Many market commentators are stating that the unwinding of the yen carry trade on August 5^th was not an economic event, did not signal a recession, and is now in the rearview mirror. This would be nice, but it may be wishful thinking.

The August 5^th selloff may not have signaled a recession, and we also characterized it as a liquidity event, but the carry trade unwinding was still significant for many reasons. First, it was triggered by the first rate hike by the Bank of Japan in 17 years and this sparked a sharp reversal in the yen. Both of these represent economic shifts in the global economy, and they are apt to have longer-term implications. Second, the intensity of the decline was the result of leverage that was no longer viable given the shift in interest rates and the yen. This leverage was what helped drive financial securities higher in the past twelve months and this excess “demand” is unlikely to return in the near future. If we are right, without a new bullish catalyst, it may be difficult for equity indices to exceed their 2024 peaks this year.

There has been a lot of focus on the VIX index since the August 5^th sell-off and many well-known strategists are calling the 65 intra-day peak in the index “the third highest in history.” The VIX hitting this “extreme” reading is a reason some believe August 5^th was a major bottom. In truth, the index was created in 1993 (based on the S&P 100 index) and revised in 2003 (based on the S&P 500 index), but the CBOE provides data that goes back to 1986. This historical data is important because it allows us to look at the October 1987 crash as a benchmark for volatility. August 5^th generated a nice jump in the index, but it was far from the third highest in history on either an intra-day or on a closing price basis (even without using the 1987 data!) See page 3. This appears to be another example of wishful thinking by bullish analysts. Moreover, what the history of the VIX index does show is that after a sharp jump in the index, it usually takes time for price volatility to subside.

One concern we have is that when deleveraging like what took place on August 5 occurs, there can be losses in some portfolios that, in time, could prove to be unmanageable. For example, when Russia defaulted on its debt in August 1998, the losses suffered by Long-Term Capital Management, a highly leveraged fixed income hedge fund founded by a former Solomon Brothers bond trader and a Nobel-prize winning economist, led to a government-sponsored bailout in September 1998. LTCM’s struggle was not widely known for weeks. The fact that the equity market has recovered much of its recent losses is comforting. Recent losses may have moderated, but they may also be temporary.

In retrospect, a number of extremes appeared in the first half of the year that were troubling. According to a recent S&P Global article, the representation of mega-cap companies in the S&P 500 reached a multi-decade high in March when the cumulative weight of the five largest companies in the S&P 500 hit 25.3%. This level has not been seen since December 1970, a 54-year record.

Additionally, data from the Office of Financial Research (OFR), a department within the Treasury Department, shows hedge funds also touched extremes at the end of the first quarter. Assets of qualifying hedge funds totaled $4.12 trillion as of March, of which the largest were “other” with $1.24 trillion, equity with $1.16 trillion, and multi-strategy funds with $702 billion. The overall borrowing relative to assets (net asset-weighted average ratio) was 1.2 for this universe of funds. See page 4.

Leverage is an important part of the equity market, particularly in a bubble market. And since hedge funds are major users of leverage this OFR data is useful. It shows that macro hedge funds ($172 billion in assets) were the most highly leveraged in March with a net asset-weighted average ratio of 6.5, a record for that category. Relative value funds followed with a ratio of 6.2 and multi-strategy ranked third with a ratio of 4.0 (also a record for that category). Equally important is the pace of borrowing. Net borrowing increased 54% YOY for relative value funds, 34% YOY for multi-strategy funds, and 28% YOY for macro funds. In terms of borrowing, $2.3 trillion was done through prime brokerage, $2.1 through repo borrowing, and $556 billion through other secured borrowing. Although this data is only quarterly and is reported with a delay, it does show that leverage was increasing substantially in the first quarter of this year. See page 5.

In terms of liquidity, the Fed’s balance sheet was $7.23 trillion as of August 7, down nearly $1.8 trillion from its April 2022 peak, and down almost $33 billion from a month earlier. But this has not significantly impacted individual investors since demand deposits, retail money market funds, or small-denomination time deposits all grew slightly in the same period. These accounts, plus “other liquid deposits” sum to $18.6 trillion that currently sit in bank deposits. See page 6. In short, the Fed’s careful quantitative tightening is not changing consumer cash balances, and this is positive for equities. Lowering interest rates, if it takes place in September, would improve investors’ liquidity even more.

