Friday

Friday is expected to be the most significant day of this investment week with the release of May’s personal income, personal expenditures, and most importantly, the Fed’s favorite inflation benchmark, the personal consumption expenditure (PCE) deflator. Economists are looking for the PCE to show no change in the headline index and a 0.1% increase in core. If so, the PCE deflator would ease a smidge to 2.6% YOY from April’s 2.7% and core would be lower by 0.2% to 2.6% YOY. Anything showing stronger inflation is apt to be a disappointment for investors, particularly after the hawkish comments heard this week from Federal Reserve Governors Lisa Cook and Michelle Bowman, both voting FOMC members.

Flying under the radar, but also important, is the fact that Friday will mark the final reconstitution of the FTSE Russell benchmark indexes. The Russell Reconstitution is an annual multi-step process of FTSE Russell to update its indexes and it typically results in one of the busiest trading days of the year. The reconstitution, which becomes official after the closing bell on Friday, motivates fund managers to adjust their portfolios to reflect the new weightings and components. And the changes are significant this year. The Russell 1000 growth index is expected to have roughly two-thirds of its components in just technology and communication services stocks. Analysts expect about 45 companies will leave the growth index, reducing the index to just over 390 names, as compared to approximately 870 in the Russell counterpart value index. This is another example of how the recent outperformance of AI-related stocks is having a major impact on the weightings of market indices. Last week we discussed the impact Nvidia Corp. (NVDA – $126.09) was having on ETFs. The end result is that it becomes ever more difficult for a portfolio manager to outperform, or even perform in line with, the indices without having a significant concentration in the top ten largest stocks. And again, we see how momentum begets momentum.

Going For a Swim

The Census Bureau and National Association of Realtors (NAR) released a range of housing-related data last week — most of it showing weakness. But it was this week’s announcement from Pool Corp. (POOL – $310.74), a wholesale distributor of swimming pool supplies, equipment, and related leisure products, which rocked the housing market. The company lowered earnings guidance from the previous $13.19 to $14.19 per diluted share to $11.04 to $11.44 per share, indicating year-to-date net sales were down 6.5%. The stock fell 8% Tuesday and carried many consumer and housing-related stocks with it. Commentators were divided on whether this was a warning sign about the consumer or a buying opportunity. It was, nevertheless, another indication of how investment expectations and forecasts pivot depending upon when, or if the Federal Reserve lowers interest rates later this year.

Housing Data

Residential building permits and starts have been declining for three consecutive months and new home permits are now down 9.5% YOY. However, single-family housing permits are up 3.4% YOY. Total housing starts fell 19.3% YOY in May and single-family housing starts were down 1.7% YOY. Not surprisingly, the National Association of Home Builders (NAHB) single-family housing index fell 2 points to 43 in June. Sales fell 3 points to 48; 6-month sales expectations fell 4 to 47, and traffic of potential buyers was down 2 points to 28. See page 3.

New and existing home sales remain well below their 2020 peaks, which is not surprising given the rise in both prices and interest rates in the interim. In April, new home sales were 634,000 units, down 4.7% month-over-month and down 7.7% YOY. The major market is for existing homes where sales were 4.11 million, down 0.7% month-over-month and down 2.8% YOY. See page 4.

Inventory of both total existing homes and single-family homes has been rising for the last five months, and this lifted single-family home inventory from 860,000 units to 1.12 million units in May. Months of supply has risen to 3.5 months from its low of 1.6 in December 2022; nevertheless, inventory remains at historically low levels. It is this lack of inventory that continues to support home prices. The median existing single-family home price reached a record-breaking $424,500 in May, up 5.7% YOY. The median home price for a new single-family home was $433,500 in April, down 5.8% from its October 2022 peak, but up 0.2% over the last 3 months, and up 3.9% YOY. See page 5.

Along with low inventory, inflation is supporting home prices. Similarly, inflation boosts nominal retail sales and there has been a long-standing correlation between retail sales growth and existing home prices. Total retail and service sales grew 4.0% YOY in April, similar to the rise seen in home prices in the same period. However, once inflation is removed, retail sales fell 0.3% YOY in real terms. In an inflationary environment, if income growth does not exceed inflation, purchasing power decreases. Both real disposable income and real retail sales have been decelerating this year and these trends could be precursors of a weaker housing market ahead. See page 6.

