September has a poor reputation for equity performance and for good reason. The month ranks last in terms of price performance and has generated declines in the S&P 500 index in 50 of the last 91 Septembers. It is the only month that has closed with price losses more than half the time. The historical record shows that since 1931, September produced an average loss of 1%. The average decline narrows to 0.7% in all years since 1950.

We think there are a number of reasons for this weak performance. First, September does not have the positive liquidity factors that November, December, and January have in terms of IRA funding, tax-loss selling and reinvesting. Nor is it a fiscal year end for most pension funds or mutual funds which usually provide portfolio inflows and readjustments. On the other hand, it is a time when investors look ahead to next year’s earnings, economic, and/or political forecasts and this is often murky. Stocks do not like uncertainty. This September includes a number of events that could move stock prices, such as the G20 New Delhi summit September 9-10, the FOMC meeting on September 19-20, a potential government shutdown October 1, and the impact of Saudi Arabia and Russia extending the oil cuts until year end. Given that the equity market is currently trading at an estimated 2023 PE of 20.3 times, there is little room for disappointment. We remain cautious but believe the equity market remains in a wide neutral trading range best represented by the Russell 2000 between support at 1650 and resistance at 2000.

Narrow is Not Noble

The Nasdaq’s weekly digest called Smart Investing had a table of stocks it called the “magnificent seven” that has been leading the Nasdaq Composite index and S&P 500 higher in recent months. Not surprisingly, it includes stocks such as Apple Inc. (AAPL – $189.70), Microsoft Corp. (MSFT – $333.55), Alphabet Inc. (GOOG – $136.71), Amazon.com (AMZN – $137.27), NVIDIA Corp. (NVDA – $485.48), Tesla, Inc. (TSLA – $256.49). and Meta Platforms, Inc. (META – $300.15). See page 3. From this table we see that these 7 stocks represent 40.43% of the Nasdaq Composite and 30.625.637% of the S&P 500. Apple and Microsoft represent nearly 21% of the Nasdaq Composite and nearly 14% of the S&P 500 and these two stocks have had year-to-date gains of 46% and 39%, respectively. However, it is NVIDIA, Meta Platforms, and Tesla that have been the biggest drivers of the indices with outsized year-to-date gains of 232%, 149%, and 108%, respectively.

The problem with a narrowly driven rally is that it forces portfolio managers to own these stocks in order to perform in line with the benchmark averages. In the longer run this means the market becomes more and more momentum driven and less driven by value. This can persist for a long while much like the bubble market in 1997 to 2000, but the eventual decline in the averages becomes greater the longer stock prices are based upon momentum rather than earnings.

August Payrolls

The pace of job creation came in slightly ahead of expectations at 187,000, but July’s number was revised down by 30,000 to 157,000 and June’s payrolls were lowered by 80,000 to 105,000. These are very large downside revisions, and it gives rise to questions about BLS statistics. The unemployment rate rose from 3.5% to 3.8% which materialized not just from the 514,000 newly unemployed, but also from the 736,000 increase in the civilian labor force. See page 4. We wonder if this increase in the labor force is a result of financial pressure experienced by many households and the need for an additional paycheck. We see other signs of stress in consumer finances. According to the credit agency Equifax, credit card delinquencies have hit 3.8%, while 3.6% have defaulted on their car loans. Both figures are the highest in more than 10 years.

Yet, despite the declining trend in employment growth, the establishment survey shows jobs grew 2% YOY, above the average rate of 1.69%. The household survey showed employment growth of 1.76%, also above the long-term average of 1.51%. In short, neither are at negative-growth recessionary levels.

Personal income grew 4.7% YOY in July and real personal disposable income increased 3.8% YOY. RPDI growth is down from 4.9% in June, nevertheless, it is the seventh consecutive month of real gains in income. At the same time, personal consumption expenditures grew 6.4% YOY in July, primarily from an 8.3% increase in services. Durable goods expenditures rose 4.5% YOY and nondurable spending increased 1.8% YOY. In general, the post-pandemic stimulus-driven economy appears to be fading. See page 6.

