What happens to the stock market when the Fed begins to tighten, as it is about to do now? More often than not, stocks hang in there. This chart shows the S&P 500 from the start of the Fed cycle. I think we can expect ongoing positive returns, but less robust, with more wobbles.
The market expects the Fed to return to 2% over the next few years, with liftoff starting in March. If so, it wouldn't be the gentlest pivot in Fed history, nor the harshest. This chart shows the Fed cycle as measured by the basis point increase from the point of lift-off.
Where goest thou, S&P 500? We may see ongoing, modest price gains through 2023, but perhaps with more wobbles. This chart shows that, historically, price gains become modest once earnings growth peaks.
We've likely seen the last of monster earnings growth rates for this cycle, but the landing looks soft. This shows past cycles indexed from the peak in earnings growth. A 9% growth rate in 2022 would be similar 2004 and 2010, which produced extended mid-cycles.
Earnings growth has been robust, but history has seen better. Similarly, the expected cool-down should not break any records. This shows earnings growth for the current cycle (with estimates through 2022) in the bars, overlaid against all peaks since 1920.
Liquidity and interest rates won't propel stocks in 2022, so if it’s all up to earnings growth, what can we expect? With Q4 earnings season getting underway, the consensus is for 9% growth in 2022. Based on historical patterns, that may well come down a few percentage points.
Price gains should now converge to earnings growth, per this chart. If EPS growth goes from 48% to 9% and there is no multiple expansion, then it’s hard to see the S&P 500 gaining more than high single digits. But after a 116% gain since March 2020 low, who's complaining?
Time will tell. The 2016-18 Fed cycle was a nothing-burger for two years, followed by an overreach at the end. This caused a swift 20% draw-down in the S&P 500, which then produced the dovish pivot. Remember: It’s not about how the cycle starts, it’s about how it ends. /END
Even with 200 basis points of tightening priced in, if the current 7% inflation rate reverts back to 3, the terminal rate will still end up well below neutral (-1.5%). That would hardly be a restrictive monetary regime. /2
Up until about six months ago, price did what it usually does at inflection points: it led earnings. Thus, a 65% multiple expansion. Then earnings started catching up and the P/E multiple came back to earth. Now earnings growth is peaking as the liquidity environment is cooling.
Fortunately, S&P 500 earnings are expected to grow 9% in 2022 and 10% in 2023, which means that, even with some P/E compression, the bull market can continue, albeit not at the pace of the past 22 months. /END