Summer Slog
Not much excitement in the equity market of late with the S&P 500 in consolidation mode over the past month (pushing above 4,400 on June 15th and closing Friday at 4,399). The release of hawkish FOMC minutes and a weaker than expected print on nonfarm payrolls were enough to send the major averages to their second weekly loss in the last three (Dow -2.0%, Russell 2000 -1.3%, S&P 500 -1.2%, and the Nasdaq -0.9%). We are seeing early signs of waning momentum with a MACD sell signal close to triggering on the S&P 500. Many market observers have been comforted by the improvement in market breadth over the last month, but you can see in the chart below from Tier1Alpha that current breadth readings have pushed stocks into overbought territory (green optimism line) and more times than not in the past have coincided with the end of a rally (see white vertical lines). Note, this isn’t implying something sinister or that a crash awaits, but rather perhaps a correction or a period of consolidation in equities is in order – kinda like we’ve seen over the past 30 days.
Be sure and keep in mind that sentiment and positioning have flipped decisively into the bull camp with the CNN Fear/Greed Index, Investors Intelligence poll, and AAII survey back to their highest levels since November 2021 (the month of the Nasdaq’s cycle peak). As for the week ahead, investors will be focused on Wednesday’s CPI report (whisper numbers are for a sub-3.0% y/y print) and the start of Q2 earnings season on Friday (Wells Fargo, Citi, and JP Morgan).
Let me take a moment to share a couple of thoughts on the June jobs report released on Friday. The headline number showed +209k jobs created, which was below consensus expectations for +230k and this was the first time in 14 months that the print came in below consensus forecasts. This was the lowest level of job growth (+209k) since December 2020 and there were negative revisions (-110k) to the prior two months. As a result, the average three-month increase in job gains slipped to +244k from +344k at the start of the year. The U-3 unemployment rate declined to 3.6% from 3.7%, but the broader U-6 measure (a far more inclusive metric) rose to a 10-month high of 6.9% from 6.7%. Lastly, the private payroll diffusion index (measures the breadth of job growth) fell to a three-month low with only 58% of industries expanding payrolls last month, down from 61.2% in May.
Bottomline, the labor market is slowing (not a surprise based on what leading indicators for the labor market have been flashing), but we are a far cry from anyone being able to proclaim it as weak. Look, with the S&P 500 at 4,400 (almost exactly the same level it was when the Fed implemented its first rate hike last March), the housing market remaining firm, and consumer spending holding in, you have to give the benefit of the doubt to the ‘immaculate soft landing’ scenario playing out. Without question, I still have my doubts and firmly believe based upon the history of business cycles, leading indicators, and the laws of financial gravity that 500 basis points of interest rate hikes within fifteen months will leave a bigger mark than it has, but such a view is lacking validation from real-time data at this point.
Sure, there have been plenty of cracks in reported economic data that support the sceptics viewpoint, but until stock prices fall, earnings decline more dramatically, and/or the housing market turns down more decisively – why would executives slash headcount more aggressively? I say this because I remain firmly of the view that nothing bad happens in asset prices or the economy until the labor market experiences a legitimate cyclical downturn (not just a churning by attrition).
We got some constructive news on the inflation front overnight out of China where the headline CPI print came in at 0.0% y/y in June and the core rate slowed to a miniscule +0.4% from +0.6% in May. The trend in the inflation data from the globe’s second largest economy suggests that outright deflation will be a reality in the months ahead. That’s already the case for producer prices, which have been deflating y/y for nine consecutive months.
Seeing inflation melt away in the U.S. and threats of deflation in China makes one scratch their head as to why yields in the global bond market continue to move higher. The Fed Funds futures market is pricing in 93% odds of another Fed hike this month and greater than 50% odds of yet another hike by November. On top of that, the bond market has priced out a good chunk of the ensuing easing cycle with futures now looking for a 4.5% funds rate by the end of 2024 (this was south of 3.9% before the recent FOMC minutes were released last week). Keep in mind that these markets can reprice quickly and aggressively if/when the economy and/or the financial markets come under significant strain – so don’t extrapolate these prices as anything more than the bond markets view of the future based on current information.
