Recession Likely; What And When To Buy (Part 2)

Introduction

I predicted a recession in an article I wrote earlier this year. GDP had fallen for two consecutive quarters at the time, but unemployment remained low. Inflation has risen significantly, partially offsetting the decline in GDP. The Fed responded by sharply raising interest rates, with the target of achieving 5% by 2023.

The stock market (SP500) is in a bear market, and investors are wondering when it will end.

In this article, I will discuss the causes of high inflation, present a chart that is a good recession indicator, when to buy, and finally, what to buy now.

Because this article is rather lengthy, I recommend that readers skip to the section of the article that interests them.

What Caused This High Inflationary Environment?

Today, high inflation is a hot topic. Inflation stands currently at 7.1% for November 2022, compared to the Fed’s target of 2%.

High inflation can compensate for a drop in GDP. However, it is widely regarded as bad because it can erode the purchasing power of people’s savings and incomes. When the cost of goods and services rises rapidly over a short period of time, it can be difficult for people to keep up and maintain their standard of living. Inflationary pressures can harm both the economy and individual households.

The Federal Reserve has taken action to return high inflation to normal levels by raising interest rates to 5% by the end of 2023.

As of today, two major factors have contributed to high inflation:

1. The increased M2 money supply
2. Rising oil prices

1. The Increased M2 Money Supply

During the COVID-19 pandemic, the M2 money supply increased significantly, which is a measure of the money supply that includes cash, checking deposits, and easily accessible near money.

The rise in the M2 money supply was largely due to the various fiscal and monetary policy responses to the crisis, such as the passage of the CARES Act and the Fed’s aggressive asset purchases. These policies were designed to provide economic support and stimulate spending in order to lessen the economic impact of the crisis. The rise in the M2 money supply was also fueled by an increase in demand for cash and near money as people and businesses sought to have more liquid assets on hand in the event of an economic downturn.

Inflation can result from an increase in the money supply. This happens because an increase in the money supply means more money available to spend on goods and services, which can lead to an increase in demand for those goods and services. As demand rises, prices may rise as businesses try to capitalize on the increased demand by raising their prices.

2. Rising oil prices

In addition to a rapid increase in the M2 money supply, oil prices rose significantly, causing inflation to surge.

The cost of producing plastic packaging can be affected by changes in oil prices. Oil is a key component in the production of plastics, and as the price of oil rises, so will the cost of producing plastics. This increase in production costs can then be passed on to consumers in the form of higher prices for plastic-packaged products. If the price of oil remains high for an extended period of time, it can contribute to high inflation by increasing the cost of producing a wide range of goods and services that rely on oil as an input. This can result in an increase in the overall price of goods and services in an economy.

Both events significantly contributed to high inflation. The Federal Reserve has responded by increasing interest rates and decreasing the M2 money supply. The high inflation numbers are currently declining sequentially and stand at 7.1% (still above the target of 2%).

Because oil prices have fallen from recent highs and the M2 Money Supply is shrinking, I believe that high inflation will end soon. I’m even concerned about a possible deflationary period. Long-term demand for oil will fall as the world population shifts away from gasoline and considering alternative fuels.

The Yield Curve As A Crystal Ball

The yield curve has historically been a reliable indicator of upcoming economic downturns and market crashes in the United States.

There are a number of different yield curves out there, but the one I found to be most reliable in predicting recessions was the difference between the 10-year Treasury rate and the 3-month Treasury yield spread. In addition to the first one mentioned, the 10 year treasury rate – 2 year treasury rate can be used.

In my earlier article, I correlated the S&P 500 market crashes to the chart (a more than 20% drop in the S&P 500). It was the graph shown below:

The gray areas indicate a US economic recession, while the yellow areas (which I highlighted) indicate a peak-to-trough drop of more than 20% for the S&P 500. It should be noted that the yellow areas may overlap the gray areas.

What was found from my previous article was that when the yield curve was inverted (lower than 0), the US would enter a recession within a year and the S&P 500 would fall by more than 20%, presenting a huge buying opportunity.

It’s worth noting that the S&P 500 increased in value so quickly after the 2020 crash. The bear market was short-lived. We have seen the peak-to-trough period end after the yield spread has increased significantly, except for the 2020 bear market. Retail investors saw a good opportunity to invest in the stock market because of the strong U.S. COVID-19 stimulus and relief measures, causing stock prices to rise significantly.

