At the end of the first half of the year, the S&P 500 closed strong with a gain of nearly 16%, which was the best six-month performance for this index in forty years! Yet the S&P 500 was not the best-performing index year-to-date. The Nasdaq Composite gained twice as much with a 32% rise. Conversely, the DJIA only advanced 3.8%, or less than a fourth of the SPX’s gain. In short, large capitalization technology stocks were at the core of the performance in the first half, while the Russell 2000 index rose 7.2% and the Invesco S&P 500 equal weight ETF (RSP – $150.01) rose less than 6%.

Still, it was a better performance than most forecasters expected, including us. And earnings also surprised. But as we pointed out recently, S&P data shows that 71.4% of companies that reported first quarter earnings had a decrease in shares outstanding from a year earlier and 18.5% reported a decrease of 4% or more in outstanding shares. This effectively boosted earnings per share, even without any overall earnings growth. Nevertheless, given the first quarter’s results, our 2023 estimate of $180 is far too bearish and we are raising our forecast to $200 and simultaneously raising our 2024 estimate from $201 to $220. See pages 5 and 12.

However, even if we use the 2023 S&P EPS estimate of $219.52, equities remain rich with a PE of 20.3 times. This is well above the long-term average PE of 15.9 times. History shows that whenever the sum of the S&P’s PE and the rate of inflation is above 23.8, or one standard deviation above normal, the market is overvalued. At present the 12-month forward PE of 20.3 times and inflation of 4% equals 24.3 and is above the normal range. The S&P trailing PE is 21.5 plus inflation, equals 25.5 and is also above the normal range. Even when the 12-month forward PE of 19.5 times is added to the inflation rate of 4% the sum is 23.5 and just at the standard deviation line. In other words, the equity market is richly valued and is therefore at risk of earnings disappointments or any negative news.  

Student Loan Moratorium

At the end of June 2023, the Supreme Court blocked President Biden’s bid to provide $430 billion of student loan forgiveness to borrowers. This was not a surprising development since the Constitution states that the “power of the purse” resides in Congress, not the Executive branch of government. And even with a string of new proposals to circumvent the Supreme Court ruling, it is very likely that the three-year moratorium of debt payment for student borrowers will come to an end in October.

A Federal Reserve Board study estimated that most student borrowers improved their credit profiles during the moratorium and savings balances increased by $80 billion dollars. However, 44 million Americans will have to start paying back student loans in less than three months, with payments ranging from $210 to $320 per month. This will be a burden for many households and most economists expect that the resumption of student loan payments will generate a loss of roughly $70 billion in annual personal spending. While $70 billion may be a small number relative to nominal GDP of $26.5 trillion, it will be a major headwind for retail sales and some consumer-driven companies.

According to the Federal Reserve Bank of NY, total household debt increased $148 billion to $17.05 trillion in the first quarter of 2023. Mortgage balances climbed by $121 billion and were $12.04 trillion at the end of March. Auto loan and student loan balances also increased to $1.56 trillion and $1.60 trillion, respectively.

Credit card balances were $986 billion at the end of the quarter and flat on a quarter-over-quarter basis. However, while credit card balances did not increase much in the last three reported months, they grew 17% YOY. This was the largest increase in the 20-year history of the Fed’s data. And the fact that credit card debt did not increase in the first quarter of 2023 suggests that many consumers may have reached or may be reaching their credit limits. If true, this could be a concern for the economy, particularly since many of these same borrowers will soon need to restart paying their student loans. In sum, the start of the fourth quarter could bring about some surprising weakness in consumer spending.

We looked further into the Fed’s data to see how important student loans are to households and the economy in general. At $1.6 trillion, student loans are the second largest category of household debt and even though student loan borrowing grew the least of all debt categories in the last four quarters, it represents 9.4% of total household borrowing. However, sluggish growth and low default rates may be due to the moratorium, and we expect delinquencies and defaults will surge once the moratorium ends in October. Moreover, according to NY Fed data, student debt is not just concentrated in the 20-year-old to 30-year-old segment of the population; in fact, it is spread across all age categories and 23% of student loan debt is held by those 50 years of age or older. Keep in mind that at the same time debt payments will begin, the Fed is expected to be increasing interest rates. All in all, this will make the fourth quarter a very interesting time for the economy and the stock market.