The NFIB small business optimism index rose 2.2 points in July, to 93.7, the highest readings since February 2022, or in 2 ½ years. However, this was still the 31^st month below the long-term average of 98. Fewer small businesses indicated that they planned to increase wages in July and 25% noted that inflation is their single most important problem. However, there was an increase in the number of businesses planning to increase inventories and this could help third quarter GDP. See page 7.

Producer price data for July showed final demand inflation was rising only 0.1% month-over-month and 2.2% YOY. This was down from the 2.7% YOY seen in June and received well by the market. However, beneath the surface, we noted that final demand for trade services fell 0.7% YOY, and this calmed prices for the month. Trade indexes measure changes in margins received by wholesalers and retailers. However, final demand services, less trade, transportation, and warehousing, showed prices rising a much more worrisome 4.1% YOY. See page 8.

Technical Update

Last week’s sharp sell-off resulted in the Nasdaq Composite and the Russell 2000 index successfully testing their 200-day moving averages on an intra-day basis. The S&P 500 and Dow Jones Industrial Average are trading well above their 200-day moving averages. But for confirmation, we are watching Microsoft Corp. (MSFT-$414.01) and Amazon.com, Inc. (AMZN-$170.23) which broke below their respective 200-day moving averages last week and are now struggling to stay just above those long-term benchmarks. See page 11.

The 25-day up/down volume oscillator is 2.02, in neutral territory, but recovering, after absorbing a 92% down day on August 5. This followed 90% down days seen on April 12, 2024, February 13, 2024, and December 20, 2023. A 90% up day would suggest the worst of the decline is over; however, the last 90% up day was recorded way back on December 13, 2023. This oscillator failed to reach an overbought reading on the last rally and therefore did not confirm the advance. To date, an uptrend in this oscillator off the 2022 low, remains intact and lends a bullish bias to an otherwise neutral position in this index. Should this trend line be broken it would be a warning sign for the longer-term stock market. See page 12.
Gail Dudack

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In previous reports we have written about the risk of the 2024 market being an equity bubble — though not an extended one — and that bubble markets are always difficult to quantify since they are driven by a combination of liquidity, leverage, and greed, not fundamentals. Leverage was concentrated in brokerage margin accounts in the late 1990s and this made the leverage driving the 2000 peak easier to measure. Today leverage is widely dispersed, and investors use a variety of tools to multiply their buying power. Some of this is displayed by the historic asset and volume levels in options, futures, ETFs, and a variety of debt instruments.

The Carry Trade

Tight monetary policy and rising interest rates work against equity bubbles, which may explain why US investors have been riveted on when the Federal Reserve would begin to lower interest rates. But this narrow focus on the Fed may be why last week’s rate hike by the Bank of Japan came as a surprise. The BOJ’s first rate increase in 17 years pricked the global financial bubble by triggering a sharp rise in the yen and squeezing the yen carry trade. Yen-funded trades have been used to finance the acquisition of stocks for years and the amount of money in the carry trade is unknown. But since it is based upon a weak-to-stable currency and zero-to-low interest rates, the yen’s surge and the BOJ’s rate hike suddenly made this source of funding less viable.

Clearly, the events of the last few trading sessions and the unwinding of the carry trade is a liquidity event and not an economic issue. But the sizeable losses in equity markets imply there are many accounts still under water and the reverberations are apt to take days or weeks to understand. In the meantime, we remain cautious.

One way to measure risk after a liquidity event is to monitor market data, in particular, daily volume levels and 90% up and/or down days. Not surprisingly, August 5^th was a 92% down day in the US market on volume that was nearly 30% above the 10-day average. It would not be unusual if there were more 90% down days in the weeks ahead. However, once a 90% up day appears on better-than-average volume, it is a sign that downside risk has been minimized. In short, while the chorus is singing “buy the dip” we would caution that a safer bet is to wait for a 90% up day. This is not a guarantee that the lows have been made, but historically it has shown that the downside risk is minimal.

The Larger Backdrop

However, the unwinding of the carry trade is not taking place in a vacuum. It is second quarter earnings season and in the long run, earnings will be more important for stock prices than the carry trade. But results for the quarter have been mixed. Disappointing results were reported by McDonald’s Corp. (MCD – $270.06) and Microsoft Corp. (MSFT – $399.61), while Meta Platforms, Inc. (META – $494.09) beat expectations. News such as Nvidia Corp.’s (NVDA – $104.25) delivery delay for its new Blackwell chip, Warren Buffett selling half of his stake in Apple Inc. (AAPL – $207.23), a recent Federal judge ruling that Google (Alphabet Inc. GOOG – $160.54) is a monopoly, Amazon.com, Inc. (AMZN – $161.93) lowering forecasts for earnings and revenue, all weigh heavily on the big tech sector and these stocks have been at the core of the stock market’s advance in the last year.

