'It's always darkest before the dawn'

As we bounce through the last stage of the “Rocky Landing” (which we first projected in the spring of 2022 and which we noted this August would be “Rocky for longer”), I’m recalling Lessons 14 and 14a from my unfinished masterpiece (working title “40 Years, 40 Lessons”), both of which are used above as the headline and subhead, respectively, for this market memo. For sure, it looks pretty dark out there at the moment. Wars in the Middle East and Ukraine. New, untried Speaker of the House at home alongside an aging president and a nearly evenly split Senate. Bond market selling off, yet again, with the all-important 10-year Treasury yield hovering near 5%. Big union strikes, looking for big pay increases, still ongoing at the UAW and the Screen Actors Guild. Economic recession looming per most experts; while it has already missed several predicted arrival dates, it apparently continues to loom just around the corner.  Housing market dead with mortgage rates above 8%. Office properties under pressure, with big city office utilization rates stabilizing nearly 40% below pre-Covid levels. On and on. You get it. It’s dark out there.

And markets, for sure, reflect a lot of this. The cap-weighted S&P 500, the most referenced market benchmark, as of Wednesday’s close, is down 9% from its July peak and 12% from its all-time high 22 months ago—even while the nominal GDP of the U.S. rose 19% over the same period. Year-to-date, all of the S&P’s 10% gain has come from the so-called “Magnificent Seven” mega-cap stocks, with the equal-weighted index through Wednesday’s close down 4% on the year and 16% from late 2021. The so-called “Value” indexes, where many stock pickers find the hidden gems that generate much of their forward returns, have hardly been a refuge. They’re off 10% from their July levels and a full 17% from two years ago. Value names in the small-cap space have been hit even harder, and within the value indexes, many names that our stock pickers at Federated Hermes like are down 20 to 30 to even 40%, trading at single-digit multiples and in most cases with solid cash flows and balance sheets. A lot of darkness priced in, it seems. And more today as I complete this note—the market is down another 1+%, with the Magnificent Seven leading the way down.

The key question for investors, however, is this: is the dawn of a better day just around the bend, or are we just now pulling into the middle of the night? Our equity team believes the balance of evidence suggests the former but acknowledges we could yet be in the latter. Our best advice, which we executed on yet again late yesterday, is leg into these markets. The move by our PRISM^® committee added another point to large-cap growth stocks in our allocation models, narrowing the asset class’s underweight to just 1% and raising our overall equity overweight vs. neutral to 500 basis points, or 50% of our maximum overweight—in our benchmark moderate growth stock-bond model, equities and equity diversifiers (REITs and commodities) represent 65% of the total portfolio, vs. a neutral 60%. We funded the move with cash, lowering its allocation to a neutral 3% in the balanced portfolio for the first time in 18 months. All the equity overweight at this point is in Value and International, the most bombed-out areas of the market. And with a 1% overweight to small-cap growth, we are now overall neutral to growth stocks.

My last several market memos have highlighted a number of reasons why we are likely nearing the end of the rocky landing. Let me summarize those in light of most recent developments. As we begin, please remember this: when things are very dark and markets reflect that, you actually don’t need the dawn to pop up immediately on the horizon for markets to begin to recover. You just need things to get less dark.

