Tonight is the first presidential debate between Vice President Kamala Harris and former President Donald Trump, and with any luck there will be another debate before the election. But either way, this debate has the potential of being a significant and market-moving event. Hopefully, the discussion will focus on foreign and economic policies and give voters clarity on the vision each has for dealing with budget deficits, burgeoning sovereign debt, immigration, crime, social issues, and America’s role in the conflicts seen in Europe and the Middle East. But few presidential debates are remembered for policy. Most debates are remembered for those special “gotcha” moments and since both candidates have the potential to create such moments, we expect the presidential debate could be entertaining, but also challenging and decisive for both candidates.

The debate comes at an interesting and uneasy time. There is a potential hurricane threatening the Gulf Coast of the US, yet the WTI future (CLc1 – $66.25) is breaking below key support in the $68-70 level. This may be due to weakening demand from China and a growing bearish sentiment in commodity markets, but it is ominous. In line with this, the 46 basis point decline in the 10-year Treasury bond yield since the end of August is a big drop in a short period of time and it suggests a global flight to safety. In response to these declines in energy prices and long-term interest rates we are making a shift in our sector weightings and lowering the energy sector from neutral to underweight and raising utilities from underweight to neutral. See pages 14 and 20.

Technology leaders continue to be under pressure with Apple Inc. (AAPL – $220.11) ordered by the European Commission to pay 13 billion euros in back taxes to Ireland. This news follows a less-than-exciting iPhone 16 release earlier in the week. The European court also threw out Alphabet Inc. A Google unit’s (GOOGL.O – $148.66) appeal against a 2.42 billion euro fine as it cracks down on Google’s anti-competitive practices in Europe. And later this week the Bureau of Labor Statistics will report the CPI, PPI, and import/export price indices for August. These reports may not prove to be as important as the debate, but they do set the stage for the long-awaited September FOMC meeting at which we expect the Fed will cut rates by 25 basis points.

In our view, the Fed’s first rate cut may be a negative for equities based on the classic “sell on the news” mentality of Wall Street. Moreover, a US rate cut could result in more unwinding of the yen carry trade if it weakens the dollar relative to the yen. If so, it would be the mirror image of the yen strengthening after the Bank of Japan raised interest rates to 0.25% on July 31, 2024, the highest level since 2008. In short, be prepared for more volatility in September.

Meanwhile, the employment report for August reflected weakness. Total nonfarm payrolls increased by a seasonally adjusted 142,000 jobs, greater than the three-month average but below the 12-month average of 197,000. Revisions to employment in June and July showed job growth was 86,000 lower than previously reported. The job gains seen in August occurred primarily in construction, up 34,000, and healthcare, up 31,000. The participation rate was unchanged at 62.7 in August. See page 3. There has been a large disparity between the two employment surveys — establishment and household — over the last twelve months. And as we show on page 4, the household survey shows a decline of 64,000 jobs since August 2023, whereas the establishment survey indicates job growth of 2.4 million. See page 4. Some of this disparity will be resolved with the benchmark revision expected early next year; but in our view, the monthly jobs number has been overstated for much of 2024. See definitions of the two surveys on page 5.

The unemployment rate for August fell from 4.3% to 4.2%, but that is not the real story. Workers with less than a high school diploma saw their unemployment rate rise from 6.7% to 7.1%, nearly three times the 2.5% rate for those with a bachelor’s degree or higher. However, the number of unemployed workers this represents is 667,000 with less than a high school diploma versus 1.64 million with a bachelor’s degree. Nevertheless, it displays the story of the haves and have-nots in this economy and why consumer sentiment readings have been so weak. See page 6.

August’s gain of 142,000 jobs was a big improvement from a month earlier, but the 1.5% YOY gain in jobs that this represents is below the long-term average of 1.69% YOY and below average for the third consecutive month. The 3-month moving average of job growth also fell from 141,000 to 116,330. The employment-population ratio was 60.0 for the second month in a row, which is down from 60.4 a year earlier. We believe the retirement of the Baby Boomer generation has been and will continue to be the driver of a long-term decline in this ratio. See page 7. The number of multiple job holders was 8.2 million in August down from 8.4 million in July, but not much lower than the record 8.7 million seen in December 2023. All these monthly readings were well above the long-term average of 7.5 million people. Multiple job holders materialize for many reasons, but most often due to financial stress. This is likely due to the increase in inflation seen in the last three years and the financial hardship this poses to many households. See page 8.

Average hourly earnings for production and non-supervisory workers were $30.27 in August, up 4.1% YOY, and up 1.1% YOY after inflation. Hourly wages have been consistently growing above the rate of inflation since March 2023 which is a positive; however, average weekly earnings were $1020.10 in August, up 3.75% YOY, and up only 0.8% YOY after inflation. Wages have edged out inflation by a mere 0.7% per month since May 2023. This is because average weekly hours were 33.7 in August, down from an average 33.8 hours in 2023 and below the average of 34.0 hours in 2022. See page 9.

BLS data on foreign and native-born employment shows that foreign-born employment has risen from 16.2% of total employment in June 2020 to 19.6% in August. In the 12 months ended in August, foreign-born employment increased by 1.24 million while native-born employment fell by 1.3 million. Since the end of 2019, foreign-born employment grew by 4.4 million and native-born employment declined nearly 1.6 million. For definitions of native and foreign-born, see page 10.

