US Strategy Weekly: Not Complacent About Inflation

It is a very busy news week. The Department of Justice is suing Alphabet, Inc. (GOOG – $136.07) in federal court for anti-trust violations. Republican US House Speaker Kevin McCarthy launched an impeachment inquiry into Joe Biden alleging that his son, Hunter Biden, and the Biden family profited in business dealings with foreign entities while Biden was Vice President.

Jay Clayton, the former chair of the Securities and Exchange Commission, appeared at a hearing hosted by the House of Representatives Select Committee on the Chinese Communist Party that is studying whether China poses a risk to US financial stability. Clayton proposed that companies with market capitalizations above $50 billion or with China-based revenues or costs above $10 billion unveil their exposure to the world’s second biggest economy and explain how their operations would be affected in the event of a disruption in US-China economic ties. This could impact a number of large US technology and finance companies and is another example of how China is becoming an uninvestible region.

Simon & Schuster released a new, and some say scathing, book by Walter Isaacson on Elon Musk. Automakers and the United Auto Workers union are quickly approaching a Thursday night deadline to reach a deal, or 146,000 autoworkers could go on strike. North Korean leader Kim Jong Un visits Russia to demonstrate the “strategic importance” of the two countries’ relations (and possibly to cut a deal to supply arms to President Putin). Morocco struggles to reach survivors from a recent earthquake that to date, has a death tool of nearly 3,000 people. At least 10,000 are missing in Libya after floods caused by a huge Mediterranean storm swept away a quarter of the eastern coastal city of Derna. Apple, Inc. (AAPL – $176.30) launched a new series of iPhones that include a new titanium shell, a faster chip, and improved video game playing abilities.

Inflation Matters

And despite all of this, the big story of the week will be inflation data. The CPI will be released Wednesday, the PPI on Thursday, and import/export prices on Friday. This week’s inflation data reports on the month of August, but we would point out that while headline inflation has been moving steadily lower for much of this year, energy prices have done likewise. However, after eight consecutive months of year-over-year declines in energy prices, WTI oil futures are up 10% YOY in September, to date. Fortunately, or unfortunately, the technical chart of WTI oil futures looks favorable and this suggests gains could continue in the weeks ahead. If they do, it would be a bad sign for September’s headline inflation number. A rebound in inflation could upset not only the consensus view of inflation, but Federal Reserve policy for the rest of the year. See page 3. In sum, we would not become complacent about inflation, and neither should the Fed. But according to a Reuters poll, the Federal Reserve will leave its benchmark overnight interest rate unchanged at the end of its September 19-20 policy meeting and probably wait until the April-June period of 2024 or later before cutting rates. In our view, next week’s FOMC meeting could bring some surprises.

The charts on page 4 are not new to readers, but they are important since they show that whenever inflation reaches a peak level like the 9% seen in June 2022, inflation has declined, but in concert with higher interest rates and a recession. Tighter monetary policy has been key to reducing inflation, and the tightening cycle typically ends with a real fed funds rate of at least 400 basis points. This suggests that even with a 3% inflation rate a typical fed funds rate would be 7%. And even if a 7% rate does not materialize, it does suggest that the fed funds rate is likely to move higher in September. We would not be surprised if it did. However, the CPI data for August is apt to set the tone for the next week and it will not include the recent rise in energy prices.

Household Haves and Have Nots

Quarterly data on household finances from the Federal Reserve shows that the net worth of households and nonprofits rose $5.5 trillion to a new record high of $154.3 trillion in the second quarter of the year. This increase came from a $2.6 trillion increase in the value of equities held directly and indirectly and a $2.5 trillion increase in the value of real estate. Keep in mind that not all households own equities or real estate, and therefore these increases accrue disproportionately to the wealthier households who benefited from rising stock and real estate prices.

