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Technology Stocks : Semi Equipment Analysis
SOXX 252.04-0.4%Jun 14 4:00 PM EDT

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To: Return to Sender who wrote (89076)9/30/2022 4:50:26 PM
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Market Snapshot

Dow 28931.32 -296.32 (-1.01%)
Nasdaq 10680.37 -56.99 (-0.53%)
SP 500 3616.60 -23.94 (-0.66%)
10-yr Note -1/32 3.79

NYSE Adv 1277 Dec 1685 Vol 158 mln
Nasdaq Adv 1762 Dec 2388 Vol 4.5 bln

Industry Watch
Strong: Real Estate

Weak: Consumer Staples, Utilities, Consumer Discretionary

Moving the Market
-- Disappointing PCE Price Index reading, indicating participants can expect continued unfavorable policy from the Fed

-- S&P 500 falling to a new low for 2022

-- Rising Treasury yields

-- Weakness in mega cap stocks

Closing Summary
30-Sep-22 16:30 ET

Dow -500.10 at 28727.54, Nasdaq -161.89 at 10575.47, S&P -54.85 at 3585.69
[BRIEFING.COM] The stock market had a decent showing to start the day but gave way to steady selling pressure that began around 11:00 a.m. ET. Economic slowdown and rate-hike concerns weighed on investor sentiment. In addition, market participants were contending with another weak session from Apple (AAPL 138.20, -4.28, -3.0%), a disconcerting inventory build reported by Dow component Nike (NKE 83.12, -12.21, -12.8%), and an uptick in the August Core PCE Price Index. Treasury yields started to rise in the afternoon, adding fuel to the sell-off in stocks. The S&P 500 closed below the 3,600 level, and settled at a new low for 2022 (3586.47).

Nike reported a huge inventory increase (+44% yr/yr) and gross margin pressure for its fiscal Q1 and warned of continued gross margin pressure for fiscal Q2. This stoked slowdown concerns while a year-over-year increase in the August Core PCE Price Index (to 4.9% from 4.7%) fed into worries that the Fed will continue with its unfavorable monetary policy.

The 10-yr note yield, which was at 3.70% earlier, settled the session up four basis points to 3.79%. The 2-yr note yield, which was at 4.13% earlier, settled the session up three basis points to 4.20%.

The upward drift in Treasury yields and losses in the mega cap stocks, especially Apple, weighed down index level performance as the session progressed. The Vanguard Mega Cap Growth ETF (MGK) closed down 1.8% versus a 1.1% loss in the Invesco S&P 500 and a 1.5% loss in the S&P 500.

Most issues pulled back in the afternoon trade. Declining issues outpaced advancing issues by a 4-to-3 margin at both the NYSE and the Nasdaq, reversing an earlier position where advancers led decliners.

Ten of the 11 S&P 500 sectors closed in the red with losses ranging from 0.4% (materials) to 2.0% (utilities). Real estate (+1.0%) was the lone holdout in positive territory.

One bright spot in the market today was Micron (MU 50.10, +0.09, +0.2%), albeit closing well off the session high. It squeezed out a modest gain after reporting better-than-expected fiscal Q4 earnings and warning of an earnings shortfall for fiscal Q2.

Energy complex futures settled the session lower. WTI crude oil futures fell 2.5% to $2.02/bbl and natural gas futures fell 0.6% to $6.82/mmbtu.

Looking ahead to Monday, market participants will receive the September final IHS Markit Manufacturing PMI reading (prior 51.8) at 9:45 a.m. ET. The September ISM Manufacturing Index (prior 52.8%) and the August Construction Spending report (prior -0.4%) are out at 10:00 a.m. ET.

