If you are focusing on the recent gains in the S&P 500 and the Nasdaq Composite index, you might think a major equity rally is underway. However, with the exception of seven technology stocks, the S&P 500 is unchanged this year as seen by the SPX equal-weighted index which is down 0.35% year-to-date. Viewed another way, the Nasdaq Composite is up 24% year-to-date, while the Dow Jones Industrial Average is down 0.3%. Our favorite index for monitoring the market is the small-cap Russell 2000 index which is up 0.3%, or essentially flat. In short, the 2023 stock market is all icing, no cake.

Most of the recent excitement in the stock market comes down to one stock — Nvidia Corp. (NVDA – $401.11) – up 30% in the last three trading sessions as a result of the billions of dollars expected to be invested in artificial intelligence in coming years. We have no doubt that there will be a lot of investment dollars directed at AI in the years ahead, but a mania seems to be the best description of the action in NVDA this week.

Volmageddon

And there are other interesting market trends that should be noted. A recent Wall Street Journal article titled U.S. Stock Market Stays Calm With Help From Quant Buying, suggests that the equity market remains calm in the face of the debt-ceiling debate due to demand from quant funds. The article states: “At the end of March, quant-focused hedge funds held about $1.13 trillion in assets, according to research firm HFR, hovering just below last year’s record high. That represents about 29% of all hedge-fund assets.”

“It’s rules-based trading,” said Charlie McElligott, a managing director at Nomura Securities International. “There’s no emotion involved.” Data from McElligott shows quants tend to move together quickly when volatility strikes. Take, for example, the stock market selloff of May 2019, when the S&P 500 slid some 7% as investors panicked about U.S.-China trade tensions. McElligott estimates that CTAs unloaded $35 billion worth of equities over the course of a month.”

However, rather than being a calming influence on the equity market, we believe this concentration of quantitative investments could prove to be risky down the road. It is reminiscent of another memorable event in equity history – Volmageddon — which is a blend of the words volatility and Armageddon. Volmageddon refers to the unusual activity that occurred on February 5, 2018. On this day, after about a year of rising stock prices and low stock market price volatility, the CBOE Volatility Index (VIX – 17.46) soared from an opening value of 18.44 to 37.32 at close. Unfortunately, the low volatility that characterized the 2017 stock market had generated huge demand in leveraged short volatility trades, especially in the Velocity Shares Daily Inverse VIX Short-Term note, whose ticker was XIV. The XIV (no longer traded) shrank from $1.9 billion in assets to $63 million in one day due to the jump in the VIX. The SPX only fell 5% on February 5, 2018, but February 5, 2018 proved to be just the beginning of a volatile year that ended in a large December sell-off, a 6.2% decline in the SPX and a 12.2% loss in the Russell 2000 index.

In short, this big increase in quant-based investment can have a calming impact on equity prices today, but if sentiment changes, it can also trigger a lot of volatility, illiquidity, and serious damage to stock prices in the future. In sum, we would not chase this rally and remain focused on recession resistant stocks with predictable earnings streams.

Economics review

After hitting cyclical lows in June or July of 2022 and rebounding to 12-month highs in February 2023, both the University of Michigan and the Conference Board sentiment surveys dropped in the month of May. The declines were across the board including the overall index, present conditions, and future expectations. May employment will be reported on Friday, and it will be interesting to see if these declines in sentiment are a leading indicator of job market weakness. See page 3.

June’s FOMC meeting is only two weeks away. Another month of inflation data will be available in early June, but April’s inflation data could support another rate hike. Both headline and core CPI were relatively unchanged at 4.9% YOY and 5.5%, respectively. Service sector inflation fell from 7.3% to 6.8%, services less rent fell from 6.1% to 5.2%, services less medical care fell from 8% to 7.6%, while other services rose from 4.4% to 4.7%. Nevertheless, all service sector inflation data remains high and well above the Fed’s 2% target. See page 4.  

