Here’s why understanding de-risking is key as the Fed readies another rate hike and earnings loom

Published Wed, Sep 21 202210:52 AM EDTUpdated Wed, Sep 21 202212:01 PM EDT

De-risked — that's the term every investor needs to be familiar with right now as we await the interest rate hike expected from the Federal Reserve after its two-day September meeting Wednesday afternoon. And then, it's on to what's next as we gear up for earnings season shortly thereafter. The concept of being de-risked starts from the premise that while the market may be under pressure, the negatives have already been thoroughly factored into stocks. As a result, when news like a rate increase breaks, the market reaction won't be too severe because most of the price action has already taken place. Similar terms might include priced-in or managed expectations. Ultimately, it means that the odds of a negative surprise have been reduced materially because that's already the consensus expectation. This week, the question of whether stocks as a whole — especially the more cyclical ones and those in the tech sector — have been adequately de-risked will hinge largely on Fed commentary. It's pretty much a lock at this point that the Fed will further raise rates by 75 basis points, which would be the third meeting in a row of a hike of that size. There's a slight chance of going as high as 100 basis points. Stock prices already plummeted earlier this month following consumer price index data showing higher-than-expected inflation. Now, we are looking to see whether the major stock market benchmarks have de-risked a hawkish outlook from Fed Chairman Jerome Powell, commentary that signals the continuation of aggressive rate hikes going forward. Unfortunately, we don't think that to be the case. Rather, following the expected rate rise Wednesday, we think the market expects Powell to message a slowdown in future hikes in order to better assess the impact of the prior increases on economic activity. Put another way, this hike has been de-risked but additional aggressive rate increases in the near term likely have not. The market wants to understand at what terminal rate the Fed will hold. As Jim Cramer detailed on Sunday , the issue is whether or not Powell is incorporating the non-macroeconomic updates we received in recent weeks. On the macro front, we know CPI came in hot — and that demands action at this week's meeting. But remember, there is a lag effect — sometimes as much as 18 months— between Fed policy adjustments and their impact being seen in the economy. To get ahead of this, central bankers may try to guide for future rate hikes so that the market knows what's coming. Earlier this month Craig Jelinek, CEO of Club holding Costco (COST), told CNBC's Jim Cramer that he expects inflation to start to fall in "maybe another six months to a year." Arguably, we are just now seeing the impact of commentary and policy actions taken at the beginning of the year — including FedEx 's (FDX) warning, in a CEO interview with Jim, of a global recession, Nucor (NUE) issuing a profit warning, the normalization of consumer balance sheets, signs of a housing market slowdown and continued volatility in commodities markets. Is Powell factoring both the microeconomic and macroeconomic updates into his thinking? Of course, we aren't arguing that Powell needs to consider updates from every individual company. But when industry bellwethers like FedEx and Nucor preannounce, it speaks to more than just single company issues, providing insights into large swaths of the economy. Beyond the Fed meeting, third-quarter earnings season kicks off in less than a month, raising the question of whether or not we have de-risked both the expected reported results and forward guidance. The benefit of preannouncements is that they do help de-risk the market overall by tempering investor expectations for all companies within the blast zone — hence why the likes of Club holding Amazon (AMZN) and United Parcel Service (UPS) traded lower on FedEx's preannounced earnings miss. Nonetheless, it's still unclear whether earnings estimates for the rest of the year and 2023 have come down enough. If analysts have sufficiently de-risked their estimates, we may be in a position to put in a bottom and look forward to the recovery. However, if that is not the case, then the stocks are not as cheap as they appear because the earnings part of the price-to-earnings equation is too high. In terms of achieving guidance and expectations, most of our confidence is in health care and in companies that can raise prices. What we hear from Powell on Wednesday and from companies next month will be key to determining aggregate S & P 500 earnings estimates through 2023. Expectations for growth, along with the Treasury yields, will be key to determining the appropriate multiple to place on those estimates, which as we've discussed previously, are the two inputs required to develop a multiple-based price target. The 2-year Treasury has been pushing ever-closer to 4%, a signal of where the market expects the terminal Fed rates to go and a return that's more competitive with stocks. If the Fed goes with a 75-basis-point hike Wednesday, that would bring the target range for the central bank's key fed funds rate to 3%-3.25%. On that note, current estimates for S & P 500 earnings are roughly $222 in 2022 and $240 for 2023. Over the past 20 years, the forward multiple bottomed out at around 10.5x in late 2008 and early 2009, before revisiting that multiple in late 2011 on the back of the global economic downturn. Outside of those extremes, the S & P 500 has tended to trade more in the 15x to 18x range, which based on that $240 estimate puts us in the region of 3,600 at 15x and 4,320 at 18x – a range we have fluctuated within all year. But again, that depends on the estimate being correct and the outlook beyond 2023 being one supportive of those more normalized multiples. This year's market low was around 3,636 on the S & P 500 in mid-June, a bottom we think can hold if the Fed goes forward with the anticipated 75 basis point hike and messages that they will slow the rate of hikes in order for prior changes to flow into the economy. However, they must get this message across without sounding too dovish and causing the market to panic that they're taking their eye off the inflation ball, a fine needle to thread for sure. The S & P 500 was more than 5.5% higher than that 3,636 bottom as of Tuesday's close. But of course, where we go from here could depend on the Fed. (Jim Cramer's Charitable Trust is long COST and AMZN. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Traders react on the floor of the New York Stock Exchange (NYSE) as a screen shows Federal Reserve Board Chairman Jerome Powell during a news conference following a Fed rate announcement, in New York City, July 27, 2022.

Brendan Mcdermid | Reuters