The same release showed that household debt increased at a 2.7% annualized rate in the quarter to $19.6 trillion. Household equity ownership increased from 25% of total household assets to 25.6% of total assets at the end of the second quarter. This ratio peaked at 29.2% in June 2021, which was just ahead of the January 2022 market peak. See page 5.

The Federal Reserve released new monthly data on consumer credit. Consumer credit made headlines recently when credit card debt exceeded $1 trillion for the first time. July’s numbers show that consumer credit continues to grow but at a decelerating rate. Whereas revolving credit grew at a 16% YOY pace in January, this dropped to a 10% YOY pace in July. See page 6. Credit card debt rose as the savings rate declined this year which could be a sign that household finances were becoming stretched. Retail sales also slowed in 2023 despite the pent-up demand in the auto sector. In general, we expect credit balances to decelerate further given that the interest rate on credit cards rose from 16.65% in July 2022 to 22.16% by July 2023.

Income and poverty data released by the US Census Bureau this week showed the child poverty rate — based on a supplemental measure that adjusts for government benefits and household expenses — jumped from 5.2% in 2021 to 12.4% in 2022. The supplemental poverty rate rose from 7.8% in 2021 to 12.4% in 2022. The official poverty rate was largely unchanged from 2021 at 11.5%. Nevertheless, family incomes failed to keep up with a 7.8% jump in consumer prices that was the largest since 1981 and real median household income fell by 2.3% to $76,330 in 2022. According to Census officials, this was about 4.7% below 2019.

Technical Update There has not been much change in the last week after the three major indices rebounded from their 100-day moving averages and the Russell 2000 bounced up from its 200-day moving average. Overall, the near-term trend appears indecisive. Even if the rally moves higher, unless 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 9. The 25-day up/down volume oscillator is at a negative 1.03 reading this week, relatively unchanged from a week ago, and at the lower end of the neutral range. See page 10. The 10-day average of daily new highs is 103 and the new lows are 91. This combination tilts slightly positive this week with new highs above 100 and new lows below 100, but not convincingly so. In sum, the broad trading range market continues and is best represented by the Russell 2000 with support at 1650 and resistance at 2000.

Gail Dudack

Click to Download

US Strategy Weekly: September’s Record

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), (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 Strategy Weekly: Beware What You Wish For

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

US Strategy Weekly: Fed Minutes – Inflation is Unacceptably High

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 8th. The Fitch Ratings service warned of a downgrade on more than a dozen banks on August 15th and S&P Global Rating downgraded five regional banks on August 21st, 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

US Strategy Weekly: Global Banking Sector Angst

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.


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

US Strategy Weekly: Things to Ponder

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

US Strategy Weekly: Charges and Changes

Oh Fitch!

As we go to print, the US has formally charged former President Donald Trump with conspiracy to defraud the US, witness tampering, and conspiracy against the rights of citizens. Separately, the ratings agency Fitch downgraded the US government’s top credit rating to AA+ from AAA, citing three years of fiscal deterioration and a high and growing government debt burden. Globally, Russia announced that a drone hit a residential building in Moscow placing responsibility at the feet of Ukraine. A coup against Niger’s elected president is triggering evacuations of US and European partners and a Ukrainian official is alleging that Russia is responsible.

Of these events, the most important for US consumers and investors will be the downgrade of US government bonds. Rating changes can impact the demand for US government bonds at a time that the debt burden is high and the need to issue more debt becomes important. Higher interest rates are good for bondholders, but they also could negatively impact economic activity and PE multiples.

Great Economic News

However, equity investors are ignoring such threats and it is not surprising given the recent string of economic releases. It begins with the report that in the second quarter GDP grew 2.4% (SAAR) which was an increase from the 2.0% seen in the first quarter. In short, economic activity accelerated in the second quarter and this was much better than we, and most economists, expected. It was a surprising development particularly since corporate profits, real retail sales, and residential investment continued to decline in the same period. Personal consumption of nondurable goods and services was the source of strength in the second quarter and inventories were less of a drag than they were in previous quarters. See page 3.