And despite the large declines in the popular averages, the stock market remains richly valued. Based upon the LSEG IBES earnings estimate for calendar 2024, equities are trading at a PE of 21.5 times. When added to inflation of 3.0%, this sum of 24.5 is above the 23.8 level that defines an overvalued equity market. Based on next year’s 2025 estimate the PE falls to 18.7 times and the sum equals 21.7 which is at the high end of the neutral range. However, 2025 estimates may be high, particularly if the economy slows. See pages 10 and 11.

Economic Review

July’s employment report showing 114,000 new jobs and a 4.3% unemployment rate was not that weak, in our view. The 3-month average actually rose from 167,670 to 169,670 because April’s payrolls added a mere 108,000 jobs. What may have made investors nervous about July’s data is that the birth/death adjustment was a positive 246,000 which means the unadjusted not-seasonally-adjusted payrolls were negative 132,000 jobs in July. However, this was not the first month of negative payrolls before the birth/death adjustment. It also occurred two times in 2023 as well as in April and May of this year. See page 5. Investors reacted badly to the jobs report because they were already worried about earnings.

The unemployment rate rose from 4.05% to 4.25%, however, the average long-term rate is much higher at 5.7%. The unemployment rate for women rose from 4.3% to 4.5% while for men, the rate much lower, rising from 4.1% to 4.2%. Unemployment by level of education was more disparate. Those with less than a high school education saw unemployment jump from 5.3% to 6.5% in July. This is a worry. A high school degree but no college saw an increase from 4.1% to 4.7%. Those with some college rose from 3.5% to 3.8% and a bachelor’s degree or higher rate edged up from 2.6% to 2.7%. See page 6.

What concerns us is the year-over-year growth rate in employment in the household survey which has been below 1% YOY all year and fell from 0.12% YOY in June to 0.04% YOY in July. This month, the year-over-year growth rate in the establishment survey slipped to 1.6%, the second month in a row below the long-term average growth rate of 1.69%. These growth rates will be important to monitor because negative job growth has been an excellent forecaster of recessions. We are not there yet, but the trend is ominous. See pages 3 and 4.

The ISM non-manufacturing index rebounded from 49.6 to 54.5 in July, with all components except supplier deliveries rising for the month. The employment index jumped from 46.1 to 51.1. Conversely, the ISM manufacturing index declined in July from 48.5 to 46.8, with five components falling for the month, four increasing and one unchanged. The employment index was weak, slipping from 49.3 to 43.4. See page 8.

Total vehicle unit sales rose to 16.3 million in July, up from 15.6 million in June, but down 0.9% YOY. Despite July’s uptick, this pace is well below the 18.5 million units seen in April 2021 and October 2017. Pending home sales rose 4.8% in June, rebounding from May’s record low reading of 70.9, and with sales rising in all regions. Nevertheless, June’s index was down 2.6% YOY. See page 9.

Technicals

Monday’s sharp sell-off led to the Nasdaq Composite and the Russell 2000 index both successfully testing their 200-day moving averages on an intra-day basis. The SPX and DJIA are trading well above their 200-day MA’s. See page 12. Stocks to watch for signs of further weakness are Microsoft Corp. (MSFT-$399.61) and Amazon.com, Inc. (AMZN-$161.93) which are currently trading below their respective 200-day moving averages. The 25-day up/down volume oscillator is 1.39 and in neutral territory after absorbing a 92% down day on August 5. This followed 90% down days seen on April 12, 2024, February 13, 2024, and December 20, 2023. The last 90% up day was recorded on December 13, 2023. This oscillator failed to reach an overbought reading on the last rally and therefore did not confirm the advance. We will be watching to see if the uptrend in this oscillator from the 2022 lows remains intact. If not, it would be a longer-term warning sign for the stock market.

Gail Dudack

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This will be a week filled with central bank announcements, the July employment report, and more than 100 second quarter earnings announcements from S&P 500 companies. According to the LSEG IBES earnings dashboard, with 238 of the S&P 500 components having reported quarterly results, 79% beat analysts’ earnings estimates but only 58% beat revenue forecasts. Second quarter estimates now show a 12.4% increase in earnings based on a 4.9% increase in revenue. This combination of revenue and earnings will be difficult to sustain over time, particularly with the pressure that higher-for-longer interest rates put on Corporate America’s ability to increase revenue growth and drive earnings.

