The last time David Rosenberg shared his outlook for the U.S. stock market and the economy with MarketWatch, in late May, it was depressing enough.
Rosenberg is the widely followed president and chief economist and strategist of Toronto-based Rosenberg Research & Associates Inc. His sobering outlook last May echoed his thinking from March 2022, when he called the Federal Reserve’s intention to hike U.S. interest rates “not a good idea” and predicted that the inflation-fighting move would trigger a painful economic recession.
Five rate hikes later, with more expected, Rosenberg is even more pessimistic about the stock market and the economy in 2023 — and to say he’s disappointed with the Federal Reserve and Chairman Jerome Powell would put it mildly.
“The Fed’s job is to take the punch bowl away as the party gets started, but this version of the Fed took the punch bowl away at 4 a.m.,” Rosenberg said, “when everybody was pissed drunk.”
Many market experts and economists are now coming to Rosenberg’s side of the fence — criticizing the Fed for waiting too long to battle inflation and warning that the central bank now may be moving too fast and too far.
But Rosenberg is leaning even further over the railing. Here’s what he says investors, homeowners and workers can expect in the year ahead: The S&P 500 tumbles to as low as 2,700 (the lowest since April 2020), U.S. home prices decline by 30%, and the unemployment rate rises. The U.S. economy sinks into a recession, for which the Fed — especially Powell — would be largely to blame.
“He went from Bambi to Godzilla,” Rosenberg says of Powell’s radical and rapid transformation from inflation skeptic to inflation slayer. Adds Rosenberg: “Powell was getting compared to [disgraced 1970s Fed Chair] Arthur Burns. Nobody in central banking wants to be compared to Arthur Burns. This is the reality.”
Reality admittedly isn’t something the financial markets have had much of a grip on in the past several years, with essentially free money and a hands-off Fed fueling a go-go investing climate. “Now that movie is running in reverse,” Rosenberg says, and the reality here is that the next scenes will be tough ones.
But since markets are cyclical, the Fed’s flushing inflation and dumping the punch bowl should lead to a new bull market for stocks, bonds and other risk assets, Rosenberg says. He sees this fresh start beginning in 2024, so don’t despair — that’s less than 15 months away.
In this mid-October interview, which has been edited for length and clarity, Rosenberg discussed the challenging conditions investors face now and offered his top ideas for their money over the next 12 months — including Treasury bonds, stock sectors that can profit from longer-term business trends and technology themes, and good old-fashioned cash.
MarketWatch: You’ve been skeptical of the Fed’s interest-rate hikes since they began last March. But it seems that your skepticism has morphed into a kind of disbelief. What is the Fed doing now that is so unprecedented?
Rosenberg: The Fed is ignoring market signals and chasing lagging indicators like the year-over-year in the CPI and the unemployment rate. I’ve never seen the Fed at any point before this version totally dismiss what’s happening on the supply side of the economy and totally ignore what’s happening from market signals. I’ve never seen the Fed tighten this aggressively into a raging bull market for the U.S. dollar
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I’ve never seen the Fed tighten this aggressively into a major decline, not just in the stock market but in the most economically sensitive stocks. I’ve never seen the Fed tighten this aggressively into an inverted yield curve or into a bear market in commodities.
“ The odds of a recession are not 80% or 90%; they are 100%. ”
MarketWatch: A focus on lagging indicators doesn’t say much about where the economy is going. What do you see happening to the economy if U.S. central bankers really are looking at just one half of the picture?
Rosenberg: The things that the Fed actually has control over are either in the process of disinflating or actually deflating. The areas that are most closely tied to the economic cycle are starting to see a deceleration in price momentum. These are areas that are very closely tied to shifts in spending.
The index of leading indicators is down six months in a row. When you’re down six months in a row on the official leading economic indicators, historically, the odds of a recession are not 80% or 90%; they are 100%.
But the leading economic indicators are not what the Fed is focused on. If I was operating monetary policy, I would choose to drive by looking through the front window as opposed to the rear-view mirror. This Fed is focused on the rear-view mirror.
The impact from the Fed hasn’t been felt yet in the economy. That’ll be next year’s story. This Fed is consumed with elevated inflation and very concerned that it’s going to feed into a wage-price spiral even though that hasn’t happened yet. They are telling you in their forecasts that they are willing to push the economy into recession in order to slay the inflation dragon.
So a recession is a sure thing. What I know about recessions is they destroy inflation and they trigger bear markets in equities and residential real estate. You get the asset deflation ahead of the consumer disinflation, which is going to happen next.
It’s not complicated. Jay Powell compares himself to Paul Volcker and not any other central banker. Volcker also had to deal with supply-side inflation and did so by crushing demand and creating conditions for back-to-back recessions and a three-year bear market in equities. What else does anybody need to know? Powell was getting compared to [former Fed Chair] Arthur Burns. Nobody in central banking wants to be compared to Arthur Burns. This is the reality.
MarketWatch: It’s puzzling that the Fed would choose the narrow path you’re describing. What do you think caused this?