However, small declines in inflation are helping households. April’s personal income rose 5.4% and CPI rose 4.9% which means real personal income is improving. Moreover, disposable income rose nearly 8% as tax payments fell and this produced a 3.4% YOY gain in real disposable income. April became the fourth consecutive monthly gain seen in real personal disposable income. See page 5. Personal consumption expenditures (PCE) rose 6.7% in April. Although expenditures are positive on a year-over-year basis, there are clear signs of deceleration in all categories including durable goods, nondurable goods, and services. See page 6. 

Several financial commentators have stated that the current savings rate is “average”, but this is far from accurate. The current savings rate of 4.1% compares to the historical average of 8.8% or the 22-year average of 6.6%. In short, savings are well below average. And while the savings rate did soar to 33.8% in April 2020 as a result of pandemic stimulus checks, that buffer has been depleted. Therefore, it is not surprising that personal consumption expenditures are also decelerating. See page 7. 

Retail sales rose a mere 0.15% YOY in April and real retail sales fell 3.2% YOY. Much of this was due to a decline in auto sales which fell 5.8% in the month and 3.4% YOY. However, a lack of motor vehicle inventory has hampered auto sales due to supply chain disruptions; but auto sales face a new hurdle from rising interest rates which will increase the cost of leases and auto loans. See page 8.

Technical Indicators The charts of the S&P 500, DJIA, and Nasdaq Composite are technically positive, but the SPX and DJIA failed to better critical resistance at SPX 4,200 and DJIA 34,500. The Nasdaq bettered the 12,500 resistance, but this was due primarily to Nvidia Corp. (NVDA – $401.11). The Russell 2000 remains our favorite guide for the broader marketplace and it remains well within a defined range with support at 1,650 and resistance at 2000. See page 12. The 10-day average of daily new highs is 94 and new lows are 109, making this combination negative since new highs are below 100 and new lows are above 100. See page 14. With the debt ceiling vote still incomplete, the Russian/Ukraine conflict escalating, Chinese GDP expected to slow from the first quarter’s 4.5%, Friday’s job report, and the FOMC meeting on June 14, there are many ways sentiment could change. Note that there was renewed weakness in crude oil and gasoline prices this week which implies fear of an economic slowdown may be increasing. We remain cautious.  

Gail Dudack

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Economic Mish Mash

One could build a case today for either a strong or weak economy based on recent data releases or from financial headlines. And it could be difficult to say who is right or wrong. In terms of economic strength, financial headlines noted that the US consumer is strong and resilient as seen by April’s total retail sales which rose 0.4%, the second month-to-month increase in the last six months. Industrial production increased 0.2% YOY in April led by a 16% YOY increase in auto and truck production. In terms of housing, the NAHB/Wells Fargo Housing Market Index (HMI) rose to 55 in May, a 10-month high. This NAHB survey of homebuilders is designed to take the pulse of the single-family housing market and it appears that housing may be on the mend. In general, economic activity appears healthy.

However, if one unpacks the April retail sales data it is easy to see that total retail & food services rose 1.6% on a year-over-year basis, a deceleration from the 2.4% YOY gain seen in March. Moreover, this 1.6% YOY increase was well below the level of inflation, which rose 4.9% YOY in April. In other words, real retail sales are negative and are decelerating which does not suggest the consumer is improving. In addition, a deceleration in sales implies corporate margins could be squeezed as consumption declines. What was notable in April’s report is that the standout segment of retail sales was, and continues to be, food services and drinking places, which rose 8.3% YOY before adjustments and 9.4% YOY after seasonal adjustments. See page 3. But in our view, this is not a broadly encouraging picture for an economy that is consumer driven.

Plus, offsetting the nice rebound in homebuilder sentiment was the University of Michigan consumer sentiment index for May. The headline consumer sentiment index tumbled to 57.7 from 63.5 in April. The decline was led by expectations, which fell a sizeable 7.1 points to 53.4. Current conditions also fell 3.7 points and as a result, each component is in recessionary territory. See page 5. In our view, the University of Michigan sentiment indices could be a warning for the homebuilders, since this survey is for May and the homebuilder survey was for April.

