At its August 8th meeting, the Fed elected to leave rates unchanged in deference to a string of soft economic data and the markets’ expectation of a pause. However, with all measures of core price inflation at new highs for this cycle, and with inflation pressures broadening out beyond the pass-through of elevated energy and materials prices (e.g. wage inflation has increased at a 4.3% annualized rate in 2006, a level not seen since 2000-2001), the Fed could not credibly announce an end to the tightening cycle--its official statement left the door open for future rate hikes. However, inflation pressures may well continue to preclude the Fed from shifting to an easier monetary bias.
With the market unable to anticipate monetary easing from the Fed and with economic and earnings growth likely to be disappointing—combined with the fact that in two weeks we will be entering what has historically been the most challenging seasonal period of the year in September and October—the downside risk in the stock markets appears to exceed the upside potential.
On the S&P 500, we think rallies will be contained by the 1300 level and that the downside risk extends to 1150. We would not necessarily wait for this downside target to be reached before deploying some of the liquidity we have raised in our portfolios. If we see evidence of an easing in inflation pressures, which would help ensure that the Fed stays on hold and opens up the door to the possibility of the Fed shifting to an easing bias, and if longer term interest rates remain well-behaved, which would raise the odds of a soft rather than hard landing in the housing market, we would anticipate beginning to increase our equity exposure around the 1200 level on the S&P 500.
When we do decide to raise our equity exposure, we will likely focus on U.S. large-cap growth stocks, which have been the weakest area of the equity markets since the technology/growth stock bubble burst in 2000. A striking illustration of the ground that large-cap growth stocks have lost is that the Russell 1000 Growth Index is still 45% below the high it recorded in March 2000 and an investment in that index would need to have been made eight years ago in order to have a positive return today.
Relative to large-cap value stocks, large-cap growth stocks currently are at their most attractive valuations since 1994. Recent leadership still belongs to large-cap value, but we suspect that a turning point in relative performance is imminent and may coincide with the broader market lows we anticipate this fall.