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Good morning. Twice on Friday the S&P 500 fell through its June lows of 3,666 (technical analysts will note the presence of the number of the beast). Twice it rebounded, and the index closed at 3,693. That the old lows held might be reassuring, but the smell of fear is unmistakable. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

The Matrix, reloaded

The market rout last Thursday and Friday got many pundits thinking about capitulation. Bob Schwartz of Oxford Economics said that “financial markets are throwing in the towel,” after at last accepting that the Fed is prepared to cause a recession if need be. Citigroup’s sentiment indicator broke into “panic” territory for the first time since early 2020. In the FT, our colleagues Eric Platt and Nicholas Megaw report a rush into puts:

Purchases of put option contracts on stocks and exchange traded funds have surged, with big money managers spending $34.3bn on the options in the four weeks to September 23, according to Options Clearing Corp data analysed by Sundial Capital Research . . . The total was the largest on record in data going back to 2009, and four times the average since the start of 2020. Institutional investors have spent $9.6bn in the past week alone . . . By contrast demand for call options, which can pay out if stocks rally, has tailed off.

We have written recently that both sentiment indicators and derivatives markets may not be sending clear signals at present but, that said, there is little doubt about the anxiety in the air.

So, how bad might things get? Seeking an answer, and humility, we looked back at our last major effort at prognostication. A little over three months ago, we presented the matrix below, giving ourselves and readers a chance to do some highly simplified scenario analysis about what the next 12 months held:

It is hard to fathom that at the start of the summer the market’s central projection was for a fed funds rate of just 3 per cent! With the policy rate at 3.25 per cent today, and the market pricing in a peak rate of 4.7 or so, June is a universe away.

Here is how Unhedged and readers judged the odds back then:

Our judgment about the trajectory of rates turns out to have been badly wrong. Here is what we wrote about our predictions:

Unhedged tends toward a successful inflation-fighting campaign that sinks us into recession (A). We figure that the Federal Reserve is dug in on bringing down inflation — but both growth and inflation are showing signs of peaking already. The Fed may push on an opening door, hard. Housing inflation will ease as wages continue moderating, and bloated inventories will prove disinflationary. Unfortunately that will spell a recession.

Our humiliation at misjudging how high rates would go and how quickly is leavened slightly by the fact that we still agree with most of the above paragraph. We remain in the recession camp, and our description of the Fed as “dug in” looks good in retrospect. But our belief that softening growth would bring down inflation quickly was grossly naive. Our readers were smarter, shifting more probability weight to the upper right quadrant.

Before drawing up a new matrix, let’s look again at what has transpired between June and September that has changed the outlook so much. Headline inflation peaked in June, at 9.1 per cent year-on-year, a report we called a “horror” at the time. Yet we also noted how indifferent markets seemed:

The S&P 500 ended a touch down and the Nasdaq was flat. The Treasury market kept its cool, too . . . The market still prices in the Federal Reserve cutting rates next year.

One possibility is that markets are focused less on CPI than on other data that suggest we are at the start of an inflation-killing recession . . . the bullwhip effect cutting spending on manufactured goods, falling commodities prices, a fast-cooling housing market and decelerating wage growth.

As the weeks have ticked by, softer economic data have left just enough room to hope inflation would fall quickly. Brent crude is down 29 per cent from June; copper 20 per cent. The housing market is in freefall. Manufacturing PMIs fell in both June and July. A gentler CPI report on August 10 — zero per cent month-on-month! — renewed the optimists’ faith, giving the bear market rally one last bump up.

The turn came on August 18 when Fed officials, probably frustrated by markets loosening financial conditions at exactly the wrong time, did their best to frighten investors. What they said, that higher rates are coming soon and cuts are probably not, wasn’t new. But repetition worked. Powell’s speech at Jackson Hole reinforced the tough talk, and then August’s hot inflation report, fuelled by sticky rents and wages, made him look prescient. Markets dropped. Last week’s economic projections from the Fed gave one final confirmation.

Now, reloading the matrix. This time, we change things up a bit by focusing on the stock market, rather than economic conditions generally. Is there another big leg down to come? This can happen by corporate earnings falling, by price/earnings ratios compressing, or both. The current consensus EPS estimate for 2023 is $231, according to FactSet, and the forward P/E of the market is 15.4. For context, here is how earnings have progressed since 2008, along with the current estimates through 2024:

And here is the S&P’s P/E ratio, back to 2005:

Placing the two variables into a matrix, we get:

Of course, in cells A and D, you might imagine an extreme scenario where a huge move in one variable overwhelms a small decline in the other, generating great or terrible returns. But the question before us is: is the main threat to returns earnings, valuation, both or neither? And remember, in recessions and booms, the two tend to travel together.

Now, one might equate the question of whether P/Es will fall with the question of whether rates will take another leg up. P/Es and rates are not in a mechanical relationship that holds under all circumstances, but it is pretty clear that recent P/E compression and higher rates are linked. Similarly, one might equate the question of whether earnings estimates will fall with the question of recession, though you can certainly have earnings fall without recessions (Jason De Sena Trennert of Strategas reckons the median earnings decline during US recessions is 22 per cent). So, though they are not exactly the same, there is a loose sense in which the new matrix is the old matrix of rates and recession, but with new labels.

What does Unhedged think? Well, we have no idea about the rates trajectory, as we proved last time around. So we will punt there, and weigh the possibility of P/E ratio contraction at 50/50. But we are pretty confident that 2023 estimates are going to come down from here, because we are pretty confident there is going to be a recession, for the simple-minded reasons that (a) big tightening cycles usually end with recessions and (b) lots of important parts of the economy are slowing fast.

So let’s say we think there is a 75 per cent chance estimates come down significantly. That renders 37 per cent probabilities for A and B, and 13 per cent for C and D. That’s a picture in which the most likely outcome (50 per cent) is that the market muddles along, but there is a much higher than usual probability of quite bad outcomes and much lower than usual probability of particularly good outcomes.

That feels OK to us, but we are much more interested in your probability estimates than our own. Please do email them to us — or share them on Rob’s Twitter account.

One good read

The death of the starter home.