The Fed Is Likely Bluffing, And The Market Knows It

I often hear that the Fed could enable the next market selloff or trigger another bear market due to its hawkish monetary stance and the “higher for longer” interest rate regime. In reality, though, we already went through the bearish increasing interest rate cycle, which led to one of the most significant bear markets in technology and other segments we’ve seen in decades.

Do you remember Nvidia at $105, Tesla at $101, Meta Platforms below $90, AMD at $55, Palantir below $6, Amazon around $80, and so on? These are generational lows seen at the bottoms of bear markets. I must highlight that the Fed’s monetary policy was the underlying reason for these and other stocks’ rise in 2019-2021 and the subsequent crashes in 2021-2023.

Zero rate policy and various asset-buying programs after the coronavirus enabled one of the most accessible monetary environments in history. This dynamic led to high inflation, at which point the Fed needed to cool things off, and it did.

Introducing an aggressive tightening policy around ultra-high valuations and a potential economic slowdown on the horizon led to one of the most epic tech market drops we have witnessed in recent history.

Here’s how badly top tech stocks crashed from the peak in 2021 to the trough in 2022:

• Nvidia (NVDA): 70%
• Meta (META): 78%
• Alphabet (GOOG, GOOGL): 45%
• Amazon (AMZN): 58%
• Tesla (TSLA): 75%
• Apple (AAPL): 32%
• Microsoft (MSFT): 39%
• Super Micro (SMCI): 28%
• Palantir (PLTR): 80%
• AMD (AMD): 67%

Now, here’s how the same top tech stocks have done after the bear market bottom:

• Nvidia: 568%
• Meta: 451%
• Alphabet: 87%
• Amazon: 116%
• Tesla: 92%
• Apple: 53%
• Microsoft: 100%
• Super Micro: 1,380%
• Palantir: 317%
• AMD: 242%

Much of the appreciation occurred over the last 12-18 months, and while some pullbacks may be in order, we are likely far from the full potential in high-quality stock prices in the intermediate and long term. Despite the massive run-ups, stock prices are supported by actual earnings, considerable sales growth, and profitability growth potential in the years ahead. Comparing the current environment to the dot-com bubble days is like comparing apples to oranges, and if we must use a ’90s analogy (Internet vs. AI boom), the market may be around the 1994 time frame, not 1999, in my view.

Escalator Up – Elevator Down

They say that stocks take an “escalator up,” meaning a bull market cycle may take many years to develop. This dynamic is especially true when a massive growth segment like AI is about to get monetized, making many businesses much more efficient and profitable. Many top companies should experience tremendous growth, making many stocks move considerably higher despite the recent run-ups.

Using a baseball analogy, we’re still likely around the third inning of AI. Therefore, many AI-related companies and industries have substantial potential ahead. Moreover, corporations, in general, should become more efficient and profitable due to advancements in AI.

The elevator took about a year for tech stocks to bottom. The escalator ride to the next significant top could take much longer. We’re only about a year into the new bull run, and we could see 3-5 years or more in this bull market cycle.

Don’t Fight The Fed

The last thing you want to do is fight the Fed in a bull market, and the Fed at some point will begin cutting rates. Whether the first rate cut is in March, May, or June is irrelevant because the future interest rate trajectory is lower, enabling a much more accessible monetary environment in H2 2024 and 2025. Lower interest rates and a likely eventual shift toward a QE-type policy should allow the Fed to support the economy and equity markets for a relatively long time (3-5 years). Therefore, we are likely in the early stages of this bull market cycle, and despite the Fed’s “hawkish” posturing, cuts are likely coming soon, and it should propel high-quality stocks much higher from here.

It’s Okay If The Fed Waits to Cut (Just Not Too Long)

“I don’t think it’s likely the committee will reach a level of confidence by the time of the March meeting” to lower rates, “but that’s to be seen.” – Fed Chair Powell said following the decision to hold the target rate at the 5.25-5.50% level (a 23-year high) for the fourth straight meeting. The Fed also reiterated that it could continue with QT, reducing its balance sheet by as much as $95 billion monthly.

