The third quarter of the year was another good period for the equity market. The Dow Jones Industrial Average rose 5.2%, the benchmark S&P 500 Composite index gained 7.8%, the Nasdaq Composite index increased 11.2% and the broader small capitalization Russell 2000 index generated an impressive 12.0% gain. The SPDR S&P Semiconductor ETF (XSD – $319.12) was a standout with a 24.4% gain in the quarter. Note that three stocks, Meta Platforms, Inc. (META – $743.38), Alphabet Inc. A (GOOGL – $243.10), and Alphabet Inc. C (GOOG – $243.55), represent more than 28% of this sector’s total weighting. By the end of September, the year-to-date gains in the indices were 9.1% in the Dow Jones Industrial Average, 13.7% in the S&P 500, 17.3% in the Nasdaq Composite index, and 9.3% in the Russell 2000 index. In short, 2025 has been an excellent year for equity investors.

Shutdowns and Debt Ceilings

However, as we go to print, it appears that Congress may not be able to pass a clean continuing resolution bill (CR) to keep the government open for another seven weeks. This means the US faces a government shutdown on October 1 (the beginning of a new fiscal year). Although a government shutdown is not a good thing, the October 1^st deadline does not create an immediate threat to the equity or fixed income markets.

A federal shutdown halts, or postpones, discretionary government spending; however mandatory payments, including interest payments on US Treasury securities, Social Security, Medicare, and Medicaid payments are legally required to continue. Normally a continuing resolution bill will also include an increase in the debt limit; but the budget reconciliation law enacted on July 4, 2025 (known as H.R.1 – One Big Beautiful Bill Act) raised the debt limit by $5 trillion to $41.1 trillion. This was an important inclusion in the July 4^th bill since it will allow the US Treasury to continue to issue debt and pay all its mandatory obligations without fear of reaching the debt ceiling in the near term. Had the debt ceiling not been lifted in the One Big Beautiful Bill Act, it could have been breached, and the US Treasury would have had to employ unusual means to pay interest on its debt, if possible. The prospect of a default on US debt would have thrown the fixed income markets (and in turn the equity market) into chaos in the fourth quarter. (Note: debt held by the public was $30.1 trillion and intragovernmental debt was $7.3 trillion, for a total outstanding debt of $37.4 trillion, as of September 3, 2025.)   

the federal reserve and the bls

The long-awaited September Federal Reserve meeting delivered the 25 basis points cut in the fed funds rate as expected. The previous rate cut was 50 basis points in September 2024. History shows that stocks tend to perform well in the six and nine months following a first rate cut, and not surprisingly, equities rallied in anticipation of this event. The Wall Street adage “Don’t Fight the Fed” is based upon historical data that shows that equities perform poorly when the Fed is raising rates but perform well when the Fed is lowering rates.

One reason we expect the Fed will continue to lower interest rates this year is that the labor market may be weaker than previously reported. The Bureau of Labor Statistics recently announced that the annual revision to payrolls in the 12 months ending in March 2025 is estimated to be a subtraction of 911,000 jobs. This means payrolls were lower than previously reported and actual job growth may have been 76,000 jobs less than reported for every month from March 2024 to March 2025.

This annual adjustment was far larger than economists anticipated, and it appears to be the largest revision ever recorded. Moreover, it would be the second huge annual revision in a row. Our concern is that job growth might have been, or is, negative on a year-over-year basis. Negative job growth is closely aligned with an economic recession. Unfortunately, the BLS will not confirm this estimate until next year. But we believe the Fed should continue to lower rates or risk being too late once again.

Equally important, in the third quarter the consensus view that tariffs would trigger high inflation and a weak economy finally began to fade and analysts became less bearish. In our opinion, the most important event of the third quarter was second quarter S&P 500 earnings results, which were expected to increase by less than 5% YOY, but actually grew 10.5% YOY. Not only was this a positive surprise, but it means that earnings were growing well above the long-term average of 8.2% YOY.

Equity valuation is high but…

There are many possible hurdles facing the financial markets in the fourth quarter including conflicts in the Middle East and Europe, political division domestically, and sovereign deficits here and in Europe that threaten fiscal stability. However, in October, aside from the FOMC meeting, the most important factor may be the start of third quarter earnings season. Underlying all bull markets are solid fundamentals. The current IBES LSEG consensus earnings forecasts for S&P 500 earnings are $266.67 for 2025 and $304.40 for 2026. This means that the market is trading at 24.9 times this year’s earnings and 21.8 times 2026 earnings. This is rich by most historical measures. Nevertheless, the 2026 S&P 500 earnings yield is 4.6%, and when coupled with the S&P 500’s dividend yield of 1.2%, the combination remains attractive relative to the 10-year Treasury yield of 4.1%.

Moreover, we expect earnings will continue to surprise on the upside due to a stronger economy. What most strategists have overlooked is the stimulative impact of fiscal policy which allows large and small businesses to fully depreciate investments in the current year. Early next year we expect many households will benefit from the reduction of taxes on tips, social security, and overtime, and special deductions on car loan interest and a $6,000 deduction for eligible seniors. In sum, while markets may remain volatile, we expect the bull market will continue.

*Stock, index, and sector prices are as of September 30, 2025

Gail Dudack, Chief Strategist

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The market’s performance in the second quarter of the year was surprisingly good with gains of 17.8% in the Nasdaq Composite, 10.6% in the S&P 500, 5.0% in the Dow Jones Industrial Average, and 8.1% in the Russell 2000 index. However, these percentages do not accurately reflect the volatility seen in equities over the last three months. Volatility – to change rapidly or unpredictably but often used by strategists in place of indicating a weak or bear market — was indeed a very accurate description of the second quarter.

The S&P 500 index reached a high of 6144.15 on February 19, 2025 before falling to a low of 4982.77 on April 8, 2025. This was a 19% decline on a closing basis and more than a 20% decline on an intra-day basis. A 20% decline, or more, typically defines a bear market. The Nasdaq Composite was even more volatile in the same period, dropping nearly 24% between February and April on a closing basis and over 25% on an intra-day basis. Yet by the end of the quarter, the S&P 500 and the Nasdaq Composite were at new record highs, with gains from their April lows of 24.5% and 33%, respectively. 

Tariff and DOGE Tizzy

The catalyst for April’s swoon in the equity market was tariff policy, or more precisely the breadth and level of tariffs proposed by President Trump. The April 2, 2025, “Liberation Day,” announcement did take us, and the world, by surprise. However, the media failed to understand the purpose of President Trump’s proposed tariff policy or the newly installed Department of Government Efficiency (DOGE). Economists began forecasting high inflation, massive job cuts, and a US recession in the wake of these policies and consumer sentiment soured.

As we noted in April’s quarterly strategy report, we think these recession forecasts totally ignored the objectives of President Trump’s trade policy and DOGE, and the likely positive impact tariffs and DOGE could have on the US economy, the trade balance, GDP, and budget deficit. From a simple perspective, it is not surprising that the stock market fell early in April, but it is also not surprising that equities recovered their losses and more. By the end of the second quarter equity indices were at all-time highs. 

Technical Vigor

The underlying strength of the rally from the April lows has been impressive. Typically, the popular indices will rally to new highs, and it takes several days or several weeks, for volume and breadth indicators to confirm these highs with positive breadth and volume signals. However, 2025 was different. The 25-day up/down volume oscillator rose to and remained in overbought territory for 9 of eleven consecutive days in May and reached a high of 5.10 on May 16. This May reading was the highest since August 18, 2022, when the market was rebounding from the 2022 low. Strong overbought readings are bullish in this indicator since it confirms that robust buying is driving stocks higher. The NYSE cumulative advance/decline line made a string of new highs in June, the latest on June 30, 2025, a sign that the rally from the April lows was solid and broadly based. In short, stocks were indicating that the popular indices would soon be making new highs. On April 2, 2025, the survey from the Association of American Investors showed 61.9% of investors were bearish, a new high for this cycle and a very favorable reading. The 8-week bull/bear is currently neutral but was positive for 17 consecutive weeks from mid-February through June. All in all, these indicators have been confirming an ongoing bull market.