Rosenberg: Powell told us in March that the Fed was going to be operating irrespective of what’s happening on the supply side of the economy. They’re really only focused on the demand side. The risk is that they’re going to overdo it.
I know what the Fed is thinking. I just don’t agree with them. Ben Bernanke thought the subprime problems were going to stay contained. Alan Greenspan thought at the beginning of 2001 that we were just in an inventory recession.
Look at what happened. In August 2021 at Jackson Hole, Powell sounded like the nation’s social worker. He came to the rigorous defense of not just transitory but secular inflation. In March 2022, he went from Bambi to Godzilla. Enough was enough. The lingering impact of Covid, Omicron, the China shutdown, the war in Ukraine, frustration with the labor force making its way back. I get all that. But in a very quick manner they changed what appeared to me to be an effective structural view.
It’s basically a policy of damn the torpedoes, full steam ahead. They’re quite prepared to push the economy into a recession. Whether it’s mild or not, who knows. But they are focused on getting demand down. They’re focused on getting asset prices down. Because the holy grail is to as quickly as possible get inflation down to 2%. The longer inflation readings are elevated, the greater the chances they’re going to feed into wages and that we’re going to recreate the conditions that happened in the 1970s. That isn’t my primary concern. But that is their primary concern.
“ In a recessionary bear market, historically 83.5% of the previous bull market gets reversed. ”
MarketWatch: Financial markets already have convulsed. Walk us through the next 12 months. How much more pain should investors expect?
Rosenberg: First, make a differentiation between a soft-landing and a hard-landing bear market. In a soft-landing bear market, you reverse 40% of the previous bull market. If you believe we’re going to avert a recession, then the lows have already been put in for the S&P 500.
In a recessionary bear market, historically 83.5% of the previous bull market gets reversed. Because you don’t just get multiple contraction. You get multiple contraction that collides with an earnings recession. On top of that we have to layer on a recession trough multiple of 12. We’re not at 12. Then layer on top of that, what is the recession hit to earnings, which typically is down 20%. The analysts haven’t even started touching their numbers for next year. And that’s how you get to 2,700.
This is the retracement from the insane, more than doubling in the stock market in less than two years — 80% of which was related to what the Fed was doing and not because anybody was smart or we had a massive earnings cycle. It’s because the Fed cut rates to zero and doubled the size of its balance sheet.
Now that movie is running in reverse. But let’s not focus so much on the S&P 500’s level; let’s talk about when will the market bottom? What are the conditions when the market bottoms? The market bottoms historically 70% of the way into the recession and 70% into the Fed easing cycle. The Fed’s not easing. The Fed is tightening into an inverted yield curve. The yield curve right now is very abnormal. Why would anybody think we’re going to have a normal stock market with an abnormally shaped yield curve?
The question is, what’s the timing of when the risk-reward is going to be there to start dipping into the risk pool? This time next year I expect we’re going to be there, which will cause me to be more bullish on 2024, which I think will be a great year. But not now.
MarketWatch: It’s likely the Fed will pause the rate hikes. But a pause is not a pivot. How should investors respond to announcements that look like changes in policy?
Rosenberg: I think the Fed is going to pause in the first quarter of 2023, and the markets will rally off that, but it will be a knee-jerk rally that you want to be very wary of. The problem is that the recession takes over and you get earnings downgrades. And the market will rally on the first rate cut, and that’ll be a sucker’s rally because the market will only achieve the fundamental low once the Fed has cut rates enough to steepen the yield curve into a positive shape. That takes a lot of work. That’s why normally the low is not close to the first Fed rate cut. It takes place closer to the last Fed rate cut.
The Fed started cutting rates in September of 2007 and the market topped that day. Did you want to buy that rally? The lows didn’t occur until March 2009, close to the last Fed rate cut. If you’re playing probabilities and respecting the risk-reward tradeoff, you will not be sucked into the vortex of the pause and the pivot but wait for the Fed to steepen the yield curve. That, to me, is the most important signal for when you want to go long in stocks for the next cycle, not for a trade.
“ The housing price bubble is bigger today than it was in 2007. ”
MarketWatch: You’re no stranger to controversial, outlier market calls. This time it’s a 30% plunge in U.S. home prices. What in your analysis brings you to that conclusion?
Rosenberg: The housing price bubble is bigger today than it was in 2007. It takes more than eight years of income to buy a single-family home today, about double the historical norm. If you take a look at home prices to rent, income and CPI, we are basically beyond a two-standard deviation event. We’ve taken out the peak ratios of 2006-2007.
These ratios mean-revert. The stock market is giving us a very important clue because the stock market and the housing market have over a 90% correlation because they share two very important characteristics. They’re the longest-duration assets in the economy and they are very interest-sensitive.
In the last cycle in the late 2000s it was the housing market first, the equity market second. This time it’s the equity market first, the housing market second. Only now with a lag are we starting to see home prices deflate. The extent of the bubble means that mean-reverting these ratios, we’re talking about declines in real estate prices of 30%.