In terms of being either strong or weak, inflation data for April was also a tale of two cities. Headline CPI was 4.9% YOY in April, down only slightly from 5% in March. Core CPI was 5.5%, nearly unchanged from the 5.6% reported in March. More importantly, core service CPI was 6.8% versus 7.1% in March and remains stubbornly high.

The producer price index data was much the same. PPI for finished goods was 2.6%, down from 3% in March and final demand PPI was 2.4%, down from 2.8% in March. However, final demand PPI for the service sector was 3%, up from the 2.8% reported in March. Core PPI was also down from the 6.4% YOY pace seen in March, but it nonetheless remains high at 5.4% YOY. See page 4.

The importance of the stubbornly high inflation seen in the service sector is that it gives the FOMC a reason to worry about the embedded inflation in the economy, and to possibly raise rates again in June. This has not been the consensus view, but it has been something that several Federal Reserve governors have hinted at in recent discussions.

Earnings and Valuation

As earning season nears completion, and with over 91% of the S&P 500 companies having reported results, the S&P Dow Jones consensus estimates for 2023 and 2024 are $218.86 and $244.26, which rose $1.15 and fell $0.59, respectively, this week. Refinitiv IBES earnings estimates for 2023 and 2024 are $220.09 and $245.83, falling $0.78 and $0.60, respectively. See page 7.

We match our historic estimates to the S&P Dow Jones estimates since they have the longest historical database and because S&P is careful to see that estimates are uniform and reflect GAAP standards. [GD1] Nevertheless, our 2023 forecast of $180 for the S&P 500 is currently well below both the S&P Dow Jones consensus estimate of $218.86 and the IBES Refinitiv consensus estimate of $220.09. But this does not change the basic valuation standing of the market.

On page 6 we show two versions of our valuation model, one with the S&P Dow Jones estimate of $218.86 for this year and one with our $180 forecast. Surprisingly, there is little difference between these various estimates in terms of whether the equity market is currently overvalued, fairly valued, or undervalued. With both estimates, equities were overvalued prior to the surge in inflation in 2021 and became even more overvalued as interest rates rose in the last twelve months. The only difference is how much the fair value range increases, or not, by the end of the year. In both cases, our other model inputs for 2023 include an inflation target of 3.6% at year end and a fed funds target of 5.25%. We can envision scenarios in which inflation is better or worse in the second half of the year, but we believe our estimates are relatively sensible.

Still, the bottom line is that the equity market appears quite overvalued at current prices when using both the S&P estimates and our forecast. The main difference is that with S&P estimates the midpoint for the 2023 year-end fair value range rises from the year-end level of SPX 2700 to SPX 3235. Using DRG estimates, the midpoint of the fair value range falls from the year-end level of SPX 2700 to SPX 2660. We may be too pessimistic in our earnings estimate; but it is worth pointing out that even with the S&P estimates of an 11% increase in earnings this year and a 12% increase next year, coupled with inflation falling to 2.4% by the end of 2024, our model shows the midpoint of the fair value range to be SPX 3860 at the end of 2024.

In sum, this exercise shows that many things would have to go much better than expected for the stock market to move significantly higher from current levels. This is one of the reasons we remain cautious and would focus on companies and stocks with the most predictable earnings and reliable dividend payouts.

Technical Update

The charts of the S& P 500, Dow Jones Industrial Average, and Nasdaq Composite are technically positive, but each has failed to better critical resistance just above current prices. These levels are: SPX 4,200; DJIA 34,500; and Nasdaq 12,500. The Russell 2000 remains our favorite guide for the broader marketplace since it remains well within a defined range with support at 1,650 and resistance at 2000. See page 9. The 25-day up/down volume oscillator fell to a negative 1.99 reading this week but it is still in neutral territory. The oscillator recorded one-day overbought readings of 3.0 or higher on April 18, April 24, and April 28, but was unable to maintain an overbought reading on a rally. These failed overbought readings revealed a weakness in underlying buying pressure, i.e., demand. See page 10.  