The latest reading for the ISM nonmanufacturing index was 51.5, ratcheting up from 51.4 in July, and still above this survey’s neutral threshold of 49. However, five of the nine underlying indices fell in the month, the weakest being backlogs which dropped from 50.6 to 43.7. The previously reported ISM manufacturing index also rose in August, but to a still-low level of 47.2, and with seven of its ten components well below the 50 benchmark. More importantly, the longer-term trends in both indices are decelerating. See page 11. With a preliminary reading of Tuesday’s market activity, our 25-day up/down volume oscillator is at 3.0 and right at the border of an overbought reading. With many of the indices at or near all-time highs, it is important for this indicator to confirm the advance with an overbought reading lasting at least 5 consecutive days. If the rally which began in October actually was a new bull market advance, it should also include several extreme overbought readings of 5.0 or better, which are typical of the first stage of a major advance. To date, both have been absent, indicating a lack of persistent buying pressure. See page 16.

Gail Dudack

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This is an interesting point in time since we are only one week away from the potentially pivotal presidential debate between Vice President Kamala Harris and former President Donald J. Trump. It is only two weeks away from the Federal Reserve’s September FOMC meeting which is widely expected to produce at least a 25 basis point cut in the fed funds rate. And it is merely two months away from the presidential election which, despite the conclusions of several political polls, seems impossible to predict. Nevertheless, the outcome of the presidential and Congressional elections could produce quite different consequences in terms of America’s role in the global political and economic arenas and its domestic economic and fiscal health. Therefore, we are not surprised that equities sold off this week. Markets can handle good news or bad news, but it has never dealt well with uncertainty.

Seasonality also shows that September tends to be the worst-performing month of the year, and we think this may have something to do with the fact that analysts shift their focus from this year’s earnings to next year’s earnings during this time frame. Although this may not be an issue in 2024 since analysts have already shifted their sights from 2024, to 2025 and 2026 earnings! One study shows that equity performance in September and October has often been a forecaster of presidential elections. See page 10. Still, early September news items have not been helpful to the market’s seasonality funk.

Technology stocks have been under pressure due to legal problems that have been compounding all year. The Department of Justice recently sent a subpoena to NVIDIA Corp. (NVDA – $108.00), along with other companies, as it deepens its enquiry into antitrust practices in the chip industry. The DOJ began this investigation after receiving complaints from competitors that NVDA abused its market dominance. Moreover, last week the company indicated it received requests for information from regulators in the US, EU, UK, China, and South Korea, regarding its investments, partnerships, and agreements with other companies.

And NVDA is not the only AI company under a microscope. An early August court ruling concluded that Google violated antitrust law by creating an illegal monopoly and spending billions of dollars to become the world’s default search engine. This federal ruling now paves the way for a possible breakup of Google’s parent Alphabet Inc. C (GOOG.O – $158.61) which could change the landscape for online advertising, an area Google has dominated for many years. The Department of Justice also sued Apple Inc. (AAPL – $222.77) back in March, accusing the company of using a monopoly in the smartphone market to block competition, inflate prices for consumers and stifle competition. Last year the Federal Trade Commission (FTC) and 17 states sued Amazon.com, Inc. (AMZN – $176.25), accusing it of protecting a monopoly by squeezing sellers on its marketplace and favoring its own services. The FTC. argued that these practices also harmed consumers and resulted in “artificially higher prices.” A judge in the US District Court for the Western District of Washington has set the trial for October 2026. In short, a rally based upon the belief that artificial intelligence will produce a boom in earnings for a variety of companies, is now finding itself mired in legal red tape.

It should also be noted that two of the biggest benefactors of the AI movement, Nvidia and Salesforce Inc. (CRM – $248.06), reported excellent earnings for the second quarter, but in both cases, it also became clear that the pace of earnings growth is slowing. For all these reasons, it is no surprise that a shift in leadership materialized in recent days — away from technology and toward defensive stocks. This shift is what drove the Dow Jones Industrial Average and the NYSE advance/decline line to new highs at the end of August. See pages 11 and 13.

The main event this week will be the Friday jobs report, and it will be the last read on employment before the Fed meeting. But recent economic releases have been mixed, at best. The National Association of Realtors’ pending home sales index for July was 70.2, the lowest reading since the pandemic low of 70.0 in April 2020. And since this indicator only began in 2018, it was the second lowest reading in history. The housing sector typically represents 15-17% of total US GDP and is an important segment of the US economy. A recent string of housing data suggests this segment of the economy is slowing significantly. The big question is whether or not lower interest rates will revive the housing market. See page 3.

The ISM manufacturing index rose to 47.2 in August from 46.8 in July but has been stuck in “contraction” territory below 50 for 21 of the last 22 months. Note that readings below 50 are typically associated with recessionary periods. The details of the report were mixed with 8 of 11 components below 50 and 4 of 11 components falling in August. New orders and production indexes fell while the employment index improved to 46.0, albeit from a very low 43.4. The ISM service index will be reported later this week, and it dropped below the pivotal 50 benchmark in two of the last four months. See page 4.

The PCE deflator was the focal point of last week’s economic releases. In July, the headline and core PCE price indices were in line with consensus expectations and remained unchanged at 2.5% YOY and 2.6% YOY, respectively. However, both indices were fractionally higher in July on a year-over-year basis but after rounding to one decimal, remained equal to June’s readings. The PCE price index that excludes food, energy, and housing rose to 2.1% YOY versus 2.0% YOY in June. The housing index was 5.3% YOY versus 5.4% in June. The services index was 3.7% YOY versus 3.8% YOY in June. The healthcare index fell from 2.8% YOY to 2.4% YOY. The PCE price indices for durable goods were negative on a year-over-year basis for the 14^th consecutive month. See page 5.