Strains in household finances can also be found in the savings rate. After hitting a peak of 26.3% in March 2021, it fell from 4.3% in June to 3.5% in July. Higher interest rates are also taking a toll on savings and spending. Personal interest payments rose 49.4% YOY in July, down from 55.3% in June, yet still increasing at a record rate. Personal interest payments were $506 billion in July after averaging $330 billion in 2018 and 2019. This is a huge jump in interest payments. See page 7.

Watching oil

The United States has stopped selling oil from its Strategic Petroleum Reserve (SPR) and has begun to buy oil in order to replenish this important reserve which is at a multi-decade low. Meanwhile, despite a rally in the oil market and analysts’ expectations of tight supply in the fourth quarter, Saudi Arabia and Russia said they would extend voluntary oil cuts to the end of the year. These two events are sparking a breakout rally in oil which could jeopardize the consensus view that inflation is trending lower. And as we already noted, the White House has called on Congress to pass a short-term “continuing resolution” to keep the government funded past Sept. 30 and to avoid the fourth shutdown in a decade. This is impacting the fixed income market. The 10-year Treasury yield bounced back up to 4.27%, closing in on the important 4.33% resistance level. See page 9.

Technical Update

The S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite, are rebounding from their 100-day moving averages and the Russell 2000 is bouncing from its 200-day moving average, but the near-term trends are indecisive. Unless, or until, all the indices exceed their all-time highs (which we doubt), the longer-term pattern remains characteristic of a long-term neutral trading range. See page 11.

The 25-day up/down volume oscillator is at a negative 1.79 reading this week, relatively unchanged from a week ago, and at the lower end of neutral. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1. However, none of these overbought readings lasted the minimum of five consecutive trading days required to confirm the advance in the averages. Strong rallies should also include at least one extremely overbought day which was also missing.

As this indicator approaches an oversold reading of minus 3.0 or less, the same will be true – five consecutive trading days in oversold would confirm the decline. See page 12. Another sign of the market’s longer-term neutral trend is found in the new high/new low list. The 10-day average of daily new highs is averaging 93 and new lows are averaging 77. This combination reverts from negative to neutral this week since both new highs and new lows are below 100.

Gail Dudack

Click to Download

US job openings in July dropped to the lowest level in nearly two and a half years and equity investors rejoiced. The news triggered a 292.69-point gain in the Dow Jones Industrial Average, carrying the index just 5.3% below its all-time high of 36,799.65 high and to a gain of 5.1% year-to-date. The JOLTS report also showed that the number of people quitting their jobs fell to the lowest level seen since early 2021, which implies jobholders feel that switching jobs has become more difficult. More importantly, the employment report for August will be released at the end of this week and it too could be a market-moving event, particularly if it confirms a below-consensus increase in jobs. However, we would be wary of being bullish about bad economic news since bad news inches the economy closer to a recession and a recession has never been good for corporate earnings or for equity prices.

We have often noted that high inflation has a debilitating impact on consumer purchasing power, corporate profit margins, and price-earnings multiples. It erodes the value of the dollar and of savings. In short, it is bad for all parts of the economy. And this is why we believe the Federal Reserve is likely to be more hawkish than dovish for all of 2023. In our opinion, the Fed understands that an inflation target of 2% will not be that easy to achieve without slowing the economy down. And while Fed Chairman Jerome Powell has danced around the question of whether a recession or no recession is part of the inflation solution, slowing inflation without a recession would be like threading a tiny needle … possible but difficult. 

History shows that whenever inflation has had a rapid rise or has been more than a standard deviation above the norm (6.5%+), like the 9% seen in June 2022, it has always been followed by a recession. A recession is most often the result of tighter monetary policy which has generally ended with a real fed funds rate of at least 400 basis points. Perhaps it will be “different this time” but that is a risky view, in our estimation. See the historical charts on page 3.

For the real fed funds rate to reach 400 basis points today, with a 3% inflation rate, means the fed funds rate would rise to 7%. We are not predicting a 7% rate, but we do believe the fed funds rate is likely to move higher in September and this would be a negative surprise to the consensus. It could also be a dampener to economic activity in the months ahead.

Is Bad News Good News?