Technicals: good and bad

The good news is that our 25-day up/down volume oscillator is at 3.78 reading as of July 3, 2023 which is the first overbought reading since April 28. It is important to see if this indicator can remain in overbought territory for a minimum of five consecutive trading days to confirm the recent advance. There have been other one-day overbought readings on April 8 and April 24; however, none of these one-day readings were sustained and none confirmed rallies in the averages. In general, this pattern reveals a lack of convincing volume in advancing stocks and the oscillator remains in neutral territory.

More importantly, NYSE volume was below the 10-day average for many days during the advance; conversely, the highest volume days in the last four weeks have taken place on May 31, 2023 when the DJIA lost 134 points, June 16 when the DJIA lost 109 points and on June 23, when the DJIA lost 219 points. These high volume down days suggest distribution, not accumulation, of equities. See page 7.

Last week’s AAII readings saw a 1.0% decline in bullishness to 41.9% and a 0.3% decline in bearishness to 27.5%. But it was also the fourth consecutive week of above average bullishness and below average bearishness. The last time this same combination was seen was October-November of 2021 when it persisted for five consecutive weeks. The market made a significant peak in January 2022. The technical patterns in the S&P 500 and the Nasdaq Composite index are bullish and explain why many strategists have now shifted to a more favorable outlook for 2023. But the DJIA is yet to break out and while it has a potentially positive pattern, it is currently ambiguous. We have put the Russell 2000 index and equal weight SPX ETF side by side on page 6 to show how similar these charts are for 2022 and 2023. Both have been in a trading range for over 12-months, and we believe this is a more accurate depiction of the equity market’s performance this year.

Gail Dudack

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According to Morningstar, US exchange traded funds saw a massive $40 billion weekly inflow for the week ending June 14, 2023. This was the sixth largest weekly amount on record and the flows, particularly into equity ETFs, appear to represent a significant shift in investor sentiment.

Meanwhile, according to the Wall Street Journal, bullish bets on artificial intelligence have been booming this month with more than 1.3 million call contracts on chip makers Nvidia Corp. (NVDA – $418.76), Intel Corp. (INTC – $34.10), and Advanced Micro Devices, Inc. (AMD – $110.39), changing hands on an average day. This burst of activity puts June on track for setting a record that would surpass the trading peak seen in November 2021. Keep in mind that November 2021 is quite memorable since the Nasdaq Composite index reached its all-time high of 16,057.44 on November 19, 2021.

And lastly, another example of extreme volume and extreme prices was seen in CBOE Global Markets data, where there has been record activity linked to S&P 500 index options, with one-day trading in calls surging and pushing up the prices of call options to extreme levels.

Couple this excitement with the $1.44 trillion sitting in retail money market funds (as of June 5), and one can see there is plenty of dry tinder on hand to move prices even higher. Market commentators on CNBC are suggesting it is “FOMO” – the fear of missing out – that is driving the surge in AI related stocks, some of which, like Nvidia have tripled in price in the last six months.

As I listen to analysts on CNBC talk about how artificial intelligence and ChatGPT will change technology as we know it, inspire trillions of dollars of investment and innovation, and disrupt companies that do not adapt, I cannot help but remember the excitement seen in similar times, like the Nifty Fifty era or the rally that led to the dot-com bubble of 2000. There is no doubt that there will be money invested and to be made in artificial intelligence; however, picking the right stocks at the right time will be crucial. Right now, it seems like patience and caution should be advised in view of the three-fold move seen in one of the best-positioned AI-related stocks – Nvidia.

