- The Fed all but confirmed a V-shaped recovery will not happen.
- Worse, the Fed projections suggest a long recovery path.
- The Fed also shrank the size of it QE program very quietly.
- Now we enter warning season.
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The Fed just gave a pretty gloomy outlook for the US economy, which suggests that the V shaped recovery hopes are pretty much dead, as I have tried to explain multiple times. A full recovery, when considering the output gap that is likely to be created, is likely to take a very long time, and the stock market is not priced for that.
The rise in the market was driven mostly by hope and optimism, with a tailwind provided by easy monetary accommodation. But the Fed just reduced its balance sheet program from basically unlimited to around $120 billion a month. But that announcement was not in the main FOMC statement or the press conference; it was in a press release issued by the New York Federal Reserve Bank. So it mostly went unnoticed.
The Fed now sees GDP contracting by 6.5% in 2020, growing by 5% in 2021 and 3.5% in 2022. That would get real GDP back to where the economy stood at the end of 2019, at about $19.5 million. However, the Fed projects a longer-run growth rate at 1.8%, which is down from 1.9% in December.
The bigger problem is the output gap, the difference between the potential GDP and real GDP, which explodes to around $1.5 trillion at the end of 2020, and gradually shrink to approximately $735 billion by the end of 2022. However, for the economy to return to its full potential, it would need to grow faster than the Fed's projection of 1.8% per year. Real GDP would need to increase by nearly 2.2% each year and would not reach its full potential until 2030.
Here is the big problem, does this extreme recession damage the long-run growth of the economy, and if it does, will that slow future earnings growth. In the chart above, one can see that the path for the potential GDP shifted lower following the 2009 recession. If the long-run potential for GDP shifts lower again, will that, in turn, slow future earnings growth, and if it slows, does that mean that equity valuations, such as the price to earnings multiple need to contract to reflect that slower long-term growth rate?
These sound like distance far off into the future issues, which nobody has the right answer for today. But the market is a forward-looking discounting mechanism, and if the longer-run earnings growth outlook is damaged, then the market needs to reprice.
Despite, what many people may think, given the recent price action of the stock market, stocks follow earnings, and earnings follow the economy. The only thing that tends to change is the earnings multiple, and that multiple changes given the expectations for future growth, with faster growth deserving higher earnings multiple and slower growth lower earnings multiples.
Also very quietly, the Fed reduced the size of its QE program, from basically open-ended to around $120 billion per month, which make no mistake is a considerable amount. But it is also a much slower pace than what we had seen initially when the Fed ramped up the program in March. The Fed's balance sheet initially saw massive amounts of money printing, by around $550 billion two weeks in a row at the end of March and beginning of April, and by around $275 billion a week in the middle of April. If the recent market rally was liquidity-driven, then the significant liquidity source is now significantly less.
Now Earnings Risk
Overall, there was nothing positive about the Fed's message yesterday, it was clear, that the hopes of the market may not come to fruition. Even worse, yesterday, we found out from Starbucks (SBUX) that their results for the full-year would be much worse than expected; additionally, Wells Fargo (WFC) cut its net interest income by 11%. Earnings shortfalls will be a significant risk for the market over the next few weeks. How many more companies that provided no guidance last quarter will come out and warn, or flat out report disappointing results? If the companies themselves were unable to have visibility into how their quarter would perform, it seems highly unlikely that investors can do much better.
The risks for investors remain high, especially given the valuation the market has currently. My earnings model suggests earnings of roughly $117.25 in 2020, $152.60 in 2021, and around $178 in 2022. At the S&P 500's current level of about 3,090, the index is trading for approximately 26.4 times 2020 estimates, and 20.2 times 2021. These are very high multiples given historical standards.
These estimates compare to Thomson Reuters' earnings estimates of $124.19 for 2020, $155.29 for 2021, and $170 per share for 2022. Both my model and the Thomson Reuters estimates are in the same ballpark. It also illustrates just how high valuations are currently for the S&P 500 on a historical basis, going back to 2013.
Overall, these are dangerous times, and the market may have been pricing in the wrong outcome. It could make things even more critical in the days and weeks ahead.
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This article was written by
I am Michael Kramer, the founder of Mott Capital Management and creator of Reading The Markets, an SA Marketplace service. I focus on long-only macro themes and trends, look for long-term thematic growth investments, and use options data to find unusual activity.
I use my over 25 years of experience as a buy-side trader, analyst, and portfolio manager, to explain the twists and turns of the stock market and where it may be heading next. Additionally, I use data from top vendors to formulate my analysis, including sell-side analyst estimates and research, newsfeeds, in-depth options data, and gamma levels.
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