Awaiting Fundamentals

Most economists have relented on their forecasts for a 2025 recession, and economic releases have been good, but somewhat mixed. Total retail & food services sales rose 3.3% YOY in May, down from the 5%+ levels seen in prior months yet showing respectable growth. Housing has been relatively glum for over six months, but many housing surveys are now rebounding from their April lows. May’s employment report showed 139,000 new jobs despite the fact that federal government headcounts declined by 22,000 in the month. Wage growth has been steady at 3.9% YOY and is beating the level of inflation.

Total personal income grew 4.5% YOY in May and real personal disposable income grew 1.7% YOY. This is a small growth rate in real income; nonetheless, it is far better than the negative monthly growth rates seen from January 2021 through December 2022. Inflation benchmarks remain low and stable despite the fact that tariffs are in place. The Federal Reserve’s favorite index, the personal consumption expenditure index, showed prices rising 2.3% YOY in May, up only slightly from 2.2% in April. Headline CPI was 2.38% YOY in May, relatively unchanged from the 2.33% YOY in April. Both inflation indices are down substantially from the

7.25% to 9.1% recorded in June 2022. Energy represents 6.4% of the CPI, and with WTI crude oil currently under $65 a barrel, down from $80 a barrel in January, headline inflation is apt to trend lower in months ahead. 

The underlying foundation of any bull market is earnings growth, and while first quarter earnings results were better than expected, the impact of tariffs is more likely to be defined by results reported in second quarter. Second quarter reporting season will begin in earnest in mid-July; however, earnings forecasts for 2026 and 2027 have been creeping higher in recent weeks. This is a good omen. If there is one area of concern it would be equity valuation which remains stretched. The 12-month forward S&P 500 earnings PE is currently 21 times and well above the long-term average of 17.9 times. This is why earnings releases and CEO forecasts will be a defining factor for equities in the second half of the year.

All in all, we have been expecting the stock market to rally to new highs in the second half of the year. Part of our optimism is based upon the passage of the Big Beautiful Bill which we expect will boost GDP as a result of retroactive tax cuts and corporate investment deductions. If this is correct, corporate earnings should also beat expectations and support a solid equity performance in the second half of 2025.

Gail Dudack

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In our April 2024 Quarterly Market Strategy Report we wrote “if the stock market is forming a bubble, and we think it is, it is still in the early stages. PE multiples are exceedingly high at 24.2 times trailing 12-months and 21 times forward 12-months earnings. Yet during the 1997-2000 bubble, the financial crisis of 2008, and even the post-COVID-19 peak, the trailing 12-month PE reached 26 to 30 times.”

We mention these comments from a year ago because the world seems to have changed so much in the two months since Donald J. Trump became president. But given these comments from a year ago, Trump’s tariff threats and the uncertainty they created may have been the trigger the market required for an inevitable correction. In short, a pullback in the market was overdue, and the uncertainties surrounding tariffs were the catalyst. As we expected, the equity market continued to rise last year and by February 19, 2025, the S&P 500 was trading at 26 times trailing earnings and 22 times forward 12-month earnings. This forward PE of 22 in February was well in excess of the long-term average of 14.3 times. In short, from a valuation perspective, it is not a surprise that the equity market had one of its weakest first quarter performances in years.

Testing the Lows

At the March 13, 2025 closing lows, the peak-to-trough declines in the S&P 500, Dow Jones Industrial Average, the Nasdaq Composite index, and the Russell 2000 index were 10.1%, 9.3%, 14.2%, and 18.4%, respectively. This means that the S&P 500’s selloff was just short of a 10% drop that defines a correction, and the Russell 2000 declined just short of the 20% drop that defines a bear market. Yet, many of the technology stocks that had been the drivers of the 2024 bull market fared much worse. For example, Nvidia Corp. (NVDA – $108.38) had a two-month peak-to-trough decline of more than 28%. In other words, depending upon the index or stock you choose, equities have been in full-blown correction or bear market in the last two months. By the end of March, the declines of 4.6% in the S&P 500 and 10.4% in the Nasdaq Composite index in the first quarter were the worst since 2022.

As the April 2 deadline for President Trump’s tariffs approaches, the equity market is retesting its March lows. From a technical perspective, a retest of the lows is a normal scenario and part of a classic bottoming process. There are several factors that suggest a bottoming process is at hand. The S&P 500 seems to be stabilizing after it experienced a 10% correction, the Nasdaq Composite index rebounded off its 2022-2025 uptrend line and the Russell 2000 index bounced off its pivotal 2000 resistance/support level. These were all important levels of support. Rebounds from these levels make it likely that the worst of the “fear of tariffs” may be over. In addition, the American Association of Individual Investors’ survey showed that bullish investor sentiment tumbled to 19.4% and bearishness jumped to 60.6% at the end of February. A combination of 20% or less bullishness and 50% or more bearishness in this indicator is rare and has been a positive sign for the market. The 8-week AAII bull/bear index is as low as it was in November 2022, just after the S&P 500’s 25% decline to 3577.03 on October 12. In short, this high level of pessimism is associated with major market lows.

The Impact of Tariffs

What history has shown is that financial markets can deal with good news or bad news, but it does not do well in a time of uncertainty. With the 25% tariff on foreign car imports now permanent and the April 2 deadline for reciprocal tariffs on the horizon, the fog of uncertainty regarding tariffs should soon begin to dissipate. That is good news.

Most economists are describing tariffs as a tax on consumers, but we disagree. Taxes of all kinds are unavoidable, and they are mandatory. Tariffs make imports more expensive, but consumers usually have choices in terms of what they buy or do not buy. In the case of vehicles, American-made vehicles will be a more attractive alternative in the future, and we expect to see consumers buying more American-made and less foreign-made vehicles. The same is true of liquor, wine, and many other products. More importantly, despite what many economists are saying, history has shown that tariffs are rarely passed on directly to the US consumer. In the past when tariffs have been levied, exporters often choose to lower prices, or in the case of China, a country can subsidize exports to the US. Domestic retailers can choose to absorb part, or all of the tariff increase in order to keep prices stable for consumers. This means that inflation may be far less than expected, but many companies that import products or parts from offshore will face margin pressure. From this perspective, the biggest negative from tariffs could be lower margins and lower corporate earnings.

If tariffs persist for a long while (and there is no certainty that they will), we expect consumer behavior will change; consequently, in the aftermath of tariffs, some companies will be winners and some will be losers. But keep in mind that the April 2 “Liberation Day” tariffs will be excluding a variety of necessities such as semiconductors and pharmaceuticals, and as a result, the overall impact will be less broad based than currently forecasted.

It is also important to remember that the US is the largest consumer in the world with a 2024 trade deficit in goods and services of $918.4 billion. The deficit in goods alone reached a record $1.2 trillion in 2024. Our largest trade deficit was with Mexico, and it hit a record $171.8 billion last year. The US had record imports from 50 countries in 2024, led by Mexico ($505.9 billion), Germany ($160.4 billion), and Japan ($148.2 billion). This trilogy of imports may explain Trump’s focus on imported vehicles. Conversely, the 2024 petroleum surplus was the highest on record at $44.9 billion.