Second quarter GDP was upwardly revised from 2.8% (SAAR) to 3.0%, which was more than double the 1.4% recorded in the first quarter. The second quarter’s pace was not far from the long-term average of 3.2%. Some of this strength was due to inventories, which had been a drag on growth in the first quarter but were additive to the second quarter. Consumption was the main source of strength in the second quarter, but government spending also increased. Fixed residential investment was slightly negative in the second quarter. This makes the low reading in pending home sales more worrisome, since it suggests that the third quarter began on an even weaker note. See page 6. The second revision of GDP also includes corporate profits. GDP corporate profits, before taxes and adjustments, rose a healthy 11.7% YOY after being up 10.2% in the first quarter. After taxes and with inventory valuation and capital consumption adjustments, profits rose 6.6% YOY, which followed a 5.3% gain in the first quarter. However, second quarter profits were negative in 2023 making this year’s comparisons relatively easy. Nonetheless, these results are in line with S&P 500 operating earnings which rose 5.4% YOY in the same quarter. It is reassuring that GDP and S&P corporate profits are moving in unison since disparities between the two series are often a warning sign for the S&P 500. See page 7. Nevertheless, despite the market’s selloff, the S&P trailing 4-quarter operating multiple is 24.2 times, and well above all long- and short-term averages. The 12-month forward PE multiple is 20.7 times and when added to inflation of 2.9%, sums to 23.6, which is at the top of the normal range of 23.8, this week. By all measures, the equity market remains richly valued. See page 8.

Gail Dudack

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Russia’s President Putin warns the US it is risking World War Three on its own shores by helping Ukraine. An Israeli hostage is rescued in a Gazan tunnel. US Special Counsel Jack Smith issues a revised federal indictment for election subversion against former President Donald J. Trump. A ratings cut on a New York City office tower marks the first significant loss on a AAA-rated bond since 2008. These are all newsworthy headlines; however, they fade into the background this week because investors are focused on NVIDIA Corp.’s (NVDA – $128.30) earnings report, expected after the close on Wednesday. The expectations for NVDA, the world’s dominant artificial intelligence chipmaker, are high and analysts say the company needs to report revenue of $30.5 billion or more to generate an upside surprise. The current estimate is for revenues of $28.7 billion and the company typically beats revenue estimates by more than 6%.

Meanwhile, traders in the equity options market are expecting NVDA’s earnings report to spark more than a $300 billion swing in the company’s shares. According to data from analytics firm Options Research & Technology Services (ORATS), current options pricing shows traders are predicting a price move of nearly 10% the day after NVDA reports earnings. That’s larger than the stock’s average post-earnings move of 8.1% over the last three years. The stock is up 159% year-to-date, has a market capitalization of $3.16 trillion, a trailing 12-month PE ratio of 75 times, a forward PE ratio of 37 times, announced earnings per share of $1.30 ($1.19 reported) for fiscal January 2024 and is forecasted to earn $2.75 per share ($2.58 reported) in fiscal January 2025. Rarely does one stock become so big and so important for the stock market. However, Nvidia has been not only the benchmark for chips, but the benchmark for everything related to artificial intelligence and has been at the core of the euphoria around AI’s potential for earnings growth. Unfortunately, the history of the stock market shows that dominance of any one company can only last for a certain period of time before expectations exceed possible outcomes. Either way, this week’s action should be revealing.  

Nvidia’s earnings are not the only focus of the week because Friday will include data on personal income, personal consumption expenditures, and the all-important PCE deflator. In June, the PCE price index rose 0.3% month-over-month and 2.5% year-over-year. Investors will be looking for something better than that in July to help support a Fed rate cut in September.

Employment Revisions

Last week the Bureau of Labor Statistics announced preliminary estimates for the upcoming annual benchmark revision to the establishment survey series. The final revision will be issued in February 2025 with the publication of the January 2025 employment report. This revision rarely receives much attention since the annual benchmark adjustments over the last 10 years have averaged plus or minus one-tenth of one percent of total nonfarm employment. However, this year the preliminary estimate shows an adjustment to total nonfarm employment as of March 2024 to be lower than previously reported by 818,000 jobs, or by -0.5%. This is obviously five-times the normal adjustment, the largest since the 2009 recession, and has given rise to controversy over the data. It is a positive for the Fed, since it denotes a weaker job market than previously reported, but it removes a positive cited by the Biden-Harris administration that has boasted of strong job creation. In our view, it puts the establishment survey in line with the household survey which has been showing weak job growth all of 2024. See page 3.

The Housing Sector

The National Association of Realtor’s pending home sales index for July will be reported this week and economists will be watching to see if June’s bounce from May’s post-pandemic low of 70.9 was a one-off blip or the start of a better trend. The housing sector is a very important segment of the US economy since it typically and consistently represents 15-17% of total US GDP. See page 4.

However, housing faces an uphill battle. During the Covid-19 pandemic when people were restricted to their homes and travel was similarly constrained, families reassessed their living conditions and their ability to travel. The demand for homes and autos rose dramatically and so did prices. But the combination of rising prices and higher interest rates has made housing and autos increasingly unaffordable for many households. Assuming that no more than 30% of gross household income goes toward housing costs, the required income for a median-priced home is $119,461 while the median household income is $83,758. In short, a massive affordability gap has opened up and buying an average home is out of reach for the majority of Americans. See page 5.

But July housing data showed some improvement. For the month of July, existing home sales were 3.95 million units, up from 3.9 million units in June, although down 2.5% YOY. Note that existing home sales have been negative on a year-over-year basis since the pandemic peak of August 2021. New home sales were 739,000 in July, up from 668,000 in June, and up 5.6% YOY. In both cases, July’s uptick in sales reversed the steadily declining trend seen for most of 2024. See page 6.