There has been a noticeable change in the yield curve over the past four months. Currently, here’s how the yield on 10-year Treasuries – 3-month T-bills yield spread looks now:

Because of the Fed’s aggressive rate hikes, the yield curve has recently inverted once again. The aggressive interest rate hikes were necessary to curb high inflation.

This increases the likelihood that the U.S. economy will fall into recession within a year.

What Will 2023 Bring For The S&P 500?

The stock market has reacted strongly to reports that several analysts have reduced their earnings forecasts for the first half of 2023, sending the S&P 500 down by about 21%. Stocks are falling because of the Fed’s hawkish policy of trying to reduce high inflation.

Analysts anticipated continued earnings growth for the S&P 500 in 2022 despite the extraordinary strong growth in 2021. During the first half of this year, earnings growth for the S&P 500 was robust. Profits for the S&P 500 increased 9.4% and 5.8% in the first two quarters, but slowed to 2.5% in the third. There will be a -2.8% drop in quarterly earnings, according to FactSet’s forecast.

FactSet and Yardeni are two well-respected research firms. Both analysts have reduced their forecasts for revenue and profit in the next two quarters. Yardeni tends to be gloomier than most analysts. Earnings for the S&P 500 and the expected growth from year to year are listed in the table below.

In columns 2 and 3, you’ll find Yardeni’s forecasts. The predictions made by various analysts can be found in the final two columns. Both anticipate a drop in S&P 500 earnings over the following two quarters.

Yardeni predicts annual earnings growth of 4.7% for the S&P 500 through all of 2023, despite its gloomy first half-year forecast.

Profits are expected to start rising again in the second half of 2023. Financial data lags behind the market at all times. So, a bullish stock market is likely in the first half of 2023.

With inflation at over 7.1 percent, the Federal Reserve has signaled its intention to raise interest rates to 5 percent by 2023. Increases in interest rates have a negative effect on asset prices because more investors consider selling stocks and buying bonds instead for higher income.

Despite Yardeni’s gloomy forecast, Yardeni anticipates 4.7% annual earnings growth for the S&P 500 in all of 2023.

Growth in earnings is anticipated to resume in the second half of 2023. When compared to economic data, the market is always one step ahead.

However, there is the Fed’s policy of attempting to bring inflation down to their target level of 2%. Current inflation rates exceed 7.1 percent, and the Federal Reserve plans to raise interest rates to 5 percent by 2023. When interest rates rise, investors may sell stocks to purchase bonds as a safer investment with a higher yield, causing a decline in the value of other assets.

Using the earnings yield as a proxy for the return on government bonds can help investors evaluate the relative merits of the two asset classes. It stands to reason that since government bonds are viewed as a safer investment option than stocks, the earnings yield (of stocks) should be higher.

In light of the Federal Reserve’s plans to raise interest rates to 5%, I believe the market’s earnings yield (S&P 500) should trade at 6.5% (premium of 1.5%). The price-to-earnings ratio is 15.4 if the earnings yield is 6.5 percent.

The table above details the S&P 500’s expected earnings, which come to a grand total of 225. At the end of 2023, the PE ratio of 15.4 would lead to a price of 3,465. As of right now, that’s a drop of roughly 10%.

Yardeni predicts an 11% increase in earnings for 2024, so the outlook is bright as we approach the end of 2023 and the beginning of 2024. (from the table above). The Fed will have reached its 5% interest rate target by the end of 2023, at this point in time I anticipate a decline or, at the very least, stability in interest rates. These two events serve as major stimuli for the S&P 500 to rise.

It’s important to remember that not every stock is falling. Shares of insurance companies, for instance, gained value both before and after the bursting of the tech bubble. Cheap stocks with rising earnings per share are examples of stocks that can grow steadily even in a down economy.

When To Buy?

When is the ideal buying opportunity? According to the yield curve chart, the bear market ended just as the yield spread began to rise sharply to 3% or higher after it inverted. When the yield spread reaches that level, the Fed is stabilizing or decreasing interest rates to normal levels, and equity prices will rise. I think the best time to enter the market will be late 2023, when the Fed has met its interest rate target.

What To Buy Now?

As a whole, stock prices fell significantly, creating an attractive buying opportunity. Many companies revised down their earnings expectations for the coming year. The future does not look good for companies that are sensitive to business cycles.