Overall, these statistics explain why the threat of tariffs is a powerful negotiating tool for the US. And despite the current anguish about tariffs, if the tariffs become permanent (which we doubt), the negative impact on our trading partners is apt to be far greater than it will be domestically. Therefore, in our view, our trading partners are more likely to sit at the negotiating table and look for a compromise, than to start a true tariff war.

Sentiment Bias

In this highly politicized environment, it is worth discussing the bias currently found in consumer sentiment indices. The recent University of Michigan consumer sentiment for March fell 7 points to 57. The current conditions component eased 1.9 points to 63.8, and the index of consumer expectations plummeted 11.4 points to 52.6. Nevertheless, these numbers appear to be highly skewed by political party affiliation. Party affiliation data has a one-month lag, but the index of consumer expectations for Democrats fell 12.6 points to 36.8 in February while Independent expectations dropped 6.4 points to 59.1. Conversely, the Republican expectations index rose 2.3 points to 106.6. This data suggests that consumer sentiment data is skewed politically and has a negative bias.

The University of Michigan survey also reveals that optimism, or pessimism may be highly correlated to the news source one chooses to follow. When respondents were asked “during the last few months, have you heard of any favorable or unfavorable changes in business conditions?” the 3-month moving average of Democrats fell 40 points to 29 while the same index rose 13 points to 101 for Republicans. Independent voters had a 9-point decline to 53. This bias in sentiment indices suggests that much like presidential election polls, consumer sentiment indicators may not be a good forecaster of outcomes.

All in all, retail sales may be a better predictor of the health and sentiment of the consumer than sentiment indices. Many indicators point to the market being in a bottoming formation in March and that implies an opportunity for investors. However, individual companies may be helped or hurt by tariffs. This means keeping portfolios diversified and avoiding companies that could face potential margin compression in the year ahead.  

*Stock prices are as of March 31, 2025 close.

Gail Dudack, Chief Strategist

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January 2025

Equities were more volatile in the second half of December after Federal Reserve FOMC meeting. Fed Chair Jerome Powell cut the fed funds rate 25-basis points, which was expected, but lowered the number of expected 2025 rate cuts to two, which was a negative surprise. In response, the S&P 500 Composite fell nearly 3%, the worst daily performance in months. In our view, this extreme reaction to less Fed stimulus is a sign that speculators, which had been boosting share prices in 2024, were becoming a bit more cautious.

Nonetheless, it was a good year for stockholders. In 2024, the Dow Jones Industrial Average gained 12.9%, the S&P 500 gained 23.3%, the Nasdaq Composite inked a gain of 28.6%, and the Russell 2000 index rose 10.0%.

What made 2024 significant is that it was the second time in a row in which all three popular indices closed with double-digit gains for the year. This is a fairly rare occurrence. There have been times when all three indices had an additional third year of double-digit gains, such as in: 1943-1945, 1949-1951, and 1995-1999. The bad news is that each of these occurrences was followed by a significant bear market. The most memorable advance was seen in 1995-1999 (five years of double-digit gains), and it was followed by a major bear market that resulted in substantial annual losses for three consecutive years.

Double-digit gains for only two years in a row are more common and have been seen in: 1954-1955, 1975-1976, 1982-1983, 1988-1989, 2009-2010, and 2016-2017. Still, each of these occurrences was followed by negative or negligible annual gains in the subsequent year. In short, two years of double-digit gains does not tell us much about 2025. It could be a weak year or another year of double-digit gains, but it does suggest that 2025 could be an important and pivotal time for investors.

January tends to be an important month for equities and the Wall Street adage “As goes January, so goes the year” could have special meaning this year. The reason January tends to be significant is that liquidity is strong early in the year due to IRA and pension funding. Therefore, a weak January performance is ominous and suggests investors are avoiding equities.

At the end of 2024 Change appeared Everywhere

Political change appeared everywhere in 2024, particularly as the year ended. On December 8, 2024, President Bashar al-Assad of Syria fled to Russia after six decades of his family’s autocratic rule. This overthrow could be a major turning point in the Middle East, and it was an obvious blow to both Russia and Iran who backed Bashar al-Assad. According to Reuters, Senior US diplomats met with Syria’s de-facto new ruler Ahmed al-Sharaa, and after a “good” and “very productive” meeting about Syria’s political transition, the US removed an existing bounty on his head. At this early stage the transformation in Syria appears to hold great promise for positive, and potentially peaceful change in the Middle East.

Change is also impacting America’s allies. French President Emmanuel Macron is under extreme political pressure to rein in France’s fiscal deficit. German Chancellor Olaf Scholz is not expected to survive a February 2025 vote. The UK had a series of Conservative Party Prime Ministers after the pandemic, including Boris Johnson, Liz Truss, and Rishi Sunak, before a Labor Party upset brought the current Prime Minister Keir Starmer to power. The Conservative Party’s newly elected leader is Kemi Badenoch, a right-wing politician who opposes identity politics and state spending. She is also the Tories’ first black female leader. And in Canada, Justin Trudeau, is expected to face a formal motion of no-confidence in the House of Commons early this year.

Change is what also re-elected Donald J. Trump in November and won not only a majority in both the House and the Senate but a majority of all voters. This election was greeted with both jubilation and trepidation, domestically and abroad. Trump, the disruptor, has cobbled together a Cabinet full of potential disruptors who promise to bring transparency and common-sense change to the federal government. However, change will not be easy to achieve in Washington DC or be pleasant for everyone, so we would expect some pushback.

The appointment of Elon Musk and Vivek Ramaswamy to head the newly created Department of Government Efficiency (DOGE), is a unique experiment. In our opinion, the effort to bring efficiency to government may be Elon Musk’s greatest challenge to date. Nevertheless, the result of the November presidential election is a renewed focus on growing jobs in America, removing government regulations that hinder corporate growth, and controlling budget deficits. Each of these will require profound change and is what could make this year a time of both promise and potential turbulence.

Our 2025 Forecasts

Our assumptions for 2025 include GDP growth of 3.2% YOY, a 15% increase in SPX earnings, a maximum of two fed funds rate cuts, Treasury bill yields falling to 4.1%, Treasury bond yields at 4.3%, and inflation remaining sticky at 2.75. This combination results in our valuation model generating a predicted PE of 17.3 times and an SPX target of 5372 based on our 2026 earnings estimate. In short, the stock market is 40% overvalued by this benchmark. However, we must point out that at the end of 2021, 2022, and 2023 the market was also 30% or more overvalued by this benchmark, yet the market continued to climb higher. Liquidity and momentum have been overriding valuation in recent years and stock prices have been boosted by stocks benefiting or expected to benefit from the adoption of artificial intelligence. Moreover, household liquidity remains favorable and offsetting the risk in valuation are the fact that the US economy remains the global engine of growth, US is the home of many, or most of the companies benefiting from the future of artificial intelligence, and global liquidity remains high due to the sizeable global monetary and fiscal stimulus seen in the post-Covid era.

Conclusion

All in all, economic activity should remain relatively healthy in 2025 due in large part to the support given to the energy sector which will help to lower energy prices. This in turn lowers expenses for the household sector and improves margins in the corporate sector — a combination that potentially increases both consumption and corporate earnings. The incoming business-friendly administration is also expected to improve the growth path for the small business sector which is the source of over 45% of all jobs in America. Prior to his inauguration, President-elect Trump has already proven that he can get foreign companies to invest in the US, and that too, increases jobs which improves household income.

Overall, we expect top line revenue growth next year will lead to at least a 15% increase in S&P earnings and this should support further gains in the equity market. However, much of this was priced in during the November rally, and we would not be surprised if stock prices were flat to lower in the first quarter of 2025.