In line with the JOLTS report, the regional Federal Reserve activity reports were a mixed bag. The Kansas City Fed Manufacturing Survey was at zero in August, but up from negative 11 in July. The Philadelphia Fed Nonmanufacturing Survey was negative 0.5 in August, down from 2.0 in July. The Richmond Fed Manufacturing Survey was negative 7.0 in August, up from negative 9.0 in July. The Chicago Fed National Activity Index was 0.12 in July, up from negative 0.33 in June. The Texas Manufacturing Outlook Survey was minus 17.2 in August, up from minus 20.0 in July. All in all, these surveys were not a recessionary package, but neither were they a sign of strength.

As interest rates rise the biggest impact may be seen in the housing and auto sectors, two areas that have been a source of strength since the pandemic. New home sales rose 4.4% in July to 714,000, an increase of 31.5% from a year earlier. The median price of a single-family home rose 4.8% in the month to $436,700, but this was down nearly 9% YOY. Home prices and sales have been relatively stable, but primarily due to a lack of inventory. The supply of existing family homes rose fractionally in July to 3.2 months, nevertheless, this is a historically low level. While low supply has been what has supported the residential market, we worry that demand may eventually fall as a result of high prices and interest rates. See page 4. Rising mortgage rates are already hurting housing affordability, which is currently at its lowest level since 1985. This is a concern since housing typically represents 15% to 18% of GDP. See page 5.

The auto industry is also hurt by higher prices and rising interest rates. The post-pandemic auto-buying surge is over, yet vehicle sales rose in July to 16.3 million units. See page 6. However, this remains well below 17-18 million units consistently seen between 2014 and 2020. Autos, along with housing, have been the most unwavering drivers of the US economy. We will be watching closely to see if higher financing rates slow auto sales.

Consumer sentiment can be a guiding indicator of the economy at both peaks and troughs, so it is worth noting that August’s deterioration in sentiment surveys follows months of steady improvement. The University of Michigan consumer sentiment index fell in August, dragged down by future expectations due in large part to rising gas prices. It was the first month-over-month decline since May for this survey. The Conference Board consumer confidence index fell from 114.0 to 106.1 in August as both present conditions and expectations fell significantly. See page 7. We had been hopeful that the improvement seen in real wages in recent months would give a boost to investor sentiment and consumption, however, we may have been too optimistic.

Important economic news will be released this week including the Fed’s favorite inflation benchmark, the personal consumption expenditure deflator. It will be released alongside personal income and real personal consumption for July. Pending home sales may give an insight into whether higher mortgage rates are taking a toll on home buyers. And the week ends on Friday with the employment report, the ISM manufacturing report, and vehicle sales for August. This should give good insight into economic activity and the health of the consumer.

Technical Indicators

The Dow Jones Industrial Average, the S&P 500 index, and the Nasdaq Composite index have all tested their 100-day moving averages and are rebounding. This is favorable. The Russell 2000 index tested its 200-day moving average and is also rebounding. We would rate these tests as tentatively positive; but even if successful, the longer-term pattern remains characteristic of a long-term neutral trading range. See page 9.

The 25-day up/down volume oscillator is at a negative 1.10 reading this week, relatively unchanged from a week ago, and at the lower end of its neutral range. This oscillator generated overbought readings in 10 of 22 trading sessions prior to August 1. However, none of these overbought readings lasted the minimum of five consecutive trading days required to confirm an advance in the averages. Strong rallies should also include at least one extremely overbought day which was also missing. However, it is also important to note that the recent rally did not generate new highs in the indices. In short, the recent rally is, to date, an advance within a larger neutral trading range. That is what this indicator has been implying for over twelve months. In our view, this trading range is a substitute for a bear market, and it is likely to persist until inflation is under control and/or earnings growth becomes more predictable and stable.

Gail Dudack

Click to Download

Fitch downgraded its credit rating for long-term US government securities from AAA to AA+ on August 1, 2023, citing an erosion of fiscal governance and rising general government deficits. Moody’s cut the ratings on 10 mid-sized lenders on August 8^th. The Fitch Ratings service warned of a downgrade on more than a dozen banks on August 15^th and S&P Global Rating downgraded five regional banks on August 21^st, focusing on lenders with commercial real estate exposure. All these rating agencies indicated that some banks face a future risk to their balance sheets due to potential bad debts in the commercial real estate area, but all banks are dealing with liquidity pressure since many portfolios are drawing interest income of 2.5% to 4.5%, while needing to pay depositors 4.5% to 5.5% in savings and money market accounts. This may seem like an isolated problem within the banking sector, but it is not. Although there is no immediate crisis in the banking sector, there are strains in the system that are likely to continue longer than some expect. More importantly, the US economy cannot do well if the banking sector is not doing well. It never has. So, in our view, with this backdrop, it is not surprising that stock prices have been in a correction in August.

