Still Bearish

If you were bullish for 2023…congratulations! The S&P 500 rose 7.0% in the first quarter and, although we still have more data to analyze before we finalize our prediction, it looks like real GDP grew at about a 2.0% annual rate in Q1. No drop in stocks, no recession. At least not yet.

While we wish we hadn’t been bearish when this year began, our forecast for a drop in stocks and a recession hasn’t changed. Using corporate profits for the fourth quarter and the current 3.5% yield on the 10-year Treasury Note, our Capitalized Profits Model suggests a fair value for the S&P 500 of 3,891, which is lower than where stocks are today.

The economy is still absorbing and responding to the 40% surge in the M2 measure of the money supply during COVID. Think of that enormous surge in the money supply as installing a furnace built for a 10,000 square foot mansion into a home that’s only 2,000 square feet, and then running it full blast.

Even when you have finally turned the furnace off – like the Federal Reserve did with the money supply in the past year, with the largest drop since the Great Depression – that 2,000 square foot home doesn’t immediately get cold. It takes time for the home to gradually cool off and eventually get cold. Given the drop in the money supply, we are headed for a much colder economy; we’re just not there yet.

And when the US economy cools off, we expect profits, which were artificially boosted by easy money and government handouts, to fall. This means our model will eventually move stocks’ fair value lower, too. The only thing that could change that forecast is if interest rates fall at the same time profits do.