Gail Dudack, Chief Strategist

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The third quarter of 2024 included the long-anticipated September Federal Reserve meeting, and the first fed funds rate cut in four years. What was equally remarkable, was the dramatic shift in equity leadership, away from the popular large capitalization companies linked to growth from artificial intelligence (AI) to a much broader range of equities. This was a positive change for most investors and as a result, the Dow Jones Industrial Average gained 8.2% in the quarter, as compared to the Nasdaq Composite index with a 2.6% increase. The benchmark S&P 500 Composite index rose 5.5%, while the broader Russell 2000 index was the biggest winner with an 8.9% gain. Perhaps the most surprising point in terms of the quarter’s performance was the spectacular 23% increase in the SPDR S&P Homebuilders ETF (XHB – $124.56), a homebuilding exchange-traded fund. Clearly, this jump was in anticipation of the Fed’s rate cut and the expectation that a shift to easy monetary policy would reignite the housing market.

50 Basis points

The 50-basis-point cut by the Federal Reserve was double the level expected only a month earlier. However, a larger cut may have been the Fed’s insurance policy to reduce the risk of the US economy experiencing a recession or a hard landing. Equally important, at the end of September the Chinese government announced its biggest stimulus package since the pandemic. This package included more than $326 billion in a variety of measures such as lower central bank rates, lower mortgage rates, minimum down payments on real estate transactions, and a 50 basis point decline in the RRR (reserve requirement ratio). The People’s Bank of China Governor Pan Gongsheng said further easing is likely to be in the pipeline, and another reduction in bank reserve requirements should be expected before year-end. These additional actions may be necessary to reverse the slump in Chinese consumer consumption, a shaky property market and growing deflationary pressures.

Asian analysts believe it will take fiscal as well as monetary measures to revive China’s economy, however China’s move was greeted favorably and triggered equity and commodity rallies around the world.

Furthermore, this stimulus trend did not start in September. Many central banks — including those in Europe, England, Canada and some emerging markets — were already cutting their benchmark interest rates before the Fed pivoted in mid-September. This policy shift by a number of central banks to lower key interest rates increases liquidity in the global financial system and should be a positive force for equities. The Wall Street adage “don’t fight the Fed” has been good advice historically.

While lowering the fed funds rate will support the US economy and a sluggish residential sector, it will also help the federal deficit. At present, 21% of outstanding marketable Treasury debt is held in short-term bills. September’s rate cut and the cuts expected to follow, will lower the government’s net interest expense in the months ahead. This factor should not go unnoticed since according to current White House data, in fiscal 2023, the government’s net interest expense was 9.5% of total spending, and in fiscal 2024 it is expected to exceed the 9.9% of total outlays spent for defense and international expense.

Rate cut history

Statistics on how the stock market reacts to an initial fed funds rate cut are quite mixed. History shows that the first rate cut typically occurs when the economy is already in a recession. But note, this fact may not have been known at the time since recessions – two consecutive quarters of negative GDP — are only identified with a six-month lag. The one easing cycle that took place prior to a recession was in June 1989, however, this cut was also followed by a recession, but not until July 1990. Moreover, inflation of 6% or greater is typically followed by a recession, even though it may take years to materialize. In short, there are reasons to be cautious, yet the current Covid/post-Covid cycle has been unusual in many ways and the stock market clearly feels we are headed for a soft landing or no recession at all. And perhaps this is true and it will be different this time. But are not convinced that a normal economic cycle of expansion/recession has been eliminated entirely. It may simply have been postponed for another time.

Equity valuation is high and an election nears

Global monetary policy currently supports equities, but what does not support equities is valuation. The S&P 500 trailing 4-quarter operating multiple is now 25.2 times earnings, and the 12-month forward PE multiple is 21.5 times. By all measures, the US equity market remains richly valued and is at levels seen only during the 1997-2000 bubble, the financial crisis of 2008, or the post-COVID-19 earnings slump. Still, it may be too soon to worry about current valuation. Even in these prior cycles, the 12-month trailing PE multiple reached a range of 27 to 31 before equity prices peaked. What is more, the current influx of liquidity has led some analysts to believe the US equity market could soon experience a “melt-up” in prices. In short, if the market is forming a bubble, or about to “melt up” valuation will not matter, at least in the short run.

2024 is a presidential election year, and while these years are rarely the best-performing years in the four-year cycle, there is a strong tendency for equity prices to rise at year end. November and December tend to be good months for stocks in most years, but they tend to be the best-performing months in a presidential election year. 

In the months ahead, the unemployment rate may become more important to equity investors than Fed policy, inflation, or earnings. If the unemployment rate continues to rise, the odds of a recession will increase substantially, and the equity rally could come to an end. Conversely, if the unemployment rate remains stable to lower, it would suggest a soft landing has indeed been achieved. This would be a good omen for both future corporate earnings and equity performance.

*Stock prices are as of September 30, 2024

Gail Dudack, Chief Strategist

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The stock market’s performance in the first half of the year was strikingly similar to the action seen in the first half of 2023. The benchmark S&P 500 index rose 14.5%, a bit less than the 15.9% gain in the first half of 2023, but still a healthy performance. And once again, the tech-heavy Nasdaq Composite index was the best-acting index, even if this year’s 18% gain in the first six months was less than the 32% increase seen last year. And, as in 2023, the stellar performances of the S&P 500 and Nasdaq Composite indices were tied to big gains in a relatively small group of large capitalization stocks, particularly those linked to artificial intelligence.

In comparison, the Dow Jones Industrial Average, despite hitting an all-time high on May 17, 2024, has delivered a mere 3.8% rise year-to-date, and the much broader Russell 2000 index was virtually unchanged, up 1% at the end of June. At mid-year, the Russell 2000 index is trading more than 16% below its November 2021 peak, in stark contrast to the S&P 500 and Nasdaq Composite indices which produced a string of record highs in June. It remains a market of haves and have-nots.

The Concentration Deepens

Large capitalization stocks kept getting bigger in 2024 and by the last week of June, Amazon.com, Inc. (AMZN – $193.25) became the fifth US company to exceed the $2 trillion valuation mark. It thereby joined the rarified air enjoyed by Google’s parent Alphabet Inc. Class C (GOOG – $183.42) and Class A (GOOGL – $182.15) valued at $2.26 trillion and $2.258 trillion, respectively, Nvidia Corp. (NVDA – $123.54) valued at $3.04 trillion, Apple Inc. (AAPL – $210.62) valued at $3.23 trillion, and Microsoft Corp. (MSFT – $446.95) valued at $3.32 trillion.

These five stocks currently represent more than 35% of the S&P 500 index. This is remarkable since it was less than a year ago when Bloomberg reported that the top ten largest stocks in the S&P 500 represented a then record 32% of the S&P index. As the concentration of value in a small number of stocks increases, it makes it more difficult to outperform, or even perform in line with, the S&P 500 index unless your portfolio was overweighted in these companies.

More importantly, this market concentration is reminiscent of the Nifty Fifty stocks of the early 1970s and the Dot-com stocks of the late 1990s. Both of these bubble markets, led by a small group of growth stocks, eventually ended in tears. Note also that the peaks of these two bubbles (January 11, 1973, and March 24, 2000) were 27 years apart and we are now more than 24 years from the 2000 top. This time spread may be significant since it suggests a new generation of investors has entered the financial markets with new investment ideas and goals. The popularity of Bitcoin and meme stocks are two examples of this. And this new generation is experiencing a historic transfer of wealth. A New York Times article⃰ recently discussed “the greatest wealth transfer in history” indicating that over the next 20 years $84 trillion in assets is set to change hands from Baby Boomers to the next generation. It is a trend worth monitoring.