Therefore, the Fed has taken the base case scenario March rate cut off the table for now. There is still about a 15% probability (which could increase) that the FOMC will move to cut rates in March, yet the likeliest scenario for the first-rate decrease is in May (62% probability).

62% Probability of a Rate Cut by May

However, inflation is no longer the primary issue. We’ve seen the core-CPI and core-PCE drop considerably over the last year. Moreover, in H2 2023, the core-PCE rose by just 2% over the same period in 2022, illustrating a 2% inflation run rate on par with the Fed’s 2% target rate for two quarters now.

Core-PCE QoQ – 2%

We see inflation running quite low recently, and there is even the risk of disinflation or deflation creeping in. The worst thing for stocks and other risk assets is deflation, which we must avoid at all costs. It could have dire unintended consequences if the Fed keeps rates elevated longer than necessary. Therefore, despite the Fed’s “tough rhetoric,” it must act soon.

Truflation Inflation is Only 1.37%

Truflation inflation is around 1.37% now, well below the Fed’s 2% target rate. PCI, PCE, and other outdated government inflation gauges are lagging indicators. Therefore, I prefer the independently calculated real-time Truflation gauge.

I believe it represents a more accurate image of inflation and can serve as a prelude to the CPI and PCE readings in future months. The inflation trend is clearly lower, and the Fed must act.

So, what’s the problem? Why has the Fed not lowered rates yet? Well, there are several reasons for the Fed’s pause in action. The most significant factor is likely a more robust than-expected labor market.

Jobs, Jobs, Jobs

The last nonfarm payrolls report was stellar. The headline number was 353K jobs, nearly doubling the 187K estimate. Moreover, private nonfarm payrolls came in at 317K, beating the estimate by over 100%.

The unemployment rate remained at 3.7%. Also, average hourly earnings increased by 4.5% YoY, better than the anticipated 4.1%. Data like consumer sentiment numbers and other gauges have been better than expected lately.

Therefore, the Fed can wait here. The labor market shows remarkable resilience and illustrates no deterioration or significant cause for concern. On the contrary, the economy is holding up exceptionally well despite the high-interest rate environment.

A soft landing scenario is the base case for the economy, but if the Fed decreases rates too quickly, it could enable inflation to come back. Also, the Fed wants to unwind some of its balance sheet to open the door to implementing more QE in the future.

The Fed’s Balance Sheet

It’s okay for the Fed to continue unloading its balance sheet, even after it starts lowering rates. Estimates point to Q4 2024/Q1 2025 for the conclusion of the Fed’s QT program. Once the Fed’s QT concludes, it can transition to QE-style programs. A QE-type program is essentially anything the Fed backstops.

The bad debt can range from mortgage-backed securities to municipal bonds, corporate debt, and whatever else the Fed wants. The Fed can purchase treasuries and other bonds to boost or create artificial demand. The Fed can inject trillions into the financial system through numerous channels and in diverse ways. Therefore, the Fed can keep the bull market going in future years, and we’re still likely in the early stages of the bull market cycle.

The Fed – Setting Up The Ideal Environment

The Fed is setting up the ideal environment for top companies to increase sales, improve profitability, and expand their multiples.

The S&P 500 (SP500, SPX) P/E ratio is around 22 here. The forward P/E ratio is slightly higher, implying the market is not factoring any growth here. On the contrary, the market is factoring in an earnings slowdown, especially considering the buybacks likely to occur over the next twelve months.

Yet, analysts project that we could see around 11.5% EPS growth this year, suggesting the forward P/E on the SPX is about 20 times earnings now. This valuation is inexpensive, provided the robust growth outlook, solid economy, and the high probability of a more accessible monetary environment soon.

Also, we’ve seen valuations go much higher in prior easy monetary cycles, and there’s no reason why valuations will stop around 20 and won’t climb to 25-30 or higher in the SPX.

The market is cheaper than it seems here, and the highest-quality market-leading companies in the most rapidly expanding segments should do best of all. Due to the improving fundamental, technical, and psychological backdrop, I am raising my S&P 500 year-end target to the 5,500-6,000 range.