As we have often noted, high levels of inflation are typically a precursor to a recession, and this has been a major concern in recent years. For example, the June 2022 GDP price deflator hit a worrisome 7.6% which was the highest level of inflation since the 8.4% reported in December 1981. However, the second quarter GDP report showed that this deflator fell to 3.6% in June, well above the Fed target of 2% but good news, nonetheless. Similarly, the monthly personal consumption expenditure deflator fell from 3.8% in May to 3.0% in June, its lowest level in 2 years. See page 4.

But the best news was found in reports on personal income and consumption. In June, personal income rose 5.3% YOY, disposable income rose a stunning 7.9% YOY, and our favorite benchmark, real personal disposable income, rose 4.75% YOY, up from 4.1% YOY in May. Personal consumption expenditures have been in a downward trend after hitting an unsustainable peak of 30% YOY in April 2021, but in June, PCE remained at a healthy 5.4% YOY pace. More importantly, the June acceleration in real personal disposable income is a positive sign for steady household consumption as we begin the third quarter. See page 5.

All the good news on the inflation front, combined with the 25-basis point hike in the fed funds rate in July, results in the real Fed funds rate increasing from 211 basis points to 236 basis points relative to the CPI. The real fed funds rate is similar when compared to the PCE deflator. What is important is that the combination is getting closer to the 300-400 basis points we believe the Fed is targeting for its monetary policy. But keep in mind that the strength seen in the economy also opens the door for the Fed to raise rates again on September 20 and perhaps even at the November 1 meeting. We believe the Fed will continue to raise rates until the real fed funds rate is at least 300 basis points and we do not believe the consensus agrees. This is a risk.

Politics Plays a Major Role

Equally important is the fact that 2023 is a pre-election year, and as is typical of a pre-election year, the incumbent party tends to pass stimulus bills to boost the economy. In this cycle, it comes in the form of the Inflation Reduction Act (IRA) which is actually a stimulus bill focused on supporting the green economy and technology sectors.

In addition, President Biden has circumvented the Supreme Court’s rejection of his sweeping student loan forgiveness plan and has launched its SAVE plan (Saving on a Valuable Education). This is a revision of a previous income-driven repayment plan, and the revisions include factors that base monthly payments on income. For many borrowers’ previous monthly payments will be cut in half and for some borrowers there will be no monthly bill. It is in fact a loan forgiveness plan of sorts. The Department of Education has stated that borrowers who sign up for the plan this summer will have their application processed before student loan repayments are expected to resume in October. In other words, the negative impact the end of the student loan moratorium might have had in the fourth quarter of 2023 has been eliminated to a large extent.

Given these developments we are raising our S&P 500 earnings estimates for this year from $200 to $212 and for 2024 from $220 to $230. These estimates remain slightly below consensus but are more in line with the fact that a recession in 2023 is less unlikely today than it was a month ago. See page 16.

However, even if we use S&P Dow Jones earnings estimates, which are higher than our forecasts, the current S&P 500 trailing PE multiple is 22 times and sits above all historical averages. We fear this means the equity market is priced for perfection. The 12-month forward estimated PE is 19.7 times, and when added to inflation of 3%, sums to 22.7. This 22.7 level is just below the standard deviation line of 23.8 which denotes an extremely overvalued equity market. See page 8. In other words, a lot of good news has been discounted in current prices. Also,  keep in mind that the earnings season currently being reported took place during the 2.4% GDP economy, which was an improvement over the first quarter’s economic activity. If earnings do not show an improvement, it could dampen investor sentiment.

Technical Tests

The charts of the S&P 500, DJIA, and Nasdaq Composite index are bullish and suggest the indices may, or should, be about to test their all-time highs. However, the Russell 2000 index has failed to break above the 2000 resistance despite numerous attempts in recent sessions. This is not conclusive, and the RUT may still break out, but it does leave the overall look of the market somewhat pivotal and uncertain at the moment. See page 10.