Technicals

From a technical perspective, there are other signs of caution. The AAII sentiment survey has had three consecutive weeks of above average bullishness coupled with three weeks of below average bearishness. The last time this combination appeared, it lasted five weeks in October-November of 2021. This is another worrisome parallel to the November 2021 top in the Nasdaq Composite index. These parallels to the Nasdaq Composite are important since it is only a small number of technology stocks that are currently leading the June advance. News headlines are focusing on the 14% year-to-date gain in the S&P 500 index, but the Nasdaq Composite index has gained 29.5% to date, or more than double the S&P’s gain. Meanwhile, the Russell 2000 index has recorded a 5% year-to-date gain and the Dow Jones Industrial Average is up a mere 2.4%. It has not been a broad-based advance. However, if there is downside risk in the equity market today, we believe it is also concentrated in the Nasdaq stocks.

The 10-day new high and 10-day new low indicator is bullish averaging 193 new highs and 52 new lows. But our 25-day up/down volume oscillator remains neutral and reveals a lack of convincing volume in advancing stocks. More importantly, NYSE volume was below the 10-day average for many days during the early June advance and the highest volume days in the last four weeks have taken place on May 31, 2023 when the DJIA lost 134 points, June 16 when the DJIA lost 109 points and on June 23, when the DJIA lost 219 points. These high volume down days suggest distribution, not accumulation, of equities. See page 12 and 13.

Last week’s decline in the indices is barely perceptible in the charts of the SPX and IXIC, just like the June rally is not significant in the charts of the DJIA and RUT. The unweighted S&P 500 ETF is similar to the RUT and has been rangebound. See page 11. The Russelll 2000 index remains our main focus and it suggests the market remains in a long-term trading range.

Valuation

If we deconstruct the drivers of the 2023 equity market, we find that gains are due to a combination of earnings expectations and multiple expansion. A chart of IBES Refinitiv and S&P Dow Jones quarterly earnings expectations for the next seven quarters shows that analysts are anticipating solid straight-line EPS growth through to the end of 2024. See page 8. Unfortunately, PE multiples are currently above the standard deviation range, a sign that stocks are not cheap. And ironically, the 12-month forward PE is higher than the 12-month trailing PE, due to the deceleration in earnings growth seen in the first quarter. That is rare, and it is a pattern that often appears before an earnings decline. Moreover, if we look at the historic relationship between nominal GDP and S&P operating earnings, we find that earnings are, and have been, well above trend since early 2021. These outsized earnings gains could be due to margin improvements or post-pandemic stimulus; however, history suggests that this excess-earnings trend is not sustainable over time. See page 9. In sum, EPS expectations are robust, PE multiples are high, and EPS are rising faster than the underlying economy. It is a treacherous combination.

Economy

May’s inflation data produced good news, particularly headline CPI which fell 0.9% to 4% YOY. Yet, prices for food, housing, recreation, and services continue to rise faster than headline CPI. What helped May’s inflation data was a decline of nearly 12% year-over-year in energy prices. Still, inflation trends are generally decelerating, even for owners’ equivalent rent. See page 3. Although most of the deceleration in inflation is due to the dramatic decline in the price of crude oil — which was the initial catalyst for surging inflation in 2021 — the residual problem is now service sector inflation. Service inflation is driven by wage inflation, not energy prices. Unfortunately, the tightness in the labor market may make it difficult to reverse this trend quickly. See page 4.

Retail sales rose 1.6% YOY in May led by restaurants, drug stores, and nonstore retailers. But based on 1982 dollars, total retail and food services sales fell 2.4% YOY, the sixth negative month in the last seven. Typically, when real retail sales have been negative for more than a month or two it has been a sign of an economic recession. It might be different this time, but other data also suggest a recession is on the horizon.

The Conference Board leading economic indicators index declined again in May marking 14 straight months of declines. This is the first time the LEI has been down for 12 consecutive months or more without an economic recession being in place. In addition, the inversion in the yield curve is the greatest of any seen in over 42 years, and it too has historically predicted both economic recessions and bear markets. In our view, the missing ingredient for an all-out recession is negative year-over-year growth in jobs. A healthy post-pandemic labor market is sustaining the US economy. See page 5.

Consumer confidence surprised favorably in June. The Conference Board Consumer Confidence Index gained from an upwardly revised 102.5 in May to 109.7 in June — its highest level since January 2022. The outlook for business and the labor market improved in June. The University of Michigan survey was up from its May low, but it remains below January’s level and is stuck at a recessionary level. Similarly, May housing data included tentative signs that the decline in the residential housing sector could be bottoming. Nonetheless, assuming interest rates will move higher in the months ahead, it could be a tentative bottoming process, at best. We remain cautious.

