, and the red bottom line is the CPI. This is because the Fed uses the PCE (Personal Consumption Expenditure Core Price Index) rather than the CPI (Consumer Price Index).

By Jonathan Bever: data from Bloomberg LLC.

Finally, the CPI began its rise above 2 percent in 2021 and would peak in 2022 at around 9.1 percent.

Inflation reached dangerous levels. GDP in 2021 was 5.7%, which we address in our blog: Inflation Gap. Here we look at the textbook case of GDP above the potential GDP. The Fed realized that inflation was not transient this time, and it had to begin one of the most aggressive rate hike cycles and reduce its balance sheet called quantitative tightening (QT). We were skeptical the Fed could raise rates and do QT too much without strangling a fragile economy as it could put us quickly into disinflation or deflation. After 13 years, did the Fed finally get the economy strong enough to stand on its own? Did we recover from the damage that had its genesis in the Great Financial Crisis?

In our opinion, the Fed's goal was to get inflation without artificial stimulus, which we call a standard economic policy. Inflation had been transitory until it wasn't. After many years of stimulus since the Great Financial Crisis, it is hard to believe the economy can thrive without economic stimulus. Has the Fed accomplished its goal? Can the economy avoid a recession without very low-interest rates and the expansion of the Fed balance sheet? We think so. It is easy to spread fear and doubt on the one hand and easy to be too optimistic on the other. If the economy slows without a hard landing, if the markets correct without crashing, and if the credit markets have enough liquidity to function, we should be firmly back to normal. Of course, recoveries are often a struggle and may not be in a straight line. Nevertheless, we are optimistic that we are in the process of returning to normal, and the Fed has done its job. Why? Because the Fed now fears inflation. Therefore, the next 11 years of investing should differ from the last 11.

Historical averages are a good measure of what normal looks like.

Historically, the S&P has a price-to-earnings multiple of 16-17. The Fed rate is somewhere near the CPI inflation. We have seen the CPI come down year over year. Ultimately, we expect the CPI to be around 3-4 percent and the Fed rate to be about 4- 5 percent. Please see the chart below illustrating the Fed rate on the bottom and CPI and PCE on the top.

By Jonathan Bever: data from Bloomberg LLC.

Our final chart will look at the PE ratio, S&P 500, and the Fed continuous rate. Again, the top red line is the P/E multiple, and the blue line is the S&P 500. The blue bottom line is the Fed target rate.

By Jonathan Bever: data from Bloomberg LLC.

Please note the inverse relationship between the Fed rate and the P/E multiple. For example, as the Fed rate was high in the 1980s, the P/E multiple was below 10; most recently, as the Fed rate was near zero, the P/E multiple was as high as 30.

So, why are all these historic ratios important? For 40 years, the stock market has had a tailwind as rates trended lower with some interruptions. The same can be said of the bond and real estate markets.

The following 20-30 years will probably be much different. When an economic paradigm shift takes place, the process is usually painful. Asset prices get reevaluated. We must rethink risk and return assumptions. An understanding of the new attributes that will drive performance is essential. New investment strategies should be adopted. When credit expands, and the cost of capital is cheap, risk assets tend to go up and, in some cases, can reach bubble levels, and volatility follows.

Long-term interest rate cycles: The Period of Inexpensive Capital is Over

Historically interest rates move in long cycles of 20-30 years. The cycles are not straight up or straight down. Please see the 10-year Treasury yields in the charts below:

We have seen rate yields go down since the peak in 1981.

By Jonathan Bever: data from Bloomberg LLC.

Yields have gone down since 1981, or about 40 years if we consider the 2021 trough. Can yields go back down and stay low for a lot longer? Indeed, this is possible. Given large sovereign deficits, rates will likely go back down. However, we do not think this is a likely outcome. We cannot ignore history. There is a cycle, and we believe we are facing higher lows and higher highs in treasury yields. Some argue that QE would not work because the math will not pencil out; likewise, some say that interest rates will be capped because the math will not pencil out. Again, history has cycles that we can observe but cannot control. The best we can do is recognize the cycles and navigate accordingly.

The 3 Parts In The Paradigm Shift Back To Normal

When what we call Quantitative Easing (QE) was new, it was indeed a paradigm shift in monetary policy. Like most new things, it was met with skepticism and criticism. After many years it seemed the new normal, and now that QE is not being used, it is also met with criticism and skepticism. Today's paradigm shift is the return to a normal economic policy.

We are likely facing three parts in the paradigm shift to normal:

  1. An end to Quantitative Easing (used only in emergencies)

  2. The second is the end of almost zero Fed target rate

  3. Higher treasury yields

All are resulting in a headwind or lower returns for risk assets.

There is a possibility that disinflation will accelerate, and the Fed must pivot. If the Fed pivots and cuts rates, it will probably initiate a new round of Quantitative Easing. We hope this does not occur, but if it does, then the S&P will have a multiple expansion, and the 10-year treasury will likely go lower.

The Outlook On The S&P 500 for 2023 Conclusion

There is nothing like years of experience in the stock market to recognize paradigm shifts. One period of investing and return attributes will be much different than another period. We have seen peaks and seen troughs on more than one occasion. Periods of inflation are more common than periods of deflation. Therefore, investing in fighting inflation is essential. Likewise, overweighting stocks to help beat inflation is usually necessary, and having the right stocks is critical.



The Fed Balance Sheet 4.1 report provides a consolidated statement of the condition of all the Federal Reserve banks in terms of their assets and liabilities. It lists all assets and liabilities, providing a consolidated statement of the condition of all 12 regional Federal Reserve Banks. May 11, 2020, Investopedia

In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements. Wikipedia

S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices, and many consider it one of the best representations of the US stock market. Wikipedia

Consumer prices (CPI) are a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate. Bloomberg

PCE deflators (or personal consumption expenditure deflators) track overall price changes for goods and services purchased by consumers. Deflators are calculated by dividing the appropriate nominal series by the corresponding real series and multiplying by 100.

The preferred measure by the Federal Reserve of core inflation in the United States is the change in the core personal consumption expenditures price index (PCE). This index is based on a dynamic consumption basket. Before that, the inflation outlook was presented in terms of the CPI. Wikipedia

The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing.

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