There are many possible outcomes here. If inflation goes down quickly from here, you could argue that the last rate hike will be in September and stocks can go up until deflation becomes a threat. If July’s inflation number was an outlier and stays high for a long time, the S&P 500 could drop to new lows. At the moment, things look very risky, but we need to see how the next few months go.
Earlier this year, I listed three keys to a market bottom, and the first (and most important) key was that we achieve peak inflation and peak hawkishness from the Fed, and after last week’s CPI data, it’s worth examining whether that key to the bottom has been satisfied. In short, no, it has not.
In order for the Fed to declare the rate hike cycle is ending, they have to be very confident that:
- The labor market will return to a better state of balance (not happening yet).
- That inflation will gradually return to the Fed’s 2% target (not happening yet).
- That inflation expectations will remain well anchored near 2% (not happening yet).
Yet before we get too excited about a “soft landing”, remember that these are the keys to a bottom, meaning we can confidently invest knowing the bottom in stocks is in and downside risk is limited. These are not the keys to a return to new highs.
From a valuation standpoint, to get to highs, we’ve got to be talking about a 19X-20X multiple on $240 for 2023 S&P 500 earnings. That’s not impossible, but it does require an environment that’s characterized by:
- Sharply decelerating inflation that’s readily approaching 2%-3%.
- A total economic soft landing where growth never really slows (meaning 10s-2s is completely wrong).
- A Fed that flips from tightening policy to actively stimulating policy (meaning aggressive rate cuts).