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Gail Dudack

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At the May meeting of the Economics Club of New York, the New York Federal Reserve President John Williams said it is too early to say if the central bank is done raising interest rates. He added that “officials have not yet decided what lies ahead in terms of possible increases in short-term borrowing costs and if more action is needed policymakers won’t hold back.” This is not in line with the consensus which shows a 78% chance that the Fed is likely to pause rate increases at the June meeting. More importantly, fed futures now reflect a 45% chance that interest rates will actually be cut 25 basis points at the September meeting.

Keep in mind that while FOMC just raised the fed funds rate 25 basis points last week and the next FOMC meeting is only five weeks away on June 13-14. Nevertheless, we believe there is a good chance that the consensus could be disappointed, and the Fed could raise interest rates again. This explains why the CPI and PPI data reported this week will be so important. It could have a big impact on sentiment.

Inflation Math

Yet from a purely mathematical perspective, the peak rate of inflation of 9.1% was recorded in June of last year, and this means it could, or should, be easier for the year-over-year inflation rate to move steadily down as we approach mid-year. When we checked our database, we found that if the headline seasonally adjusted CPI data remained unchanged on a monthly basis for April, May, and for June, headline inflation would fall to 2.4%. This would be a very pleasant surprise for most economists. Either way, new inflation data will be crucial in the coming months.

But first, it will be important to see what headline and core inflation were in April and if there is any moderation in service sector pricing. Inflation data for May will be reported prior to the June FOMC meeting, which means the Fed governors will have several new data points on inflation before their next meeting.

The controversy surrounding the May FOMC meeting was whether the Federal Reserve should raise interest rates in the wake of a banking crisis. However, the crisis appears to be fading. Loans on the Fed’s balance sheet rose by $339 billion at the onset of the March banking crisis, but loans have been on the decline and by early May fell $36.4 billion from the March 22 peak of $354.2 billion. From a broader perspective, the Fed’s total balance sheet has been contracting, which means that quantitative tightening has been reinstated. This is good news since it lowers the risk of inflation in the broad economy, nevertheless, it does remove the positive bias that quantitative easing has for equities. See page 3.

Recession Math

April payrolls increased by 253,000 and the unemployment rate fell 0.1% to 3.39%. This decline in the unemployment rate now matches the low last seen in 1969, or 54 years ago! This robust growth in jobs and a historically low unemployment rate reflect a resilient job market and unfortunately for the Fed, a strong job market will only make its inflation goals more difficult to achieve. The bottom line is that it adds credence to the possibility of another rate hike in June.

Rising interest rates usually increase the risk of a future recession, however, there is another interesting math equation worth pointing out about recessions. The data series we have found to be the best lead indicator of a recession is a year-over-year decline in total employment. In fact, in the eleven recessions recorded since 1950, each was immediately preceded by a decline in total employment. Given that job growth has been robust, the US economy does not appear to be at risk of slipping into a recessionary state in the near future. However, this may also be one reason the Fed will continue to raise rates further than expected. The strong job market should give them a safety blanket, at least in the near term. See page 4.

On the other hand, small business owners are not optimistic about their future. The NFIB optimism index slipped to 89 in April. This was the 16^th consecutive month below the long-term average of 98 and it leaves the index at levels typically associated with a recession. Twenty-four percent of business owners indicated that labor quality was the top business problem. Inflation was in second place by one point at 23%. Plans for capex, employment, or to increase inventories have been declining for much of the last twelve months. Expectations for real sales, economic improvement, and better credit conditions also fell in April. See page 5.

Earnings Math

The economy may not be on the brink of a recession, but earnings are already experiencing their own recession. According to IBES, first quarter earnings for this year are currently $438.1 billion, down 0.7% YOY and down 0.4% month-over-month. This marks the second consecutive quarter of negative growth. Earnings declines are expected to continue into the next quarter when estimates suggest a 4.7% YOY decline. See page 7.