Reviewing today's economic data:

  • Personal income increased 0.3% month-over-month in August ( consensus 0.3%) in after a revised 0.3% increase (from 0.2%) in July. Personal spending rose 0.4% month-over-month in August ( consensus 0.2%) after a revised 0.2% decrease (from +0.1%) in July.
    • The key takeaway from the report is that the inflation the Fed says it can control (i.e. core inflation) did not move in a friendly direction in August; therefore, market participants can continue to expect the Fed not to be their friend with monetary policy.
  • Final September University of Michigan Consumer Sentiment reading came in at 58.6 ( consensus 59.5) after the prior reading of 59.5.
    • The key takeaway from the report is that the decline in consumer sentiment across the income distribution (low to high) has been consistent for the past six months, underscoring the shared concerns about inflation pressures.
  • September Chicago PMI came in at 45.7 ( consensus 51.9) after the prior reading of 52.2.
Dow Jones Industrial Average: -21.0% YTD
S&P Midcap 400: -22.5% YTD
S&P 500: -24.8% YTD
Russell 2000: -25.9% YTD
Nasdaq Composite: -32.4% YTD

Market lifts off lows into the close
30-Sep-22 15:30 ET

Dow -295.89 at 28931.75, Nasdaq -69.07 at 10668.29, S&P -27.04 at 3613.50
[BRIEFING.COM] The market is lifting somewhat off session lows ahead of the close.

Energy complex futures settled the session lower. WTI crude oil futures fell 2.5% to $2.02/bbl and natural gas futures fell 0.6% to $6.82/mmbtu.

Looking ahead to Monday, market participants will receive the September final IHS Markit Manufacturing PMI reading (prior 51.8) at 9:45 a.m. ET. The September ISM Manufacturing Index (prior 52.8%) and the August Construction Spending report (prior -0.4%) are out at 10:00 a.m. ET.

Market continues to fall
30-Sep-22 15:00 ET

Dow -296.32 at 28931.32, Nasdaq -56.99 at 10680.37, S&P -23.94 at 3616.60
[BRIEFING.COM] The S&P 500 again fell below the previous low for 2022 and continues to fall.

Index level performance is driven lower by weak mega cap stocks, namely Apple (AAPL 139.81, -2.66, -1.9%). The Vanguard Mega Cap Growth ETF (MGK) is down 1.0% versus a 0.7% loss in the Invesco S&P 500 Equal Weight ETF (RSP).

Treasury yields move higher at the same time. The 10-yr note yield is up four basis points to 3.79% and the 2-yr note yield is up three basis points to 4.20%.

J.B. Hunt falls after KeyBanc downgrade, Charles River gains after Jefferies upgrade
30-Sep-22 14:30 ET

Dow -257.05 at 28970.59, Nasdaq -30.26 at 10707.10, S&P -19.77 at 3620.77
[BRIEFING.COM] The benchmark S&P 500 (-0.54%) sits firmly in second place at this point on Friday.

S&P 500 constituents AbbVie (ABBV 136.21, -6.51, -4.56%), J.B. Hunt Transport (JBHT 158.65, -6.63, -4.01%), and Skyworks (SWKS 86.40, -2.86, -3.20%) are among today's top laggards. ABBV is still decently weaker despite a corrected sell side analyst note that retracted bearish guidance claims, JBHT slips after KeyBanc Capital Markets downgraded the stock to a Sector Weight, while SWKS fails to pick up a boost from chip peer Micron's (MU 50.96, +0.95, +1.90%) solid Friday showing.

Meanwhile, Charles River (CRL 197.87, +7.86, +4.14%) is atop the standings after this morning's upgrade to Buy out of Jefferies.

Gold pares monthly losses on Friday, week
30-Sep-22 14:00 ET

Dow -217.19 at 29010.45, Nasdaq -23.74 at 10713.62, S&P -14.91 at 3625.63
[BRIEFING.COM] With about two hours to go the tech-heavy Nasdaq Composite (-0.22%) is today's "best" performing index, down only 24 points.

Gold futures settled $3.40 higher (+0.2%) to $1,672.00/oz, this week's +1% showing pared losses for the month to "just" -3.14%; today's move was helped by a modest retreat in treasury yields, a soft dollar, and down action in equities.

Meanwhile, the U.S. Dollar Index is down less than -0.1% to $112.22.

September ending with expected bad news
The month of September is mercifully coming to an end for investors. Entering today, the Dow Jones Industrial Average is down 7.3%, the S&P 500 is down 8.0%, the Nasdaq Composite is down 9.1%, and the Russell 2000 is down 9.2%.