Earlier this month the University of Michigan consumer sentiment indices showed multi-point declines in the overall, present conditions, and expectations indices for June. This week the Conference Board consumer confidence index indicated that the June index fell from a downwardly revised 101.3 (May) to 100.4. The expectations index fell from a downwardly revised 74.9 (May) to 73.0, but present conditions rose from 140.6 (May) to 141.5. Not surprisingly, consumer sentiment indices have been declining in recent months. See page 7.

Valuation and Technical Updates

The S&P 500 trailing 4-quarter operating multiple is now 24.9 times and well above all its long- and short-term averages. The 12-month forward PE multiple is 21.1 times and when added to inflation of 3.3% sums to 24.4, which is also above the top of the normal range of 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.

The Nasdaq Composite index and the S&P 500, led by big-cap technology stocks, made new record highs last week. The Dow Jones Industrial Average, despite a rebound this week, is 2.2% below its record high of May 17, 2024 and the Russell 2000 index remains 17.2% below its high of 2442.74 made on November 8, 2021. The Russell is trading below its 50-day and 100-day moving averages this week and the DJIA is trading slightly above its two moving averages. See page 9. It continues to be a stock market of haves and have-nots, much like previous bubbles. The 25-day up/down volume oscillator is at negative 1.75, still in neutral territory, but threatening to break the bullish uptrend in place in this oscillator since the October 2022 low. The indicator was last in overbought territory for four consecutive trading days between May 17 and May 22, but since a minimum of five consecutive trading days in overbought is required to confirm a new high, this indicator has not yet confirmed any of the new highs made in the S&P 500 index and Dow Jones Industrial Average since January. See page 11.

Gail Dudack

Click to Download

Recent comments by several Federal Reserve Board governors suggest they agree with our base case that there will be only one rate cut this year, if any. However, in our view, Fed policy is no longer the pivotal factor driving financial markets. At mid-year, the S&P 500 and the Nasdaq Composite indices have been setting a string of new all-time highs based on a consensus view that inflation is falling, interest rates are coming down, earnings are rising, and most importantly, the future of generative AI will provide outsized profits for some companies. As a result, the stock market is moving into rarefied air in terms of valuation, with the trailing 12-month operating PE ratio for the S&P 500 reaching 25 this week. See page 10. This multiple has only been higher in 1999-2000 (dotcom bubble), 2009 (due to collapsing earnings), and 2020 (also due to collapsing earnings).

This week’s market mover is Nvidia Corp. (NVDA – $135.58), up 3.5%, to a valuation of $3.34 trillion, just four months after it bettered the $2 trillion mark and a year after breaching the $1 trillion milestone. It is now ahead of both Microsoft Corp. (MSFT – $446.34) at $3.32 trillion and Apple Inc. (AAPL – $214.29) at $3.29 trillion, after tripling in price over the last year. According to Matthew Bartolini, the head of SPDR Americas Research, the Technology Select Sector SPDR Fund (XLK – $231.41) is set to rebalance and recent calculations showed Nvidia’s weighting increasing to 21% from 6% as of June 14. The stock’s performance over the last three trading sessions is apt to boost this weighting. As our tables on pages 16 and 17 show, the XLK has severely trailed the performance of the S&P 500 technology sector, due in large part to its being underweight in NVDA. We expect NVDA’s upgrade in weighting in the XLK will increase demand for the stock, particularly from money managers also underperforming the indices. This will move the stock price even higher. Momentum begets momentum. Nvidia also completed a 10-for-1 stock split on June 10, a factor that often increases demand for stock.

In terms of the consensus view, it is important to point out that interest rates have come down recently due largely to political uncertainties in the European Union. US treasury securities have become the global safe-haven investment for the moment. The European Parliament elections which took place earlier this month resulted in a major shift toward conservative parties which forced President Macron of France, to call for snap elections on June 30 and July 7. Current polls show Macron losing the election. Moreover, the fiscal situation of both France and Italy threaten the stability of the EU. France’s debt-to-GDP ratio of 111% is similar to Italy’s before the euro crisis in the early 2010’s. The IMF forecasts that Italy’s public debt will reach approximately 140% of GDP in 2024. Countries with debt above 90% of GDP must reduce it by an average of 1% per year according to European Union fiscal rules, although the EU is considering new proposals that could replace or amend these rules. Nevertheless, the EU is in political and fiscal disarray, and this boosted Treasury security prices recently.