Using S&P Dow Jones earnings estimates on a 12-month trailing basis, earnings turned negative in April. When looking at reported earnings, the 12-month trailing earnings stream has been negative since October 2022, i.e., for the last two quarters. See page 6. In short, while the job market may not suggest a recession is in sight, earnings are already experiencing a recession. This is apt to continue since the consumer and small businesses have been crippled by high inflation and rising interest rates this year. All in all, this explains why the stock market has been stuck in a trading range for most of the last twelve months. See page 10.

Technical Roundup

The charts of the S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite are all technically positive, but each faces a critical level of resistance near current levels. These levels are SPX 4,200; DJIA 34,500; and Nasdaq 12,500. The Russell 2000 remains our favorite guide for the market since it remains well within a defined range with support at 1,650 and resistance at the 2000 level. It is worth noting that the Russell 2000 has been underperforming the larger capitalization indices and this is a cause for concern. And even though the index is moving toward the bottom of its range, we remain cautious. Our main near-term concern centers on our lack of faith that the debt ceiling negotiations in Washington DC will be done in good faith and if we are right, it will have a negative impact on the dollar and the securities markets. Most other technical indicators are neutral and inconclusive. The 25-day up/down volume oscillator is at negative 0.62 this week. This is in neutral range, but only after being unsuccessful at sustaining an overbought reading. In sum, we remain cautious and continue to focus on recession-resistant stocks where both earnings and/or dividends are most predictable.

Gail Dudack

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Bank Turmoil

Equity investors turned cautious ahead of this week’s FOMC meeting and we are not surprised. For one thing, regional banks continue to be under pressure despite the fact that over the weekend, in a relatively smooth transition, the FDIC stepped in, seized control of First Republic Bank, and sold its assets to JPMorgan Chase & Co. (JPM – $138.92). Yet, this buyout is no guarantee that the banking industry has stabilized. In fact, the stocks of many regional banks continue to suffer from intense selling pressure. There are multiple reasons for this.

Even though the 2023 banking crisis has been managed relatively well so far, it is not a “small event.” The three US banks that collapsed this year (First Republic, Silicon Valley Bank, and Signature Bank of New York) had more combined assets under management than all 25 federally insured lenders that failed in 2008. According to the New York Times, this year’s three failed banks held a massive $532 billion in total assets versus the $526 billion in combined assets of the 25 banks with FDIC insurance that failed in 2008.

Meanwhile, deposits continue to leave the banking industry. In the twelve months ending in late April, commercial bank deposits fell by $960 billion, with $464.0 billion exiting the banking system since the early March banking crisis. And unfortunately, it is questionable if the banking system has stabilized since loans in the Fed’s new Bank Term Funding Program rose to a new high of $81.3 billion on April 26, 2023. This is a sign of illiquidity in the system. At the same time, the Fed’s balance sheet contracted $171 billion in the 5 weeks ended April 26, 2023. See page 3.

In short, the Fed has resumed its monetary tightening at the same time that money is leaving the banking system for higher yielding assets. Confirming this trend is data from Refinitiv Lipper which indicates that investors purchased a net $42.68 billion worth of money market funds in the week ending April 26, which makes the cumulative money market fund inflows for the year $427.4 billion.

And the commercial banking industry faces the risk of rising bad debts later in the year. The Wall Street Journal recently reported that a 22-story glass and stone tower at 350 California Street in San Francisco, worth about $300 billion in 2019, is now for sale and expected to see bids come in around $60 billion! More surprisingly, life-sciences buildings, typically less vulnerable to the remote-work movement since lab work requires specialized equipment and mechanical systems that can’t be replicated at home, are also coming under pressure. A deluge of new supply in industry hubs such as San Diego, South San Francisco, and the Boston-Cambridge region, is generating a rise in life-sciences vacancies, according to commercial real estate services firm CBRE Group. In short, we expect banking will continue to be under duress from a combination of dwindling deposits, an inverted yield curve, and potential defaults. And note, short-term interest rates have not yet reached their peak.

