The Federal Reserve did not raise interest rates last week, but Chairman Powell’s prepared statement and his question-and-answer period were sufficiently hawkish to convince investors that another interest rate hike may be needed this year. The dot plot revealed that most governors expect the fed funds rate will still be above 5% by the end of next year. And Chairman Powell’s comments underscored that interest rates are not likely to come down for a long time. None of this surprised us, but this had an impact on sentiment since there has been a staunchly held view that both inflation and interest rates would be coming down in the foreseeable future.

In the wake of the Federal Reserve’s hawkish stance, the benchmark 10-year Treasury yield rose to a 16-year high above 4.5%. More recently, Minneapolis Federal Reserve Bank President Neel Kashkari, one of the more dovish Fed governors, stated that there is a 40% chance the Fed will need to raise interest rates “meaningfully” to beat inflation. He indicated there was a 60% chance that one more rate hike would bring inflation in line and maneuver the economy to a soft landing. Kashkari gave no percentage for a recession. However, in our view, only if “it is different this time” will the US economy be able to escape a recession before inflation is once again under control.

Higher for Longer – Inflation and Interest rates

We continue to repeat several charts that show the history of inflation, interest rates, and the economy, since these charts are at the foundation of our stance. On page 3, the charts show that whenever inflation reaches a high level, such as the 9% seen in June 2022, inflation has declined, but only in concert with a recession. A tighter monetary policy has always been the key to reducing inflation, but the cycle of tightening typically ends only after the real fed funds rate reaches a minimum of 400 basis points. With inflation now at 3.7%, this suggests a 7.7% fed funds rate. We doubt that the fed funds rate will reach 7% or more, but we do believe the Fed is behind the curve and needs to keep rates higher for longer than most investors expect in order for monetary policy to be successful. This will also raise the risk of a recession.

Jamie Dimon, CEO of JPMorgan Chase & Co. (JPM – $144.93) told the Times of India in an interview this week that many businesses and investors were not prepared for a worst-case scenario in which interest rates hit 7% and stagflation grips America. Again, the risk of a recession is greater than Kashkari’s zero. We think there is a better-than-even chance that a recession is on the horizon, and it does not have to be a long debilitating recession, but it is part of a normal economic cycle. A recession would have come earlier and probably be over by now, if it were not for the multiple stages of fiscal stimulus put into place in the last three years.

One thing is clear – inflation is not apt to come down quickly. After 12 months of a disinflationary trend in the CPI, and after 8 months of negative year-over-year pricing in crude oil, both trends began to reverse in August. Sequentially, the CPI was up 3% YOY in June, 3.2% YOY in July, and 3.7% YOY in August. The PPI for finished goods was 2.2% YOY in August, the first positive year-over-year gain in four months. Oil was still negative in August on a year-over-year basis, and this helped to dampen headline CPI, but to date, it is up 14% YOY in September. This is likely to fuel price increases in September. Moreover, the technical chart of light crude oil shows that it has broken above a downtrend line and has no significant upside resistance prior to $100 a barrel. This is good news for energy sellers but bad news for inflation. See page 4.

The Impact on the Economy and Earnings

Interest rates are up over 500 basis points since the end of 2021 and the lag effect is beginning to be felt. The housing sector is showing weakness again with a 15% YOY decline in existing home sales in August and a 5-point decline in the National Association of Home Builders index. This puts the NAHB index below 50 for the first time since the banking crisis this Spring. New home sales in August were down 8.7% from July’s level, but still up 5.8% YOY. Housing affordability has been declining substantially this year as mortgage interest rates continue to rise. See page 5. These are signs that “higher for longer” could translate into a weaker economy ahead.

A weaker economy has implications for corporate earnings. There is a close relationship between GDP corporate profits and S&P reported earnings and both were negative on a year-over-year basis in the first two quarters of 2023. However, the consensus earnings growth forecasts for the S&P 500 for the next four quarters look rather arbitrary to us with analysts plugging in a 10-12% growth rate. A 10% earnings growth rate is a typical estimate whenever the outlook is unknown. See page 6.

However, there are many variables in earnings growth rates. GDP data shows that nominal final sales fell sharply in the second quarter as fiscal stimulus is fading. Plus, GDP after-tax margins have been slipping in recent quarters. Strangely, S&P operating margins increased as GDP profit margins decreased. This disparity between GDP and S&P profit margins has happened in the past and it is often a symptom of tax law changes or financial engineering, neither of which has longevity. See page 7. This data suggests that there could be both a decline in revenue and a margin squeeze ahead for corporate America.

