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  • The Federal Reserve plans to further increase interest rates.
  • Core inflation remains much higher than the Fed's 2% target.
  • The economy continues to add jobs, contributing to inflation.
  • Stocks are at a crossroads.

Investors hoped news this week would further confirm that the Federal Reserve is happy with its progress in battling inflation, allowing it to become friendlier soon. But, unfortunately, there’s little new conviction that lower interest rates are on the horizon.

Investors came into the week expecting the Federal Reserve’s next rate increase on December 14th would slow to 0.50% from its current 0.75% pace. That thinking is little changed following Fed Chair Jerome Powell’s speech on Wednesday, Personal Consumption Expenditures inflation data on Thursday, and jobs data for November on Friday.

According to the CME FedWatch tool, the probability of a 0.50% increase in December is 77%, up just a smidge from 76% last week.

In his speech, Powell suggested smaller increases could make sense soon, depending on the data. However, he also said rates would go higher from here and stay high for longer than many expect.

The PCE and jobs reports likely did little to shift his thinking.

In October, the Bureau of Economic Affairs reports that PCE headline inflation decelerated from its peak this summer, but core inflation, excluding volatile energy and food, remained stubbornly high. The 6% headline figure compares favorably to 7% in June, but the core PCE of 5% matched June.

That wasn’t enough to move the needle for investors, given stocks had already run up considerably following the October Consumer Price Index data earlier this month and Powell’s speech the previous day.

Meanwhile, the Bureau of Labor Statistics jobs report showed the unemployment rate was unchanged at 3.7%, nonfarm payrolls increased more than anticipated, and wage growth remained inflationary in November.

Specifically, the U.S. economy created 262,000 new jobs last month, significantly more than the 200,000 job gains Wall Street anticipated. Moreover, average hourly earnings increased 5.1% from last year, a tick above October’s core PCE, suggesting wages continue to make the Fed’s job difficult.

The fact wage growth remains below headline inflation means negative real wages continue to put household balance sheets at risk. That’s not good news, given revolving debt levels have skyrocketed and savings have dwindled to levels last seen in the 2000s.

In a note to clients, Bleakley Advisory Group’s Peter Boockvar highlighted another discouraging statistic. According to Vanguard, the percentage of people taking hardship withdrawals from the roughly 5 million plans it administers is the highest since it began tracking the data in 2004. Since that’s happening while unemployment is low, any acceleration in layoffs could leave households in a precarious financial position.

Of course, this isn’t news to the Federal Reserve. It has been acknowledged for months that battling inflation will cause pain for businesses and workers.

What’s all this mean for investors? The Federal Reserve remains unfriendly, and the economy is still in jeopardy of tail-spinning next year.

Yesterday, Action Alerts PLUS co-Portfolio Managers Bob Lang and Chris Versace reminded investors that corporate revenue and profit track manufacturing PMI data. Unfortunately, recent manufacturing data isn’t encouraging. They write:

“ISM's November Manufacturing PMI fell to 49 and into contraction territory…The new orders component fell deeper into contraction territory during November, falling to 47.2 from 49.2 in October, signaling the December data is likely to remain in contraction territory…Adding to that likelihood, backlogs of work fell to 40 in November after hitting 45.3 in October, and new export orders also continued to contract in November.”

That’s bad for corporate income statements next year; something analysts are waking up to.

Back to Lang and Versace:

“JPMorgan cut its 2023 EPS to $205 from its below consensus forecast of $225. JPMorgan is looking for 2023 EPS to come in below 2021, falling some 7% compared to the consensus forecast of $221.12 for this year…In 2005, while the S&P 500 grew its EPS at 3%, the market bottomed out at 15.5x expected earnings before finishing the year at 17x. By comparison, the S&P 500 is currently trading at 18.4x 2022 EPS of $221…If 2023 EPS for the S&P 500 is flattish year over year, we're likely to see the current market multiple contracts from the 18.4x level. A potentially generous multiple of 17.5x flat 2023 earnings suggests something near 3,870 for the S&P 500, roughly 5% below its current levels.”

The Smart Play

This week’s news doesn’t change much.

The bond market continues to suggest we’re on the precipice of a recession, given the 3-month Treasury bill yield remains above the yield on the 10-year Treasury note. The Fed continues to talk about higher rates and stubbornly high inflation. Workers continue to struggle to make ends meet, despite the job growth.

Those in the ‘green shoots’ camp can still point to declining headline inflation as evidence the Fed’s hawkish policy is working. It’s also potentially encouraging to the Fed pivot argument that while more jobs were created than thought, the pace of job creation has declined from an average of 392,000 per month this year and 562,000 per month in 2021. Perhaps, that deceleration, alongside a deceleration in job openings and increasing reports of headcount reductions, means weaker future job data that will ultimately force the Fed to the sidelines.

There’s also an argument that the jobs data still keeps the “soft-landing” theory alive.

For now, the stock market has climbed nicely since the mid-October lows. Now it’s time to see if it can follow through on its gains. Will this recent rally be one of many failed snapbacks like in 2000 through 2002 and 2008 to 2009? Or will it mature similarly to early 2019 or mid-2020? Historically, December’s treat investors kindly, but that’s not always the case. For example, December was a lousy month in 2018, the last time the Fed raised rates.

Given the stock market is challenging downtrends and resistance levels where sellers may emerge, active investors can consider putting some profit in their pockets and waiting for more conviction before increasing their net long exposure. We’re near the top end of Doug Kass’ 3700-4100 range for the S&P 500, so risk/reward isn’t favorable. Furthermore, Helene Meisler’s advance/decline oscillators could be overbought soon, increasing the risk of a pullback.

Long-term investors can continue with their dollar-cost-averaging plans into retirement accounts, recognizing that scaling into indexes during bear markets has always eventually paid off. Of course, the past is no guarantee, but history tends to rhyme, and increasing the number of shares while lowering average costs during a bear market has historically worked in investors’ favor.

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