Revisiting the Weather Forecast

With the headlines this week regarding monthly inflation data, it is clear (pun not intended) that the gray storm clouds of the spring and summer months have not dissipated, and we believe the time is right to give a 3-month update on the state of the economic weather. A few key items to consider:

• The lead story continues to be hotter-than-expected inflation data, leading to more and larger Federal Reserve rate hikes. There are many areas of the market, including housing costs, that are showing falling prices when using real-time data, but the official government statistics remain higher due to lagged data. Policy decisions like rate hikes take multiple months to be fully reflected in the economy, and so there appears to be some mismatch of official and real-time data. A key cog in the inflation wheel is the state of employment, which has remained reasonably solid, and the Fed wants to see employment numbers soften as further evidence of the efficacy of their rate hikes. Thus far, the Fed has remained adamant about viewing embedded inflation as the worst of the potential evils, leading to the conclusion that rate hikes are most likely not nearing completion.  Key takeaway: Inflation has become more embedded than the Fed hoped would happen, and this will lead to higher rates for a longer period of time, but real-time data suggests that the rate hikes are starting to flow through to the real economy. Even so, inflation and interest rate storm clouds will remain for a while longer.

• Valuation of the market becomes more compelling by the month, and this is especially true in small- and mid-sized stocks. Large cap stocks are trading at a level that is approximately median relative to intermediate and long-term history, but still well above the nadir of Fall 2011 levels. Large cap growth stocks are still trading expensive versus history, but large cap value valuations are below-average and represent an attractive entry point. Mid cap stocks are trading cheaper than at any point in the last 40 years, with the exception of the 2001 timeframe. And small cap stocks, with a P/E of 11.5, are cheaper than they have ever been in 40 years. Key takeaway: Large cap growth remains pricey, but all other parts of the market are cheap relative to history. The valuation storm cloud appears to be clearing, though sunny skies may not present themselves immediately.

• Market history shows us that markets bottom well before the actual economy bottoms. It is likely that storm clouds remain in the forecast for the coming months, but that doesn’t mean the market will fall significantly. Key takeaway: We believe staying invested after major market downturns ensures that you capture the full upside when the skies turn sunny again, the timing of which is impossible to predict.

In summary, the most likely scenario at this point is that the rain clouds persist for the coming months, a view that is fully in line with the range of expected outcomes that we anticipated over the summer and that has influenced the composition of the portfolio for the last several months. But with valuation becoming so compelling, real-time data showing some headway being made on the inflation front, and with employment remaining relatively strong, there are reasons to believe that the market has already experienced the worst of the downturn. While there could always be more downside ahead, we believe the worst-case scenario is unlikely at this stage.