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Stocks have been all over the place in recent days, but the overall direction has been to the downside.

Stocks sold off in a major way in recent days, after reaching record levels at the start of the New Year. Driving this rapid shift in sentiment is the fear of tighter Fed policy in response to inflationary pressures. The indiscriminate sell-off appears to reflect the market’s anxieties about the speed and magnitude of Fed interest rate hikes this year.

Many in the market interpreted the Fed Chairman’s words at the latest post-FOMC meeting press conference as very hawkish and indicative of tougher times ahead. Valuation worries also figure prominently in the bearish view of the market.

There are others in the market with more optimism about the outlook who see the recent sell-off as providing an opportunity to buy quality stocks at discounts. This narrative is sanguine about the Fed, sees ongoing inflationary pressures as mostly Covid centric and sees nothing wrong with valuation given the favorable outlook for interest rates and earnings.

The interplay of these competing views will determine how the market performs in the coming months and quarters. To that end, let’s examine the landscape of bullish and bearish arguments to help you make up your own mind.

Let's talk about the Bull case first.

Inflation & the Fed: The outlook for inflation and what that means for Fed policy is the biggest point of difference between market bulls and bears at this point in time. The bulls see the ongoing inflationary run as a direct result of Covid-related factors that will ease once the pathogen becomes endemic.

It is hard to argue with the bulls’ view that the pent-up demand in a number of product and service categories will eventually normalize, which will have beneficial effect on prices. Related to the above argument are expected favorable developments on the supply side of the equation as the pace of infections ease.

The Fed has stepped back from its earlier ‘transitory’ explanation of inflationary pressures and adopted a more hawkish posture. But bulls see that change as likely nothing more than securing greater flexibility for the central bank. In effect, the Fed purchased an insurance policy with this language change that allows it greater room to maneuver as the inflation picture evolves.

The Fed’s hard-won credibility on the inflation question is one of the biggest tools in its arsenal as it leads the market in the current environment of evolving inflation expectations.

A Strong Economic Rebound: The U.S. economy’s growth pace likely moderated a bit in the current period as a result of Omicron-related effects, but it was literally firing on all cylinders in the last quarter of 2021, as this week’s better-than-expected +6.9% Q4 GDP growth rate shows.

Growth is expected to resume from Q2 onwards, as the Omicron effects recede and supply-chain issues ease, with 2022 GDP growth at an above-trend +3.5%. 

Driving this favorable growth outlook is the U.S. household sector that remains in excellent financial health. The unprecedented fiscal support was instrumental in helping keep household finances in good shape through the pandemic, with labor market gains expected to sustain the momentum going forward. In addition to the elevated consumer spending outlook, adding depth to the economic rebound is a strong housing sector and continued factory sector momentum. These positive growth projections do not include contribution from any fresh fiscal measures.

All in all, the growth outlook hasn’t looked this good in a long while.

Valuation & Earnings: Tied to the economic and interest rate outlook is the question of stock market valuations that have become even more alluring after the recent pullback.

Granted there are pockets of the market that need to get rerated as the Fed shifts course. These at-risk or exposed pockets consist of relatively smaller companies that require many more years of investments to reach their full profitability levels way out in the future.

Many of these stocks had lost ground even before the recent market weakness and the Fed uncertainty could very well weigh on the space a lot longer. But there are many other stocks in the market that are best positioned to drive sales and earnings in the current positive economic growth environment.

Earnings growth was very strong in 2021 and the momentum is expected to continue in 2022 and 2023, albeit at a decelerated pace. This line of thinking sees current valuations and earnings outlook as a tailwind for the stock market.

Let's see what the Bears have to say in response.

Endemic Inflation & Fed Tightening: Included in the recent strong 2021 Q4 GDP report was the red hot ‘core’ PCE reading of +4.9%, the Fed’s preferred measure of inflation which is not only above its +2% target, but also at a multi-decade high.