The consensus view on inflation may also be on thin ice. Investors celebrated May inflation numbers showing a 0.1% decrease in headline CPI to 3.3% YOY, and a 0.2% decrease in core CPI to 3.4% YOY. However, both indices remain well above the Fed’s target of 2% and it is not just housing that is currently keeping headline inflation above 3%. Food away from home and medical care rose much faster in May than headline CPI and are areas of concern. See page 3.

In terms of inflation coming down, many economists are saying CPI numbers are overstated due to the owners’ equivalent rent (OER) index which lags home prices. However, insurance, and fuels and utility prices are soaring, not just rents. Moreover, OER began to decline 12-18 months after housing prices peaked in 2021. Year-over-year house prices were negative in the first half of 2023, but prices are trending higher once again. This suggests OER could start trending higher later this year. See page 4.

And the main issue for inflation is no longer housing, but services. Rising insurance costs have been a major hurdle for families and more recently prices have been increasing for medical care services and other areas of personal care. Core CPI indices that exclude shelter, food, energy, and medical care, have flattened out in recent months, but are not trending lower, a sign that prices are rising-to-stable in a broad range of areas. See page 5.

Another potential roadblock for the Fed’s target of 2% is the rising price of oil. The year-over-year declines in WTI futures (CLc1 – $81.71) and gasoline futures (RBc1 – $2.50) were factors that helped lower the CPI in 2023, but oil prices are rising once again. WTI futures are up nearly 16% YOY. Some PPI indices, like the PPI for finished goods, rose from 2.0% YOY to 2.4% YOY in May. This uptick is apt to continue. See page 6. Overall, we are not convinced that inflation will be steadily moving lower in the months ahead.

The financial crisis of 2008-2009 appears to have triggered a dovish change in Fed policy. The crisis, which had bad mortgage securities and derivatives at its core, required a long period of easy monetary policy to support the balance sheets of global banks which owned too much of these securities. Prior to 2008, the Fed was willing to quickly hike interest rates and slow the economy. But since the Fed was much slower to increase rates and inflation in this cycle, inflation became endemic and it will be more difficult to suppress, in our opinion. See page 7.

And earnings may not be as robust as the consensus believes since there are signs that the consumer is getting tapped out. Retail sales for May were up 0.1% from April’s level, which was below expectations. Total retail & food services rose 2.3% YOY, were up 2.5% YOY excluding autos, and rose 2.6% YOY excluding autos and gasoline. However, real retail sales fell 0.9% YOY, declining on a year-over-year basis for the 14^th time in the last 19 months. See page 8. As the impact of multiple fiscal stimulus packages begins to fade, the consumer is showing signs of fatigue on the higher income level and actual weakness in the middle-to-lower income level.

This also shows up in consumer sentiment. The main University of Michigan consumer sentiment index for June fell 3.5 points to 65.5, the present conditions index declined 7.1 points to 62.5, and the expectations index was down 1.2 points to 67. 6. All three indices returned to recessionary levels. The Michigan survey showed an 11-point decline in income expectations for consumers, to 67, a reading that brings expectations back to levels seen at the end of 2023. See page 9.

Technical Update The Nasdaq Composite index and the S&P 500, led by big-cap technology stocks, continue to make record highs. The Dow Jones Industrial Average is 3% below its record high of May 17, 2024 and the Russell 2000 index remains 17% below its high of 2442.74 made on November 8, 2021. The Russell is trading below its 50-day and 100-day moving averages this week and the DJIA is trading slightly above its two moving averages. It is a stock market of haves and have-nots, much like previous bubbles. However, as deficits and debt-to-GDP levels increase around the world (US, China, France, Italy) it may be the debt markets that become the real concern in the months ahead.