The year-to-date losses, as everyone is aware, are much worse. We won't get into the specifics there, but suffice to say, there are a lot of potential tax-loss selling candidates as we move into the fourth quarter.

There is also a lot of inflation still, which was seen this morning, beginning with a record 10.0% year-over-year print in eurozone CPI for September and some less-than-soothing PCE Price Index data in the August Personal Income and Spending Report.

Briefly, personal income increased 0.3% month-over-month in August, as expected, personal spending rose 0.4% ( consensus +0.2%) following a downwardly revised 0.2% decline (from +0.1%) in July, the PCE Price Index increased 0.3% ( consensus +0.2%) and the core-PCE Price index, which excludes food and energy, jumped 0.6% ( consensus +0.4%) following a downwardly revised unchanged reading (from +0.1%) for July.

On a year-over-year basis, the PCE Price Index was up 6.2%, versus 6.4% in July, but the core-PCE price Index was up 4.9%, versus 4.7% in July.

The key takeaway from the report is that the inflation the Fed says it can control (i.e. core inflation) did not move in a friendly direction in August; therefore, market participants can continue to expect the Fed not to be their friend with monetary policy.

Then again, they already knew that judging by how the Treasury market has behaved this month. The 2-yr note yield has risen 74 basis points in September. That helps explain why the fallout in the futures market and the Treasury market this morning is nowhere close to what it was following the release of the August CPI report on September 13. In fact, there hasn't been any real fallout.

Currently, the S&P 500 futures are up six points and are trading 0.2% above fair value, the Nasdaq 100 futures are up 12 points and are trading 0.1% above fair value, and the Dow Jones Industrial Average futures are up six points and are trading slightly above fair value.

The 2-yr note yield, at 4.18% just before the release, is at 4.17%, and the 10-yr note yield, at 3.72% just before the release, is at 3.71%.

Arguably, the Treasury market is getting back to its roots and is responding to both economic slowdown and geopolitical concerns.

An earnings warning from Rent-A-Center (RCII), which cited continued deterioration in external economic conditions, a Bloomberg report that Meta Platforms (META) is implementing a hiring freeze and warning employees of restructuring, and a jarring inventory build (+44% year-over-year) and gross margin pressure reported by Dow component Nike (NKE) for its fiscal first quarter, have fueled the slowdown concerns.

Meanwhile, President Putin inflamed the geopolitical concerns by formally announcing the annexation of four Ukraine regions, as expected.

It is remarkable that the equity futures are holding up as well as they are at this point. Of course, like the Treasury market, the stock market has fared terribly in September as rate-hike pressures have left investors thinking they would likely hear more earnings warnings in coming weeks and months. That perspective also shows up in some extremely bearish sentiment readings.

None of today's news, then, is a shocker, yet it is still bad. With the market down 8.0% this month, though, one can say it is bad, as expected, which is why the initial response to it isn't awful from a broad market standpoint.

-- Patrick J. O'Hare,

Meta Platforms adds some friends by cutting costs, but its hard to shake gloomy feeling (META)

Coming off a rough Q2 in which Meta Platforms (META) missed EPS expectations, experienced its first ever yr/yr decline in revenue, and guided Q3 revenue well below expectations, the company is reportedly implementing a hiring freeze and a workforce restructuring program. According to Bloomberg, CEO Mark Zuckerberg held a Q&A session with employees this week, warning that the company will likely be smaller in 2023 compared to 2022, and that it will reduce budgets across most business areas.

The news doesn't come as much of a surprise, though. Earlier this month, the Wall Street Journal reported that META is planning to reduce expenses by 10% in the coming months, including through job reductions. Additionally, META signaled during its Q2 earnings conference call that it planned to steadily reduce headcount growth over the next year, with Zuckerberg commenting that the macroeconomic situation "seems worse than it did a quarter ago."