Where things could get less dark

• Domestic politics could shift from “totally paralyzed” to “grinding forward.” Right now, given the reality of a nearly paralyzed government and, perhaps depending on your political affiliation, shaky leadership in either Congress, the executive branch, or both, my guess is that perception of how bad things are in Washington couldn’t get any worse. Fortunately, there are multiple pathways to things getting less worse. The House might actually get a bill passed on the budget as the new Speaker enjoys a brief honeymoon period. The divisive “cancel culture” that has plagued all of us, including the politicians, might itself be on the edge of being cancelled, given its latest misstep of falling in line behind what most normal human beings would define as horrific acts of human barbarity in the Middle East. Polls as we approach 2024 might continue to suggest that a change in government and government policy, directed more toward correcting the supply-side problems plaguing the economy could be coming, and the market will try to get ahead of this. A little less dark.
• The Mideast war outcome could shift from “edge of WWIII” to a “protracted grind toward a new equilibrium.” As much as everyone is convinced the war is going to spread into a multifront disaster for all concerned, there’s a good chance it won’t. For nearly all the parties involved, that outcome would be far worse than a quick settlement once Israel neutralizes the threat to its citizens from Hamas terrorism. Although many generalists assume the Arab countries in the Mideast are of one mind, they are most certainly not and religious differences between and among Shiites (e.g., Hezbollah) and Sunnis (e.g., Hamas) are dramatic. All sides might actually figure out that giving the Palestinians their own state might have its drawbacks for some factions of the conflict but might be better than the current mess. If news flow starts to ebb out of the Middle East in the weeks ahead, all the market gossip about $120 oil will as well. Market supportive.
• The bond market might stabilize. As painful as the run-up from zero percent interest rates has been, the recent push toward 5% on the 10-year Treasury is most likely the beginning of the end of this run-up, not a prelude to yet another step up. Unlike the 1970s, this Fed is not going to reignite inflation with premature cuts, and absent that, most of the big drivers on the inflation front have either already rolled over (e.g., shipping costs, wages, input prices) or are about to (e.g., Owners’ Equivalent Rent, price of imports from China). Importantly, despite the UAW headlines, wage growth is already softening and the gap between jobs on offer and workers available already has shrunk considerably from a year ago. Core inflation already is just under 4% and probably within reach soon of what we believe is the Fed’s soft target, 3%. At that level, even if the term premium of rates remains elevated, the bond market yield should slow its ascent and even take a rest near present levels—i.e., less “dark.”
• Earnings might stop going down. Even amid all the clamor around all the above, earnings have continued to—that’s right—bottom out and begin year-over-year (y/y) gains, as we’ve been expecting. Through the current reporting season, earnings are now running +3% y/y, their first up quarter in four. The tech stocks getting slaughtered this week are being punished not so much for weak reports but ambiguous outlooks, as if corporate CEOs are the only folks out there right now unwilling to make a forecast. We won’t know for sure till late next week whether we have in fact finally inflected upward, but for now consensus expectations for the full-year 2023 also have bottomed and now are modestly above where they were last August. For sure, misses have been punished, even when the “miss” was a double-digit earnings gain (i.e., Alphabet this week). But with the equal-weighted S&P trading at just 13.7x 2024 estimates, stocks to us seem to be setting up for earnings news to get worse, not better. So, all we need is less worse; our own forecast at Federated Hermes is actually “better,” expecting a strong fourth quarter to take us nearer to $230 on the S&P this year than the $221 consensus forecast. And for those questioning our $250 earnings forecast for 2024, I’d remind them (if Coke’s report this week didn’t already do so) that stocks eat nominal GDP, not real GDP. By the end of 2024, nominal GDP will be up 32% off of 2019’s level, when S&P EPS were $163. If we’re right, this probably is better than just “less dark.”
• Supply and demand for long-dated financial assets might come more into balance. Lesson 3 from my aforementioned “masterpiece” was the answer given at my first ever big mutual fund board meeting from one of the grizzly value team veterans I worked with at the time. When asked by a prestigious director (unnamed in this story but quite well known) why a certain company he owned with seemingly strong fundamentals was down 20%, the value manager curtly grumbled, “There were more sellers than buyers.” Here in October, we’ve certainly been plagued partly by just that. Heavy government issuance calendar plaguing bonds. Plenty of equity and bond investors spooked by the “Dark” and frozen in record levels of mutual fund cash. Corporate buyers sidelined from share buybacks due to earnings season block-outs. And lots of mutual funds and ETFs taking realized losses to offset gains in a tough overall year. A lot of this supply overhang and demand shortage will begin to heal itself in early November, just as we approach one of the most seasonally strong calendar periods for stocks historically. Less dark. And maybe even outright bright if the forever forestalled recession, now rescheduled for 10:30 a.m. on Jan. 12, 2024, once again fails to arrive on time in light of the continued healthy job market and consumer.

So, I get it. It’s dark out there. But from our perch, it’s at least likely to get less dark ahead. We legged further into equities this week and are planning to do so again if we get lucky and the market plumbs lower. (We are still only 50% of maximum bullish.) Perhaps the dawn is nearly upon us, or perhaps it’s still several months out. But one thing is sure: it’s less further away than it was yesterday. Tomorrow, the dawn will be closer still.