Gail Dudack

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A Hostile Pause

The Federal Reserve is likely to pause at this week’s FOMC monetary meeting for a number of reasons, but none greater than the fact that this is precisely what the market has discounted and is expecting on June 14. To date, the Fed has been successful in molding sentiment for a rate hike well in advance of each meeting and therefore it has not shocked investors with its actions. This is done quite adeptly through presentations and speeches made by various Board Governors in the weeks preceding each FOMC meeting. However, while sentiment is currently looking for a pause, we do not think Chairman Powell is convinced that rate hikes are over. We believe he is being honest when he says that future policy will be driven by future data.

Right now, it is difficult to predict how weak or how strong future data and the economy will be in the second half of the year. As we pointed out last week, there were a number of weaknesses in May’s jobs report that were hidden by a strong headline number. Plus, no one can predict what will happen in October when the moratorium on student loans ends and 40 million borrowers will begin repayment for the first time in over three years. This will be an unprecedented event. What is certain is that it will dampen consumer spending.

Yet as the FOMC meets this week, a major discussion is likely to center on the impact of the debt ceiling resolution on the second half of this year. How the debt markets will respond to what is expected to be the issuance of more than $1 trillion in Treasury bills will be another unknown. This massive debt issuance is a double-edged sword since the increase in supply is expected to result in rates moving higher. And with so much of America’s debt on the short end of the curve, interest payments will also rise, increasing America’s overall debt load. This circular problem of higher rates and more debt issuance may not become a problem in the near term but barring a change in the trend of US debt and US interest rates, it will become a significant problem in the intermediate-to-long-term.

Nevertheless, investors have been celebrating the expectation that the Fed will pause in June and may or may not raise rates again in July. There is a growing consensus that a July rate hike is one and done, or that rate hikes are already done. But keep in mind that this has been what has been fueling the June rally. Recent equity gains are due to a shift in sentiment and not a result of good earnings. Yes, the first quarter’s earnings reports did generally beat expectations, but only because those expectations were already beaten down dramatically. What really matters is whether earnings are growing on a year-over-year basis. According to Refinitiv’s “This Week in Earnings” report, the first quarter earnings results are expected to show a rise of 0.03% on a year-over-year basis, and if the energy sector is excluded, earnings are expected to fall 1.7% YOY. According to S&P Dow Jones consensus data, which uses GAAP accounting, first quarter earnings are expected to rise 6% year-over-year, but from a much lower 2022 base. S&P Dow Jones data shows S&P 500 earnings per share fell 5.4% YOY in calendar 2022; whereas, Refinitiv had earnings rising 4.8% YOY in calendar 2022.

Equity prices have not been rising due to expectations of a stronger economy. According to data from the Mortgage Bankers Association, housing has become unaffordable for most Americans. In April the industry group’s Purchase Applications Payment Index rose to a record high of 172.3. Similarly, a recent report from the National Association of Realtors and Realtor.com states that over 75% of homes on the market are too expensive for middle-class buyers. In sum, a combination of inflation and rising interest rates is having a very negative impact on most households.

There has been some good news recently. The Fed’s balance sheet is contracting again following the liquidity boost in March done to offset the banking crisis. Although reserves are still $50 billion above the low level seen in early March, there is a sense that the banking crisis has eased. Meanwhile, a key liquidity benchmark – the 6-month rate of change in total reserves at the Fed – continues to be negative, indicating that the Fed is generally draining reserves from the system. This could become meaningful in coming months. While an increase in the Fed’s reserves tends to coincide with bull markets, the draining of reserves has been less predictive for the equity market; however, it tends to coincide with flat trends. See page 3.

Money supply (M2) continues to contract at a record pace as bank deposits and other liquid deposits leave the banking system in search of higher-yielding substitutes. This is not surprising, but it does hinder banks that need to borrow on the short end of the interest rate curve and loan at the higher end. It points to the fact that credit will be tighter in the months ahead. See page 4. And since the Fed has raised the fed funds rate nine times in the last twelve months, higher interest rates also impact borrowers. It is notable that the real fed funds rate is now positive for the first time since October 2019. See page 5.