There was some hope that conditions were improving, and that advertising demand was picking up a bit when Snap (SNAP) issued upside Q3 revenue guidance on August 31. That forecast for 8% yr/yr growth, though, was accompanied by the disclosure that SNAP is also cutting its headcount by 20% in an effort to focus on profitability. Therefore, it was evident that SNAP wasn't anticipating demand to meaningfully recover anytime soon. Recent hiring freezes at Twitter (TWTR) and Google (GOOG) further solidify that notion.

With META's looming headcount reductions adding to the gloom, it may seem strange that its stock is moving higher today. There are a few explanations for the strength.

  • It's well understood that the digital advertising space is suffering a steep downturn. Likewise, META's troubles -- market share losses to TikTok and Apple's (AAPL) iOS privacy changes -- are largely baked into the equation, too, as illustrated by the stock's 60% year-to-date plunge.
  • Consequently, the focus has swung from META's top-line growth potential to its EPS and cash flow generation potential. Relatedly, cost cutting initiatives are now at the top of many investors' wish lists, and META has recognized that fact. On that note, the company lowered its FY22 expense guidance in both Q1 and Q2. After reducing its expense outlook to $87-$92 bln from $90-$95 bln in Q1, META further trimmed its expense outlook to $85-$88 bln last quarter.
  • Prior to this downturn in META's advertising business, there was plenty of skepticism regarding Zuckerberg's ambitious plans to invest billions into the metaverse. That intense focus on the metaverse seemed to come at the expense of META's social media platforms as TikTok and SNAP gained ground. Now, META is forced to re-prioritize its investments on applications that make it more competitive today, such as Reels, rather than on an idea that may never fully pan out.
It's hard to feel too warm and fuzzy over META's gains today. Clearly, its latest plans to cut costs through hiring freezes and job reductions indicate that business conditions are not improving and may in fact be worsening. For now, though, investors are rewarding the company for trying to stay ahead of the curve and focus on profits as macroeconomic risks mount.

Rent-A-Center weak guidance really crystallizes the strains lower income people are under (RCII)

Rent-A-Center (RCII -18%) is under heavy pressure today after lowering Q3 guidance and announcing that its CFO stepped down. RCII dropped its Q3 EPS guidance pretty sharply to $0.85-0.95 from $1.05-1.25 while the revenue guidance drop was more modest.

  • As one of the largest rent-to-own operators in North America, we view RCII has an excellent barometer for the economic health of lower income consumers. This retail model appeals to people who perhaps cannot afford to buy furniture or TVs outright.
  • Instead they make weekly payments. This guidance reaffirms what we have heard from other retailers/restaurants (ROST, DRI, WMT, TGT etc.) specifically about lower income consumers. However, RCII has even more direct exposure to this segment of the market and this guidance makes it really clear that these consumers are feeling the pinch.
  • RCII says that external economic conditions have continued to deteriorate over the past few months. And it sounds like RCII is being hurt on two fronts: reduced retail traffic and customer payment behavior. We read this last part as: perhaps default rates are rising, although RCII did not say that specifically.
  • While a CFO stepping down is not typically a big deal, what makes this more troubling is that it happens just as the company guided lower. That makes us think that maybe she was concerned about the financial health of the company. To be clear, RCII did not say that, but the market draws inferences. Typically, you will see a company reaffirm guidance when a CFO steps down in order to reassure investors. But that was not the case here. It was a bit of a Yikes! moment for us. We think that is spooking people a bit and is adding to the weakness today.
Overall, this was some weak guidance from RCII. We already knew that lower income consumers were struggling more than other groups because necessities like gas/food are taking up a larger percentage of their budgets. However, this guidance from RCII really crystallizes our concerns. Big guide downs from giants like FDX and NUE, to name just a couple, already made us nervous about the upcoming Q3 earnings season. However, RCII now adds to our unease, especially about retailers who cater to lower income consumers.

NIKE is going to "just do it" and aggressively clear its inventory, weighing on outlook (NKE)

In the face of inflationary headwinds and a more cost-conscious consumer, NIKE (NKE) extended its earnings winning streak, narrowly beating 1Q23 EPS estimates on healthy demand in North America. However, the company's ninth straight quarterly EPS beat is far from the focal point this morning. Instead, NKE's mountain of inventory, which jumped by an eye-popping 44% yr/yr, is the main storyline that's driving the stock action. While already operating in a highly promotional environment, NKE plans to aggressively unload out-of-season product at discounted prices, deeply cutting into margins.