Trading Ranges Defined

The last year has produced a series of issues that have chastened both optimists and pessimists. From a longer-term perspective, the last 18 months have been frustrating for both the bulls and the bears. Our long-held view is that the stock market is in a broad sideways trading range, best defined by the Russell 2000 between support at 1650 and resistance at the 2000 level. The other indices have less obvious trading ranges, although it is clear that price action has been contained by resistance at the January 2022 peaks and support at the October 2022 lows.

Long-term trading ranges are not unique in equity history, but they have not materialized in a while. Since the March 2009 low, equities have been in a relatively consistent uptrend. In short, for most of the last 14 years, stock prices have been “trending” and as result, new investors might be unfamiliar with rallies that have limited leadership and declines that lack follow through. However, trading ranges are not unusual, and in our view the current trading range is a substitute for a more dramatic bear market.

Classic bear markets are often triggered by an unexpected event that shakes investors’ confidence and this event becomes the catalyst for an unforeseen earnings decline. A dramatic bear market ensues and produces a relatively sudden but quick repricing of risk. A trading range is simply another way of repricing risk and can be a subtle substitute for a bear market.

In the current environment, a trading range is a way for earnings to catch up with prices. Earnings for the S&P 500 declined on a year-over-year basis during the second, third, and fourth quarters of last year. Earnings are now expected to grow modestly from these much-reduced levels; nevertheless, the outlook for earnings growth remains uncertain.

If we look at S&P Dow Jones operating earnings data, it shows that the four-quarter sum in earnings peaked in March 2022 at $210.16. The S&P Dow Jones consensus estimates show that four-quarter earnings could reach a new high by the end of the 2023 third-quarter earnings season, with earnings of $212.89. However, these are estimates and data shows essentially no earnings growth for most of 2022 and 2023. In sum, prices moved higher in 2023, but the fundamentals did not. The recent trading range is a way for earnings to eventually catch up with stock prices. In our view, the catalyst needed for stocks to break out of this trading range is for the Fed to successfully tame inflation and this will take more time. In the interim, we believe focusing on stocks with reliable earnings streams and reasonable PE multiples will be the best way of managing through this environment. 

FOMC September 20

One reason to believe the Federal Reserve will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 3, in previous cycles, the fed funds rate typically increased ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend, and this allowed inflation to become ingrained in the service sector. Since service sector inflation is less commodity driven and more salary driven, it is more difficult for the Fed to control. It also explains the Fed’s attention to service sector inflation. Meanwhile, it is important to note that the real fed funds rate usually reaches 400 basis points in a tightening cycle, and though the real rate has been rising, it is now only at 230 basis points. In short, we believe another rate hike is likely on September 20 and we do not believe this is discounted in stock prices.

The path of interest rates is important to the economy since it will impact both the auto industry (see page 4) and the residential housing market. The National Association of Home Builder Confidence index fell from 56 to 50 in August, which is not surprising, since the June NAR Housing Affordability index fell from 93.7 to 87.8, the lowest level since January 1984. This decline in affordability was before the Fed’s July rate hike! The June decline was attributed to a combination of median family income ratcheting down to $91,319, the median price of a single-family home rising to $416,000 and the NAR mortgage rate increasing 28 basis points to 6.79%. See page 5.

Although the housing market has been in a slump for almost two years, it is possible that housing is about to slow further as interest rates rise and remain high. This risk can be seen in the fact that both existing and new home prices have stopped increasing and in recent months have registered year-over-year declines. Also interesting is the fact that home prices and retail sales have been highly correlated over the last 60 years, and both appear to be on the cusp of a negative cycle. See page 7. Some may think that these are reasons for the Fed to pause, but underlying these risks are a tight labor market and wage growth that recently has exceeded the pace of inflation. We believe the Fed will remain higher for longer in order to be confident that inflation will reach its target of 2%. 