Lastly, valuations appear stretched. When we index nominal GDP, GDP corporate profits, S&P earnings, and the S&P Composite index on one chart, it is easy to see when, or if, profits and/or the SPX become extended relative to GDP growth. There can be reasons for this disparity such as an increase in productivity from both workers and technology. However, the current disparity between the SPX and GDP is greater than that seen at the 2000 peak in equities. The March 2000 peak was also a time of great technological changes, but it ended in a dot-com bubble. Our valuation model tells a similar story since it suggests equities are nearly as overvalued as they were in 2000. See page 8.

Technically, Still in a Trading Range

What looked like a consolidation phase last week turned into a clear downtrend this week, with the Dow Jones Industrial Average and the Russell 2000 index now trading below their 200-day moving averages. The S&P Composite and the Nasdaq Composite are still trading above their 200-day moving averages but look like they might be about to test these levels in the near term. Nevertheless, the major patterns in the market remain characteristic of a long-term neutral trading range. This trading range is best seen by the Russell 2000 index which has support at 1650 and resistance at 2000. See page 10. There has been some clear deterioration in breadth data this week. The 10-day average of daily new highs fell to 65 and new lows rose to 199. This combination is solidly negative this week with new highs below 100 and new lows well above 100. In addition, the NYSE advance/decline line is 33,612 net advancing issues from its November 8, 2021 high. This disparity fell below 30,000 in July for the first time in two years; but in recent days it increased to more than 30,000 issues once again. See page 12.

Gail Dudack

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The CME FedWatch tool suggests there is a 99% chance that the Fed pauses this week and a mere 31% chance for a Fed rate hike in November. This makes sense since the UAW strike does not seem to be ending soon, the writers’ strike has been ongoing since May 1, and although over 800,000 student loan borrowers received forgiveness under the IDR Account Adjustment, for the first time since March 2020, millions of borrowers will soon get a notice to restart student loan payments in October. These three items will dampen economic activity, along with the fact that the impact of fiscal stimulus packages are waning, and a government shutdown looms in the background. A final reason to expect a pause this week is that Federal Reserve Chairman Jerome Powell has never surprised the financial community with a non-consensus rate hike.

Still, we believe the Fed could, or should, raise the fed funds 25 basis points this week since monetary policy has been persistently behind the curve in terms of fighting inflation. Not only did the Fed postpone raising rates in all of 2021, implying that inflation was “transitory”, but the real fed funds rate only became positive, net of inflation, in April 2023, or roughly five months ago. In other words, monetary policy has been easy and feeding an inflationary cycle for a very long time. This is likely to make inflation more difficult to curb.

Is It Different This Time?

Typically, a Fed tightening cycle ends only once the real fed funds rate reaches a positive 400 basis points. See page 3. With the fed funds rate currently only 200 basis points above the PCE index (July) and 170 basis points above the CPI rate (August), the end of this cycle appears to be several rate hikes away unless inflation suddenly falls. A real decline in inflation appears to be a long shot, in our view, particularly with crude oil on the rise. Keep in mind that on a year-over-year basis, WTI crude oil has been negative every month of this year, a factor that has helped headline CPI decline from 6.4% YOY to 3.3% YOY in the same timeframe. See page 4. For example, fuels and utilities were down 1.2% YOY in August. See page 5. But at the current level of $91.66, WTI is up 15% YOY and gasoline futures are up 8% YOY. In other words, the benefit from falling energy prices, which has helped cool inflation this year, is disappearing and this may become much clearer with September inflation data.

It should be obvious to economists and investors that inflation will be difficult to tame, even if energy prices were not rising. A warning was already visible in August data. After 12 months of decelerating inflation in the CPI, and after 8 months of negative YOY pricing in crude oil, both trends are beginning to reverse. The CPI rose 3% YOY in June, 3.2% YOY in July, and 3.7% YOY in August. The PPI for finished goods was 2.2% YOY in August, the first positive YOY gain in four months.

Some economists had been pointing to the fact that the biggest driver of the CPI was owners’ equivalent rent of residences, and that the OER was an outdated and overstated method to measure housing. But as seen on page 5, it is the service sector and not housing that is the current inflation problem. Other goods and services saw prices rise 0.4% MOM and 5.8% YOY. In addition, while fuels and utilities fell 1.2% YOY in August and helped lower headline CPI, it also rose 0.6% month-over-month, which was more than the CPI. This is a negative sign for future CPI reports. Therefore, if the Fed agrees that inflation will be sticky, it would be appropriate to raise the fed funds rate by 25 basis points this week.