Gail Dudack

Click to Download

Apple, Inc. (AAPL – $207.15) shares jumped over 7% to a record high after announcing that later this year the “Apple Intelligence” platform – its foray into the generative AI space — will be integrated across the company’s hardware and software products using M1 chips or higher. Apple’s surge lifted the S&P 500 and Nasdaq to new highs and boosted Apple’s market capitalization by $215 billion to $3.18 trillion. According to Dow Jones Market Data, this was the third-largest one-day market cap surge in history, and it also made AAPL the second-largest stock in the S&P 500. Apple is now second only to Microsoft Corp. (MSFT – $432.68) with a market cap of $3.22 trillion. Nvidia Corp. (NVDA – $120.91) is currently in third place with a market cap of $2.97 trillion. Together, these three stocks now represent 21% of the S&P 500’s $44.3 trillion market cap. The concentration of performance continues to narrow.

Apple was not the only news of the day. Stocks were also supported by bonds after a solid $39 billion Treasury sale triggered speculation that this week’s CPI reading may help build the case for the Federal Reserve to cut rates later this year. Demand in the auction of 10-year debt was strong, with the bid-to-cover ratio of 2.67, the highest since February 2022, or prior to the start of the Fed’s tightening cycle. Treasuries were also seen as a safe haven vehicle given the current political upheaval in Europe. French stocks and bonds were rattled this week after French President Emmanuel Macron’s political party suffered a defeat in the European Parliament election over the weekend. Macron called for a snap parliamentary election that will take place in two rounds concluding on July 7. Macron was not the only European leader to see this weekend’s election results shift power to the conservative right, but the political risk of a snap election in France resulted in a sell-off in French banking stocks and sovereign bonds. To make matters worse, S&P Global Ratings had downgraded France last week. In sum, US Treasuries became the beneficiaries of European turmoil.

In the US, a survey conducted by 22V Research showed that most investors are betting that both the consumer price index and the Fed decision will be “risk on” events. According to the median estimate in a Bloomberg survey, 41% plurality of economists expect the Fed to signal two cuts in the closely watched “dot plot,” while an equal number expect the forecasts to show just one or no cuts at all. We would put ourselves in the latter category. Inflation has not been tamed, in our view, and the economy is showing both strength and weakness, which should give the Fed pause until a clearer trend appears.

It was a busy week for economic releases. The NFIB small business optimism index rose 0.8 points to 90.5, the highest level since December. Job openings, hiring plans, capex plans, and plans to raise prices all rose, while most other components fell. The uncertainty index jumped 7 points to 85, the highest since November 2020. Actual earnings, sales, sales expectations, inventory satisfaction, and inventory plans all fell in May. It was confusing to see hiring and capex plans increase as earnings and sales declined. See page 3.

Similarly, May’s ISM indices showed a mixed picture. The manufacturing index fell to 48.7, the 18th reading below 50 in the last 19 months. The nonmanufacturing index rose to 53.8, up nicely from its first reading below 50 since December 2022. Business activity fell to 50.2 for manufacturing but jumped to 61.2 for nonmanufacturing, the highest since November 2022. Ironically, employment rose to 51.1 for manufacturing, one of the highest readings in 2 years, while nonmanufacturing employment also rose, but remained below 50 at 47.1. See page 4.

The employment report for May was far better than expected, showing a gain of 272,000 new jobs, and previous months were revised down by only 15,000. Our concern is the discrepancy between the household and establishment surveys. The establishment survey shows job growth of 1.8% YOY in April and May, better than the long-term average of 1.69% YOY. However, the household survey shows near-zero job growth of 0.3% YOY in April and 0.2% YOY in May. This survey is important since a negative annual growth rate in total jobs has historically been a key indicator of a recession. Moreover, the household survey showed a decline in employment, a decline in the civilian labor force, and an increase in those unemployed in May. These numbers help explain why the unemployment rate rose from 3.9% to 4.0% in May. See page 5.

Average hourly earnings rose 4.2% YOY in May, up from 4.1% YOY in April. This gives the impression of accelerating wage growth. But, after adjusting for inflation, average hourly earnings rose 0.74% YOY, just slightly better than the 0.70% recorded in April. See page 6. Total private weekly earnings were $1197.41 in May, up 3.8% YOY; while production and non-supervisory weekly earnings averaged $1013.66, up 4.2% YOY. However, if indexed to inflation, average real weekly earnings for non-supervisory workers rose 0.7% YOY and were down 3% from the May 2020 cyclical peak. See page 7. In short, due to inflation, the purchasing power of households has been declining for the last four years.