And the pressure is not just domestic. McDonald’s Corp. (MCD – $266.44) reported its first drop in worldwide sales in 13 quarters, and was one of several companies citing weakness in China’s economy as an issue. Procter & Gamble Co. (PG – $161.70) reported $1.40 adjusted earnings versus $1.37 expected. However, P&G’s diluted earnings per share of $1.27, was a 7% decline from a year earlier and below expectations of $1.33. China is P&G’s second largest market, and organic sales in China slid 9%. Merck & Co. Inc. (MRK – $115.25) cut its annual profit forecast. CrowdStrike Holdings Inc. Cl A (CRWD – $233.65) fell after Delta Air Lines Inc. (DAL – $43.23) announced it is seeking compensation from the cybersecurity firm and Microsoft Corp. (MSFT – $422.92) for losses from the massive computer outages seen earlier this month.

Given its investment in OpenAI, Microsoft is viewed as a significant player in the race to make money from generative artificial intelligence (AI). However, this week the company reported results that missed expectations for growth in its Azure cloud-computing service. The company said it will raise its capital spending this fiscal year, but growth for its Azure cloud platform would be below current estimates. (Sounds like margin pressure.) AI services accounted for 8% of Azure’s growth in the quarter, up from 7% in the first three months of the year. Meanwhile, MSFT’s capital expenditures, including finance leases, rose 77.6% to $19 billion, up from $14 billion in the previous quarter. Microsoft explained that additional spending was needed to expand its global network of data centers and overcome the capacity constraints that were hampering its efforts to meet AI demand. Overall, this report from MSFT suggests that the earnings surge expected from AI may be further in the future than many have been anticipating. Other technology giants like Apple Inc. (AAPL – $ 218.80), Amazon.com Inc. (AMZN – $181.71), and Meta Platforms Inc. (META – $463.19) are all expected to report earnings this week and may give more insight into whether AI will prove profitable in the near future.

We believe earnings reports will be more important than central bank news. Nonetheless, the Bank of Japan is expected to announce plans to taper its huge bond buying this week and debate whether to raise interest rates. This would be in line with its resolve to steadily unwind an entire decade of massive monetary stimulus. The Federal Reserve Bank is not expected to announce any change in its monetary policy this week, but economists will be looking for hints regarding a first rate cut, widely expected to be in September. And on Thursday, the Bank of England is expected to cut UK interest rates, despite data that shows service sector inflation is sticky. UK interest rates are currently at a 16-year high of 5.25%, and a cut would be the first in over four years.

Meanwhile, the US economy is also giving mixed signals. July’s Conference Board Consumer Confidence Index increased to 100.3 from June’s downwardly revised 97.8 (previously 100.4), which was much better than consensus forecasts. The expectations index – based on consumers’ short-term outlook for income, business, and labor market conditions – rose to 78.2 from 72.8 in June but remains below the 80 level – a threshold that usually signals a recession. The present situation, however, declined to 133.6 from 135.3 in June. Conversely, data from the University of Michigan sentiment survey indicated that confidence fell in July with the headline index dropping from 68.2 to 66.0. The present conditions index fell from 65.9 to 64.1 and the expectations index was the weakest, falling from 69.6 to 67.2. See page 3.

The housing market continues to slow. Existing homes data recently showed sales fell 5.4% YOY in June even though the median price of a single-family home rose to $432,700, up 4.1% YOY. New home sales declined 7.4% YOY in June, but the median price of a single-family home was down 0.1% YOY. See page 4.

The first estimate for second quarter GDP was 2.8%, double the pace seen in the first quarter and much stronger than expected. Consumer spending was the largest contributor to growth, although fixed non-residential was strong and inventory investment was also positive after being negative for the previous two quarters. There seems to be a discrepancy between GDP’s personal consumption data and US Census retail sales data. For example, retail sales were negative on a year-over-year basis for most of the last two years, yet consumption has been the main driver of GDP. However, much of this can be explained by the components of consumption. In the second quarter, GDP data shows consumption of services grew 6.9% YOY, nondurable goods increased 3.1%, but durable goods consumption fell 0.4% YOY. It could be that the rising costs of services, such as home and auto insurance, are squeezing out the consumption of durable goods, and autos are a large part of retail sales. See page 5-6.    