Similarly, the 25-day up/down volume oscillator is at a 4.03 reading this week and overbought for the third consecutive trading session. The good news is that the oscillator has had overbought readings for 10 of the last 21 trading sessions; however, to date, none of these overbought readings have lasted the minimum of five consecutive days needed to confirm the advance in the averages. Strong rallies should also include at least one extremely overbought day. Nonetheless, these requirements are what should be seen at a new market high and none of the indices have recorded new record highs. The rally has only produced new “cyclical” highs in most indices. See page 11.

Gail Dudack

Click to Download

US Strategy Weekly: The Elusive Pivot

The Dow Jones Industrial Average

We expected the last few trading days to be a pivotal time for the stock market, particularly since the DJIA and Russell 2000 indices were both so close to breaking above important resistance levels. Plus, our 25-day overbought/oversold volume oscillator was at the brink of possibly confirming the current advance with a lengthy overbought reading. However, some, but not all of this came to pass.

The Dow Jones Industrial Average did break above the 34,500 level on July 18th, but mostly thanks to a 14-point gain in Microsoft Corp. (MSFT – $350.98). Microsoft, up nearly 50% year-to-date with a market capitalization of $2.6 trillion, added over 90 points to the DJIA on July 18 and this boosted the DJIA to its highest level since February 2022. The catalyst for Microsoft’s hefty move was a free online event called Microsoft Inspire where Satya Nadella told corporations they could “learn how to accelerate AI transformation, drive customer success, and fuel business growth” with a future product called Microsoft 365 Copilot.

This week the company reported fiscal fourth quarter earnings which beat expectations with an 8% increase in revenues and net income of $2.69 per share, up from $2.23 a year earlier. But according to Yahoo Finance, the stock is currently trading at a trailing 12-month PE ratio of 38 times, which is rich even if Microsoft 365 Copilot proves to be successful. Technology analysts estimate Microsoft 365 Copilot product could add 10% to future revenues (although not before 2024) and this would be helpful since only revenues grew 7% in the last fiscal year. However, even 10% growth could be a hurdle since companies like, Inc. (AMZN – $129.13) and Alphabet Inc. (GOOG – $122.79) are competing for the same customers in the gen AI space. Competition usually lowers margins. Again, Big Tech has been core to the 2023 advance and earnings expectations are high.

The Russell 2000 Index

The Russell 2000 index did not move above the 2000 resistance, nor did the Invesco S&P 500 Equal Weight ETF (RSP – $154.65). Both are hovering at the top of the trading ranges that have contained both charts for the last 15 months. See page 9. It is still pivotal for these two indices. It is a week that could be market moving since it includes many earnings reports, an FOMC meeting, the advance report on second quarter GDP, and June’s personal consumption expenditure index. But for now, these indices continue to be in a long-term trading range.

The 25-day overbought/oversold volume oscillator

Our 25-day overbought/oversold volume oscillator is at a 2.53 reading this week and in the neutral range after recording a number of overbought readings on July 3, July 7, July 12, July 13, July 18, and July 19. See page 10. These were the first overbought readings since the one-day overbought readings recorded on April 28, April 24, and April 18. However, none of these overbought readings lasted the minimum of five consecutive days required to confirm the advance in the averages. Sustainable rallies are characterized by significant volume in advancing stocks which is denoted by a lengthy overbought reading. Impressive advances will include at least one extremely overbought day. This has not appeared to date. However, these technical requirements are required at a new market high and so far, none of the major indices have recorded new all-time highs. All in all, it is not that surprising that our indicators are mixed.


