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
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