MarketWatch: This really is the end of an era of easy money and even easier investment gains. Yet it didn’t have to end so abruptly. What’s the Fed’s responsibility for this turn of events?
Rosenberg: What can we say about this version of the Fed? Let’s take a look at what they did. They opened up their balance sheet to the capital structure of zombie companies to save the system back in the winter of 2020.
You could argue, well, the markets weren’t functioning and we were in lockdown and thought it was the Black Plague. But even after we knew it wasn’t the Black Plague, we got loaded with all this fiscal stimulus and the Fed kept easing policy. They were still buying RMBS [residential mortgage-backed securities] earlier this year in the face of a massive house price bubble. How could they continue to expand their balance sheet?
“ This version of the Fed took the punch bowl away at 4 a.m. when everybody was pissed drunk. ”
Look at the behavior of the investor base. The meme stocks, Robinhood, crypto, the speculative stocks, companies losing money — all of them outperforming companies that actually had a business model. Then you had FOMO, TINA — the Fed always has your back.
And the Fed knew all this. But was there any moral suasion, ever any commentary from the Fed to “cool your jets”? You have the Fed telling you, we are going to inflict pain. The same central banker never said a word as they were playing the role of bartender, handing out the drinks for free for most of 2020 and all of 2021.
Now it’s payback time. They are taking the punch bowl away. The Fed’s job is to take the punch bowl away as the party gets started, but this version of the Fed took the punch bowl away at 4 a.m. when everybody was pissed drunk.
David Rosenberg
Rosenberg Research
MarketWatch: Jay Powell is making no secret of his adulation for former Fed Chair Paul Volcker, to the point that some are calling him Volcker 2.0. Powell must enjoy this, because Volcker, of course, is revered as the greatest inflation-fighter ever. But back in 1980, Volcker was not so beloved.
Rosenberg: Volcker was back-to-back recessions and three years of hell for the economy and equity investors. Ultimately the trail was blazed for a phenomenal reduction in inflation and everything bottoms out in the summer of 1982, and all Paul Volcker is remembered for is that he paved the way for 20 years of nearly uninterrupted economic expansion and a bull market in equities. Even though at the time he was reviled and hated and despised.
“ This time next year we’ll be talking about a revival and I will turn into a permabull for 2024. ”
There’s a reason why Powell is comparing himself to Volcker — short-term pain for long-term gain. The short-term pain under Volcker was three years and I think that’s what we’re in for. They are moving to crush inflation and turning a blind eye to the supply side, focusing on demand. They’re going to make sure inflation gets crushed. That is going to happen. Then we’ll go through a new easing cycle. This time next year we’ll be talking about a revival and I will turn into a permabull for 2024.
Read: Paul Volcker didn’t wait for inflation to get back to 2% before pivoting
MarketWatch: With all of these investing and economic challenges, which investments are most attractive to you in the coming year?
Rosenberg: I’m very bullish on bonds. I could be accused of being wrong, and a lot of that is because the bond market has been forced to reset itself to this new Fed policy. But I’m very encouraged by the fact that market-based inflation expectations have been extremely well-contained. That’s a nice setup for the future of a big rally in Treasurys
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All we need is for the Fed to cease and desist, which I think they will next year. We’ll get the pause, the pivot and the easing. We’ll have the recession and bond yields will come down significantly. I wouldn’t be surprised if they come down 200 basis points from where they are now. I think that at the long end of the Treasury curve, investors will likely get a total return of more than 20% over the next 12 months. I don’t think the stock market is going to do that for you.
Two important things to recognize: First is that the stock market desperately needs lower bond yields to put in a bottom. The bottom in the S&P 500 will not happen in advance of the rally in Treasurys. At the stock market lows, the equity-risk premium has generally widened 450 basis points. We need lower bond yields to give the stock market the relative valuation support that it always gets at the fundamental low. Bond yields have to come down first; equities will follow. So we have to reestablish a more appropriate equity-risk premium to pave the way for the next bull market.
Second, historically, the first asset class that enters the bear market is the first to exit the bear market. The first asset class to enter this bear market was the Treasury market, followed by equities and then commodities. So bonds will be the first asset class to buy. We all desperately want the stock market to bottom, but it’s not going to happen without the bond market rallying first.
Now that you get paid to be in cash, it’s no longer trash. Also there are segments of the corporate bond market that look very attractive. Single-B, double-B high-yield looks attractive. A lot of these bonds are trading at a discount to par. I would have a barbell of shorter-duration corporate bonds against longer-duration government bonds. If we get the recession, the low-duration bonds will do extremely well, the shorter duration not quite as well, but you have protection because of the discounts they’re trading at.
In the equity market, I’m not going to tell anybody to be zero percent equities. But you want to be a long-term investor. You want to be thinking about long-term sector changes. You want to be involved in green energy, cybersecurity, parts of the market that behave like utilities, aerospace and defense, because every country is expanding their military budget. You certainly don’t want to be exposed to cyclicals right now. Put on your big-picture hat and think about the long-term themes.