We expect the Federal Reserve will raise interest rates 25 basis points at this week’s meeting and remain “data dependent” about policy choices in future meetings. Fed Chairman Jerome Powell is apt to keep his comments somewhat hawkish about expectations for the September meeting, since any indication of a pause in monetary policy would inspire speculation and there are already signs of bubbling speculation in the stock market. Moreover, with the midpoint of the fed funds rate at 5.13% and inflation at 3%, it leaves the real fed funds rate at 213 basis points. Historically, a fed tightening cycle will generate a real fed funds rate of 400 basis points and we believe Powell’s goal is a minimum of 300 basis points. This 300-400 basis points can materialize through a combination of rising interest rates and falling inflation. This explains why the next few CPI and PCE deflator reports will be very important for the Fed and for the stock market. In our view, the Fed will likely raise interest rates again in September. At present, the consensus is not expecting a September rate hike which means it could be a negative shock. Therefore, we would not be surprised if Fed board members publicly discussed the possibility of another rate hike in the weeks ahead.

A Mixed Economy

The relationships between quantitative tightening, contracting money supply, and stock price movement have not been consistent in recent decades. But it is clear that the Fed’s liquidity boost in March done to offset the regional banking crisis is now over and their quantitative tightening program is back on trend. As a consequence, money supply measures, in particular M1 and M2, are now declining at a remarkable pace. See page 3.

Money supply is commonly defined as a group of safe assets that households and businesses can use to make payments or to hold as short-term investments. For example, US currency and balances held in checking accounts and savings accounts are included in many measures of the money supply. In past decades, money supply provided important information about the near-term course of the economy, equity prices, and inflation in the long run. We expect M2 to be less predictive today, but with the 6-month rate of change in money supply now contracting at a historic 3% YOY it could be a sign of slowing economic activity ahead.

The Conference Board’s leading economic indicator fell in June for the 15th consecutive month. As seen on page 4, this has been a reliable recessionary signal over the last 25 years. This indicator also suggests a recession is directly ahead.

Existing home sales were 4.16 million units in June, down 19% YOY. The median home price rose to $416,000, up 3.6% for the month but down 1.2% for the year. The recent rise in existing home prices is a result of near-record-low inventory. Not surprisingly, the National Association of Home Builders survey was at the best levels seen since June 2022, although traffic of potential buyers still remains in recessionary territory. Residential real estate appears to be recovering, but the potential for higher interest rates continues to be a risk. See page 5. The Conference Board confidence index rose to 117.0, its highest level since July 2021. Gains were driven by an improvement in consumers’ outlook for income, business, and job market conditions. The University of Michigan sentiment index jumped to 72.6 in July, up 41% YOY and its highest level since September 2021, yet the index still remains in recessionary territory. A rising stock market and stable gas prices helped boost the index in July. See page 6. In sum, consumer sentiment is improving but the stock market appears to be pivotal to this view. Unfortunately, equity prices have had a big advance without a big uptick in earnings. The second quarter earnings season has the potential to be important for investor sentiment and we remain somewhat cautious and would not chase current leaders but focus on companies with solid and predictable earnings streams.

Gail Dudack

Click to Download

US Strategy Weekly: Do Earnings Matter?

Inflation Changes Everything

There was a perfect storm of good news this week. It started on July 12 with the release of June’s CPI data. Headline inflation tumbled from 4% to 3% in June and core CPI fell from 5.3% to 4.8%. Both were better than expected. And though many subcategories of CPI showed price gains greater than 3% YOY, most trends appeared to be decelerating. The transportation sector showed prices falling 5.1% YOY and motor fuel fell 27% YOY. One surprise in June was that all items less food rose only 2.5% YOY, down from 3.6% in May. What most impressed us was that for the first time since March 2021, June’s inflation of 3% fell below the average long-term inflation rate of 3.5%. This was a significant hurdle in our view and a sign that the Fed’s target of 2% inflation is possible. See page 3.

The PPI was also released last week. It showed finished goods prices declining 3.1% YOY, although finished goods excluding fuel and energy rose 4.3% YOY. But in general, PPI data indicated that commodity prices are no longer driving inflation. Service sector inflation remains an issue, but less so in June. Service sector CPI, although still high at 5.7% YOY, was down from 6.3%. What could be encouraging for service sector inflation was the deceleration in wage growth inflation from 5.6% YOY in January to 3.8% in June. Also decelerating was owners’ equivalent rent which eased from 8.1% in May to 7.8% in June. In sum, there was good news in most CPI categories, and this cannot be underestimated in terms of Fed policy, household purchasing power, and its impact on PE multiples. See page 4.