If you wonder why there is a big debate among economists about whether a recession is at hand, or not, the charts on page 6 may help. It might be different this time, but history suggests a recession is on the horizon when we look at historical parallels. The current inversion in the yield curve is the greatest seen in over 42 years, and inversions have historically preceded economic recessions. Economic recessions produce bear markets in equities. The inversion of the yield curve may come early, but an inversion of this depth and length has predicted a recession in every case since 1954. We are of the view that history is a good guideline for defining risks in the equity market despite the fact that market sentiment is now tilting toward a mild recession or no recession. The one indicator that does not (yet) point to a recession is the year-over-year change in employment. That remains positive.

The acceptance of the current advance in stocks has been swift and dramatic and this is worrisome to us. Last week’s AAII sentiment survey resulted in a 15.4% surge in bullishness, now at 44.5%, and a 12.5% fall in bearishness, now at 24.3%. Investor bearishness is currently at its lowest level since November 11, 2021. Bullishness is now above average for the first time since February 2023 and at its highest level since November 11, 2021. Note that November 11, 2021 was less than two months prior to the major top in equities seen in January 2022. The Bull/Bear 8-week Spread remains in positive territory, but barely. See page 11.

Several technical indicators have improved this week including the 10-day averages of new highs, now at 172, and new lows, now at 60. This combination has turned positive with new highs above the 100 benchmark. But our 25-day up down volume oscillator remains neutral at 1.26 and is actually down from last week’s high. More importantly, the NYSE volume has been below the 10-day average for the last nine consecutive trading sessions and has not been impressive. The last high-volume day took place on May 31, 2023 when the DJIA lost 134 points. In sum, we would not chase this rally, particularly the large cap technology stocks that have been in the lead. If it is true that the real catalyst for the advance is the expectation that the Fed will pause in June, the wisest thing may be to follow the Wall Street adage “sell on the news.”

Gail Dudack

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Regional Banks

Last week’s passage of a bi-partisan debt ceiling bill extended the worrisome debt ceiling debate to January 2025. This bill resolved a major crisis that could have triggered a default on US obligations and crushed the US dollar and economy. However, the aftermath of this bill could result in different unintended circumstances. And while some investors may be celebrating these consequences, we believe the short-term positives may not outweigh the longer-term problems.

The balance in the Treasury General Account dropped from $140 billion in mid-May to under $23.4 billion last week and the lifting of the debt ceiling means the Treasury can and must refill its coffers in the coming months. Analysts at Deutsche Bank have estimated that a whopping $1.3 trillion in Treasury bills will be issued over the remainder of 2023, bringing total issuance for the full year to about $1.6 trillion. This massive issuance of Treasury bills will almost certainly drain liquidity from the financial system and could also steepen the yield curve.

The problem with this is that a further rise in short-term interest rates and a further steepening in the yield curve will make the environment even more difficult for the banking system and for the regional banks in particular. Banks borrow on the short end of the yield curve and lend on the long end and a steep yield curve is not a profitable situation. Regional banks are already suffering from a serious exodus of deposits as account holders seek higher-yielding investments found in the Treasury market and/or money market funds. And as deposits continue to leave the financial sector, credit conditions will continue to tighten, and this will slow economic activity.

Adding to the pressure on the banking sector is the fact that regulators are currently planning to increase capital requirements for all banks with $100 billion in assets or more (down from $250 billion in assets) and this could mandate increases in capital cushions for some banks by as much as 20%. Again, this would add another burden on regional banks.

Last, but far from least is the potential for a crisis in commercial real estate and the ramifications on the commercial real estate debt market. According to the Wall Street Journal, in the next three years an estimated $1.5 trillion in commercial mortgage loans will come due. Data provider Trepp indicates that interest-only loans as a percentage of newly issued commercial mortgage-backed securities have represented 65% or more over the last ten years but this increased to 88% in 2021. And while borrowers typically pay off these mortgages by selling real estate or getting a new loan, falling real estate prices, and rising interest rates make neither of these options attractive in the current environment.