The median price for an existing single-family home was $428,500 in July, up 4.2% YOY, but down from June’s all-time high of $432,900. The median price of a new single-family home was $429,800, down 1.4% YOY and down 7% from the October 2022 peak of $460,300, but up 3% from June. It is possible that a decline in mortgage rates lent support to the housing market in late July and in August, but August data will be needed to confirm this trend. See page 7.

The Conference Board’s consumer confidence index inched up from an upwardly revised 101.9 (previously 100.3) in July to 103.3 in August. This index has been in a narrow range of 95.3 to 115.2 since August 2021 and is currently in line with its long-term average. However, expectations, at 82.5, held above 80 for the second consecutive month, which is an improvement. This follows the University of Michigan sentiment index which also displayed an uptick in expectations in August, led by Democrats encouraged by the Kamala Harris nomination. See page 9.

Technical Update

The 25-day up/down volume oscillator is 2.19, in neutral territory, but up from a week ago. More importantly, a 91% up day on August 23 neutralized the 90% down day from August 5. But with many indices at all-time highs, it will be important for this indicator to confirm with an overbought reading of at least five consecutive days. If the rally which began in October actually was the beginning of a new bull market advance, it should also include several extreme overbought readings of 5.0 or better, which are typical of the first stage of a major advance. To date, this has been absent and represents a lack of persistent buying pressure. The last stretch of five or more days in overbought territory took place between December 13, 2023 and January 5, 2024. See page 12. Nevertheless, the positives in the technical area are seen in the 10-day average of daily new highs at 396 with lows averaging 36, and a new high in the NYSE advance/decline line on August 27, 2024.

Gail Dudack

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Stocks bounced back quickly from a steep early August sell-off that was triggered by recession fears and the first rate hike by the Bank of Japan in 17 years. However, it was actually driven by a massive unwinding of the yen carry trade. This was followed by eight days of consecutive gains which were the longest winning streaks for the S&P 500 and the Nasdaq since November and December, respectively. And if the S&P 500 index had closed higher for one more day, the 9-day winning streak would have been the longest in 20 years. The streak was broken, nevertheless, it was the best week of the year for stocks. We would not be surprised if these gains prove difficult to sustain, particularly as representatives from central banks around the globe are expected to converge in Jackson Hole, Wyoming, this week for their annual Economic Symposium. Traders will be laser-focused on Federal Reserve Chair Jerome Powell who is expected to deliver remarks on Friday. Markets are currently pricing in a 69.5% likelihood of a 25 basis-point reduction of the Fed funds target rate at the conclusion of the Federal Open Market Committee meeting on September 17 and 18, with a 30.5% chance of a super-sized cut of 50 basis points, according to CME’s FedWatch tool. In our view, the markets have been discounting a Fed rate cut all year and the actual event may prove to be less than satisfying for investors.

Economic News

There were a number of economic releases in recent days and in summary, the results display a mixed economy with the exception of housing, which is clearly in a slump.

The University of Michigan consumer sentiment index was at 67.8 in August, up from July’s 66.4, and up for the first time in five months. Present conditions dropped to 60.9 from 62.7, its lowest reading in twenty months. But expectations were the driver of the overall index rising to 72.1, up from 68.8. The gain in expectations had an interesting twist and was led by a 6% uptick from Democrats in an apparent response to the Harris nomination. The expectations index for Republicans fell 5% and rose 3% for Independents. The survey showed that expectations for inflation remained the same and the job market, the housing environment, and political uncertainty continued to weigh on sentiment. See page 3. Conference Board confidence data for August will be released at the end of the month.

Investors were relieved that headline CPI rose the expected 0.1% in July versus a month earlier. On a year-over-year basis CPI fell 0.08% and, on a decimal-rounding basis, fell from 3.0% YOY in June to 2.9% YOY. Core CPI fell from 3.3% YOY to 3.2% YOY. Service sector inflation fell from 5.0% YOY to 4.9%. Services less rent of shelter fell from 4.8% YOY to 4.6%. Transportation services fell from 9.4% YOY to 8.8%. Hospital & related services fell from 7.1% YOY to 6.2%. In short, service inflation is trending lower but almost all segments remain substantially above 3% YOY. See page 4.

Retail sales were surprisingly buoyant in July, rising 1.0% for the month and up 2.7% YOY. This news helped to spark the equity market’s rebound, particularly since June’s report showed a 0.2% decline for the month and a lower 2.0% YOY gain. Excluding autos, year-over-year retail sales were up in July, but lower than a month earlier. Excluding autos, sales rose 3.1% (3.3% YOY in June) and excluding autos and gas sales increased 3.4% (3.6% in June). The strongest gain was seen in electronics and appliances where sales rose 5.2% YOY after being up only 1.0% YOY in June. Still, after inflation, retail sales fell 0.3% YOY in July following a 0.9% YOY loss in June. Retail sales have been negative on a YOY basis for 19 of the last 29 months, a pattern typically seen only during recessions. See page 5.

Consumer credit is an area we are monitoring. Total consumer credit rose 1.6% YOY in June and nonrevolving credit rose a mere 0.3% YOY. These decelerating growth rates in credit are critical because negative growth is a characteristic of a recession. And note that after adjusting for inflation, total consumer credit growth has been negative for the last 13 months. See page 6.