I have written many articles, and one thing has struck me: some stocks still have excellent earnings and share price potential, despite the looming economic recession. To name a few:

• Bausch + Lomb (BLCO)
  • Article published August, 25
  • Bausch + Lomb offers a variety of lenses that provide a competitive advantage for every type of consumer.
  • Lowest price contact lenses + anticipated earnings per share growth + low valuation.
  • Still a buy after IPO lock-up date
• Cisco (CSCO)
  • Article published November 6.
  • Cisco Systems expects strong macro-economic growth in IT, driven by multi-year megatrends in hybrid cloud, hybrid work, security, IoT, 400G and beyond, 5G and Wi-Fi 6.
  • 25% FCF margin. A strong dividend compounder, promising future profits, and a low price-to-earnings ratio.
• Comcast (CMCSA)
  • Article published October, 5
  • I think Comcast stock is a strong buy because analysts expect earnings per share growth in the coming years, and the generous share buyback program could drive up the share price.
  • Diversified player in the field of communication that has an improving EPS forecast and a low stock valuation.
• Elevance Health (ELV)
  • Article published August 18
  • Positively revised forecast; accelerating earnings per share growth anticipated.
  • Management expects a CAGR of 12-15% from 2020 to 2025 and raised the outlook for 2022.
• Globe Life (GL)
  • Analysts expect revenue and earnings per share to grow in the coming years.
  • Positive earnings outlook and low price-to-earnings ratio.

• Innovative Industrial Properties (IIPR)
  • Article published December 23
  • An expanding total addressable market (TAM), strong industry positioning, low stock valuation, and a 7% dividend yield.
• Linde (LIN)
  • Article published August 15
  • The CHIPS for America Act and FABS Act drive massive expansion in semiconductor manufacturing. Linde will benefit greatly as it supplies industrial gases to reputable customers in this industry.
  • Linde’s increased raw materials can be passed on to customers. All sectors of the economy rely critically on gas supplies. Linde is fairly valued.
• Markel (MKL)
  • Article published September 5
  • The strong growth in premiums, the strong expected growth in their investment portfolio, and significant undervaluation make Markel shares a ‘strong buy’.
  • Also called the Baby-Berkshire. Strong non-GAAP EPS growth is anticipated due to rising interest rates. The valuation is favorable. One caveat: the portfolio’s significant equity portfolio is susceptible to volatility.
• Nomad Foods (NOMD)
  • Article published December 21
  • Capability to pass through higher costs to customers. Buyback yield of 17%. Cheap stock valuation.
  • Robust recovery in growth figures, strong growth prospects, high buyback yield and favorable valuation metrics make Nomad Foods a strong buy.
• Sempra (SRE)
  • Article published September 12.
  • The US has become the number 1 exporter of LNG and Sempra sees the opportunity to help Europe in this energy crisis.
  • As a result of Europe’s boycott of Russia, the firm is the leading supplier of LNG to Europe.

These businesses are well-prepared to weather the impending economic downturn, and as a result, investors stand to reap significant gains from the situation.

Conclusion

The stock market is already experiencing a bear market since the beginning of this year. Hot inflation numbers due to the sharply increased M2 money supply and higher oil prices had taken the Fed action to increase interest rates, causing asset prices to decline. The Fed plans to raise interest rates to 5% by the end of 2023. An investment in the S&P 500 is opportunistic now that the S&P 500’s earnings yield has reached 5%.

I anticipate the S&P 500 to be about 3,465 by the end of 2023. Earnings yield will be at 6.5%, and the forward PE ratio will be around 15.4. This is a premium of 1.5% compared to the forward interest rate of 5%.

The treasury yield curve can be used as a crystal ball to forecast economic downturns and stock market collapses. The current inverted yield curve indicates a stock market crash is imminent. When the yield curve inverts and the yield spread rises to around 3 percent, investors might consider making an investment in the S&P 500.

Despite the overall market decline, not all equities go down during a recession. During the next few years, investors should expect strong returns from non-cyclical companies that have both rising profits and a favorable stock valuation. The companies I mentioned in my article could do well in the coming years.

Editor’s Note: This article was submitted as part of Seeking Alpha’s 2023 Market Prediction contest. Do you have a conviction view for the S&P 500 next year? If so, click here to find out more and submit your article today!