For all these reasons, markets are apt to remain volatile. But over the longer term, it is wise to be thoughtful in one’s investment decisions and maintain a diversified portfolio focusing on stocks with predictable future earnings streams.

Recession on Hold

Meanwhile, the US economy continues to outperform expectations in 2024 and the long-awaited recession is yet to materialize. The labor market has stayed resilient and so has the consumer, even though consumer sentiment remains at recessionary levels. Small business sentiment continues to show concerns about future revenues and cost of goods, but sentiment is up from previous lows. Housing is showing signs of weakness due to rising home prices and substantially higher mortgage rates which is making housing less affordable for many. Still, GDP for the first quarter was recently revised upward from 1.3% to 1.4%.

The Federal Reserve’s favorite inflation benchmark, the personal consumption expenditure deflator (PCE) ticked down from 2.7% year-on-year in May to 2.6% in June; while core PCE, which strips away food and energy prices and is the key metric on the Fed’s radar, fell from 2.8% year-on-year to 2.6%. This was good news for economists since it opens the door for a possible rate cut in the month of September. The one caveat for inflation would be if crude oil prices continue to rise and this increases the cost of gasoline, heating oil, and private and public transportation.

We do not believe that the economic cycle of expansion and recession has been eliminated completely, but it is clear that fiscal stimulus, not just through spending packages passed by Congress, but federal spending done through government agencies, has boosted the economy. And while spending is good for the economy it has also pushed the US debt-to-GDP ratio to 123% as of September 2023. The Congressional Budget Office estimates that the 2024 deficit will be $2 trillion, or 7% of GDP, which is nearly double the 50-year average of 3.7% of GDP. Unfortunately, this uncontrolled deficit spending could mean that the next recession will be worse than it would have been otherwise.

EARNINGS and valuation

Corporate earnings, reported as earnings per share, have been mixed but are generally better than most forecasts. Much of this is due to efficiency gains but some of this is due to the record level of stock repurchases. According to S&P Dow Jones, a total of $236.8 billion was spent on stock buybacks in the first quarter, up from $219.1 billion in the previous quarter. This was also up 10% from $215.5 billion in the first quarter of last year. The largest 20 companies in the index were responsible for 50.9% of the buybacks in the first quarter, slightly down from last quarter’s rate of 54%, but still above the historical average of 47.5%.

The companies with the biggest buyback campaigns in the first quarter were Apple, Meta Platforms Inc. (META – $504.22), Alphabet, Nvidia, and Wells Fargo & Co. (WFC – $59.39), in that order. The impact of stock buybacks is two-fold. It lowers the number of shares outstanding, which will increase “earnings per share” without any change in revenues. And it also decreases the supply of stock, which theoretically increases the stock price.

The S&P 500 trailing 4-quarter operating multiple is now 24.9 times which is well above all long- and short-term averages. The 12-month forward PE multiple is 21.1 times which is substantially above its long-term average of 15 times or its 10-year average of 19.5 times. When 21.1 is added to inflation of 3.3%, it sums to 24.4, which is also above the top of the normal valuation range of 14.8 to 23.8. By all measures, the equity market is at valuations seen only during the 1997-2000 bubble, the financial crisis of 2008, or the post-COVID-19 earnings slump. This is a reason to be watchful particularly with uncertain elections ahead in the UK, France, and the US.

* The New York Times, “The Greatest Wealth Transfer in History Is Here, With Familiar (Rich) Winners,” May 14, 2023.

Stock prices are as of June 30, 2024

Gail Dudack, Chief Strategist

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Comments by Federal Reserve Chair Jerome Powell following the December 13, 2023 Fed meeting triggered a strong yearend rally that led to all four of the major US equity indices closing the year with impressive double-digit gains. The gist of Powell’s December comments was that while there would be no immediate change in Fed monetary policy, rate cuts could be coming in 2024.

Two subsequent FOMC meetings that ended on January 31, 2024 and March 20, 2024 followed a strikingly similar pattern, that is, no change in policy, a hint of rate cuts this year, followed by a strong stock market rally. Note that this sequence of events suggests that the equity market has been discounting the possibility of 2024 interest rate cuts multiple times. And since forecasts for 2024 corporate earnings have declined slightly in the interim, this means the price-earnings ratio for equities has been climbing. It is this rise in the price-earnings ratio that has led many to feel the market is or is becoming overvalued and it is also the reason the fear of an equity bubble is rising. To date, the 2024 equity market has been a momentum-driven market and not a value-driven market.

However, if the stock market is forming a bubble, and we think it is, it is in the early stages. PE multiples are exceedingly high at 24.2 times trailing 12-months and 21 times forward 12-months. Yet during the 1997-2000 bubble, the financial crisis of 2008, and even the post-COVID-19 peak, the trailing 12-month PE reached 26 to 30 times earnings.

The financial media has heralded the S&P 500’s 10.2% gain in the first three months of the year as the best first-quarter performance in five years, but this is a bit disingenuous since this only applied to the S&P 500 index and not to other indices. The Nasdaq Composite index had a solid gain of 9.1% in the first quarter, but this was less than the 16.8% gain seen in 2023. The Dow Jones Industrial Average rose 5.6% in the quarter which was the best first quarter since the 2021 gain of 7.8%. The Russell 2000 index rose 4.8%, the best first quarter since the 12.4% also seen in 2021. In short, it was a good first quarter performance for most stocks and most portfolios, but not the best first quarter in five years.

Cryptocurrency

Still, the first quarter of 2024 may go down in history, not as the best equity performance in five years, but as the first time ETFs were introduced on spot bitcoin. After more than a decade of rejecting spot bitcoin ETFs in hopes of protecting investors from market manipulation, the Securities and Exchange Commission (SEC) was forced to approve them in January after an appeals court ruled that the SEC had not sufficiently detailed its reasoning for rejecting the products. The SEC approved 11 spot bitcoin ETFs in late January. And according to LSEG data, net flows into the ten largest spot bitcoin funds reached a stunning $2.2 billion in the week ended March 1. The cryptocurrency has soared nearly 162% since October, jumped 44% in February alone, reached a high of $73,157.00 on March 13, 2024, and generated a year-to-date gain of nearly 67%.

This surge in demand for Bitcoin (BTC= – $70,841.00) may be representative of today’s financial markets for several reasons. Bitcoin has the backing of a new generation of investors, ETFs are a form of leverage that attracts a larger audience of buyers, and there are no underlying fundamentals. Bitcoin has no assets, earnings, or revenues to analyze, yet it is surging based upon the belief that it will go higher. Likewise, momentum, liquidity, and leverage drive the typical equity bubble, not fundamentals. Bitcoin and the equity market are also similar in that they are both driven by an underlying expectation of lower inflation and lower interest rates. In sum, inflation and interest rates are the Achilles heel to both markets.

Leadership changes

Much like the popularity of spot bitcoin ETFs, many investors are using ETFs to participate in the equity market rather than buying individual stocks. And the performance of various ETFs reveals an interesting change in leadership in 2024.

In 2023 the best performing ETFs were linked to S&P sectors and industries related to technology, homebuilders, communication services, consumer discretionary, and semiconductors.

This year’s best performers have been found in oil, homebuilders, energy, communication services, financials, and industrials.

What we find most interesting about the shift in the first quarter of the year is the outperformance of oil and energy, which suggests there could be a risk of higher energy pricing and higher inflation. The good news about this shift is the outperformance of the financial sector implies a better economic environment in 2024.