The National Association of Home Builders confidence indices deteriorated in August from negatively revised numbers in July. The headline NAHB index fell from 41 to 39, the lowest reading this year, and down to recessionary levels. Current sales of single-family homes fell from 46 to 44. Next six-month sales rose a notch from 48 to 49, but traffic of prospective buyers fell from 27 to 25, its lowest level in 8 months. Construction data was not any better. In July, housing starts fell 6.8 % MOM and 16.0% YOY. Permits fell 4.0% MOM and 7.0% YOY. Single-family permits were slightly better, falling 1.6% YOY. See page 7. By most measures, the housing sector is slowing significantly, and it will be interesting to see if August’s decline in long-term interest rates buoys this market. See page 7.

Valuation

With stock prices backing up near record highs, and consensus earnings forecasts for this year and next year ratcheting lower, valuation benchmarks are getting worse. The SPX trailing 4-quarter operating multiple is now 24.8 times, and well above all long- and short-term averages. The 12-month forward PE multiple is 21.2 times and when this is added to inflation of 2.9%, it sums to 24.1 which is above the top of the normal valuation range of 14.8 to 23.8. By all measures, the equity market remains richly valued. Current valuation levels have only been seen during the 1997-2000 bubble, the financial crisis of 2008, or the post-COVID-19 earnings slump. See pages 8 and 9.

Technical Update

The VIX index is a good measure of panic in the marketplace and is therefore helpful in defining lows. But as we pointed out last week, the extremes seen on August 5^th were not the third highest in history or that unusual. Since 1986, there have been 286 higher closes in the VIX and 47 higher intraday highs. We dug deeper to see if days with both higher intraday and closing highs were important in defining significant price lows. What we found was there were 9 days of more extreme readings than August 5^th between October 19, 1987 and October 29, 1987 and the market troughed on December 13, 1987. In 2008, there were 26 nonconsecutive days between October 10, 2008 and December 5, 2008, plus 132 consecutive trading days with higher closing VIX prices. The SPX had an interim trough of 752.44 on November 20, 2008 but eventually troughed at 676.53 on March 9, 2009. In 2020, 12 nonconsecutive extreme days between March 12, 2020 and March 30, 2020 did include a low made on March 23, 2020. Overall, the peak levels in the VIX index on August 5^th appear to be neither historic nor predictive. Moreover, extremes in the index usually last substantially longer and precede major lows by several days and/or months. See page 10. The equity indices have made a remarkable recovery from their early August lows and the Dow Jones Industrial Average and the S&P 500 index are now challenging their all-time highs. However, the easy part of the rebound is over, in our view, and we expect the old highs to be resistance due to the unlikelihood that the carry trade will be reinstated, the fact that earnings season is nearly over, and that the market has already factored in a rate cut in September. A new catalyst for further gains may be needed to drive prices higher.

Gail Dudack

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Many market commentators are stating that the unwinding of the yen carry trade on August 5^th was not an economic event, did not signal a recession, and is now in the rearview mirror. This would be nice, but it may be wishful thinking.

The August 5^th selloff may not have signaled a recession, and we also characterized it as a liquidity event, but the carry trade unwinding was still significant for many reasons. First, it was triggered by the first rate hike by the Bank of Japan in 17 years and this sparked a sharp reversal in the yen. Both of these represent economic shifts in the global economy, and they are apt to have longer-term implications. Second, the intensity of the decline was the result of leverage that was no longer viable given the shift in interest rates and the yen. This leverage was what helped drive financial securities higher in the past twelve months and this excess “demand” is unlikely to return in the near future. If we are right, without a new bullish catalyst, it may be difficult for equity indices to exceed their 2024 peaks this year.

There has been a lot of focus on the VIX index since the August 5^th sell-off and many well-known strategists are calling the 65 intra-day peak in the index “the third highest in history.” The VIX hitting this “extreme” reading is a reason some believe August 5^th was a major bottom. In truth, the index was created in 1993 (based on the S&P 100 index) and revised in 2003 (based on the S&P 500 index), but the CBOE provides data that goes back to 1986. This historical data is important because it allows us to look at the October 1987 crash as a benchmark for volatility. August 5^th generated a nice jump in the index, but it was far from the third highest in history on either an intra-day or on a closing price basis (even without using the 1987 data!) See page 3. This appears to be another example of wishful thinking by bullish analysts. Moreover, what the history of the VIX index does show is that after a sharp jump in the index, it usually takes time for price volatility to subside.

One concern we have is that when deleveraging like what took place on August 5 occurs, there can be losses in some portfolios that, in time, could prove to be unmanageable. For example, when Russia defaulted on its debt in August 1998, the losses suffered by Long-Term Capital Management, a highly leveraged fixed income hedge fund founded by a former Solomon Brothers bond trader and a Nobel-prize winning economist, led to a government-sponsored bailout in September 1998. LTCM’s struggle was not widely known for weeks. The fact that the equity market has recovered much of its recent losses is comforting. Recent losses may have moderated, but they may also be temporary.

In retrospect, a number of extremes appeared in the first half of the year that were troubling. According to a recent S&P Global article, the representation of mega-cap companies in the S&P 500 reached a multi-decade high in March when the cumulative weight of the five largest companies in the S&P 500 hit 25.3%. This level has not been seen since December 1970, a 54-year record.

Additionally, data from the Office of Financial Research (OFR), a department within the Treasury Department, shows hedge funds also touched extremes at the end of the first quarter. Assets of qualifying hedge funds totaled $4.12 trillion as of March, of which the largest were “other” with $1.24 trillion, equity with $1.16 trillion, and multi-strategy funds with $702 billion. The overall borrowing relative to assets (net asset-weighted average ratio) was 1.2 for this universe of funds. See page 4.