On page 8, an overlay of the growth rate of inflation and average weekly earnings helps display when, and how much, inflation eats into earnings. This chart also shows that when inflation has been higher than wage growth for a period of time (like it was for all of 2022), a recession follows. This is logical since inflation is negative for consumption. But, in this cycle, a variety of fiscal stimulus programs has compensated for falling real wages and prevented a recession. One positive sign for the economy is that average weekly hours, which have been declining since the post-pandemic spike, have begun to slowly increase in recent months. See page 8.

The Federal Reserve is not expected to change its policy this week, but the inflation data released for May could have an impact on both future Fed policy and the stock market. While many inflation benchmarks have generally been decelerating, recent data has been mixed. We are less optimistic than most about rate cuts because in past tightening cycles the Fed has increased rates until the real fed funds rate reached a minimum of 400 basis points. The recent peak in the current cycle was 270 basis points in April. This may not be enough to beat inflation. See page 9.

Several other factors concern us. After the June 2022 CPI peak, what dampened inflation was the fact that energy prices were falling for most of 2023 and were negative on a year-over-year basis. But even with Biden’s recent release of oil from the strategic oil reserve, WTI prices remain firm, and the price of oil was up over 13% YOY in May and up nearly 11% YOY in June, to date. This could be a hurdle for inflation in the coming months. Many economists still suggest CPI would be at 2% or lower if owners’ equivalent rent was excluded. This is simply not true. The CPI index less shelter and the index less food and shelter have been trending higher for the last 12 months. This debunks the theory that owners’ equivalent rent is driving inflation this year. See page 10. There was little change in technical indicators this week. The S&P 500 and the Nasdaq Composite made new highs this week. The Dow Jones Industrial Average made a record high on May 17, 2024. The Russell 2000 index remains 17% below its high of 2442.74 made on November 8, 2021. Both the Russell and the DJIA are trading below their 50-day and 100-day moving averages this week. See page 13. The 25-day up/down volume oscillator remains close to zero, a sign that volume in advancing stocks has been equal to volume in declining stocks. See page 14.

Gail Dudack

Click to Download

The stock market has been advancing strongly based on the belief that 1.) inflation is trending lower 2.) the Fed’s next move will be a rate cut not a rate hike and 3.) that there will be two rate cuts this year. Yet, when the JOLTS report showed that job openings fell to more than a three-year low in April, investors got uneasy about the economy, stocks sold off, and bond yields fell. We find this reaction naïve. Moreover, it suggests that investors have been expecting a perfect soft landing of slower economic growth, inflation trending to 2%, and earnings growth in the low double digits. In our view, even if the Federal Reserve were to navigate the economy to the perfect “soft landing” it is apt to be a bumpy ride at best.

Moreover, historical precedent indicates that once inflation reaches more than double the long-term average of 3.4%, the aftermath has always included a recession. We admit it is slightly different this time. As we noted last week, the massive fiscal stimulus that has been employed by the Biden administration through various bills passed by Congress and through federal agency spending over the last three and a half years has successfully postponed a recession. But we are not convinced it has eliminated one forever. And since this stimulus and deficit spending pushed the US debt-to-GDP ratio to 123% as of September 2023, it might mean that the next recession will be worse than it would have been otherwise. Politics and economics simply do not mix.

At the end of this week, the Bureau of Labor Statistics will release the employment report for May. It will be an important indicator in terms of the economy, particularly since recent data releases are giving a mixed picture. However, the Atlanta Fed’s GDPNow tracker — which uses data inputs from throughout the quarter to extrapolate how GDP is pacing — has moved its estimate down to 1.8% after forecasting growth above 4% at the beginning of May. The second estimate for first quarter GDP was revised from 1.6% to 1.3% last week by the Bureau of Economic Analysis.

If Only Earnings Mattered

However, none of these aforementioned items worried equity analysts who raised estimates significantly last week. The S&P Dow Jones consensus estimate for calendar 2024 is now $241.02, up $0.14, and the 2025 estimate is $276.50, up $1.05. The LSEG IBES estimate for 2024 is currently $244.68, up $0.42 and for 2025 is $279.67, up $0.92, reflecting a 21.7% YOY increase. But the optimism of analysts is best seen in the IBES guesstimate for 2026 earnings which has been steadily jumping higher. Last week this forecast rose $1.23, making the 2026 S&P 500 earnings estimate $314.81, a 12.6% increase.