Pivot or No Pivot

While the stock market is rallying in anticipation of a Fed pivot and lower interest rates, we believe a pivot is unnecessary. What many overlook is the fact that monetary policy is already very accommodative despite the rise in interest rates. Government yield curves may be inverted — and this has been the longest inversion without a recession in history – but as the Federal Reserve made a succession of interest rate hikes, underlying fiscal and monetary policies have remained surprisingly stimulative.

For example, the Federal Reserve has been shrinking its balance sheet down to $7.7 trillion as of March 20, 2024 from a peak of $9.0 trillion in April 2022. Yet this $7.7 trillion remains well above the $4 trillion seen in normal times before the pandemic. In short, the Fed’s balance sheet continues to provide considerable liquidity to the economy. Not surprisingly, this means there is plenty of liquidity in the banking system including a near-record level of total bank assets of $23.2 trillion and commercial bank deposits of $17.5 trillion (as of mid-March). These are down only modestly from the record $18.2 trillion seen in April 2022. In other words, government spending and a large Fed balance sheet have been providing liquidity and offsetting both the Fed’s interest rate hikes and the inversion of the yield curve. In our view, if the Fed should cut interest rates, we hope it is accompanied by substantial quantitative tightening. If not, it could open the door for another round of higher inflation.

*Stock prices are as of March 28, 2024 close

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2023 ended with a flourish after Federal Reserve Chairman Jerome Powell indicated that interest rate cuts were likely in 2024. This surprising “Fed pivot” by Powell following the last FOMC meeting of the year, unleased a buying surge that generated one-month gains of 4.8% in the Dow Jones Industrial Average, 4.4% in the S&P 500, 5.5% in the Nasdaq Composite and a stunning 12% in the smaller cap Russell 2000 index. The December 2023 rally carried the Dow Jones Industrial Average to a new record high and the S&P 500 came within 1% of its all-time high.

Chairman Powell’s indication that rates would soon come down, unleashed a liquidity-driven advance fueled by the $7.5 trillion in cash seen in demand deposits, retail money market funds, and small-denomination time deposits. Yet, despite strong December performances, the Nasdaq Composite closed the year 6.5% from a record high and the Russell 2000 ended 17% below its November 8, 2021 high of 2442.74.

For the full year, the Dow Jones Industrial Average gained 13.7%, the S&P 500 gained 24.2%, the Nasdaq Composite inked a gain of 43%, and the Russell 2000 index rose 15%. Overall, it was an amazing yearend performance for a year that until then had been only modestly successful and a time most analysts expected to include a recession and a poor stock market.

Remembering 2023

The first half of 2023 was expected by many, including us, to be the final chapter of the post-pandemic hangover. There were many signs of an imminent recession, including a long and severely inverted Treasury yield curve, a slump in the real estate markets, recessionary levels in consumer and business sentiment surveys, historic weakness in the leading economic indicators, and negative year-over-year retail sales. Consumers were experiencing declining purchasing power due to rising prices, and corporations suffered profit margin squeezes from escalating costs for labor, transportation, and raw materials. Yet despite all these warnings, the economy continued to grow a bit each quarter, and in the third quarter of 2023, GDP reached 4.9% on a seasonally adjusted annualized basis.

In the early and unsettled environment of 2023, some investors began to focus on the long-term growth prospects of artificial intelligence. This led to the popularity of a small group of stocks called the Magnificent Seven, which included Apple Inc. (AAPL – $192.53), Microsoft Corp. (MSFT – $376.04), Amazon.com (AMZN – $151.94), Nvidia Corp. (NVDA – $495.22), Alphabet Inc. (GOOG – $140.93), Tesla Inc. (TSLA – $248.48), and Meta Platforms Inc. (META – $353.96). These companies quickly became the investment darlings of 2023 driven in part by an analysis from PwC indicating that artificial intelligence was expected to improve productivity by 40% by 2035 and the global AI market was expected to grow 37% annually from 2023 to 2030. Not surprisingly, at a time when a recession appeared to be around the corner, these stocks became the most exciting investments to own. From our perspective, we felt it was also important to note that PwC’s surveys also showed that 73% of US companies have already adopted artificial intelligence in some areas of their business. This poses questions about the near-term potential of AI.

A Wall Street Journal article (“It’s the Magnificent Seven’s Market. The Other Stocks Are Just Living in It.” December 17, 2023) noted that these seven stocks soared 75% in 2023, while the remaining 493 stocks in the S&P 500 rose only 12% and the S&P 500 index gained 23%. But more importantly, these stocks represented 30% of S&P’s market value, which approaches the highest-ever share for seven stocks. Perhaps most surprisingly, the group represents more than the combined weighting of all stocks in Japan, France, China, and the UK, in the MSCI All Country World Index.

This outsized performance of a small group of stocks is reminiscent of the bubbly Nifty Fifty and the Dot-Com eras. In these earlier equity manias, a small group of stocks led dramatic advances that persisted for a year or two. But eventually, an extremely overvalued market later ended in tears. In our opinion, even though the current advance may not be over, there is risk in the overall market, and more importantly in these seven stocks. The Magnificent Seven stocks have discounted a substantial amount of future growth which means they would be vulnerable should anything challenge the expectations of AI-driven earnings growth. At the same time, these numbers suggest there is much better value found in the broader marketplace.

Our 2024 Forecasts

Our assumptions for 2024 include GDP growth of 0.8% YOY for the full year, which implies slowing economic activity and the possibility of a negative quarter of growth, but the year should escape a full recession of two consecutive falling quarters of GDP. In this environment we are assuming some weakness in topline revenues, but efficiencies developed during the economic shut down and a rocky economy in 2023 will help companies generate modest earnings growth of 10%. Given the Fed’s recent pivot we are expecting a possible 75 basis point decrease in the fed funds rate. To do this, we are assuming a modest decline in inflation to 2.75% which will allow the Fed to maintain a real yield of 220 basis points in the fed funds rate throughout the year. In line with this, our forecast expects Treasury bill yields to fall to 4.25% in line with an easier Fed policy, and for Treasury bond yields to be lower and stable at 3.6%.

There are many risks to these forecasts since external factors like the Houthi’s attacks in the Red Sea have the potential to interrupt trade and send oil prices higher. Other risks include the possibility that efficiencies from artificial intelligence may prove to be less than expected. The wars in Ukraine and Israel could increase past current borders and trigger fear of a widening escalation. Politics should be a major topic in 2024 since there will be nine parliamentary elections in Europe in 2024, as well as elections in the UK, Mexico, Taiwan, and the US.

Although the economy may manage to muddle through a year of sluggish growth in the economy and earnings, equity valuation remains a hurdle. Our forecasts for 2024 coupled with our valuation model, yield a mid-point predicted PE of 15.8 and a top-of-the-range PE of 18.4. This, combined with our 2024 S&P 500 earnings forecast of $230 creates a midpoint S&P 500 target of 3634 and a high of 4295 for 2024. Using a higher IBES 2024 earnings estimate of $245.21, these targets rise to 3875 and 4511, however, yearend prices have already exceeded these levels. And for those who think our model’s predicted PE multiples are too low, note that at the end of 2023, the S&P trailing PE was 22.3 and the 12-month forward PE was 19.6. These are at or above the top of the normal range for PE multiples. In sum, this implies that next year’s earnings growth has already been factored into current prices and this will leave the equity market vulnerable during every earnings season in 2024.

Sector changes

A shift in relative performance at the beginning of an advance is often a sign of new sector leadership and we are using December’s relative performance as a predictor of 2024 price action. As a result, we expect good performance from the consumer discretionary, financial, and materials sectors. Weak relative performance in December suggests underperformance in energy, staples, and utilities. December’s good performance in financials is a bullish factor since new bull market cycles require participation from this sector. However, the out-performance in the materials group may be a warning that inflation is not yet under control. Altogether, 2024 may be a year that requires nimbleness and attention to good fundamentals.

