Powell’s Put: Out Of Money And Time

Despite all the fanfare and cheerleading, the recent bounce in equity prices has just been a rather pedestrian bear market rally. Bull markets are not engendered by a faltering global economy, very high rates of inflation, and the most hawkish global central bank tightening cycle in history. Despite these dynamics, stock prices have now completely priced in a perfectly soft landing for the US economy. 

How else would you characterize trading at 17.5 times the 2023 S&P 500 ebullient earnings estimate of $245? 

Keep in mind the $6 trillion of helicopter money ended in 2021, and earnings growth for Q2 2022 is negative 4%, excluding the energy sector. However, Wall Street is still projecting an increase of 50% for 2023 EPS from the pre-COVID level.

Nevertheless, the consumer still faces a barrage of negative shocks: A reverse wealth effect from falling equity and bond prices. The complete virtual shutdown of cash-out refinancing and the lower mortgage payments that come with it are down over 80% year over year. Anemic GDP and Earnings growth. Falling real incomes. And in addition to all this, we still have to deal with aggressive fed rate hikes and a double-dosed pace of QT.

Wall Street is trying to convince you that peak inflation will lead to a Powell Pivot towards dovishness. A dovish fed is one that is cutting rates back to zero percent and engaging in QE. But, peak inflation, which will still be 3-4 times higher than the target rate, should only cause the fed to reduce its hiking pace to 50 basis-point increments from 75 bps. In this age of redefining the meaning of recessions and bear markets, a dovish central banker is now being defined as one that wants to raise rates by “only” 50bp increments.

Meanwhile, in September, $95 billion of base money supply will be destroyed each month. This will happen in the context of a falling stock market, housing prices rolling over, and a potential spike in the unemployment rate. And, for those who still have a job, real incomes continue to fall.

Lower bond yields and peaking inflation were a green light for higher stock prices in July. But that enthusiasm over an improving inflation rate should soon just become another signal of faltering economic growth.

The National Association of Realtors’ housing-affordability index, which factors in home prices, mortgage rates, and family income, fell to 98.5 in June. That is the lowest level of affordability in the past 33 years. Mortgage costs are up 54% y/y in June. And the median existing-home price is $423k this June. It was just $94k 33 years ago. But what else would you expect when you have unelected money printing maniacs in control of the money supply? 

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In other words, a house that does nothing but decay closer back to the dirt over the years has gained 350% in value. That rate of appreciation has been many times greater than incomes over the decades. The real estate market is dysfunctional and posing systemic risk once again. At 40% of core CPI, home price appreciation must be put back into a tractable situation for inflation to be tamed, and that will require a hawkish Fed for many months to come.

The US August Homebuilder Index fell to 49, which is now in contraction territory--the estimate from economists was for a reading of 54. Housing starts fell by 9.6%, and single-family home construction dropped by 18.5% year over year. 

The last time the Fed hiked the Fed Funds Rates above 2.25% was Sept 27th, 2018. Simultaneously, it was doing just $45 billion per month of Quantitative Tightening (QT). That caused the S&P 500 to lose 20% and the Russell 2000 to lose 28% of their respective values by the end of the year. During this timeframe, GDP growth was 3%. The carnage in markets was so sharp that Fed Chair Powell had to promise to stop hiking rates by the end of December. But then again, he could afford to pivot easily back then because CPI was just 1.9%.

Today, much like the fall of 2018, the Effective Fed Funds Rate is 2.3% and is heading towards 3.3% by year’s end. But unlike the strong economy seen in 2018, GDP growth was negative in the first half of this year and is projected to be just 1.6% in Q3, according to the Atlanta Fed. Also, the pace of QT is more than double the rate it was back in 2018. In addition, the stock market is more expensive today and with more leverage in the economy than at any other time in history prior to the start of this year. And as for that much anticipated Powell Pivot, 8.5% consumer price inflation is a much bigger hurdle to overcome than any other time in the past forty years. Mr. Powell’s equity “Put” is way out of the money and far out of time.

Therefore, rather than getting caught up in chasing the FOMO rally, it is much smarter and beneficial to your financial health to get positioned for what is happening next: a global recession, which pushes money into US sovereign debt and the US dollar, and out of equities. That is, at least until Powell has the cover to perform an actual pivot back to QE and ZIRP, which will then start to cause the dollar to tank and stagflation to run intractable.

Some perma-bulls liken today’s market to that of 1982. This was also a time when inflation peaked. Back then, Fed Chair Paul Volcker was cutting rates from 15%, in March of ’82, to 8.5% by year’s end. The only salient similarity between 1982 and today is that inflation has peaked. However, the Fed is not cutting rates at this juncture. As stated, Powell is only slowing the pace of rate hikes from 75 bps to 50bps. And unlike 40 years ago, the Fed is also engaged in the most destructive pace of money destruction in history—more than a trillion dollars per year for the next 2-2.5 years. Most importantly, the PE ratio of the S&P 500 was just 7.7 back in 1982--not the overvalued 21.5 PE ratio we see today. Also, the total market cap of stocks as a percentage of the underlying economy was just 34% 40 years ago, not the frothy 170% we witness now. And, there was no Ronald Reagan in office cutting taxes and reducing regulations.

No time in history compares with today’s record-high inflation and overvalued stock, fixed income, and real estate markets.

This dysfunctional and deformed market is prone to 30%, or even 50%+ plunges—as it has done in the past and is even more likely to do so in the future. Avoiding such a massacre in your retirement plans is a really good idea. Hence, successfully navigating these inflation/deflation cycles is the smartest way to invest.

Written By: Michael Pento