Personal income rose 4.5% YOY in June and personal consumption expenditures rose 5.2% YOY. After taxes and inflation, real personal disposable income increased 1.0% YOY in June. This is much lower than the 3.8% YOY seen at the end of 2023, but still positive. More importantly, it is much better than the negative growth in real income seen for much of 2022 and 2023. However, with spending exceeding income in June, it is not surprising that the savings rate fell from 3.5% to 3.4%. See page 7.

The PCE deflator was 2.5% YOY in June, down from 2.6% in May. Much of this improvement was due to falling prices for durable goods (down 2.9% YOY), particularly motor vehicles (down 3.6% YOY). Prices also declined for recreational goods and vehicles which fell 2.4%. In addition, gas prices, which rose 4.8% in May, increased a mere 0.35% in June. The major problem in terms of stubborn inflation is found in financial services and insurance, which rose 5.6% and household services which rose 3.9%. See page 8.

Not Yet Overbought Last week we noted that our 25-day up/down volume oscillator was rising toward an overbought reading that could confirm the recent advance. To date, it is yet to reach overbought territory and sits at 2.12. If the current advance is the start of a major advance, this indicator should rise to 4.0 or 5.0 and remain overbought for a minimum of five consecutive trading days, but hopefully many more than that. In short, there is no confirmation as yet. See page 12. There was considerable rotation in the market recently. One sign of that is the S&P 500 and Nasdaq Composite indices are trading below their 50-day moving averages, whereas the Dow Jones Industrials and Russell 2000 are still trading above all their moving averages. Another sign is that the Russell, which had been 17% below its record high and is now only 8% below this peak. To date, the pullback in the large cap stocks appears to be a normal correction within a larger rally. The 2024 stock market has been driven more by liquidity than earnings, or at least the expectations of great earnings, which is what makes this earnings season important.

Gail Dudack

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In “A Shift in Breadth” (July 17, 2024), we wrote that on July 11, 2014 a major change had taken place in the equity environment as seen by money flowing out of the large capitalization market leaders and into lagging financial and smaller capitalization stocks. The shift was so sudden that it was most likely due to professional traders using ETFs and futures to expedite a major portfolio change. Nonetheless, the move generated a solid improvement in breadth data and produced a perpendicular breakout in the Russell 2000 index carrying it well above the 2100 resistance level. Volume increased and the NYSE cumulative advance/decline line made a series of record highs confirming the gains in the indices.

Technicals Might Get Better

Technical confirmations of the advance continued this week and our favorite indicator — the 25-day up/down volume oscillator — is currently at 2.84. This is neutral territory, but close to an overbought reading of 3.0 or more, which in our view, deserves an upgrade from neutral to slightly bullish. However, a minimum of five consecutive trading days above 3.0 is required to confirm an advance in a bull market, which makes the market’s near-term action important. If this is the start of a major advance, this indicator should go to an extreme reading of 5.0 or more and stay overbought for much longer than five consecutive trading days. From a mathematical perspective, this indicator is a good barometer of buying and selling pressure. Since bull markets are characterized by strong and consistent buying pressure, this indicator should reach and remain in overbought territory for a long period of time. A lack of buying pressure, i.e., no overbought reading, is a sign of weak buying pressure or strong selling pressure. In other words, a rally without an overbought reading is a warning signal. See page 10.

Investors are becoming more bullish as seen in the AAII bull/bear sentiment readings where neutral readings declined, but bullishness reached 52.7% and bearishness also rose to 23.4%. This is moving toward a warning signal of more than 50% bullish and less than 20% bearish. However, the last important reading from this indicator was in January 2018 when bullishness hit 59.8% and bearish sentiment fell to an extreme low of 15.6%. In short, bullish sentiment is high, but not too high, and bearish sentiment is not nearly at the levels denoted as extreme. See page 12.

On a pure technical basis, the uptrends in all the major indices appear to be forming a third upleg in a possible 3-leg advance that began in 2022. See page 9. This pattern suggests further upside that could carry prices higher in the months ahead. But it also implies a significant correction or peak could materialize in 2025.

