A lower S&P 500 is the price to pay (SPX)

Ultima_Gaina

Thesis

The market broadly expected the Fed to make a rate hike of 75 basis points at the FOMC meeting in September. But the Federal Open Market Committee (“FOMC”) managed to surprise even the most aggressive estimates. The median interest rate for 2023 is now standing at 4.5-4.75%, which once again sends a strong signal to the markets that the Fed is not planning to take a short pivot.

Notably, in the press conference following the interest rate decision, President Powell aggressively confirmed that reducing inflation is the committee’s most pressing ambition, even if it would cause a recession. As a result, he is unsurprising that equity markets suffered strong sell-offs after the announcement: the S&P 500 lost about 1.7% and the more growth-sensitive Nasdaq 100 fell 1.9%, respectively. %. Powell commented that:

We must have inflation behind us. I wish there was a painless way to do it … (But) there isn’t.

After the FOMC meeting, I am confident to reiterate my bearish thesis that a material revaluation for the S&P 500 (SPX) is imminent. I argue that the S&P 500 could drop to levels as low as 3,000. And investors should cover this scenario by buying put spreads of 95/85 percent.

The September FOMC meeting

The Federal Open Market Committee meeting was held September 20-21, and following a warmer-than-expected CPI press for August, markets were expecting a hawkish tone. And rightly so. How is the Fed “strongly committed to bringing inflation back to the 2% target.“the FOMC raised the federal funds rate for the third consecutive time by 75 basis points, bringing it to a target range of between 3 and 3.25%.

Additionally, the Fed’s dot plot has changed significantly. The FOMC committee now expects rates to end the year 2022 at around 4.4% and climb even higher in 2023, to 4.6%. Traders reacted immediately and the two-year treasury bond yield jumped to a 15-year high, above 4.1%.

FOMC September Dot Plot

FOMC summary of economic projections

But the rate on funds is not the only variable that has seen a substantial revision. In particular, all the main economic variables have seen an important and unfavorable rate of change. According to the Fed, GDP growth in 2022 is expected to be only 0.2%, down from 1.7% three months earlier. GDP for 2023 was reduced to 1.2%. At the same time, unemployment expectations have increased: the projection for 2023 has increased from 3.9% to 4.4%.

The projections, including the dot plot, represent “assessment by each participant of the value at which each variable is expected to converge. “

FOMC summary of economic projections

FOMC summary of economic projections

Implications for Investors

Fed chairman Powell hinted at what the market has already known and feared: there is little chance of taming inflation without plunging the economy into a recession. This means that lower employment levels, depressed corporate earnings, lower consumption – and consequently falling asset valuations – are a price the Fed is willing to pay. Powell commented:

Higher interest rates, slower growth, and a softening labor market are all painful to the audience we serve, but they’re not as painful as failing to restore price stability and having to go back and do it again along. the street.

Powell’s September remarks are in stark contrast to the soft landing scenario announced in June. And I argue that equity markets have yet to pay for the change in the situation.

The thesis is simple: if you can get a return greater than 4.1% on “risk-free” treasury yields, how attractive is the S&P 500 with a 5.3% return (ratio 1 / PE, 1/19), who is exposed to shrinking EPS? Not much, I say. And I believe that traders and investors re-evaluate the index until a risk premium of around 3% is restored. This would imply a P / E for the S&P 500 of around x13 and an index valuation of 3,000 (pegged to the consensus earnings estimate of $ 231). Given President Powell’s rhetoric, I believe there is little hope that the Fed will support the market above this index level with liquidity.

Conclusion

My personal view from the September FOMC statements, economic projections and press conference is that in order to have lower inflation, you have to accept a much economic slowdown and as an indirect consequence of falling asset prices. As a result, it seems to me, the Fed is actively trying to drive the stock market down. And since a relative valuation is trading for risk-free 2-year Treasury bills now yielding north of 4%, a new price of the SP&P 500 at lows of 3,000 would not be unreasonable.

Commercial recommendation

Personally, I feel that there is currently no better trade than buying the 95/85% Moneyness PUT PUT spread on the SPX. Consider that the valuation is still high both relative to returns and historical levels and that multidimensional risk is suspended in the markets, waiting to bring the market to new intra-year lows. That said, I recommend and aim for 60 DTEs, which would give a payout of around 5: 1, if the SPX closes at 85% liquidity at maturity (ref, around 3200 strikes).

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