Given all these pressures on the real estate and financial markets, we find it curious that regional bank stocks have rallied in recent trading sessions. However, it may be that investors have viewed this from a short-term perspective and have concluded that the Federal Reserve is unlikely to raise interest rates next week. Given the fact that the Treasury market will already be dealing with a significant increase in supply in the month of June and is faced with an unknown amount of demand, this may prove to be true. In fact, it is questionable whether the Fed can continue with its quantitative tightening policy in the face of record debt issuance. Therefore, we are less convinced that the Fed will raise rates in June. But while the Fed may choose to pause next week, this is not great news, and it does not make us bullish. 

Labor Markets

The BLS establishment survey indicated an increase of 339,000 jobs in the month of May, which was stronger than expected. However, the accompanying household survey suggested that employment fell by 310,000 jobs and that unemployment grew by 440,000. This discrepancy explains the increase in the unemployment rate from 3.4% to 3.7% for the month, but it also raises questions about the real strength of the job market. Job trends are important since one of the best leading indicators of a pending recession is a year-over-year decline in jobs. From this perspective, neither BLS survey suggests the economy is on the verge of a recession. See page 5. And the household survey showed other cracks in the data. Permanent job losers as a percentage of all unemployed was 26% in May, up from 21% in October. Of job losers and those completing temporary work, 36% were permanently laid off in May. The number of workers no longer counted in the labor force, but who indicated they want a job, increased from 5% to 6%; while discouraged workers increased 93,000 in the last 2 months to 396,000 in May. See page 6. Overall, the headline 339,000 job increase with upward adjustments to previous months was just not what it seemed. There were signs of weakness beneath the surface.

The Stock Market

Tesla Inc. (TSLA – $221.31), Alphabet Inc. C (GOOG – $127.91), Amazon.com (AMZN – $126.61), Apple Inc. (AAPL – $179.21), Meta Platforms, Inc. (META -$271.12), Microsoft Corp. (MSFT – $333.68), Netflix Inc. (NFLX – 399.29) and Nvidia Corp. (NVDA – $386.54) , represented about 22% of the S&P 500’s market capitalization at the start of the year, and now account for more than 30%. These stocks have been investor favorites this year which helps to explain why the equally weighted version of the S&P 500 (.WEGSPC – $5842.49) is up just 1.1% this year, the DJIA is up 1.3%, and the Russell 2000 index is up 5%, while the SPX is up 11.6% and the Nasdaq Composite has gained nearly 27% YTD. The recent rally clearly generated breakouts in the SPX and the Nasdaq Composite but is not visible in either the DJIA or the Russell 2000. See page 11. And despite the drama of a 701-point gain in the DJIA on June 2, 2023, there was no meaningful change in our 25-day volume oscillator or the NYSE cumulative advance/decline line in recent days. Moreover, the 701-point move materialized with NYSE volume that was below the 10-day average and volume continues to trend below its 10-day average. See pages 12-13. These are not impressive breadth statistics. We remember the Nifty Fifty and Dot-com eras, so we know narrow markets can be sustained longer than many expect. But we are not chasing this rally and believe the broad market will remain in a wide trading best seen in the Russell 2000 between 1650 and 2000.

S&P Earnings As the first quarter earnings season ends, the S&P Dow Jones consensus estimates for 2023 and 2024 were $218.69 and $244.70, up $0.77, and $1.03 for the week, respectively. Refinitiv IBES earnings estimates for 2023 and 2024 were $220.89 and $246.70, up $1.54, and $1.63, respectively. But note that last week’s big increases effectively erased the declines seen in estimates over the prior three weeks. We did not see any major earnings release to account for this big change and therefore believe it is due primarily to positive forward guidance. However, it is also important to note that S&P data shows that 18.4% of companies reporting first quarter earnings had a decrease of 4% or more in their shares outstanding. This decline in shares outstanding boosts earnings per share but does not represent a significant change in overall earnings growth. In sum, earnings are not all that it seems. See page 9.

Gail Dudack

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