After initially guiding for FY23 gross margin to be flat to down 50 bps yr/yr, the company now expects gross margin to decline by 200-250 bps yr/yr. Most of the damage will take place in Q2 as NKE employs a "rip the band-aid off" approach to clearing out its inventory. Specifically, NKE is forecasting a 350-400 bps plunge in Q2 gross margin, following a 220 bps decline in Q1 to 44.3%.

A number of factors are at play regarding the inventory situation.

  • Entering Q1, inventory levels were already high (+23% in Q1) as late deliveries with out-of-season product piled up at shipping ports. Now, that problem is being exacerbated by earlier than expected holiday ordering patterns from retailers and improving transit times. As a result, in-transit inventory spiked by 85% in Q2.
  • Making matters worse, promotional activity in the retail space is accelerating. That's particularly the case in the apparel category, where NKE's inventory reduction efforts largely center on. Even though Q1 sales in North America were up by 13%, EBIT fell by 4% to $1.38 bln due to margin contraction. Next quarter, the yr/yr decline in North America EBIT is likely to be more severe.
  • The silver lining is that NKE believes that inventory in North America peaked in Q1. Accordingly, the company expects to see sequential improvements throughout the fiscal year with supply coming into better alignment with strong demand.
Another positive is that NKE reaffirmed its FY23 currency-neutral revenue growth guidance, sticking with a low double-digit increase versus last year. A solid back-to-school season is helping the cause with month-to-date retail sales climbing by double-digits, driven by strength across the NIKE, Converse, and Jordan brands.

Similar to the past several quarters, though, softness in the Greater China market is weighing NKE down. Following a 20% drop in sales last quarter, the region experienced a 13% dip in Q1, which is worse than analysts anticipated. Once again, NKE singled out COVID-related disruptions as the main culprit, but we worry that macroeconomic weakness in China is more to blame. Recall that Adidas (ADDYY) cut its FY22 sales forecast in late July due to a slower than expected recovery in China.

If all of this wasn't enough, NKE is also facing intensifying FX headwinds as the dollar strengthens. In fact, it doubled its FX headwind outlook for the year to 800 bps from 400 bps, resulting in estimated FY23 reported revenue growth of low-to-mid single digits. The bottom line is that NKE is taking hits from multiple sides, but the massive jump in inventory really caught investors by surprise. That inventory will act as an albatross during the all-important holiday shopping season, causing plenty of disappointment among investors.

Micron's forecast of slowing demand materialized in Q4; however this set realistic expectations (MU)

Micron's (MU +3%) gloomy forecast of slowing demand throughout the semiconductor industry finally materialized yesterday in the form of a sales miss in Q4 (Aug) and dismal Q1 (Nov) guidance. Furthermore, MU plans to cut back supply, reducing its CapEx by 30% yr/yr in FY23, with a 50% reduction in wafer fab equipment CapEx.

However, on the flip side, MU's warnings over the past few months set realistic expectations for investors leading into its Q4 earnings report. Starting with guiding Q4 revs well below consensus in late June, MU already saw noticeable signs of the industry entering a down cycle. Then, early last month, MU grew even more bearish, cautioning that Q4 revs would likely land at or below the low end of its prior outlook. Meanwhile, chip suppliers like Advanced Micro (AMD), NVIDIA (NVDA), and Intel (INTC), as well as others in the memory space, like Seagate Tech (STX) and Western Digital (WDC), delivered either lackluster earn2ings reports or weak guidance. As a result, investors priced in plenty of negativity, explaining why shares of MU are holding up relatively well today.