Closing prices are as of December 29, 2023

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After a spectacular equity performance in the second quarter of 2023, the six-month surge of 16% in the S&P 500 index was the best first-half performance seen in this index in forty years. However, it did not last. The third quarter took much – or in the case of the Russell 2000 index, nearly all – of these gains away. Losses in the third quarter were 2.6% in the Dow Jones Industrial Average, 3.6% in the S&P Composite, 4.1% in the Nasdaq Composite index, and 5.5% in the Russell 2000. By the end of September, the popular indices closed with more modest year-to-date gains of just over 1% in both the Dow Jones Industrial Average and the Russell 2000 index, nearly 12% in the S&P Composite, and a still substantial 26% in the Nasdaq Composite index. In short, a narrow list of large-capitalization technology stocks that dominate the Nasdaq Composite continued to be the outperforming segment of the stock market in 2023. On the other hand, the average stock ended mostly unchanged after the first nine months of this year.

Higher and Longer

There was a multitude of reasons for the price weakness experienced in August and September, beginning with the fact that a government shutdown was at hand. Financial markets have weathered many government shutdowns in the past without much difficulty. But distinct from other recent shutdowns, such as the record 35-day government shutdown that began in December 2018, the Federal Reserve’s monetary policy is currently restrictive and expected to remain so. It was different in December 2018 when the Fed was signaling it was tilting dovish and about to wrap up its hiking cycle. In short, the overriding problem at the end of the third quarter was that the 10-year Treasury yield hit a 16-year high above 4.5% and may continue to climb upward. This could become a major hurdle for equities in the months ahead.

The concept of higher interest rates was also made clear by Fed Chairman Jerome Powell and his fellow Board members. Although the Federal Reserve chose to pause rate hikes in September, comments following the September FOMC meeting indicated that additional rate hikes were likely in the near future and interest rates were apt to remain high throughout most, if not all, of 2024. This crushed the consensus view that rate cuts would likely materialize by mid-2024. Adding to the view that interest rates would remain higher for longer were comments by Jamie Dimon, CEO of JPMorgan Chase & Co. (JPM – $145.02) who stated that many businesses and investors were not prepared for a worst-case scenario in which interest rates hit 7% and stagflation grips America. As a result, investors were forced to reassess equity risk and valuation at the end of the third quarter.

October Turnaround

From a historical perspective, September tends to be a seasonally weak month for equity performance. In fact, September ranks dead last in terms of performance and is the only one of all twelve months that averages a loss. Conversely, October, which tends to have a worse reputation than September, ranks seventh of all twelve months with an average gain of 1.0% in the S&P Composite. What is unique about October is that it tends to be a turnaround month and while its performance has often been dramatic it has also been a month that includes a number of bear market lows. This year October could be a particularly interesting time since so many risks are on the horizon and apt to be discounted.

The End of Goldilocks

In addition to the risk of the government shutting down, there is a United Auto Workers strike that is ongoing and negotiations do not seem to be close to an agreement. Whatever agreement passes, it will be scrutinized by economists for signs of future wage cost pressures and linkages to inflation. In terms of household finances, the reinstatement of student loan payments on October 1st and the October 15th due date for individual tax payments for Californians are likely to take a bite out of future spending. This could slow the economy.

Large-capitalization technology stocks have been at the core of positive price performance this year, but the Federal Trade Commission and 17 State Attorneys General are currently suing Amazon.com, Inc. (AMZN – $127.12) for monopolistic and unfair business practices with an aim to break up the company into smaller pieces. Simultaneously, the Department of Justice and eight states are also suing Alphabet Inc.’s Google (GOOG – $131.85), the second DOJ antitrust lawsuit against the company in just over two years. This suit focuses on Google’s monopolistic activities in the online advertising business and seeks to make Google divest parts of its business. Both suits could produce landmark changes in the internet space and could unsettle the market in October.

From a global perspective, it is important to monitor the crisis facing China’s property development sector. China Evergrande Group (3333.HK – 0.32), collapsed in 2021 and set off a panic in global markets. Now Country Garden Holdings Company (2007.HK – 0.91), the country’s largest real estate giant, is in default. The property sector represents roughly a quarter of China’s economy, is closely tied to China’s financial system, and many Chinese individuals who paid deposits on properties could lose all of their investment if the company fails. Experts feel these real estate troubles could spread into China’s broader financial markets and this could do significant damage to the world’s second largest economy. If so, it would be a major negative for global economic activity.

Oil prices surged at the end of September after government data showed that US crude stocks fell to the lowest level since July 2022. This announcement drove energy futures to their highest settlement in 2023 and compounded worries about tight energy supplies as we head into the winter heating season. This event coupled with the previously announced production cuts of 1.3 million barrels a day by Saudi Arabia and Russia have energy analysts forecasting crude oil prices of $100 a barrel in the near future. The technical charts for WTI energy futures also suggest higher prices. Higher energy prices will be a problem for future inflation benchmarks and will only add to the view that further Fed rate hikes may be necessary in the future. All in all, the Goldilocks view of a soft landing for the economy, lower inflation, and lower interest rates was debunked in September and this left equities vulnerable.

Trading Range Market

However, this has not changed our view that the equity market will be stuck in a broad trading range in 2023. This range is best defined by the chart of the Russell 2000 index which has been trading between support at 1650 and resistance found at 2000. Trading range markets are not unusual from a historical perspective, and they typically result from an overhanging issue in the economy such as high inflation or broad-based debt problems. We believe they can be a substitute for a more dramatic bear market cycle, and they allow equity valuations to normalize. Keep in mind that equity prices rose substantially in the first half of the year, but earnings did not. As a result, equity valuations became stretched.

However, trading range markets do require a change in strategy since there tends to be a rotation in leadership throughout this “flat” cycle and this experience can be frustrating for long-term investors. Yet in the long run, buying stocks which represent good value, a solid predictable earnings stream, and an above-average dividend yield tends to generate the best overall performance. Look for stocks where earnings growth is greater than that of the S&P Composite, but the PE multiple is lower than the S&P. This combination should outperform in the long term.

Meanwhile, we would not rule out a decline in early October that creates an excellent buying opportunity!

*Stock prices are as of September 29, 2023

Disclosure: The information herein has been prepared by Dudack Research Group (“DRG”), a division of Wellington Shields & Co. The material is based on data from sources considered to be reliable; however, DRG does not guarantee or warrant the accuracy or completeness of the information. It is published for informational purposes only and should not be used as the primary basis of investment decisions. Neither the information nor any opinion expressed constitutes an offer, or the solicitation of an offer, to buy or sell any security. The opinions and estimates expressed reflect the current judgment of DRG and are subject to change without notice. Actual results may differ from any forward-looking statements. This letter is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the specific needs of any person or entity.

This communication is intended solely for use by Wellington Shields clients. The recipient agrees not to forward or copy the information to any other person without the express written consent of DRG.

Copyright © Dudack Research Group, 2023.

Wellington Shields is a member of FINRA and SIPC

Gail Dudack, Chief Market Strategist

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The increases seen in equity indices in the first six months of 2023 exceeded most forecasters’ projections and the first half ended with a gain of nearly 16% in the S&P 500 index. This was the best six-month performance in this index since 1983; however, the action of the S&P 500 index was not the experience of all equity investors. The tech-centric Nasdaq Composite index rose nearly 32%, or over twice the performance of the S&P 500. Conversely, the Dow Jones Industrial Average advanced a mere 3.8%, or less than one-fourth the performance of the S&P 500. The broader-based small capitalization index, the Russell 2000, rose 7.2%, and the Invesco S&P 500 equal weight ETF (RSP – $149.64) gained less than 6% year-to-date.

