US Strategy Weekly: The Elusive Pivot

The Dow Jones Industrial Average

We expected the last few trading days to be a pivotal time for the stock market, particularly since the DJIA and Russell 2000 indices were both so close to breaking above important resistance levels. Plus, our 25-day overbought/oversold volume oscillator was at the brink of possibly confirming the current advance with a lengthy overbought reading. However, some, but not all of this came to pass.

The Dow Jones Industrial Average did break above the 34,500 level on July 18^th, but mostly thanks to a 14-point gain in Microsoft Corp. (MSFT – $350.98). Microsoft, up nearly 50% year-to-date with a market capitalization of $2.6 trillion, added over 90 points to the DJIA on July 18 and this boosted the DJIA to its highest level since February 2022. The catalyst for Microsoft’s hefty move was a free online event called Microsoft Inspire where Satya Nadella told corporations they could “learn how to accelerate AI transformation, drive customer success, and fuel business growth” with a future product called Microsoft 365 Copilot.

This week the company reported fiscal fourth quarter earnings which beat expectations with an 8% increase in revenues and net income of $2.69 per share, up from $2.23 a year earlier. But according to Yahoo Finance, the stock is currently trading at a trailing 12-month PE ratio of 38 times, which is rich even if Microsoft 365 Copilot proves to be successful. Technology analysts estimate Microsoft 365 Copilot product could add 10% to future revenues (although not before 2024) and this would be helpful since only revenues grew 7% in the last fiscal year. However, even 10% growth could be a hurdle since companies like Amazon.com, Inc. (AMZN – $129.13) and Alphabet Inc. (GOOG – $122.79) are competing for the same customers in the gen AI space. Competition usually lowers margins. Again, Big Tech has been core to the 2023 advance and earnings expectations are high.

The Russell 2000 Index

The Russell 2000 index did not move above the 2000 resistance, nor did the Invesco S&P 500 Equal Weight ETF (RSP – $154.65). Both are hovering at the top of the trading ranges that have contained both charts for the last 15 months. See page 9. It is still pivotal for these two indices. It is a week that could be market moving since it includes many earnings reports, an FOMC meeting, the advance report on second quarter GDP, and June’s personal consumption expenditure index. But for now, these indices continue to be in a long-term trading range.

The 25-day overbought/oversold volume oscillator

Our 25-day overbought/oversold volume oscillator is at a 2.53 reading this week and in the neutral range after recording a number of overbought readings on July 3, July 7, July 12, July 13, July 18, and July 19. See page 10. These were the first overbought readings since the one-day overbought readings recorded on April 28, April 24, and April 18. However, none of these overbought readings lasted the minimum of five consecutive days required to confirm the advance in the averages. Sustainable rallies are characterized by significant volume in advancing stocks which is denoted by a lengthy overbought reading. Impressive advances will include at least one extremely overbought day. This has not appeared to date. However, these technical requirements are required at a new market high and so far, none of the major indices have recorded new all-time highs. All in all, it is not that surprising that our indicators are mixed.

FOMC

We expect the Federal Reserve will raise interest rates 25 basis points at this week’s meeting and remain “data dependent” about policy choices in future meetings. Fed Chairman Jerome Powell is apt to keep his comments somewhat hawkish about expectations for the September meeting, since any indication of a pause in monetary policy would inspire speculation and there are already signs of bubbling speculation in the stock market. Moreover, with the midpoint of the fed funds rate at 5.13% and inflation at 3%, it leaves the real fed funds rate at 213 basis points. Historically, a fed tightening cycle will generate a real fed funds rate of 400 basis points and we believe Powell’s goal is a minimum of 300 basis points. This 300-400 basis points can materialize through a combination of rising interest rates and falling inflation. This explains why the next few CPI and PCE deflator reports will be very important for the Fed and for the stock market. In our view, the Fed will likely raise interest rates again in September. At present, the consensus is not expecting a September rate hike which means it could be a negative shock. Therefore, we would not be surprised if Fed board members publicly discussed the possibility of another rate hike in the weeks ahead.

A Mixed Economy

The relationships between quantitative tightening, contracting money supply, and stock price movement have not been consistent in recent decades. But it is clear that the Fed’s liquidity boost in March done to offset the regional banking crisis is now over and their quantitative tightening program is back on trend. As a consequence, money supply measures, in particular M1 and M2, are now declining at a remarkable pace. See page 3.

Money supply is commonly defined as a group of safe assets that households and businesses can use to make payments or to hold as short-term investments. For example, US currency and balances held in checking accounts and savings accounts are included in many measures of the money supply. In past decades, money supply provided important information about the near-term course of the economy, equity prices, and inflation in the long run. We expect M2 to be less predictive today, but with the 6-month rate of change in money supply now contracting at a historic 3% YOY it could be a sign of slowing economic activity ahead.

The Conference Board’s leading economic indicator fell in June for the 15th consecutive month. As seen on page 4, this has been a reliable recessionary signal over the last 25 years. This indicator also suggests a recession is directly ahead.

Existing home sales were 4.16 million units in June, down 19% YOY. The median home price rose to $416,000, up 3.6% for the month but down 1.2% for the year. The recent rise in existing home prices is a result of near-record-low inventory. Not surprisingly, the National Association of Home Builders survey was at the best levels seen since June 2022, although traffic of potential buyers still remains in recessionary territory. Residential real estate appears to be recovering, but the potential for higher interest rates continues to be a risk. See page 5. The Conference Board confidence index rose to 117.0, its highest level since July 2021. Gains were driven by an improvement in consumers’ outlook for income, business, and job market conditions. The University of Michigan sentiment index jumped to 72.6 in July, up 41% YOY and its highest level since September 2021, yet the index still remains in recessionary territory. A rising stock market and stable gas prices helped boost the index in July. See page 6. In sum, consumer sentiment is improving but the stock market appears to be pivotal to this view. Unfortunately, equity prices have had a big advance without a big uptick in earnings. The second quarter earnings season has the potential to be important for investor sentiment and we remain somewhat cautious and would not chase current leaders but focus on companies with solid and predictable earnings streams.

Gail Dudack

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