Of course, it could be different this time, and the Fed might be able to maneuver a soft landing for the US economy without completing a full monetary tightening cycle and still manage to get inflation to cool back to the 2% level. But the odds seem slim, particularly since the crude oil futures chart shows little resistance between current prices and $100 a barrel. In short, higher energy prices are one item that could upset the consensus, the stock market, and monetary policy.

On the Horizon

It is more likely that other things could upset the market. The Department of Justice’s hearing into Google’s (Alphabet Inc. – $138.83) search engine is the first antitrust case in decades. The results of this could easily impact large capitalization technology companies. China’s property developer, Country Garden Holdings Co. Limited (2007.HK – 1.01 HK), is facing a deadline this week to pay $15 million in interest for an offshore bond. Plus, the long-standing inversion in the yield curve always poses problems to the finance sector, as the series of bankruptcies in March warned.

There are signs of weakening in the economy. August’s retail sales growth was above expectations, but beneath the surface the details were less strong since the excess growth came entirely from gasoline stations, and prior months were revised lower. Consumer spending is shifting back from goods to services, with restaurants being the fastest-growing segment over the last year. Inflation continues to be a problem eating into consumer incomes and higher interest rates make purchasing big-ticket items on credit more expensive than consumers had been accustomed to. When adjusted for inflation, retail sales have been negative on a year-over-year basis for the last seven consecutive months. This is a typical sign of a recession. See page 6.

The University of Michigan consumer sentiment survey fell in August for the second consecutive month. The weakness in the survey continues to be found in present conditions and is likely due to the rise in energy and gasoline prices. Conversely, a separate University of Michigan survey on consumer inflation expectations fell early in September. Neither the Conference Board nor NFIB business surveys have released September data, but both were lower in August. See page 7.

Technical Changes and Review

The market has been in a consolidation phase this week and in all three indices the near-term trend appears indecisive. Perhaps the most important event is that the Russell 2000 index is currently trading below its 200-day moving average. This could be a sign that the other indices will also test their 200-day moving averages in the weeks ahead. However, the longer-term pattern remains unchanged and is characteristic of a long-term neutral trading range. See page 9.

The 25-day up/down volume oscillator is at a negative 0.79 reading this week and relatively unchanged in recent weeks. It is at the lower end of the neutral range, and also indecisive. See page 10.

The 10-day average of daily new highs is 81 and new lows are 123 this week. This combination is now negative since new highs are below 100 and new lows are above 100. The NYSE advance/decline line fell below the June low on September 22 and is 26,543 net advancing issues from its 11/8/21 high. In sum, the trading range, best defined by the Russell 2000 index between support at 1650 and resistance at 2000, remains intact.

Gail Dudack

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

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

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

Inflation Matters

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

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

Household Haves and Have Nots

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

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

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

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

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

Gail Dudack

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September has a poor reputation for equity performance and for good reason. The month ranks last in terms of price performance and has generated declines in the S&P 500 index in 50 of the last 91 Septembers. It is the only month that has closed with price losses more than half the time. The historical record shows that since 1931, September produced an average loss of 1%. The average decline narrows to 0.7% in all years since 1950.

We think there are a number of reasons for this weak performance. First, September does not have the positive liquidity factors that November, December, and January have in terms of IRA funding, tax-loss selling and reinvesting. Nor is it a fiscal year end for most pension funds or mutual funds which usually provide portfolio inflows and readjustments. On the other hand, it is a time when investors look ahead to next year’s earnings, economic, and/or political forecasts and this is often murky. Stocks do not like uncertainty. This September includes a number of events that could move stock prices, such as the G20 New Delhi summit September 9-10, the FOMC meeting on September 19-20, a potential government shutdown October 1, and the impact of Saudi Arabia and Russia extending the oil cuts until year end. Given that the equity market is currently trading at an estimated 2023 PE of 20.3 times, there is little room for disappointment. We remain cautious but believe the equity market remains in a wide neutral trading range best represented by the Russell 2000 between support at 1650 and resistance at 2000.