The New Student Loan Forgiveness Plan

Good news continued with the Biden Administration’s new proposal on July 14 to replace a loan forgiveness plan that was recently struck down by the Supreme Court. This new complex repayment plan — called the SAVE plan or Saving on a Valuable Education plan — is expected to save borrowers thousands of dollars by keeping their monthly payments small – often as small as $0 — while preventing interest from exploding on balances that they owed. According to the Department of Education, borrowers would now pay back just $6,121 for every $10,000 borrowed. A DOE fact sheet states that borrowers who earn less than $32,805 a year ($67,500 for a family of four) will not have to make any payments and more than 800,000 borrowers could have their remaining loan balances erased. This latter point would be the equivalent of $39 billion in debt forgiveness.

Law experts believe this complex and multifaceted plan is likely to survive since it is a revision of an existing income-driven repayment plan (IDR) called Revised Pay As You Earn (REPAYE). The estimated cost to taxpayers for this plan ranges from $138 billion (DOE), to $230 billion (CBO), and to $361 billion (Penn Wharton Budget Model), depending upon the source. Yet regardless of the cost, the new SAVE plan is clearly another fiscal stimulus program. And to a large extent, it reverses the risk that faced many households on October 1 when the student debt moratorium was scheduled to end. As we had noted, the end of the student debt moratorium would have meant 44 million Americans would restart monthly debt payments averaging between $210 to $320 and this would have been a big negative for the economy at the end of the year. The Biden Administration has erased this risk.

Merger Mania

On July 18, a US court ruled that Microsoft Corp.’s (MSFT – $359.49) $69 billion takeover of Activision Blizzard Inc. (ATVI – $92.74) could proceed despite objections from the Federal Trade Commission. MSFT rose 13.76 points for the day, giving the Dow Jones Industrial Average a big boost. But it also was an important milestone for the merger-arbitrage sector of the financial industry which has been going through a rough patch. There are several mergers lined up in the technology industry that could now start moving through the pipeline. This lifted stock prices and Wall Street’s confidence. Another catalyst for MSFT was its announcement of Microsoft 365 Copilot, which is a major bet on the value of AI to Microsoft corporate clients. The stock responded favorably and its market capitalization of $2.71 trillion is now second only to Apple Inc. (AAPL – $193.73) which is valued at more than $3 trillion.

Global news was also good for inflation, for example, Canada’s inflation rate fell to 2.8% in June. And global growth is slowing. Argentina’s GDP fell 5.5% YOY in May, and some forecasters expect China’s economic growth slow to 3%. In the US, retail sales for June rose only 1.5% YOY which means that after inflation, retail sales fell 1.5%. This was the seventh month in the last eight months in which sales were negative on a year-over-year basis. See page 5. Historically, negative real retail sales are associated with declining nominal GDP and a recession. Inverted yield curves and monetary tightening are also recessionary. But the offset to these items may be that job growth remains resilient, and this may be the most important indicator of all.

Earnings and Valuation are weak

The July 14, 2023 “This Week in Earnings” report from IBES Refinitiv showed a $1.86 decline in 2023 consensus estimates last week. See page 6. It is important to mention this since the stock market has been responding positively to the early second quarter earnings reports, due in large part to the fact that IBES also writes that “80% of the 30 companies that have reported earnings to date have beaten expectations.” Yet IBES also indicates that the 2023 S&P 500 earnings estimate is now $217.28, and below the 2022 earnings number of $218.09, representing a decline in earnings growth for 2023. See pages 6, 8 and 15. The current IBES EPS estimate for next year is $244.74, reflecting a 12.6% increase, but up from an earnings decline in 2023. All in all, this is not the earnings backdrop one would expect when the SPX is up 18.6% year-to-date and the Nasdaq Composite is up 37.1%. It is more in line with the Dow Jones Industrial Average which is up 5.4% year-to-date, or the Russell 2000 index which has gained 12.2%.