Leverage is an important part of the equity market, particularly in a bubble market. And since hedge funds are major users of leverage this OFR data is useful. It shows that macro hedge funds ($172 billion in assets) were the most highly leveraged in March with a net asset-weighted average ratio of 6.5, a record for that category. Relative value funds followed with a ratio of 6.2 and multi-strategy ranked third with a ratio of 4.0 (also a record for that category). Equally important is the pace of borrowing. Net borrowing increased 54% YOY for relative value funds, 34% YOY for multi-strategy funds, and 28% YOY for macro funds. In terms of borrowing, $2.3 trillion was done through prime brokerage, $2.1 through repo borrowing, and $556 billion through other secured borrowing. Although this data is only quarterly and is reported with a delay, it does show that leverage was increasing substantially in the first quarter of this year. See page 5.

In terms of liquidity, the Fed’s balance sheet was $7.23 trillion as of August 7, down nearly $1.8 trillion from its April 2022 peak, and down almost $33 billion from a month earlier. But this has not significantly impacted individual investors since demand deposits, retail money market funds, or small-denomination time deposits all grew slightly in the same period. These accounts, plus “other liquid deposits” sum to $18.6 trillion that currently sit in bank deposits. See page 6. In short, the Fed’s careful quantitative tightening is not changing consumer cash balances, and this is positive for equities. Lowering interest rates, if it takes place in September, would improve investors’ liquidity even more.

The NFIB small business optimism index rose 2.2 points in July, to 93.7, the highest readings since February 2022, or in 2 ½ years. However, this was still the 31^st month below the long-term average of 98. Fewer small businesses indicated that they planned to increase wages in July and 25% noted that inflation is their single most important problem. However, there was an increase in the number of businesses planning to increase inventories and this could help third quarter GDP. See page 7.

Producer price data for July showed final demand inflation was rising only 0.1% month-over-month and 2.2% YOY. This was down from the 2.7% YOY seen in June and received well by the market. However, beneath the surface, we noted that final demand for trade services fell 0.7% YOY, and this calmed prices for the month. Trade indexes measure changes in margins received by wholesalers and retailers. However, final demand services, less trade, transportation, and warehousing, showed prices rising a much more worrisome 4.1% YOY. See page 8.

Technical Update

Last week’s sharp sell-off resulted in the Nasdaq Composite and the Russell 2000 index successfully testing their 200-day moving averages on an intra-day basis. The S&P 500 and Dow Jones Industrial Average are trading well above their 200-day moving averages. But for confirmation, we are watching Microsoft Corp. (MSFT-$414.01) and Amazon.com, Inc. (AMZN-$170.23) which broke below their respective 200-day moving averages last week and are now struggling to stay just above those long-term benchmarks. See page 11.

The 25-day up/down volume oscillator is 2.02, in neutral territory, but recovering, after absorbing a 92% down day on August 5. This followed 90% down days seen on April 12, 2024, February 13, 2024, and December 20, 2023. A 90% up day would suggest the worst of the decline is over; however, the last 90% up day was recorded way back on December 13, 2023. This oscillator failed to reach an overbought reading on the last rally and therefore did not confirm the advance. To date, an uptrend in this oscillator off the 2022 low, remains intact and lends a bullish bias to an otherwise neutral position in this index. Should this trend line be broken it would be a warning sign for the longer-term stock market. See page 12.
Gail Dudack

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In previous reports we have written about the risk of the 2024 market being an equity bubble — though not an extended one — and that bubble markets are always difficult to quantify since they are driven by a combination of liquidity, leverage, and greed, not fundamentals. Leverage was concentrated in brokerage margin accounts in the late 1990s and this made the leverage driving the 2000 peak easier to measure. Today leverage is widely dispersed, and investors use a variety of tools to multiply their buying power. Some of this is displayed by the historic asset and volume levels in options, futures, ETFs, and a variety of debt instruments.

The Carry Trade

Tight monetary policy and rising interest rates work against equity bubbles, which may explain why US investors have been riveted on when the Federal Reserve would begin to lower interest rates. But this narrow focus on the Fed may be why last week’s rate hike by the Bank of Japan came as a surprise. The BOJ’s first rate increase in 17 years pricked the global financial bubble by triggering a sharp rise in the yen and squeezing the yen carry trade. Yen-funded trades have been used to finance the acquisition of stocks for years and the amount of money in the carry trade is unknown. But since it is based upon a weak-to-stable currency and zero-to-low interest rates, the yen’s surge and the BOJ’s rate hike suddenly made this source of funding less viable.

Clearly, the events of the last few trading sessions and the unwinding of the carry trade is a liquidity event and not an economic issue. But the sizeable losses in equity markets imply there are many accounts still under water and the reverberations are apt to take days or weeks to understand. In the meantime, we remain cautious.

One way to measure risk after a liquidity event is to monitor market data, in particular, daily volume levels and 90% up and/or down days. Not surprisingly, August 5^th was a 92% down day in the US market on volume that was nearly 30% above the 10-day average. It would not be unusual if there were more 90% down days in the weeks ahead. However, once a 90% up day appears on better-than-average volume, it is a sign that downside risk has been minimized. In short, while the chorus is singing “buy the dip” we would caution that a safer bet is to wait for a 90% up day. This is not a guarantee that the lows have been made, but historically it has shown that the downside risk is minimal.

