The Stock Market Is Trying to Recover. Why It Could Drop 10% From Here.

Worrying investors is the rate of inflation, which came in higher than expected for January at a 3.1% annual pace. That caused fixed-income markets to walk back their bets that the Federal Reserve is on the cusp of lowering interest rates. A swath of data suggests the economy remains too strong, and the Fed will likely keep rates a little higher for longer than initially anticipated, as it stays focused on reducing demand and inflation. 

While the stock market appears to be tepidly recovering Wednesday, a couple key indicators show it likely will resume its drop. 

Interest-rate expectations are the biggest clue. The stock market’s current level appears to price in too many Fed rate cuts. The fed funds futures market has dialed back its previous expectations for six cuts: It is now pricing in three to four rate cuts this year for a drop of nearly one percentage point by the end of the year.

Looking at the correlation between the stock market’s earnings multiple and fed funds futures, the S&P 500 should be trading at just over 18 times earnings, according to Seaport Research Partners. But the index is trading at about 20.3 times analyst’s aggregate expected earnings for the coming 12 months. That drop in the index’s earnings multiple—holding earnings forecasts constant for the moment—would indicate a roughly 10% decline in the index’s price.

One key reason for this potential decline is higher rates mean there’s a greater chance earnings will come in lower than currently expected—something the stock market can reflect well before analysts reduce their estimates.

“We expect a broader absolute derating of the market multiple as assets reprice for stubbornly high real rates,” wrote Seaport’s Victor Cossel. 

The goods news is a stock market dip doesn’t necessarily have to be to the tune of 10%. As Cossel points out, buyers have consistently come in and propped up the index just above the 4700 after brief dips since December. There’s a solid chance that this buying “support” will emerge yet again around that level—as long as markets still believe the Fed will cut rates at least a few times and there are no unexpected geopolitical crises. A drop to 4700 would be a mere single-digit decline in percentage terms. 

But support levels are meant to be broken. If investors see more signs that the Fed wants to hold off even longer on rate cuts, the market could easily drop below 4700. Sevens Report’s Tom Essaye points out the S&P 500 was much lower the last time rate-cut expectations were at these levels.

In fact, “Fed rate cut expectations are now for three to four cuts, which is the same level it was late last summer, when the S&P 500 was trading around 4,400,” Essaye writes.

Beware of this runaway market. 

Write to Jacob Sonenshine at [email protected]