Technical Update

As a result of the recent weakness in the equity market, all the popular indices are currently trading below their 50-day moving averages and are about to test their 100-day moving averages. However, the Russell 2000, is about to test its 200-day moving average which is now at 1843. We would not be surprised if all these moving averages were broken in the near term since this would be typical of a long-term neutral trading range environment. See page 9. 

The 25-day up/down volume oscillator is at negative 2.05 this week, which is at the bottom of the neutral range. It is close to registering an oversold reading of negative 3.0 or less, which would neutralize the recent unsustained overbought readings. Meanwhile, the 10-day average of daily new highs is 54 and new lows are 111. This combination turned negative this week since new highs fell below 100 and new lows rose above 100. All of the above is normal for a trading range market.

Gail Dudack

Click to Download

In last week’s US Strategy Weekly (Things to Ponder; August 8, 2023), we wrote “we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.” In truth, there was not a big reaction to last week’s CPI report. See page 3. But the PPI report, which showed intermediate service sector inflation rose from June’s 4.4% YOY to 4.6% YOY, seemed to make investors anxious. And in a market priced for perfection, any unpleasant or unexpected news will make equities vulnerable.

There were a few other developments this week. Chinese economic reports for industrial production, retail sales, and property investment were weaker than expected. More importantly, the combination of this data reflected an economy that is potentially faltering. The PBOC responded by lowering key interest rates by 15 basis points. Yet the real concern is China’s real estate sector, which is estimated to represent as much as 30% of China’s GDP, and which has already weathered a string of defaults by residential property developers. This week the focus is on Country Garden Holdings Co. Ltd. (2007.HK: 0.81), a giant Chinese real estate developer that is expected to deliver nearly a million apartments in hundreds of cities throughout China. Unfortunately, Country Garden has not been paying its bills, indicated it would report a loss of as much as $7.6 billion in the first six months of the year, and in August skipped two interest payments on loans. A default is possible in September. The big concern is the exposure of China’s $3 trillion shadow banking sector to this potential real estate risk, as well as the risk to the broader Chinese economy.

Separately, Russia’s central bank raised its key interest rate from 8.5% to 12% to help stop the slide in its currency which has lost more than a third of its value since the beginning of the year. The ruble passed 101 to the US dollar earlier this week and continues to weaken due to capital outflows, big government spending on the Ukraine war, and a shrinking current account surplus as a result of Western sanctions on Russian oil and gas. Inflation reached 7.6% over the past three months, and according to Russia’s central bank, inflation is expected to keep rising, noting that the fall in the ruble is adding to the inflation risk.

Closer to home the Fitch Ratings service warned that the agency could downgrade more than a dozen banks, including some major Wall Street lenders. Fitch already lowered the score of the “operating environment” for banks to AA- from AA at the end of June – although this went largely unnoticed. And Fitch’s warning comes weeks after Moody’s cut the ratings of 10 mid-sized lenders, citing funding risks, weaker profitability, and increased risk from the commercial real estate sector.

Retail Sales

Advance estimates for July retail sales showed a month-to-month gain of 0.7% and the May and June estimates were revised from up 0.2% to up 0.3%. This acceleration in retail sales concerned investors who had been expecting a Fed pause, since economic momentum opens the door for a rate hike in September. On a seasonally adjusted basis, retail sales rose 3.2% YOY in July; on a non-seasonally adjusted basis, sales were up 2.5% YOY. However, when adjusting for inflation, real retail & food service sales, based on 1982 dollars, fell 0.1% YOY. See page 5. In other words, despite a month-to-month acceleration in sales, real YOY retail sales declined and have been negative for nine of the last 10 months. This pattern is a classic sign of an economic recession, not strength. See page 6.

Historically, a negative trend in retail sales is tied in with a decline in nominal GDP and that is true in this cycle as well. On page 7 we show a table that highlights, in red, all the months since January 1968 that have experienced below average retail sales. This table is important because a string of below average sales has always defined a recession and negative real retail sales in any year has also characterized recessions. The current string of “red” is the longest since 2008-2009, and to date, real retail sales are averaging negative 1.3% in 2023. Nonetheless, GDP continues to grow. It is uncanny. Still, we would not describe July’s retail sales report as strong.