Humor me as I put on my tinfoil hat for a moment. I ponder how much of the rise in U.S. Treasury yields is attributable to the high and rising level of outstanding government debt. As can be gleaned from the below chart, the U.S. habitually runs budget deficits, but the uniqueness about the current fiscal year deficit/GDP ratio of 8% is that it is happening with GDP still growing and the economy at full employment. What’s it going to look like in a recession? Exacerbating this trend are interest rate hikes by the Fed which have assisted in expanding the deficit from 3.5% to almost 8% of GDP in the past year (other factors contributing as well). But this increased interest expense to Uncle Sam is an interest subsidy to those holding Treasuries. Given deficits have become perpetual, this can act as a stimulus to the economy as it is funded from the Treasuries printing press – eventually the piper will have to be paid and the U.S. will make good on these claims (wink, wink, nudge, nudge).
I have to say it’s pretty impressive to see the equity market performing the way it is with interest rates moving to near their highs of the cycle – Fed Funds north of 5.5%, 2-year yields back to March highs (when the S&P 500 was 10% lower), 10-year yields at the highest level since November (when the S&P 500 was 15% lower), and the long-end challenging cycle highs. The last time the S&P 500 traded above 4,400 was in July 2021 when the 2s/10s yield curve was +108 basis points versus -90 basis points today and 10-year real rates were sitting at -1.1% versus +1.80% today. It goes to show you that it is never just one thing that drives asset prices. However, these corresponding moves do call into question the narrative that higher rates have a more detrimental impact on long-duration assets (Tech, Discretionary, and Communication Services) than they do cyclical assets (Financials, Energy, & Industrials).
As for the upcoming Q2 earnings season, the consensus is at -7% year-over-year in what would be the worst showing since the second quarter of 2020 if final numbers meet expectations. In addition to earnings falling, analysts are also forecasting a fall in profit margins to 11.4%, a meaningful slide from the 13% peak reached at the heights of the speculative mania and meme stock craze in the spring of 2021. Without question earnings have held up better than feared (although, so has economic growth – the two are correlated after all), but an S&P 500 up 15% ytd and a Nasdaq up 31% with profits contracting, 500 basis points of interest rate hikes in the rearview mirror with lags still working their way through the system, and a deeply inverted yield curve is history in the making. As a result, the S&P 500’s 12-month forward P/E multiple has climbed to just over 19x from 15x at the start of the year. The S&P 500 Equal Weight index is far more reasonable at a 15x forward multiple.
Currently, the Dow is the index I prefer the most out of the three major averages with an enticing combination of quality, earnings stability, balance sheet strength, and catch-up potential if the ‘immaculate soft landing’ materializes. One other area of interest and screens as deep value right now are the battered bank stocks – down 20% on the year and trading at 8x multiple. Sure, they have some challenges ahead in the form of impairment charges and interest rate risk, but their loan books will continue to be rolled over at much more favorable yields and that should create a nice uptick in earnings down the line. In a nutshell, there looks to be quite a bit of pessimism priced in, for valid reasons, but it does look overdone.
As for bonds, this has been the bane of my existence this year in that I didn’t expect yields would threaten their highs from last fall. But this is now the 8th time the 10-year T-note has tested the 4% yield level in the past fifteen years, and none have been sustained. Time will tell whether this time is different, but history argues otherwise and those brave enough to buy or own bonds when the 10-year yield previously flirted with 4% were rewarded with positive total returns to the tune of +5 – +20% over the ensuing 12 months.
We are in an investment environment where opportunities are scarce in some areas, risky in others, and abundant in fewer and fewer segments. It’s a great time for a broadly diversified portfolio mix of assets – call it an allocation to everything with a commitment to nothing strategy. This will give you unbridled flexibility to adapt and make those ‘committed’ adjustments to your asset mix when/if the backdrop changes. In the meantime, you should be content to carry some risk assets in order to participate in a continuation of this year’s trends and carry some cash/high quality fixed income that is yielding mid-single digits. Sprinkle in a little precious metals, foreign equities, and commodities exposure and you have a portfolio that should hold up reasonably well no matter what the future holds.
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