  • In Q4, MU met its prior earnings guidance despite the figure falling 40.1% yr/yr to $1.45. Revs falling 19.7% yr/yr to $6.64 bln was a weak point since it missed MU's expectations of $6.8-7.6 bln. However, given MU's caution last month, the sizeable miss was not a major surprise.
  • Outside of automotive, all of MU's end markets experienced sales declines yr/yr in the quarter. However, there were a few encouraging remarks, including an anticipated bright second half for automotive, strong long-term fundamentals in industrial IoT, and healthy cloud end market demand. Still, many bearish comments tempered these developments, including ongoing supply constraints in automotive and cloud, as well as deteriorating client and memory end market demand.
  • The usual headwinds were at play in Q4, including COVID-related lockdowns in China, a war in Ukraine, and elevated inflation.
  • Looking ahead, the demand backdrop is not shaping up to turn around rapidly. A significant culprit affecting the memory and storage industry is ongoing inventory adjustment at customers across all end markets, which will cause supply growth to be meaningfully higher than demand for the remainder of CY22.
  • As a result, MU is expecting a rough quarter ahead, predicting adjusted EPS of $(0.06)-$0.14 and revs of just $4.0-4.5 bln, both considerably below consensus. Furthermore, MU is slashing its CapEx for FY23. However, MU believes that despite the adverse impact this will have on its FY23 costs, it is a necessary step to bring its supply down closer to industry demand.
    • On a side note, MU's move will likely hurt wafer fab equipment suppliers like Lam Research (LRCX), ASML (ASML), and KLA Corp (KLAC).
Bottom line, MU may have posted a weak earnings report in Q4. Still, investors appreciate its approach to reducing supply to avoid an even worse inventory imbalance. Although this will sting in the coming quarters, it may prove to be the correct strategy over the long term.

MillerKnoll shares sink below pandemic lows after a Q1 sales miss and weak Q2 guidance

The warning signs flashed by fellow office furniture manufacturers HNI Corp (HNI) and Steelcase (SCS) materialized in the form of a Q1 (Aug) sales miss and downbeat Q2 (Nov) guidance for MillerKnoll (MLKN -12%) yesterday after the bell. While MLKN was optimistic in late June regarding the foundation its elevated backlog provided for AugQ, HNI's slashed FY22 outlook and SCS's missed AugQ sales expectations on weak order growth set an uneasy backdrop for MLKN heading into its AugQ report. Coinciding with MLKN's disappointing results is an analyst downgrade at Craig Hallum today.

  • Many of MLKN's AugQ numbers illuminate the headwinds its peers faced recently. Softness has ticked up globally, with some areas much worse than others. In the U.S., which is included in MLKN's Americas Contract segment (~50.0% total AugQ revs), businesses displayed inflation concerns, placing smaller orders. Meanwhile, in MLKN's Global Retail segment, performance was adversely affected by a shift in consumer tastes toward experiences, such as travel, similar to what we heard from Wayfair (W) last month.
  • The challenges in AugQ culminated in revenue growth of 36.6% yr/yr, coming in at the low end of MLKN's prior guidance of $1.08-1.12 bln. Meanwhile, organic revs fell 12% yr/yr as orders slumped 11%, primarily driven by MLKN's Americas Contract and Global Retail segments.
  • A bright spot stemmed from MLKN's International Contract & Specialty segment, where organic sales climbed 30% yr/yr on a 1% improvement in new orders. MLKN's international presence acts as a key competitive advantage, and the company does not expect to let up on expanding anytime soon. In fact, MLKN is looking to bolster its overseas footprint by introducing its international dealer cross-sell pilot to India and the EMEA region later this year.
  • MLKN's guidance illustrated the stickiness of current headwinds. For NovQ, the company expects EPS of $0.39-0.45, a 17.6% drop yr/yr at the midpoint, and revs of $1.027-1.067 bln, just 2.0% growth yr/yr at the midpoint.
Conversely, MLKN noticed supply chain stabilization as lead times returned to near normal levels in the quarter. Also, MLKN expects to see traction from net price hikes and cost reduction initiatives translate to meaningful margin expansion in subsequent quarters. Although this does depend on moderated inflationary pressures, recent CPI reports indicate that this massive headwind may be cooling off.