However, one reason to believe the Fed will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 4, the fed funds rate typically increases ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend. This suggests more work needs to be done. Moreover, while the real fed funds rate has increased to 200+ basis points, it usually reaches 400 basis points in a tightening cycle.

Earnings

The second quarter earnings season is close to ending and as is usual, retail stocks are the last to report. Home Depot Inc. (HD – $332.14) beat the consensus estimate for quarterly earnings per share, and though same-store sales fell 2% YOY this was less than the expected 3.5% decline. The company announced a $15 billion share repurchase program and it reiterated its muted forecast for the year. The company noted caution on the part of consumers towards big-ticket items. Walmart Inc. (WMT – $159.18) is expected to raise its full-year earnings forecast this week when it reports quarterly results. A research report by Stifel, Nicolaus & Company estimates more people plan to shop at Walmart compared to Costco and Target, even though they expect to spend 16% less on back-to-school purchases compared to a year ago. Retail is a sector of winners and losers in this environment.

All in all, earnings season has gone better than expected and the S&P Dow Jones consensus estimates for 2023 and 2024 are currently $219.41 and $244.06, up $2.31, and $1.00, respectively. Refinitiv IBES estimates for 2023 and 2024 are $219.09 and $245.55 up $0.41, and down $0.25, respectively. What is notable is that S&P Dow Jones and Refinitiv IBES are both showing a $219 estimate for this year. These two surveys tend to diverge in the second half of the year. Nevertheless, based on this year’s earnings estimate of $219.41, equities remain overvalued with a PE of 20.2 times. The 12-month forward operating earnings PE is 19.0 times, and the December 2024 PE is 18.1 times. When we add inflation of 3.2% to these PE multiples, we get 23.2, 22.2, and 21.2. All of these sums hover just under the 23.8 range that defines an extremely overvalued equity market. This is what explains the market’s nervousness.

Technicals are Slipping

The S&P 500, Nasdaq Composite, and Russell 2000 are all trading below their 50-day moving averages, a key level for some traders. However, the RUT, a useful benchmark for the last 18 months, failed to break above the 2000 resistance level in July, implying that the recent rally was simply part of a much larger neutral trading range. See page 9. The 25-day up/down volume oscillator is at a negative 0.51 reading this week and neutral. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1, but failed to remain overbought for the minimum of five consecutive trading days required to confirm the advance. This week the 10-day average of daily new highs fell to 88 and new lows rose to 75. This combination turned positive on June 8 when new highs rose above 100 and new lows fell below 100 but it turned neutral this week with both averages now below 100. In short, upside momentum appears broken.

Gail Dudack

Click to Download

More Credit Rating Risks

Last week Fitch stunned the financial sector with its downgrade of US Treasury debt. This week Moody’s surprised investors by cutting credit ratings on 10 small- to mid-sized US banks. In addition, Moody’s put six banking giants, including Bank of New York Mellon (BK – $45.72), U.S. Bancorp (USB – $40.23), State Street Corp. (STT – $72.73) and Truist Financial Corp. (TFC – $32.41), on review for potential downgrades. Moody’s indicated there is no immediate crisis, but “banks will find it harder to make money as interest rates remain high, funding costs climb, and a recession looms. Some lenders’ exposure to commercial real estate is a concern.”

Several financial analysts suggested these warnings were unwarranted, however, rating agencies are paid to point out risks and there is no doubt that an unbridled federal debt burden is a long-term hazard, particularly as interest rates rise. For most banks an inverted yield curve combined with the potential of commercial real estate defaults are real risks that should not be ignored.

Although stocks sold off on both credit rating warnings, the pushback from some analysts and even the Biden administration are more disturbing to us than the actual agency warnings. The gains in equity prices this year have been primarily multiple expansion, not earnings gains. According to IBES Refinitiv, earnings in the last two quarters of 2022 and first quarter of this year were 4.4%, negative 3.2%, and 0.1%, respectively, and estimates for calendar 2023 show an S&P 500 earnings growth rate of a measly 1.2%. According to S&P Dow Jones, the last three quarters of 2022 had year-over-year declines in earnings, and though a modest rebound in growth is forecasted for coming quarters, it is coming from a diminished earnings base. Perhaps this lack of earnings power is why investors are flocking into generative AI stocks and looking far into the future for earnings growth. But after massive price gains, these stocks now have extremely high PE multiples and even fans feel the stocks are richly valued.