Yet even as estimates rise, the market is not cheap. Based upon the IBES earnings estimate for calendar 2024, equities remain overvalued with a PE of 21.6 times. Incorporating inflation at 3.4%, the sum of the PE and CPI is 25.0 and above the 23.8 level that defines an overvalued equity market. Even at current S&P 500 prices and with next year’s earnings, the market is trading at a PE of 19.1 times. And assuming inflation does fall to 2% next year, this sum of 21.1 is not far from the 23.8 level that has defined an extremely overvalued market. Overall, this points to an equity market that continues to be driven by liquidity and momentum and not by fundamentals. See page 10.

Technical Indicators Struggling to Remain Positive

The Nasdaq Composite index made a record high on May 28, 2024, the S&P 500 made a record high on May 21, and the Dow Jones Industrial Average made a record high on May 17, 2024. On the other hand, the Russell 2000 index remains 14% below its high of 2442.74 made on November 8, 2021. This week, both the Russell and the DJIA are trading below their 50-day moving averages, and at 2033.94, the Russell 2000 index remains just slightly above the 1650 to 2000 range that contained prices for most of the last 2 ½ years. See page 11.

The 25-day up/down volume oscillator is at 0.97 and neutral after being in overbought territory for four consecutive trading days between May 17 and May 22. This followed six weeks in neutral territory. Since a minimum of five consecutive trading days in overbought is required to confirm a new high, this indicator has not confirmed any of the new highs made in the S&P 500 index and Dow Jones Industrial Average since early January. See page 12.

Daily new highs are falling, and new lows are increasing and this week the 10-day average of daily new highs is 187 and new lows are 72. This combination of new highs above 100 and new lows below 100 is still positive. The NYSE advance/decline line made a new record high on May 20, 2024, is positive, and confirms the new highs in the popular at that time. However, with the exception of May 28th and May 31st, daily volume has been weak for most of the last three weeks, and largely trailing behind the 10-day average for most of the recent advance.

Economics

The PCE deflator for April showed prices rising 2.65% YOY versus 2.7% YOY in March — a fractional decline — but still faster than the 2.46% YOY pace seen in January. The core PCE deflator was 2.75% YOY in April versus 2.8% YOY in March and this index has been sequentially lower since the 5.47% YOY rate recorded in September 2022. Core CPI has been only fractionally lower in the last three months and core PPI has been virtually unchanged for the last four months. Nonetheless, consensus scored this as an inflation victory. See page 3.

Personal income increased 4.5% YOY in April, which was a slight improvement over March’s 4.4%, while disposable personal income rose 3.7% YOY. However, after inflation and taxes, real personal disposable income rose merely 1.0% YOY, down from the 1.3% YOY reported in March. Personal consumption expenditures increased 5.3% YOY, down from 5.6% in April, and this was well above the 4.5% increase in personal income and the 3.7% rise in disposable income. April was the third consecutive month in which consumption exceeded disposable income. The pattern cannot last forever. See page 4.

Real disposable income rose 1.0% YOY, bringing the 3-month average down to 1.3%. There is a close relationship between income and job growth which will make May payrolls important. In April the household survey employment growth was 0.8% YOY, well below trend. Whenever job growth turns negative on a year-over-year basis, the economy is usually entering a recession. Still, establishment payrolls grew 1.8% YOY in April, which is the average pace. See page 5.

Personal income trends in April included a deceleration in personal interest payments; however, these were still growing at 13.25% YOY. Tax payments are trending higher and were up 9.96% YOY in April. Government transfers have been volatile in recent years but rose 4.25% YOY in April. Also notable is the continuous increase in government wages which rose 8.6% YOY in April, as compared to private industry wages which rose 4.2% YOY. This disparity may explain why Washington DC believes inflation is not and has not been, a problem for consumers. See page 7.

The ISM manufacturing index fell to 48.7 in May and has been below the 50 benchmark for 18 of the last 19 months. The one bright spot in the May report was the increase in the employment index from 48.6 to 51.1. The pending home sales index fell to 72.3 in April, down 7.7% for the month and down 7.4% YOY. This was the lowest reading since the pandemic low of 70 seen in April 2020. This does not bode well for the housing industry in the second half of this year.

Gail Dudack

Click to Download