The Power of Powell

2022年11月7日

CME: E-Mini S&P 500 Futures (ES1!)
If the characters of Game of Thrones were on the financial markets, who would be the unchallenged “King of Wall Street” in your eyes?

Since Federal Reserve set sail on tightening monetary policy, all markets fell under the spell of Fed rate hikes. Federal Open Market Committee meetings are major market-moving events. Investors around the world not only watch what the Fed does, but also listen closely to what it says and does not say.

The Fed raised 75 basis points last Wednesday. It is bad news for households and businesses alike. The cost of living and the cost of running a business both went up at the same time. The cumulative effect of +3.75% in eight months has been extraordinary.

Interestingly, US stock markets jumped upon the release of Fed statement. Rate hike of 75 bp was expected, but investors thought they found some signs of Fed softening, which sparked the “Fed Pivot Trade” and pushed the Dow up 400 points and the S&P up 1.5%.

However, when Chairman Powell delivered his speech half an hour later, the market immediately headed to a 4% plunge. His words, “it’s premature to think about pausing”, ditched any hope of easing in the foreseeable future.

What Economic Data?
I have an interesting observation: major economic data has mostly been reduced to a data point for interpreting future Fed decisions.

Discussion of CPI data is not focused on how much food and rent cost went up and why, but whether the decline from 9.1% to 8.2% is sufficient to alter the rate-hike trajectory.

Good non-farm payroll data and low unemployment rate are not celebrated for a strong employment market but being interpreted as the Fed needs to do more.

Corporate profit may be good for a stock, but not for the stock market. If inflation is stubbornly high and six consecutive rate hikes have not cooled down the economy, more tightening is needed.

When interpreting Fed’s policy decision, good could be bad and bad could be good. That is absurd.

Repricing with the Gordon Growth Model
On August 29th, I launched a series on “The Great Wall Street Repricing”. As high interest rate and high inflation rate become the new fundamental assumptions in investing, all financial products would go through repricing.


Based on the Discounted Cash Flow (DCF) Model, a company’s valuation is the present value of its future cash flows. High interest rate raises its cost of capital. High inflation raises its cost of good sold and reduces its sales volume, resulting in lower cash flows. The combined effect is a decline in the stock price. Since high interest rate and high inflation affect all companies, this devaluation applies to stock market indexes as well.

How much will the market decline? This is a $1 trillion question. I use Gordon Growth Model (GGM) to come up with a more quantitative estimate of stock index valuation. The formula for Gordon growth model:
P = D1/(r-g)
Where:
• P = stock price
• g = constant growth rate
• r = rate of return
• D1 = value of next year's dividend

Like DCF, GGM states that the stock's value equals the sum of the present value of future dividends. However, GGM assumes that there is a constant growth in dividends. Free cash flow in the Terminal Period determines the intrinsic value of a company. Let’s see how GGM values $1 dividend per share under various assumptions.

First, we use Year End 2021 data as a baseline case:
• Given that BBB corporate bond rate was below 3%, I assume r = 4%
• Perpetual growth rate g = 2.5%, which is very reasonable
• P = 1.025 / (0.04-0.025) = $68.33
• S&P 500 closed at 4,766.18 on December 27th, 2021

Now, let’s make a forward-looking estimate based on what we know today:
• Fed Funds rate is 4% now, and I expect it to go up to 5% next year
• BBB corporate bond rate is now 6.34%. Adding the expected increase in risk-free rate, I assume the new r = 7.5%
• With a pending recession, dividend growth rate will be reduced to g = 2%
• P = 1.02 / (0.075-0.02) = $18.55
• S&P 500 settled at 3,770.55 last Friday, down 20.9% year-to-date

Based on our GGM calculations, the fair value of S&P 500 index should be at 1294 points, or 73% below its 2021 year-end value. This indicates that the index could fall 2,477 points further from here, or -65%.

GGM is by no means an accurate stock market pricing model. You could twist the assumptions to your liking and come up with very different values. It’s okay that you disagree with the logic behind GGM and prefer a different valuation model.

However, our illustration is a shocking revelation of how vulnerable stock prices are to rising interest rates and slowed growth.

There is a lagging effect in monetary policy. We have not seen the full extent of the impact from rising rates. Companies are partially insulated with fixed-priced costs negotiated from prior year, such as office lease, supplier contract, business loan interest, and wages of existing workforce. However, they will all go up when the contract is up for renewal.

There is another reason for a downward trend in stocks – year-end selling. Many investors have taken a hit of -20% or more this year. They would sell the losers before the end of the year for tax purposes. Institutional investors will also need to rebalance their portfolio at this time. They are highly unlikely to take on new risks.

The bear market is far from over. And the worse has yet to come. Shorting the E-Mini S&P futures (ES1!) is still a viable strategy. Meanwhile, as long as Fed continues tightening the money supply, we’d better buckle up the seatbelt for a bumpy ride.

Happy trading.

*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

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