Things to Ponder

There are three things that we often wonder about although they are not part of our official forecast. The first is a risk that the stock market is on the verge of a bona fide bubble. This thought emanates from the excitement surrounding generative AI, estimates that the AI market will grow to $126.5 billion by 2031, and the massive runup that these stocks have had. AI has created a two-tiered market with the Nasdaq Composite up 33% year-to-date while the DJIA is up only 6.5%. This divergent price action is very reminiscent of the Nifty Fifty era that led to the January 11, 1973 peak and the Dot-com bubble era that ended on January 14, 2000. We have also thought about the fact that there were 27 years between those two market bubble peaks, and we are now 23 years past the 2000 peak. Since bubbles tend to be generational, we are in the right time frame to be on the lookout for a bubble. And the pattern we see of analysts ignoring fundamentals only adds to this worry.

Second, is the fact that bullishness is now consensus and the bears on Wall Street have been converted. Many sentiment indicators, particularly the AAII sentiment indices, are showing extremes last seen between February and May of 2021. The stock market did not peak until January of 2022; however, this is how sentiment indicators work. Sentiment are not timing indicators, rather they tend to be early warnings systems and only point out that risks are rising. See page 13.

Our last consideration is COVID, and the global pandemic it sparked. COVID resulted in an unprecedented manmade global recession in 2020 produced by many government leaders who decided to shut down their economies. It was not a normal economic recession. The subsequent recovery was also unusual, manmade, and manufactured with monetary and fiscal stimulus. This fiscal stimulus continues to drive many segments of the US economy to this day. History is often an excellent guide for economists and equity strategists, but there is no rule book for what has transpired over the last three years. Therefore, perhaps the typical signals of a recession such as an inverted yield curve, the 15-month decline in the Conference Board’s Leading Economic Index (the longest streak of decreases since 2007-2008), and the 7 months of negative real retail sales, are not applicable today. This seems strange to us. Nonetheless, the years of monetary and fiscal stimulus have kept the US economy afloat and it also provides the liquidity that could set off a stock market bubble. Thus, we ponder and worry. However, we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.

Household Debt: the Good and the Bad

Total household debt rose by $16 billion in the three months ended in June and increased $909 billion in the prior 12 months. In short, household debt rose 5.6% YOY in June versus the 7.6% YOY increase seen in March. Of the $909 billion increase, $627 billion (or 69%) was in mortgages and $144 billion (or 16%) was in credit card debt. Credit card debt grew 16.2% YOY in June exceeding $1 trillion for the first time. As a result, credit card debt now represents 6.0% of total debt versus 5.5% a year earlier. See page 4.

A broader look at household debt shows that debt grew fairly rapidly in 2021 and 2022 but grew at a slower pace in 2023. A large part of the increase in household debt occurred in the under-40 age group and was likely linked with a period of significant increases in new credit card accounts. Note that the 2021-2022 period overlaps with the moratorium on student loan payments and a healthy trend in personal consumption. While the number of credit card accounts grew, the number of outstanding auto loans, mortgages and HELOC loans remained fairly stable in the same period. See page 5.

The good news in household debt data is that delinquencies have not had much of an increase from the low recorded last year. However, there are two big changes on the horizon. First is the massive increase in financing rates seen for revolving credit lines over the last year. This will make credit card debt less viable for many households. Second, the end of the moratorium on student loan payments which begins in October will also reduce liquidity for some households, particularly for middle class borrowers. See page 6.

Fundamentals The current S&P 500 trailing PE multiple is 21.5 times and above all historical averages; in short, the market is priced for perfection. The forward PE is 19.3 times, and when added to inflation of 3%, sums to 22.3, which is just below the standard deviation line of 23.8 denoting an overvalued equity market. In sum, earnings growth is pivotal to the market’s intermediate and longer-term trends. See page 8.

Gail Dudack

Click to Download