The Fed risked damaging its hard-won inflation-fighting credentials had it stuck to its ‘price-pressures-are-transitory’ narrative in the face of persistent inflationary readings month after month. Many in the market believe that the central bank took too long to accept this reality, which will necessitate even tighter and stringent measures than would have otherwise been the case.

This line of thinking sees the economy’s ongoing inflation bout as resulting from the Fed’s super easy monetary policy and excessive fiscal stimulation over the last two years.

Given this situation, the Fed is on course to do its first rate hike at its March meeting, having finished the QE program by then. This restrictive outlook envisions the central bank implementing at least 5 rate hikes this year, a significantly tighter policy than what the central bank had originally guided towards.

The Valuation Reality Check: A big driver of the stock market’s bull run has been thanks to the Fed’s ability to flood the market with liquidity. The central bank achieved that by keeping interest rates at zero and buying a boat-load of U.S. treasury and mortgage-backed bonds that expanded its balance sheet to almost $9 trillion at present, more than the double its size at the start of 2020.

Fed tightening and the associated higher interest rates has a direct impact on the prices of all asset classes, stocks included. Everything else constant, investors will be required to use a higher discount rate, a function of interest rates, to value the future cash flows from the companies they want to invest in.

This means lower values for stocks in a rising interest rate environment.

The Growth Question: The +6.9% GDP growth rate in Q4 brings the full-year 2021 growth rate to +5.5%, the highest annual growth rate since the +5.6% in 1984.

The growth pace is expected to decelerate going forward, with the Zacks economic team projecting GDP growth of +3.5% in 2022 and +2.9% in 2023.
These projections assume that the Fed is successful in executing a ‘soft landing’ for the U.S. economy as it moves towards tightening monetary policy.

There is no basis for us to doubt this confidence in the central bank’s abilities, but we shouldn’t lose sight of history that tells us that economic growth typically falls victim to inflation-fighting efforts.

A handy metric to keep an eye on for growth outlook is the spread between the 2-year and 10-year treasury bond yields. A flattening trend will suggest the need for reigning in growth expectations.

Where Do I Stand?

I am very skeptical of the bearish narrative’s Fed tightening outlook and see this scenario as nothing more than a worst-case or low-probability event.

My base case sees the Fed moving from the current ‘stimulative’ policy stance to one that is essentially ‘neutral’. In a ‘neutral’ policy setting, the Fed is neither ‘stimulating’ nor ‘restricting’ economic activities.

They reach the ‘neutral’ policy stage by starting to raise interest rates in March after having completed the QE ‘taper’. They likely need to do two more interest rate hikes, in addition to starting a conversation about unwinding the balance sheet to reach the ‘neutral’ stage.

I see the Fed pausing at that stage to see what data shows about inflation trends, which will most likely have started easing already as the pandemic related effects start to ease. This wait-and-see approach from the Fed in the second half of the year appears to be the most plausible scenario given the risks to growth as a result of premature tightening, a threat to the Fed’s second ‘full employment’ mandate.

The bottom line on the Fed front is that it is shifting policy towards normalization as the U.S. economy no longer needs the extraordinary stimulative measures that were put in place in the wake of Covid-19.

As policy moves towards ‘neutral’, we see stable financial conditions and interest rates that keep the economy’s growth trajectory in place.

Regular readers of my earnings commentary know that the earnings picture has not been this good in a long time. The growth pace is undoubtedly expected to decelerate going forward, but the overall earnings picture will remain very strong. We expect the overall trend in earnings estimate revisions to be stable to positive in the coming weeks and accelerate as we put the pandemic behind us.

Markets are forward-looking pricing mechanisms and the recent weakness is highlighting this interest rate and growth uncertainty on the horizon. We don’t envision this uncertainty dissipating next week, but we do see investors eventually coming around to our view of inflation, the Fed, and great times ahead after a short period of volatility.

We take advantage of this period of turmoil by slowly building positions in great stocks that are currently available at significant discounts to their true values.