September has not been a good month for stocks, with the market returning to its volatile ways and continuing to give up gains from July and August.
August inflation data and the Federal Reserve's comments from its recent September meeting seem to have everyone on edge about what kind of recession the U.S. economy might enter after all of the Fed's interest rate hikes.
The S&P 500, a broader benchmark for the market, had fallen to around 3,650 as of this writing. It's firmly back into bear market territory, now down close to 23% this year. Given this recent drop, is the market nearing a bottom?
Inflation worries are turning into recession worries
With inflation this year at the highest level seen in 40 years, the Fed has seemingly been playing catch-up to get it under control with aggressive rate hikes to its key benchmark rate, the federal funds rate. The goal is to slow the economy enough so prices stop rising.
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But so far, it's been difficult to tell if the Fed's rate hikes have been working. In recent months, prices have shown softening but have been unable to make it a real trend, with the Consumer Price Index (CPI) bouncing around a little bit. The problem is that the Fed's rate hikes need time to work their way through the economy, so we haven't seen their full impact just yet.
Another problem is that with the Fed having done three 75-basis-point hikes since June, that's a lot of ammo now being thrown at inflation, and more big rate hikes could be coming. It's now very possible the Fed goes too far and ends up really drying up consumer demand and business activity, throwing the economy into a much more severe recession.
I firmly believe inflation will start to show signs of slowing toward the end of this year and into 2023, but it seems less likely that the Fed can engineer a soft landing.
With the labor market still showing signs of strength, it's hard to say how high all of these rate hikes will push unemployment.
What is now being priced in?
A big question among investors since the Fed's recent meeting is if the market has priced in a severe recession that could come next year.
If we look at the S&P 500, the market clearly got way ahead of itself in late 2021 but has since fallen to levels not too far above where they were before the pandemic hit, and it's normal for the market to appreciate over a few years. After all, over the long term, stocks usually go up.
However, analysts are still more optimistic about company earnings than prior to the recession. About 85% of the companies in the S&P 500 still have higher earnings outlooks over the next year than they did in February of 2020, according to The Wall Street Journal. But the silver lining here is that very few of these companies trade at valuations that reflect these earnings estimates.
The other thing I am keeping an eye on is how quantitative tightening (QT) will impact markets, as the Fed unwinds its massive balance sheet and effectively pulls liquidity out of the economy. The impact of QT on markets is more of an unknown, but in general, the idea is that the more money the Fed pumps into the economy, the more inflated that assets will become because this money tends to get soaked up, at least part of it.
With this reasoning, QT should effectively hurt stocks. But the Fed's balance sheet is still more than double the size that it was prior to the pandemic. It's also going to take some time to reduce because the Fed is only running off about $100 billion a month from its balance sheet right now, which is still currently over $8.8 trillion. So the fact that markets are not significantly higher right now than pre-pandemic does not seem to factor in all of the excess liquidity still in the economy.
Is the market nearing a bottom?
Economists at Goldman Sachs predict the S&P 500 to finish the year at around 3,600. The median target is still about 4,200, which implies some decent upside from here. Other analysts, though, suggest 3,200 is not out of the realm of possibility.
Ultimately, I do think stocks could go lower if a severe recession hits and there is a big recalibration in earnings estimates.
However, given that valuations are not factoring in current earnings estimates and there is still a ton of excess liquidity in the system, I do believe we are at least nearing a bottom. I do not think the market should be below pre-pandemic levels when the S&P 500 traded a little higher than 3,200.