The Larger Backdrop

However, the unwinding of the carry trade is not taking place in a vacuum. It is second quarter earnings season and in the long run, earnings will be more important for stock prices than the carry trade. But results for the quarter have been mixed. Disappointing results were reported by McDonald’s Corp. (MCD – $270.06) and Microsoft Corp. (MSFT – $399.61), while Meta Platforms, Inc. (META – $494.09) beat expectations. News such as Nvidia Corp.’s (NVDA – $104.25) delivery delay for its new Blackwell chip, Warren Buffett selling half of his stake in Apple Inc. (AAPL – $207.23), a recent Federal judge ruling that Google (Alphabet Inc. GOOG – $160.54) is a monopoly, Amazon.com, Inc. (AMZN – $161.93) lowering forecasts for earnings and revenue, all weigh heavily on the big tech sector and these stocks have been at the core of the stock market’s advance in the last year.

And despite the large declines in the popular averages, the stock market remains richly valued. Based upon the LSEG IBES earnings estimate for calendar 2024, equities are trading at a PE of 21.5 times. When added to inflation of 3.0%, this sum of 24.5 is above the 23.8 level that defines an overvalued equity market. Based on next year’s 2025 estimate the PE falls to 18.7 times and the sum equals 21.7 which is at the high end of the neutral range. However, 2025 estimates may be high, particularly if the economy slows. See pages 10 and 11.

Economic Review

July’s employment report showing 114,000 new jobs and a 4.3% unemployment rate was not that weak, in our view. The 3-month average actually rose from 167,670 to 169,670 because April’s payrolls added a mere 108,000 jobs. What may have made investors nervous about July’s data is that the birth/death adjustment was a positive 246,000 which means the unadjusted not-seasonally-adjusted payrolls were negative 132,000 jobs in July. However, this was not the first month of negative payrolls before the birth/death adjustment. It also occurred two times in 2023 as well as in April and May of this year. See page 5. Investors reacted badly to the jobs report because they were already worried about earnings.

The unemployment rate rose from 4.05% to 4.25%, however, the average long-term rate is much higher at 5.7%. The unemployment rate for women rose from 4.3% to 4.5% while for men, the rate much lower, rising from 4.1% to 4.2%. Unemployment by level of education was more disparate. Those with less than a high school education saw unemployment jump from 5.3% to 6.5% in July. This is a worry. A high school degree but no college saw an increase from 4.1% to 4.7%. Those with some college rose from 3.5% to 3.8% and a bachelor’s degree or higher rate edged up from 2.6% to 2.7%. See page 6.

What concerns us is the year-over-year growth rate in employment in the household survey which has been below 1% YOY all year and fell from 0.12% YOY in June to 0.04% YOY in July. This month, the year-over-year growth rate in the establishment survey slipped to 1.6%, the second month in a row below the long-term average growth rate of 1.69%. These growth rates will be important to monitor because negative job growth has been an excellent forecaster of recessions. We are not there yet, but the trend is ominous. See pages 3 and 4.

The ISM non-manufacturing index rebounded from 49.6 to 54.5 in July, with all components except supplier deliveries rising for the month. The employment index jumped from 46.1 to 51.1. Conversely, the ISM manufacturing index declined in July from 48.5 to 46.8, with five components falling for the month, four increasing and one unchanged. The employment index was weak, slipping from 49.3 to 43.4. See page 8.

Total vehicle unit sales rose to 16.3 million in July, up from 15.6 million in June, but down 0.9% YOY. Despite July’s uptick, this pace is well below the 18.5 million units seen in April 2021 and October 2017. Pending home sales rose 4.8% in June, rebounding from May’s record low reading of 70.9, and with sales rising in all regions. Nevertheless, June’s index was down 2.6% YOY. See page 9.

Technicals

Monday’s sharp sell-off led to the Nasdaq Composite and the Russell 2000 index both successfully testing their 200-day moving averages on an intra-day basis. The SPX and DJIA are trading well above their 200-day MA’s. See page 12. Stocks to watch for signs of further weakness are Microsoft Corp. (MSFT-$399.61) and Amazon.com, Inc. (AMZN-$161.93) which are currently trading below their respective 200-day moving averages. The 25-day up/down volume oscillator is 1.39 and in neutral territory after absorbing a 92% down day on August 5. This followed 90% down days seen on April 12, 2024, February 13, 2024, and December 20, 2023. The last 90% up day was recorded on December 13, 2023. This oscillator failed to reach an overbought reading on the last rally and therefore did not confirm the advance. We will be watching to see if the uptrend in this oscillator from the 2022 lows remains intact. If not, it would be a longer-term warning sign for the stock market.

Gail Dudack

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This will be a week filled with central bank announcements, the July employment report, and more than 100 second quarter earnings announcements from S&P 500 companies. According to the LSEG IBES earnings dashboard, with 238 of the S&P 500 components having reported quarterly results, 79% beat analysts’ earnings estimates but only 58% beat revenue forecasts. Second quarter estimates now show a 12.4% increase in earnings based on a 4.9% increase in revenue. This combination of revenue and earnings will be difficult to sustain over time, particularly with the pressure that higher-for-longer interest rates put on Corporate America’s ability to increase revenue growth and drive earnings.

And the pressure is not just domestic. McDonald’s Corp. (MCD – $266.44) reported its first drop in worldwide sales in 13 quarters, and was one of several companies citing weakness in China’s economy as an issue. Procter & Gamble Co. (PG – $161.70) reported $1.40 adjusted earnings versus $1.37 expected. However, P&G’s diluted earnings per share of $1.27, was a 7% decline from a year earlier and below expectations of $1.33. China is P&G’s second largest market, and organic sales in China slid 9%. Merck & Co. Inc. (MRK – $115.25) cut its annual profit forecast. CrowdStrike Holdings Inc. Cl A (CRWD – $233.65) fell after Delta Air Lines Inc. (DAL – $43.23) announced it is seeking compensation from the cybersecurity firm and Microsoft Corp. (MSFT – $422.92) for losses from the massive computer outages seen earlier this month.

