CWS Market Review – December 6, 2022

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The Case for the U.S. Economy

So far, December hasn’t been so merry for the bulls. The stock market fell today for the fourth day in a row. This comes after an impressive run since the middle of October. Today was the second day in a row that more than 400 stocks in the S&P 500 lost ground.

Is this a small pause in the middle of an overall bull market, or is it the sign of bad things to come? We don’t know the answer just yet. Unfortunately, the market gods can be an ill-tempered bunch.

In this week’s issue, I want to look at the case for optimism. What if everyone, including me, has been wrong about the economy for next year?

For the last several weeks, I’ve believed that the U.S. economy was headed toward a recession next year. I still think it’s very likely, but I want to look at the opposing case. What if the economy surprises us all and continues to grow in 2023?

One of the hardest parts of investment analysis is that it forces you to rethink your prior beliefs constantly. Investors often cause trouble for themselves by clinging to a position that’s no longer tenable. It’s not easy to admit that you had something wrong, but that’s why we have sell orders.

For starters, let’s look at why the economy might face an uphill climb next year. Obviously, the Federal Reserve has hiked interest rates several times, and it’s probably not done. The central bank is also reducing its gigantic balance sheet. That’s a hurdle for economic growth.

The housing sector has already felt the squeeze. This sector stands directly in the line of fire between the Fed and the economy. One of our favorite stocks, Trex, the deck company, is down sharply this year. We also know that the U.S. economy posted negative growth for both Q1 and Q2, although that was for technical reasons.

The tech industry is facing a slowdown and many well-known firms are laying off people. Meta Platforms is down 60% this year. Tesla is down by 48%. Pepsi just announced some corporate layoffs today as well. The economy’s biggest problem is that a few months ago, inflation reached its highest levels in 40 years. It’s not just energy prices that are up. We’ve seen inflation hit nearly every consumer category.

With higher interest rates, the yield curve has become flat and even inverted. That’s often one of the best early indicators that a recession is on the way. Over the last month, the yield on the 10-year Treasury is down about 70 basis points.

The spread between the two- and ten-year Treasuries has been negative every day since early July. The two-year yield has recently been more than 80 basis points higher than the ten-year yield. We haven’t seen a gap like that in over 40 years.

Of course, the most prominent early warning sign was the stock market, which is an imperfect predictor. The S&P 500 peaked on the first trading day of this year. By mid-October, the index was down more than 25%. The damage was particularly felt among growth stocks.

Now let’s look at reasons for optimism. I want to be careful not to overstate the case. Last week, the government revised higher its report for Q3 GDP growth. The initial report said the economy grew in real terms at a 2.6% annualized rate. Now the numbers say it was up by 2.9%.

The Atlanta Fed’s GDPNow forecast now expects Q4 GDP growth of 3.4%. If that’s right, it’s telling us that not only is the economy growing, but it’s accelerating into next year.

Last Friday’s jobs report was a decent one. The U.S. economy added 263,000 net new jobs last month. Wall Street had been expecting an increase of 200,000. The unemployment rate stayed at 3.7%.

Perhaps the best news is that wage growth is finally heating up. During November, wages increased by 0.6%. That was double the rate Wall Street had been expecting.

Leisure and hospitality led the job gains, adding 88,000 positions.

Other sector gainers included health care (45,000), government (42,000) and other services, a category that includes personal and laundry services and which showed a total gain of 24,000. Social assistance saw a rise of 23,000, which the Labor Department said brings the sector back to where it was in February 2020 before the Covid pandemic.

Construction added 20,000 positions, while information was up 19,000 and manufacturing saw a gain of 14,000.

The CNBC article had a great quote from Brian Coulton, chief economist at Fitch, “the Fed is tightening monetary policy, but somebody forgot to tell the labor market.” I think that’s right.

Most importantly, more good news may be brewing on the inflation front. Some commodity prices are starting to cool off. Charlie Bilello points out that lumber prices are at their lowest levels since June 2020. That’s down 78% from its peak in May 2021. Oil futures closed today at their lowest prices of the year. Next Tuesday, the government will release the CPI report for November.

Another omen for better economic news is that the stock market has done well over the last several weeks. From October 12 to November 30, the S&P 500 gained 14%. The Fed meets again next week, and the consensus is that the Fed will hike by 0.5%. This will break the run of four consecutive 75-point increases. It’s clear that the Fed is close to the end of its rate hikes.

Real consumer spending has been increasing (see chart above), and these numbers will look better as inflation continues to cool. For October, real PCE rose 0.5%. That’s the highest rate since January. Jamie Dimon said that consumers are sitting on $1.5 trillion in excess savings.

I’m not yet convinced that the economy can avoid a recession next year, but I do have to concede that there are growing reasons in favor of a “soft landing.” The most important factor to watch is the path of inflation. The more inflation cools off, the better it is for investors and the economy.

World’s Simplest Stock Valuation Measure

This week, I’d like to show you something special. I call it the world’s simplest stock valuation measure:

Growth Rate/2 + 8 = PE Ratio

Let me emphasize that this is simply a quick-and-dirty valuation tool, and it shouldn’t be used as a precise measure of a stock’s value. But when I’m first looking at a stock and want to see roughly how it’s priced, this is what I’ll use.

For example, let’s look at Bristol-Myers Squibb (BMY). Wall Street expects the company to earn $7.94 per share next year. They also see the company’s 5-year growth rate at 4.14%. (You can find this data at Yahoo Finance. This is the page for BMY.)

If we take half the growth rate and add 8, that gives us a fair value P/E Ratio of 10.07. Multiplying that by the $7.94 estimate gives us a fair price for Bristol of $79.96. The current price for Bristol-Myers Squibb is $79.92, so it’s almost perfectly in line.

Let’s look at FedEx (FDX) which has a higher growth rate. Wall Street sees FedEx earning $17.98 per share next year. They peg the five-year growth rate at 9.3%. Our formula gives us a fair value multiple of 12.65, and that multiplied by $17.98 works out to a value of $227. FedEx is currently at $173.

I like to find stocks that are going for more than 30% below our fair value. As I said, that’s just one tool I use to find bargain stocks.

This tool doesn’t work well with highly cyclical stocks because those companies tend to have earnings that soar and plunge depending on where we are in the economic cycle. Energy stocks are a good example. Also, the valuation tool tends to be conservative. Not many investors buy a stock like Tesla (TSLA) because it passes some valuation screen.

There’s no magic behind the tool. It’s a simplified version of a very complex model that I used to use. I found that I could get 90% of the results with 10% of the work. That’s how the World’s Simplest Tool was born.

I’ve found that the valuation tool is good at spotting anomalies. For example, Wall Street expects earnings next year from Altria (MO) of $5.05 per share. The Street’s five-year estimated growth rate is 4.16%. That gives us a price of roughly $51 per share. MO is currently going for $46, or about 10% below our price. To me, that indicates not how cheap the shares are but rather how nervous Wall Street is about owning controversial and legally problematic stock.

When you see a stock that may superficially be a bargain, you then need to look at why. Oftentimes, a cheap stock is cheap for a very good reason. There truly are diamonds in the rough, but you really need to hunt for them.

Before I go, I want to draw your attention to a strong period of outperformance for our ETF which is based on our Buy List. Over the last eight months, the stock market is down 13% while we have a tiny gain.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

P.S. If you want to learn more about the stocks on our Buy List, please sign up for our premium service. It’s $20 per month, or $200 per an entire year.

Posted by on December 6th, 2022 at 6:52 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.