To The Moon

Summary

• It appears to us as if the Fed is fighting an asset bubble rather than trying to lower inflation, looking at the shelter component of CPI.
• We think the Fed, like every other time in history, will continue to raise interest rates and keep them there until something breaks, listening to their Fed talk.
• As the Fed continues to raise interest rates, the 20-year-old concept of 'TINA' appears to be called into question as treasuries become more attractive.
• With a P/E ratio near 22 and crushing yields hanging over its head, we caution investors buying into this S&P 500 rally so far, and suggest what better alternatives might be.

The S&P 500 (NYSEARCA:SPY) has had an explosive year so far, rebounding and already up more than 6% YTD. This is in stark contrast to the Federal Reserve, which continues to raise interest rates and maintains its hawkish stance.

Fed fund futures are already currently assuming a Fed Funds rate of 5.50% in November 2023. It also means that the Fed is playing with fire or lighting a fire under what used to be "TINA" or "there is no alternative," now that the 6-month interest rate has broken through the 5% barrier.

CME Group

Fed Talk

Last week, the calendar was full of FOMC members speaking out and giving subtle hints about the future of interest rates and where they believe inflation to be going. For example, one of the disturbing trends we noticed was that FOMC members were constantly drawingcomparisons between the current inflationary environment and that of the 1970s.

Inflation is a pernicious problem. One of the lessons of the last two years is that everybody feels the effects of inflation. It's pretty much across the spectrum. So rich and poor, young and old, everybody notices. So if we can't get this problem under control soon, we risk a replay of the 1970s. (St. Louis President James Bullard)

He also said he would not rule out a 50bp rate hike at the March meeting, and reportedly advocated that at the previous meeting. Bullard also said he would like to bring the Fed's policy rate to 5.375% and reaffirmed his position on the duration of this inflation:

My overall judgment is it will be a long battle against inflation, and we’ll probably have to continue to show inflation-fighting resolve as we go through 2023.

Bullard is another member who has advocated the "front-loading" of monetary policy in the past. Worse, the FOMC member opposed monetary policy slowdowns, one of the main factors preventing the Fed from raising interest rates faster:

I have pushed back against the long and variable lags argument… because I think in the modern era the transmission of monetary policy is much faster than it would have been in the 50s, 60s and 70s.

Federal Reserve (FRED)

Loretta Mester, another hawkish FOMC member,also sawa "compelling case for another 50 basis point rate hike" earlier this month. But more importantly, about what steps to expect at subsequent meetings, she said in the question-and-answer session:

The Fed could accelerate the pace of rate increases again if economic conditions warrant. It’s not always going to be, you know, 25(bp).

A pause certainly does not seem to be on FOMC member Mester's books just yet, for when asked when they would pause, she noted that Fed officials are still raising interest rates to levels that are restrictive enough. Finally, she also noted that inflation risks are still on the upside, and those upside risks argue for "overshooting."

Nothing right now is leading me to think that I need to really be focused on that question at this point.

Other members, such as Member Bowman and Member Barkin, affirm their view that it will be a long battle against inflation. Richmond Fed Chairman Thomas Barkin also raises the message not to make the mistakes made in the 1970s.

I think there's a very good case for leaving rates higher, for a longer period of time to allow the tightening to hit. I do think the lesson of the 70s was very clear, which is don't give up too early.

Federal Reserve (FRED)

Remarkably, Barkin also referred on Bloomberg to that period that "their predecessors did the right thing," by which he probably meant Paul Volcker and called it a pursuit of him and the Fed.

To sum up all the Fed talk: FOMC members don't even think or consider a pivot, some would even prefer to overshoot and like to refer to the 1970s, basically calling for keeping interest rates higher for longer despite seeing inflation already coming down.

Our position is that while the markets continue to rally, Fed members still seem to want to take the stance of Volcker. And eventually, something has to give. In this game of chicken, it looks like the Fed will stick to its game plan to get inflation back to 2%, which seems impossible at the moment without causing a recession. Though thing seems certain: interest rates are probably going nowhere but up this year.

What Recession?