Bottom line, with investors sending shares of MLKN below pandemic lows, MLKN is in the hot seat. If inflationary pressures are not enough, the company must also adapt to increasing levels of hybrid work. Its brands are strong, and overseas growth is encouraging. However, we view the near term as too uncertain and think it is better to remain on the sidelines until MLKN works through some of its challenges.

The Big Picture

Last Updated: 30-Sep-22 14:52 ET | Archive
First, the pain, then the gain
Market rates have moved up appreciably this year. The 2-yr note yield, which started the year at 0.73%, is at 4.17%. The 10-yr note yield, which started the year at 1.51%, is at 3.75%.

Normally, the 10-yr would be yielding more than the 2-yr, but we are not in a normal time. Things have gotten abnormal, because, ironically, high inflation has necessitated a normalization of monetary policy.

The worry for the market is that the Fed's rush to normalization will go too far and invite a material economic slowdown, if not an actual recession. Hence, the 2-yr note and the 10-yr note are inverted with the former yielding more than the latter.

Things have gotten abnormal, because, as we stated last week, the Fed kept rates close to the zero bound for the better part of the last 14 years. Investors got used to this, so much so that a new generation of investors considered it a "normal" interest rate situation.

It was not. The pace at which policy rates and market rates have risen, however, has been abnormal. Be that as it may, it has also been a game changer.

A Changing Landscape

Treasuries have yield again. That is good news for fixed-income investors. It is also good news for investors looking for more balance in their investment portfolios.

It is bad news for prospective home buyers, as mortgage rates generally move in tandem with the 10-yr note yield.

It has not been good either for the stock market for a couple of reasons:

  1. A higher risk-free rate lowers the present value of future cash flows, making stocks worth less, which in turn drives multiple compression.
  2. Higher Treasury yields attract more investment capital, which in turn creates money flow competition for stocks.
We can see the changing landscape in the charts below.

When the year began, the forward 12-month P/E multiple for the S&P 500 stood at 21.2. It now stands at 15.4, or a 10% discount to the 10-year average (17.1), according to FactSet. There has been multiple compression with the move in the 10-yr note yield from 1.51% to 3.75% (and 4.00% earlier this week).

Notwithstanding the sharp drop in stock prices, the dividend yield for the S&P 500 is a paltry 1.81%. That is little return for a higher risk investment, especially knowing stock prices could fall further and that companies could decide to cut their dividends to preserve cash in a tougher economic environment.

Risk-free Treasuries (assuming the position is held to maturity) offer yields that exceed the S&P 500 dividend yield by close to 200 basis points in most cases.

What It All Means

The environment for stocks and the economy has gotten more challenging with the Fed's rate hikes and suggestion that there are more rate hikes to come. The environment for stocks has also gotten more competitive because the yield that had been missing in the Treasury market during an abnormal period of rock-bottom interest rates has been found again.

That discovery process has not been without its pain. What fixed-income investors are gaining these days in yield has led to a painful transition for stocks.

Earnings multiples have compressed sharply as market rates have risen. That is a normal trade-off, but it sometimes happens in a more painful way when the pace of change is quick like it has been this year.

Bonds have certainly had their fair share of pain this year, too. The trade-off for the more attractive yields available today is lower bond prices. In other words, no pain, no gain.

That is also true for stocks. It has been a painful adjustment, but lower valuations create better long-term return opportunities. There is static on that line, though, because earnings estimates are still too high. According to FactSet, analysts' consensus earnings growth projection for calendar 2023 is 8%.

That number is destined to come down in our estimation, meaning the lower market multiple today is not the true value it appears to be.

Better bargain-hunting opportunities will avail themselves when earnings estimates come down further to reflect the tougher economic environment that lies ahead. That will be true, because interest rates will eventually come down when that tougher climate avails itself more fully in the economic data.

Bear markets are painful no matter the catalyst. Rising interest rates are the source of pain for this bear market. They are making bonds more competitive for stocks, and they are compressing market valuations. It hurts now, but eventually there will be some healthy gains from that pain, which is normal coming out of a bear market.

-- Patrick J. O'Hare,

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