Investors are too bearish on the US stock market.

The writer is president of Yardeni Research

In my opinion, investors have become too pessimistic about the prospects for the US economy and stock market. I don’t remember such a downtrend in the stock market in a long time.

I think it’s mainly because the “Fed put” is kaput. The US Federal Reserve has long been expected to step in to bail out the markets whenever the going gets tough. But now you can no longer count on it. That’s because inflation hasn’t been as serious a problem as it is today since the 1970s.

The Fed finally recognized this late last year and has moved further and further away from its dovish stance throughout 2020 and 2021 and started to tighten monetary policy. It is widely expected that he will have no choice but to raise the benchmark federal funds rate to more than 2 percent to control inflation. However, bond market watchdogs have already significantly tightened credit conditions.

The yield on the 2-year US Treasury note, which tends to lead the fed funds rate, soared from just 0.16 percent a year ago to 2.68 percent on Friday. The yield on the 10-year US Treasury bond soared from a record low of 0.51 percent on July 31 last year to 3.13 percent on Friday. The 30-year mortgage rate jumped from 3.29 percent earlier this year to 5.45 percent last week.

As a result, the Nasdaq fell 24.4 percent in a bear market from its all-time high on Nov. 19 through Friday, and the S&P 500 fell 14.0 percent from its all-time high on Jan. 3.

Over this same period, the S&P 500 price-to-expected earnings ratio has fallen from 21.5 to 17.5. That reflects the decline in the S&P 500 index, as well as the increase in expected earnings per share of its components.

That’s right: as investors lower the valuation multiple they’re willing to pay for consensus earnings, analysts have been raising those same earnings projections! Up to a point, downgrading the forward PE ratio makes sense, as it tends to be inversely correlated with inflation and bond yields, both of which are rising. But it also indicates that investors are much more concerned than industry analysts that tighter financial conditions will cause a recession.

I side with analysts even though they are not particularly good at anticipating recessions. On the other hand, investors have been prone to numerous panic attacks since the 2008 financial crisis about impending recessions that have not occurred.

On the bright side of the outlook ledger, American consumers are in good shape. They are upset about inflation, but the job market is tight and many employees are quitting their jobs for better pay. And consumers have accumulated a lot of savings since the start of the pandemic.

Meanwhile, nonfinancial corporations have refinanced debt and still have plenty of cash on their balance sheets after raising $2.3 trillion in the bond market over the past 24 months to the end of March. Past recessions have generally been caused by credit constraints resulting from Federal Reserve tightening. I doubt that is likely now that the M2 money supply exceeds its pre-pandemic trend by $3 trillion currently. I expect inflation to peak this summer in the 6-7 percent range and drop to 3-4 percent next year without a recession. Inflation for consumer durables has been especially high over the past year and is likely to cool down over the next year as pent-up demand has been largely satisfied. Supply chain disruptions should also decrease.

Most of the decline in the S&P 500 valuation multiple so far this year has been attributed to eight mega-cap stocks: Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia and Tesla. They currently represent 23 percent of the index’s market capitalization. Their collective forward PE ratio spiked during the first year of the pandemic to around 35.0, and it stayed there last year. Now it’s at 25.

On the other hand, the energy sector of the S&P 500 has significantly outperformed this year. There have also been opportunities to make money on “economic reopening” trades as investors reduced their bets on consumer goods and increased their positions in consumer services. Finances, especially those related to insurance, have also performed well. Another winning group of industries are those related to the production and sale of food. There are plenty of good opportunities to buy stocks in sectors that have underperformed so far this year.

The bottom line is that I am in the field of proofreading for now. I expect to see the S&P 500 in record territory again next year. The strength of the dollar contributes to that bullish outlook, suggesting that global investors view the US as a safe haven in our turbulent world.

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