The disparity among the performances of the indices is best explained by the fact that the returns in the Nasdaq Composite and S&P 500 indices were due to gains in a relatively small group of large capitalization technology stocks, primarily those companies with exposure to generative artificial intelligence. It was a classic display of “FOMO: fear of missing out” that drove the momentum of AI-related stocks. As an example, Nvidia Corp. (NVDA – $423.02), which designs the chips and software used to power generative AI systems, soared nearly 190% in the first half of the year and Microsoft (MSFT – $340.54), which recently partnered with OpenAI, a company that debuted its ChatGPT generative AI-powered chatbot in November 2022, gained 42% year-to-date.

According to S&P Global Intelligence, in the first six months of the year, the top 10 performing companies in the index accounted for 37.4% of the total gains in the S&P 500 and several of these stocks hit major milestones at the end of the second quarter. Apple (AAPL – $193.97) breached the $3 trillion market capitalization mark and Microsoft was next in line with a market capitalization exceeding $2.5 trillion at the end of June.

What was most surprising was the market’s positive performance in spite of significant hurdles, in particular, the aggressive interest rate increases done by the Federal Reserve Bank and a series of US regional bank failures. Typically, either of these two scenarios would have triggered a decline in equity prices. However, in the month of June there were a number of developments that boosted investor optimism. The Federal Reserve Bank decided to pause its series of interest rate increases on June 14. CPI and PPI data for May showed inflation pressures were decelerating in most sectors of the economy. May housing statistics hinted at a possible turnaround in the residential housing recession. And finally, the last revision of first-quarter GDP growth showed economic activity increased at a 2% annualized rate, up from an earlier estimate of 1.3%. This latter point may be the good news/bad news story for the second half of the year since a strong 2% number gives the Federal Reserve more leeway to increase the fed funds rate in the months ahead without fear of pushing the economy into a recession.

Recession or no Recession?

Those looking for a recession in 2023 have been stymied to date, but according to historical precedents, there have been a number of reasons to expect a recession is on the horizon. First and foremost, the inversion of the government yield curve has been near historic levels and exceeded only by the inversions seen in January 1981 and September 1973. In both 1981 and 1973, a deeply inverted yield curve predicted severe recessions ahead. Economists have focused on the yield curve as a warning shot because in the last 70 years an inverted yield curve preceded each of the 9 recessions defined by the NBER.

Another economic caution signal is the Conference Board Leading Economic Index (LEI). This index is a composite of 10 variables that typically foresees turning points in the business cycle by about seven months. Over the last 60 years, a sustained decline in the LEI has preceded all but two US recessions. False signals in the LEI are rare, although a decline for several months in October 2019 did not result in a recession. Nevertheless, the LEI has been declining for 14 consecutive months and this is the first decline of this length without an economic slowdown.

Monthly retail sales are an important indicator of economic activity since roughly 70% of US GDP is driven by personal consumption expenditures. When monthly retail sales are adjusted for inflation, it is easy to see if real sales are increasing or decreasing. Typically, if real retail sales are declining for more than three months it is either a symptom of a recession already in place or of one about to appear. As of May, real retail sales have been negative for six of the last seven months, yet GDP for the second quarter was revised upward to 2%. In short, a series of economic indicators have been waving warning flags of a recession and supporting a cautious view. Nonetheless, the economy has been resilient.

However, our favorite indicator for predicting a recession may hold the key to economic strength or weakness. Year-over-year changes in total employment have accurately predicted recessions in each of the last seven economic cycles. When the total number of people employed in the US turns negative on a year-over-year basis, it is a precursor of a recession. When this deceleration or decline in job growth reverses, it signals the end of a recession and the start of an economic recovery. By this simple measure, the US economy appears to be in fine shape because as of the end of May job growth was 2.7% YOY and well above the long-term average of 1.7%. The strength in the job market supports those economists who believe the Federal Reserve may be able to get inflation down to 2% without a major recession. Overall, this mix of indicators is likely suggesting that the second half of 2023 will be a mix of hot and cold sectors and of generally sluggish growth.

Student Loan Forgiveness

Several post-pandemic stimuli will end in the second half of the year, and this could negatively impact the consumer. The biggest of these is the end of student loan forgiveness. At the end of June 2023, the Supreme Court blocked President Biden’s bid to provide $430 billion of student loan forgiveness to borrowers. It was not a surprising development since according to the Constitution, the “power of the purse” resides in Congress, not the Executive branch of government. And though the White House responded with a string of new proposals to circumvent the Supreme Court ruling, it is very likely that a three-year moratorium of debt payment for student borrowers is coming to an end in October.

As a reminder, in March 2020, the CARES Act suspended payments for federally sponsored student loans, or roughly debt totaling $1.4 trillion. The Act also mandated a zero percent interest rate on outstanding balances and suspended collection activities on defaulted student loans. A Federal Reserve Board Study, “Implications of Student Loan COVID-19 Pandemic Relief Measures for Families with Children (May 2023), quoted an analysis which estimated that most student loan borrowers were able to improve their credit profiles during the pandemic and as of the Spring of 2022, grew their savings balances by $80 billion. This was a plus for economic activity. An analysis by Goss, Mangrum, and Scally (2022) estimated that approximately $200 billion in aggregate payments were waived for all borrowers that were eligible.

In other words, $100 billion per year in debt payments were frozen whether or not borrowers were current or in default on their loans, and this provided a substantial boost to consumer spending. However, in October, 44 million Americans will have to start paying back student loans with payments ranging from $210 to $320 per month and this will become a burden for many households. Moreover, many debtors will have had a change in their servicing companies in the last three years and this will add to the confusion in October and what is expected to be an increase in defaults and reductions in credit ratings for many borrowers.

All in all, economists expect that the resumption of student loan payments will generate a loss of roughly $70 billion in personal spending. While $70 billion may be a small number relative to nominal GDP of $26.5 trillion, it will be a major headwind for retail sales and some consumer-driven companies.

offense or defense?

In our view, the reason investors focused on stocks linked to generative artificial intelligence is that earnings growth for the overall market has been negative for three consecutive quarters and the outlook for 2023 corporate earnings remains uncertain. Although it has not received much attention, S&P Global data shows that in 2022 earnings for the S&P 500 declined by 5.4% and expectations for 2023 include an increase of 10% year-over-year. Overall, this does not support a robust bull market.

The June runup in equity prices was driven more by sentiment, and excitement in AI, than by earnings growth and as a result PE multiples have expanded. The S&P 500 index is now trading at 21.6 times earnings, which is 36% above the historical average of 15.9 times. This makes the equity market vulnerable to any unexpected surprises, particularly if the Federal Reserve continues to raise interest rates in the second half of the year.

However, since most of the recent gains have been concentrated in the AI favorite stocks which dominate the Nasdaq Composite index, this is where most of the risk is concentrated. The excitement in AI stocks is reminiscent of the Nifty Fifty era which led to the 1970 peak or the technology bubble of 2000. And the $1.44 trillion sitting in retail money market funds means there is plenty of dry tinder that could move these stock prices even higher. But we would not chase large capitalization stocks at this point. Instead, we would invest for the longer term and focus on companies with the most predictable earnings streams for 2023 and 2024 and where PE ratios are below the S&P 500 level of 21.6 times.

*Stock prices are as of June 30, 2023

Gail Dudack, Chief Strategist

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