The Big Picture
It is good to be an economic report these days, because the stock market likes you either way. If you are better than expected, then you are the picture of a soft landing. If you are worse than expected, then you are the reason why the Fed will stop raising the target range for the fed funds rate.
You can do no wrong -- or so it seems -- but in truth you are a problem either way.
Multiple Expansion
The problem isn't so much the data as it is the position in which the stock market now sits.
With the run in stocks we have seen this month, the S&P 500 trades at 18.0x forward twelve-month earnings. That is a premium to the 10-year historical average of 17.2x, which has been established with the 10-yr note yield averaging 2.17% over the same period and core PCE price inflation averaging 2.12%. Today, the 10-yr note yield sits at 3.52% and core-PCE is up 4.4% year-over-year.
The multiple for the S&P 500, however, has expanded from 16.7x at the start of the year with price gains exceeding the change in earnings estimates. Specifically, the S&P 500 is up 6.5% year-to-date while the forward twelve-month earnings estimate has declined 1.2% over the same period to $226.59, according to FactSet.
Judging by the early returns of the fourth quarter earnings reporting period, the forward 12-month earnings estimate is not done going down yet either.
Accordingly, an economic report that gets the stock market excited about a soft landing at this point, and which drives stock prices higher, should create only fleeting satisfaction because it will also create a stiffer valuation headwind for the stock market.
In other words, the upside should be capped because a floor in earnings estimates hasn't been reached yet.
That is where a weak economic report creates bigger problems, notwithstanding the notion that it will convince the Fed to stop raising interest rates.
There isn't a floor in earnings estimates yet; hence, data that point to a continued deterioration in economic activity also point to the likelihood of a further deterioration in earnings estimates, which creates... valuation concerns.
An Open Question
In effect, the stock market, which has had an undeniably strong start to the year, is stuck between a rock and a hard place. That's true because the economy appears to be stuck between a rock and a soft place, which is to say it is neither strong nor in recession.
The question is, does it get stronger or weaker? The answer is self-evident with the long and variable lags of prior rate hikes that began last March. The open question is, just how much weaker will the economy get?
The answer is instrumental for earnings estimates, which in turn are instrumental for the stock market's return prospects.
Judging by the price action alone to begin the year, the stock market thinks an inflection in the earnings estimate trend is near. We think the price action is misleading in that respect.
In our estimation, the price action is more tactical than fundamental. To that end, it has not escaped our eye that the gains this month have come on relatively light volume, that highly-shorted stocks have been some of the biggest winners, and that low-priced, profitless "story stocks" have found a following again. It has been fun, if not entirely fundamental.
Granted there is a fundamental component with long-term rates having come down, inflation improving, and some economic data not being as bad as feared, particularly the employment data. Still, a 16.6% year-to-date gain in the Invesco S&P 500 High Beta ETF underscores the tactical rush to capitalize on beaten-down growth stocks that suffered the final blow of 2022 in the form of tax-loss selling.
What It All Means
The rally to start the year has been a welcome sight for investors, yet it is pulling forward valuation concerns knowing that stock prices have been rising sharply while earnings estimates have been falling.
In turn, it has led to an easing of financial conditions, along with the decline in Treasury yields, that is running afoul of the Fed's policy tightening efforts. How that registers at next week's FOMC meeting remains to be seen, yet we suspect Fed Chair Powell will provide some pushback.
Even if he doesn't, though, the main concern is that the stock market has gotten ahead of itself, having spun the economic reports in its favor whether they have been better than expected or weaker than expected.
The market, however, will do what it wants to do. In January it has wanted to trade higher, but it is running itself into a wall of valuation constraint.
With earnings estimates destined to keep slipping, and the 10-yr note yield and core PCE sitting well above their 10-yr average, the forward 12-month P/E ratio for the S&P 500 should not be trading at much of a premium, if any at all, to its 10-year average.
Our thinking is that the new year rally will be hitting a top soon given that the bottom is still falling out on earnings estimates.