This week’s FOMC is expected to result in an additional 25-basis point increase in the fed funds rate to a range of 5.00% to 5.25%. However, important information will be found in whether the vote was unanimous for this rate hike or not, and whether or not the Fed’s comments suggest a pause in rates will follow the May increase. Equity investors expect the Fed to be more accommodating in the second half of the year, which means anything slightly hawkish in Chairman Jerome Powell’s comments would be a negative surprise for the market. We expect Chairman Powell will try to be as vague as possible about future monetary policy and will resort to being “data dependent.” And economic data is quite a mix at the moment. Keep in mind that the Fed’s meeting will be followed by expected rate increases by the European Central Bank on Thursday and the Bank of England next week, which means credit conditions are contracting globally. This means equity markets no longer have the wind at their back.

Economic Data Jumble

The March JOLTS report showed 9.6 million job openings, down 2.5 million over the last year and now at the lowest level since April 2021. In another sign that the labor market is cooling, the quits rate edged lower to 2.5%, the lowest point since February 2021.

GDP grew at 1.1% in the first quarter of the year, disappointing consensus expectations, but it is worth noting that personal consumption rose a fairly healthy 3.4%. It was the drag from inventories which contracted 2.3% that lowered GDP. See page 4.

However, the drag from inventories may not be over as seen in recent ISM data. The ISM manufacturing index rose from 46.3 to 47.1 in April but for the sixth consecutive month it remained below the 50 level that shows a contraction in activity. Nine of the 11 components rose in April, and surprisingly two of these, employment and prices paid rose above 50. This is not a good sign for the Fed since it is looking for weakness in both inflation and employment. The major drag on the April ISM index was inventories, which means second quarter GDP is starting on a weak note. See page 5. The ISM services index will be reported later this week.

Personal income rose 6% YOY in March and wages rose a more robust 7% YOY – a sign that wage inflation continues. But after being negative for 19 of the 21 months between April 2021 and December 2022, real personal disposable income increased 4% YOY in March for the third consecutive month this year. This shift is an indication of a gain in purchasing power and it is good news for the consumer. As a side note, March disposable income benefited from a 7.3% YOY decline in tax payments. The savings rate rose from 4.8% to 5.1% in the month and now exceeds $1 trillion. See page 6.

Personal consumption expenditures continue to increase on a year-over-year basis, but the trend is decelerating. Spending on services is highest with an 8% YOY increase, while nondurable spending is growing at a modest 2.6% pace. What surprised us in the data was that personal outlays rose 6.9% YOY in March whereas personal consumption expenditures rose only 6% YOY. Digging through the data we found that interest payments rose a stunning 52% YOY in March, which helps explain the differential. In other words, wages are rising, inflation is moderating, and real personal disposable income is improving. But at the same time, a steady increase in interest rates and interest expenses are eating up a good portion of these gains. In sum, higher interest rates are clearly hurting household consumption. See page 7.

Technical Update

The combination of falling crude oil and gasoline prices, coupled with the relatively positive performance of gold this week, implies that investors have become increasingly worried about a recession. The dollar has been stable in recent sessions despite its weakness since early March, but this is not surprising given that interest rates are expected to rise this week. See page 9.

This year’s equity gains have been concentrated in the most depressed stocks of 2022, the high PE growth stocks. And with interest rates headed higher this week it is not surprising that the April rally hit a roadblock. The Russell 2000 remains the best guide for what we believe is a trading range market as it trades between support at 1650 and resistance at 2000. See page 10. We would point out that the 10-day average of daily new highs is 87 and new lows are 87. This combination is neutral since neither new highs nor new lows are above 100; but the combination is also turning negative as the number of daily new highs declines. See page 12. Although we focused on the risk in the banking industry this week, the looming debt ceiling debate may be the biggest problem for investors in coming weeks. Friday’s employment report is another potential market-moving event. Plus, this is the biggest week for first quarter earnings reports. In the long run, it is valuation that will strengthen or weaken equity prices. We remain cautious.

Gail Dudack

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