We believe the Federal Reserve will continue to raise interest rates until the economy breaks, and also like to refer to the Federal Reserve's attitude toward economic growth in the past for that matter. After GDP was negative for 2 consecutive quarters last year, theFed's attitudewas essentially: recession? What recession?

I do not think the U.S. is currently in a recession. And the reason is, there are just too many areas of the economy that are performing, you know, too well, and of course I would point to the labor market in particular.

A rather strange statement, as most people and the Fed itself knows thatthe labor market is seen as a lagging indicator. In the past, whenever the labor market began to deteriorate, it was already too late to take action because the recession was already underway.

Take even recent data, from 2000 and 2008, where the Fed cut interest rates, and the labor market just kept deteriorating with a slowing effect until the end of the recession.

Federal Reserve (FRED)

There are very few reasons to believe that some sort of "soft landing" is in the books, as the Fed has single-handedly crashed the economy in the past every time it raised interest rates. The notion "the Fed raises interest rates until something breaks" has proven true throughout history.

Returning to the Fed's earlier speech, it is in fact what FOMC members have also indicated, with member Mester, for example, indicating that they prefer to "overshoot." Will it be different this time? The yield curve tells us a story.

Federal Reserve (FRED)

The Fed and the National Bureau for Economic Research (NBER) do not want to label current economic conditions as a recession yet. But funnily enough, by the time a period is defined as a recession, employment is already in the gutter and the S&P 500 is down by more than 30% in recent history.

Fighting An Asset Bubble?

When we talk about CPI, we are often surprised how little the various components of that inflation are mentioned. If we look at the CPI index, it is still up 6.34% year-on-year, well above the 2% target.

But if we take the shelter component out of the equation, we see that inflation has been absolutely flat in recent months. When we hear "sticky inflation," we hear little about the housing market.

Federal Reserve (FRED)

The shelter component consists of both rent and 'owners' equivalent rent'. When we plot both elements of the shelter component, we see something remarkable.

Owner-equivalent rent and rent itself have still gone completely vertical in recent months, despite reports from the housing market showing a notable slowdown due to higher mortgage rates, which nearly reached 7% last November.

Federal Reserve (FRED)

Both of these are known as lagging indicators, and yet market participants seem to overlook them completely. Because if we look at actual data, from sources that have real-time data, such asRedfinand theNational Association of Realtors, we see that the median sales price of a home is more than 11% lower than at its peak.

Data by YCharts

Every measurement of the housing market showed cracks last year, with the median sales price falling significantly from its highest point ever.

Data by YCharts

And so it should be, as interest rates have risen at the fastest pace since the 1980s, and mortgages have become much more expensive, with 30-year mortgage rates well above 6%.

Yet the Federal Reserve's website shows that housing indicators are still resilient and stagnant around current levels. On the Fed's website, the median sales price of a home sold in the United States rose from $329K in early 2020 to $468K today. That's a 45.34% increase over three years.

Federal Reserve (FRED)

Rents, according toreal-time datafrom mostsources, also point to a decline, in contrast to the Federal Reserve's lagging data, which indicates that the huge inflationary pressures in that market are still being felt.

This discrepancy between the Federal Reserve and many economists looking at lagging data raises many questions for us as to whether, when they talk about sticky inflation, they are looking at all components of the CPI.

Rent.com

To put that in perspective, we have seen exactly the same increase in house prices over the past three years that we saw between Q4 2004 and 2020. So we ask: is the Fed fighting inflation, or an asset bubble?

In our view, if the Fed wants to get interest rates below 2%, they are either waiting for the year-over-year equations in the housing market to fall, which is a lagging indicator, or have profound deflation in other parts of the economy. And right now we don't see those other parts showing strong deflation. On the other hand, if the housing market cracks, or the equations drop from year to year, we could end up with inflation well below target.

And if that happens, we end up as usual in a recession with a significant drop in the S&P 500 and perhaps even deflation on a YoY basis. This could be the scenario as the Fed is keen to keep interest rates higher for longer.