Narrow is Not Noble

The Nasdaq’s weekly digest called Smart Investing had a table of stocks it called the “magnificent seven” that has been leading the Nasdaq Composite index and S&P 500 higher in recent months. Not surprisingly, it includes stocks such as Apple Inc. (AAPL – $189.70), Microsoft Corp. (MSFT – $333.55), Alphabet Inc. (GOOG – $136.71), Amazon.com (AMZN – $137.27), NVIDIA Corp. (NVDA – $485.48), Tesla, Inc. (TSLA – $256.49). and Meta Platforms, Inc. (META – $300.15). See page 3. From this table we see that these 7 stocks represent 40.43% of the Nasdaq Composite and 30.625.637% of the S&P 500. Apple and Microsoft represent nearly 21% of the Nasdaq Composite and nearly 14% of the S&P 500 and these two stocks have had year-to-date gains of 46% and 39%, respectively. However, it is NVIDIA, Meta Platforms, and Tesla that have been the biggest drivers of the indices with outsized year-to-date gains of 232%, 149%, and 108%, respectively.

The problem with a narrowly driven rally is that it forces portfolio managers to own these stocks in order to perform in line with the benchmark averages. In the longer run this means the market becomes more and more momentum driven and less driven by value. This can persist for a long while much like the bubble market in 1997 to 2000, but the eventual decline in the averages becomes greater the longer stock prices are based upon momentum rather than earnings.

August Payrolls

The pace of job creation came in slightly ahead of expectations at 187,000, but July’s number was revised down by 30,000 to 157,000 and June’s payrolls were lowered by 80,000 to 105,000. These are very large downside revisions, and it gives rise to questions about BLS statistics. The unemployment rate rose from 3.5% to 3.8% which materialized not just from the 514,000 newly unemployed, but also from the 736,000 increase in the civilian labor force. See page 4. We wonder if this increase in the labor force is a result of financial pressure experienced by many households and the need for an additional paycheck. We see other signs of stress in consumer finances. According to the credit agency Equifax, credit card delinquencies have hit 3.8%, while 3.6% have defaulted on their car loans. Both figures are the highest in more than 10 years.

Yet, despite the declining trend in employment growth, the establishment survey shows jobs grew 2% YOY, above the average rate of 1.69%. The household survey showed employment growth of 1.76%, also above the long-term average of 1.51%. In short, neither are at negative-growth recessionary levels.

Personal income grew 4.7% YOY in July and real personal disposable income increased 3.8% YOY. RPDI growth is down from 4.9% in June, nevertheless, it is the seventh consecutive month of real gains in income. At the same time, personal consumption expenditures grew 6.4% YOY in July, primarily from an 8.3% increase in services. Durable goods expenditures rose 4.5% YOY and nondurable spending increased 1.8% YOY. In general, the post-pandemic stimulus-driven economy appears to be fading. See page 6.

Strains in household finances can also be found in the savings rate. After hitting a peak of 26.3% in March 2021, it fell from 4.3% in June to 3.5% in July. Higher interest rates are also taking a toll on savings and spending. Personal interest payments rose 49.4% YOY in July, down from 55.3% in June, yet still increasing at a record rate. Personal interest payments were $506 billion in July after averaging $330 billion in 2018 and 2019. This is a huge jump in interest payments. See page 7.

Watching oil

The United States has stopped selling oil from its Strategic Petroleum Reserve (SPR) and has begun to buy oil in order to replenish this important reserve which is at a multi-decade low. Meanwhile, despite a rally in the oil market and analysts’ expectations of tight supply in the fourth quarter, Saudi Arabia and Russia said they would extend voluntary oil cuts to the end of the year. These two events are sparking a breakout rally in oil which could jeopardize the consensus view that inflation is trending lower. And as we already noted, the White House has called on Congress to pass a short-term “continuing resolution” to keep the government funded past Sept. 30 and to avoid the fourth shutdown in a decade. This is impacting the fixed income market. The 10-year Treasury yield bounced back up to 4.27%, closing in on the important 4.33% resistance level. See page 9.

Technical Update

The S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite, are rebounding from their 100-day moving averages and the Russell 2000 is bouncing from its 200-day moving average, but the near-term trends are indecisive. Unless, or until, all the indices exceed their all-time highs (which we doubt), the longer-term pattern remains characteristic of a long-term neutral trading range. See page 11.

The 25-day up/down volume oscillator is at a negative 1.79 reading this week, relatively unchanged from a week ago, and at the lower end of neutral. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1. However, none of these overbought readings lasted the minimum of five consecutive trading days required to confirm the advance in the averages. Strong rallies should also include at least one extremely overbought day which was also missing.

As this indicator approaches an oversold reading of minus 3.0 or less, the same will be true – five consecutive trading days in oversold would confirm the decline. See page 12. Another sign of the market’s longer-term neutral trend is found in the new high/new low list. The 10-day average of daily new highs is averaging 93 and new lows are averaging 77. This combination reverts from negative to neutral this week since both new highs and new lows are below 100.

Gail Dudack

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