According to our valuation model, the equity market has been trading well above the fair value range since the first quarter of 2021, or for the last two years. The last time this happened was early 1997 leading to the peak in March 2000. In short, the market remained extremely overvalued for three years. This is what characterizes a bubble. Our earnings forecasts are well below consensus, but we show the model with both S&P and DRG estimates, and the “overvalued” results are similar. See page 7. In our view, the market is at a turning point. It either continues to soar ahead led by a limited number of stocks, much like a bubble where fundamentals are disavowed, or it consolidates or retreats waiting for earnings power to support higher stock prices.

Technical Help The charts of the indices may help in this time of indecision. The technical patterns of the SPX and IXIC are extended after recent gains and look vulnerable near term. Conversely, the DJIA appears to have just broken out (thanks to MSFT). The RUT continues to trade within its long-term trading range between 1650 and 2000, but is closing in on the 2000 level. The answer to whether the equity market is going to make a dramatic run up to new highs or take a pause, may be found in the near-term action of the Russell 2000 index. A clear breakout in the RUT well above the 2000 resistance level would be a big catalyst for further equity gains. Either way, we would not chase the recent market leaders but would look for stocks with solid earnings growth and reasonable multiples.

Gail Dudack

Click to Download

US Strategy Weekly: An Optimistic Consensus

The Consensus View

Stock markets may have their foundations built on fundamentals, but the short and intermediate-term moves are, more often than not, driven less by fundamentals and more by expectations and sentiment. And in our view, the expectations for the second half of this year are now a consensus that includes the following: 1.) the Federal Reserve will raise rates one or two more times and then pause; 2.) headline inflation will continue to decelerate to the 3.5% level or lower by year end; 3.) a recession is possible but the economy may instead suffer a rolling recession over the next twelve months; 4.) the housing sector is showing green shoots; 5.) interest rates are at, or close, to peaking all along the curve; and last, but far from least, 6.) earnings growth will rebound over the next four to six quarters.

The Media Plays a Role

However, we have noticed that the media is also playing a role in boosting investor sentiment. The National Federation of Independent Business (NFIB) released its Optimism Index for June this week. Reuters ran the story with the headline “Small business confidence reaches 7-month high in June, NFIB says.”  That is not what we read on the NFIB website. The NFIB’s headline was “Small Businesses Raising Prices Falls to Lowest Level Since March 2021.” And the NFIB’s opening text was “Small business optimism increased 1.6 points in June to 91.0; however, it is the 18th consecutive month below the 49-year average of 98. Halfway through the year, small business owners remain very pessimistic about future business conditions and their sales prospects.” We were stunned at how different the Reuters story was from that of the NFIB. Reuters was clearly editorializing and not reporting. On page 7, we show charts of the NFIB’s survey, and you can judge for yourself which headline is more appropriate for the June report.

Too Optimistic Too Quickly

Perhaps the “optimism” we are reading in the financial press stems from the fact that the residential real estate market may, at last, be finding some sunlight. A recent Bloomberg headline states: “Homebuilding Set to Boost US Economy After Two-Year Contraction.” The NAHB housing index ticked up to 55 in June from 50 in May and it was the first time this index rose above the 50 benchmark in nearly a year. Condo sales rose in May, but single-family sales declined. A dwindling supply of single-family homes partly explains the housing market’s buoyancy. But to the extent that a lack of supply of single-family homes is due to the fact that homeowners are locked into their homes as a result of higher interest rates and higher home prices, this may not be a good thing. Right now, remodeling is cheaper than buying a new home for many households. Plus, recent consumer credit data shows that nonrevolving credit fell at an annualized rate of 0.4% in May. Revolving credit increased at an annualized rate of 8.5%, but this was down from 14.2% in April. In other words, a combination of tighter lending standards and higher interest rates are triggering a slowdown in consumer credit. This may make housing less affordable and as a result, the housing market bounce may be short-lived. Last, but far from least, one should not forget that the moratorium on student loans will end in October!