Federal Reserve (FRED)

And that also raises the question of what would happen when we finally felt the effect of these interest rates. As some FOMC members pointed out, they have come to believe that "long and variable lags" in this modern economy may not be that long or variable.

Whereas research shows that it takes 12 months formonetary policy changes, such as interest rate changes, to take effect and 18 months for the full effect to be felt. To put that into context, we have already experienced profound deflationary forces recently, while according to the research, no interest rate hike has been felt yet.

These changes should not be felt until the end of this year and take full effect in 2024. Therefore, we still see a recession by the end of this year or at the start of 2024.

Federal Reserve (FRED)

But what was the Fed focusing on this week? The main focus seems to be onretail sales, which came in hot and indicated that consumer spending remains strong. This raises the odds of the Fed raising interest rates.

And for us, it increases the likelihood that the Fed will continue to raise interest rates to a much too tight level, and that the Fed will make such policy mistake worse if just a couple of bad inflation prints show up. We urge investors to ask the question: when was the last time the Fed made the right decision? And let's face it: we don't know where the Fed will go with interest rates, we can't predict the future. But right now, looking at the Fed's past actions and their comments, it doesn't look good.

One thing we can take away from every meeting that is a given is that under no circumstances will the Fed consider a 2% inflation target increase. And it seems that certain market participants don't understand why that should be, and just tolerate a 3% or 4% target.

Federal Reserve (FRED)

Wages are not keeping up with inflation, and personal savings at its lowest point in decades. For example, more than half of Americanscannot cover $1,000 for emergencies with savings.

If inflation continues at these levels, the average American will be crushed by it. This time the Fed will rally behind the average American, who does not own the assets that have been inflated, and the Fed will keep going, probably until those assets are crushed.

The Fed has reiterated, time and again, that difficult markets are not as bad as vastly increased inflation for the average household. Also from a technical standpoint, we think the 2022 lows will be tested again this year.

TradingView, Author

Finally, another factor is how this higher interest rate may affect the dynamic we have had over the last 20 years or so of "TINA," or lack of good alternatives to stocks.

As you can see in the chart below, we took Federal Reserve data and plotted the earnings yield of the S&P 500 over the past 60 years and compared it to the yield investors get from 10-year Treasuries. We chose 10-year Treasuries because this is often used as the discount rate in discounted cash flow models, looking 10 years ahead. The 10-year yield broke 4% last year and currently stands at 3.82% in an upward trend.

This compares with an earnings yield for the S&P 500, which is only 4.59%. For example, if that 10-year yield approaches the earnings yield of the S&P 500, investors are essentially only getting earnings growth as a premium. In short, the 10-year yield could put severe pressure on the S&P 500 multiple if it keeps going higher.

Author's Visualization, Federal Reserve Data

The last time the 10-year yield was around 4%, in the early to mid-2000s, the earnings yield was closer to 6%, or a historical average valuation of about 16x the P/E ratio. And that does not include any earnings deterioration that usually occurs in a recession.

Currently, stocks justaren't cheapat 22x earnings, we think, with a Federal Reserve that wants to keep interest rates above 5% for a long time, perhaps until something breaks.

The Bottom Line

While the Fed focuses on lagging indicators such as the labor market or prefers not to take too much account of what is going on in the housing market and its effect on the CPI, we believe these questions should be raised and made a real concern.

We think that the Federal Reserve, as always in history, will raise interest rates until something breaks. The deflationary forces we are seeing, along with the Fed's attitude that it thinks it is fighting inflation as it did in the 1970s, lead us to believe that the Fed will massively overshoot and keep interest rates high until the jobs market breaks and the S&P 500 is once again down more than 30% than ever before. Since it looks to us like the Fed is in pole position to crash the economy, we advise investors to be cautious about equity rallies based on the assumption that the Federal Reserve will pivot soon.

Data by YCharts

We are cautious about long-duration, such as pure growth stocks, and prefer short-term t-bills with yields around 5%, cash, and a concentrated portfolio of stocks that already have strong free cash flow. Or ones who have the potential to generate said cash soon to buy back shares or pay dividends.