Given its investment in OpenAI, Microsoft is viewed as a significant player in the race to make money from generative artificial intelligence (AI). However, this week the company reported results that missed expectations for growth in its Azure cloud-computing service. The company said it will raise its capital spending this fiscal year, but growth for its Azure cloud platform would be below current estimates. (Sounds like margin pressure.) AI services accounted for 8% of Azure’s growth in the quarter, up from 7% in the first three months of the year. Meanwhile, MSFT’s capital expenditures, including finance leases, rose 77.6% to $19 billion, up from $14 billion in the previous quarter. Microsoft explained that additional spending was needed to expand its global network of data centers and overcome the capacity constraints that were hampering its efforts to meet AI demand. Overall, this report from MSFT suggests that the earnings surge expected from AI may be further in the future than many have been anticipating. Other technology giants like Apple Inc. (AAPL – $ 218.80), Amazon.com Inc. (AMZN – $181.71), and Meta Platforms Inc. (META – $463.19) are all expected to report earnings this week and may give more insight into whether AI will prove profitable in the near future.

We believe earnings reports will be more important than central bank news. Nonetheless, the Bank of Japan is expected to announce plans to taper its huge bond buying this week and debate whether to raise interest rates. This would be in line with its resolve to steadily unwind an entire decade of massive monetary stimulus. The Federal Reserve Bank is not expected to announce any change in its monetary policy this week, but economists will be looking for hints regarding a first rate cut, widely expected to be in September. And on Thursday, the Bank of England is expected to cut UK interest rates, despite data that shows service sector inflation is sticky. UK interest rates are currently at a 16-year high of 5.25%, and a cut would be the first in over four years.

Meanwhile, the US economy is also giving mixed signals. July’s Conference Board Consumer Confidence Index increased to 100.3 from June’s downwardly revised 97.8 (previously 100.4), which was much better than consensus forecasts. The expectations index – based on consumers’ short-term outlook for income, business, and labor market conditions – rose to 78.2 from 72.8 in June but remains below the 80 level – a threshold that usually signals a recession. The present situation, however, declined to 133.6 from 135.3 in June. Conversely, data from the University of Michigan sentiment survey indicated that confidence fell in July with the headline index dropping from 68.2 to 66.0. The present conditions index fell from 65.9 to 64.1 and the expectations index was the weakest, falling from 69.6 to 67.2. See page 3.

The housing market continues to slow. Existing homes data recently showed sales fell 5.4% YOY in June even though the median price of a single-family home rose to $432,700, up 4.1% YOY. New home sales declined 7.4% YOY in June, but the median price of a single-family home was down 0.1% YOY. See page 4.

The first estimate for second quarter GDP was 2.8%, double the pace seen in the first quarter and much stronger than expected. Consumer spending was the largest contributor to growth, although fixed non-residential was strong and inventory investment was also positive after being negative for the previous two quarters. There seems to be a discrepancy between GDP’s personal consumption data and US Census retail sales data. For example, retail sales were negative on a year-over-year basis for most of the last two years, yet consumption has been the main driver of GDP. However, much of this can be explained by the components of consumption. In the second quarter, GDP data shows consumption of services grew 6.9% YOY, nondurable goods increased 3.1%, but durable goods consumption fell 0.4% YOY. It could be that the rising costs of services, such as home and auto insurance, are squeezing out the consumption of durable goods, and autos are a large part of retail sales. See page 5-6.    

Personal income rose 4.5% YOY in June and personal consumption expenditures rose 5.2% YOY. After taxes and inflation, real personal disposable income increased 1.0% YOY in June. This is much lower than the 3.8% YOY seen at the end of 2023, but still positive. More importantly, it is much better than the negative growth in real income seen for much of 2022 and 2023. However, with spending exceeding income in June, it is not surprising that the savings rate fell from 3.5% to 3.4%. See page 7.

The PCE deflator was 2.5% YOY in June, down from 2.6% in May. Much of this improvement was due to falling prices for durable goods (down 2.9% YOY), particularly motor vehicles (down 3.6% YOY). Prices also declined for recreational goods and vehicles which fell 2.4%. In addition, gas prices, which rose 4.8% in May, increased a mere 0.35% in June. The major problem in terms of stubborn inflation is found in financial services and insurance, which rose 5.6% and household services which rose 3.9%. See page 8.

Not Yet Overbought Last week we noted that our 25-day up/down volume oscillator was rising toward an overbought reading that could confirm the recent advance. To date, it is yet to reach overbought territory and sits at 2.12. If the current advance is the start of a major advance, this indicator should rise to 4.0 or 5.0 and remain overbought for a minimum of five consecutive trading days, but hopefully many more than that. In short, there is no confirmation as yet. See page 12. There was considerable rotation in the market recently. One sign of that is the S&P 500 and Nasdaq Composite indices are trading below their 50-day moving averages, whereas the Dow Jones Industrials and Russell 2000 are still trading above all their moving averages. Another sign is that the Russell, which had been 17% below its record high and is now only 8% below this peak. To date, the pullback in the large cap stocks appears to be a normal correction within a larger rally. The 2024 stock market has been driven more by liquidity than earnings, or at least the expectations of great earnings, which is what makes this earnings season important.

Gail Dudack

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