Investor Sentiment Warning

Nevertheless, optimism is spreading. Last week’s AAII sentiment readings produced a 4.5% rise in bullishness to 46.4% and a 3.0% decline in bearishness to 24.5%. This was the highest bullish reading in the AAII survey in 2023 and it was the highest since the 48% reading on November 11, 2021. In addition, bullish sentiment was above average for the fifth consecutive week, matching the streak last seen in October and November 2021. Unfortunately, in this case, sentiment is a contrary indicator. It is important to point out that current readings are similar to those seen in November 2021 and in this latter case, they appeared a month or two ahead of the January 2022 peak in equity prices. See page 13.

Inflation and Earnings

June inflation data will be released this week and many economists are looking for good news. Moody’s Analytics has inflation falling to 2.8% in the second half. That would be excellent news, but it may also be optimistic. The good news is that many areas of the CPI are seeing prices declining on a year-over-year basis, particularly since crude oil prices are currently down 33% YOY. Most energy-related and transportation-related areas of the CPI are seeing declining prices, and so are used cars, personal computers, and nondurables. On the other hand, the service sector showed prices rising 6.3% YOY in May.

The service sector is labor intensive and therefore, the Fed is also focusing on both service sector inflation and wage inflation in forming its monetary policy. Average hourly earnings rose 4.7% YOY in June, which is down nicely from the March 2022 level of 7% YOY; yet from the Fed’s perspective, this is still more than double its target of 2% inflation. Moreover, it means wages grew 70 basis points above May’s inflation rate which could create demand pull inflation. See page 5.

Average weekly earnings rose 3.8% YOY in June, quite a bit less than the average hourly earnings gain of 4.7% YOY, because hours worked dipped from a year ago. But after adjusting for inflation, real weekly earnings in dollar terms, have been declining since January 2021. Only recently have wages been growing faster than inflation. Again, what is good for consumers (real purchasing power) will be bad for employers (higher cost of labor) and this balance will impact consumption and margins in the second half of the year. Economists will be watching June inflation numbers to see how this impacts real earnings. See page 6.

Beating inflation is important. As we have pointed out, inflation erodes the purchasing power of consumers, it pressures corporate margins, and typically lowers PE multiples. Based upon the IBES Refinitiv earnings estimate of $219.14 for the S&P 500, equities remain overvalued at the current PE of 20 times. We define the market as being overvalued if the sum of the PE and inflation exceeds the top of the standard deviation range, or 23.8. The current PE of 20 and inflation of 4% puts the market above the standard deviation line of 23.8. See page 9. It also makes earnings season important. In terms of the second quarter earnings season, investors appear to have discounted a lot of good news in advance. One example of this is the rally seen in financial stocks this week, just ahead of their earnings releases later this week. Meanwhile, less heralded is the fact that consensus estimates continue to fall. The S&P Dow Jones consensus estimates for 2023 and 2024 are $216.59 and $242.80, down $0.29, and $0.26, respectively this week. Refinitiv IBES estimates for 2023 and 2024 are $219.14 and $244.88, down $0.38, and $0.58, respectively. S&P Global data shows that 18.4% of companies reporting first quarter earnings had a decrease of 4% or more in shares outstanding, which effectively boosted earnings per share, but not overall earnings growth. This pattern of lowering shares outstanding is not quality earnings. In general, this is a stock picker’s market. There are good companies to buy, but we see a pattern of bullish optimism that needs second quarter earnings to be outstanding. If they are not, the recent rally is in peril in our view.

Gail Dudack

Click to Download

© Copyright 2023. JTW/DBC Enterprises