The last two weeks in the stock market environment has been dramatic, erratic, but clearly moving toward the view that a Fed rate cut is on the horizon and a soft landing is likely in 2025. We are not convinced. And no one should overlook the fact that the political environment has been equally dramatic and changeable in the last two weeks. Two weeks ago, we thought we knew who the candidates for US president would be, but one was nearly assassinated and the other has withdrawn. The Republican support around Donald Trump at the Republican Convention was palpable. Now, the Democratic movement around Vice President Kamala Harris’s candidacy is equally amazing. These two candidates have vastly different economic views and platforms which could impact the economy and the stock market. The next major political event that could impact the polls, and the markets, would be a presidential debate between former President Trump and Vice President Harris. Back in May, ABC News had announced that a debate between Republican nominee Donald Trump and President Biden would take place on Tuesday, September 10, 2024 at 9 pm ET. If that schedule stays intact, it means six weeks without meaningful polling data. In this vacuum, the equity market should respond solely to second quarter earnings results. But overall, it continues to be a fluid situation.

More Weak Housing Data

All components of the NAHB Housing Market Index (HMI) were below the key 50 threshold in July. The overall HMI index lost 1 point to 42, present conditions fell 1 point to 47, expected sales over the next 6 months rose 1 point to 48, and traffic of prospective buyers lost 1 point to 27. High mortgage rates and elevated rates for construction and development loans were the factors that continued to dampen builder sentiment. Recent housing releases also showed fragility. Permits were off 3.1% MOM and fell 1.3% YOY in June; housing starts rose 3.0% MOM but fell 4.4% YOY. See page 3.

Existing home sales were 3.89 million units in June, the lowest pace of the year, and represented a 5.4% decline year-over-year. Nonetheless, the median price of an existing single-family home was $432,700, up 2.4% for the month and up 4.1% YOY. In sum, June repeated the pattern of slower sales but higher prices. See page 4.

Home prices have been supported by a lack of supply. In June, existing single-family home inventory was 1.16 million homes, up 4% for the month and up 22% YOY, yet this was still low by historical standards. Months of supply rose from 3.6 to 4.0. But the market for newly constructed homes has been much weaker. New home sales were down 16.5% YOY in May and the median price of a new single-family home has been stagnant for the past 4 months. See page 5.

Industrial production for June rose 1.6% YOY, led by auto and truck production which grew 5.3% YOY. Auto production can be volatile, but durable consumer goods rose 2.3% YOY and nondurable goods production increased 3.0% YOY. Industrial production was strong in June; but note that July’s total US industrial production index was 103.994 and still below the 104.10 level reached in September 2018.

The Beige Book for the period ending mid-July showed economic conditions were rather mixed across the country with seven districts reporting some level of growth and the five others noting either no change or a decline in activity. Two districts were unchanged or down in the last report. Most districts reported little change in household spending and demand was also soft for consumer and business loans. Employment rose at a slight pace, on average, and inflation was modest in most districts. Looking ahead, most of those surveyed expected growth to slow in the second half of the year. Meanwhile, the Conference Board Leading Economic Index declined again in June, to its lowest level in four years when the economy was shut down during the pandemic. This week we get a first look at second quarter GDP, the University of Michigan Consumer Sentiment survey revision for July, and personal income, personal consumption expenditures, and the Fed’s favorite benchmark, the PCE deflator for June. These reports will give economists a sense of how strong the economy was as we head into the third quarter. This week will also include second-quarter earnings releases from 134 S&P 500 components. To date, 70 companies have released earnings reports and nearly 83% have reported earnings better than analysts’ estimates. This compares to the prior four-quarter average of 79%. The market is likely to focus on earnings season amidst this ever-changing political backdrop.

Gail Dudack

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A major shift took place in the stock market last week and money flowed out of the few popular large-cap stocks that had been the major drivers of this year’s market rally and into financial and a broad range of small-cap stocks that had been among the laggards. It was such a sudden and dramatic shift that it suggests this change was the result of professional traders using ETFs and futures to facilitate a major portfolio shift. Nonetheless, it triggered a major uptick in breadth data and produced a perpendicular breakout in the Russell 2000 index — well above the 2100 resistance level. Volume increased and the NYSE cumulative advance/decline line made a series of record highs confirming the gains in the indices. These are all technical confirmations of the advance. See pages 11 and 12.

This portfolio shift materialized prior to the assassination attempt on former President Trump on Saturday. However, this cowardly act by a 20-year-old man and the emotion that it unleashed in its aftermath, unified the Republican Party, and may have solidified Trump’s win in November. We mention this because a Trump win in November’s presidential election would put two businesspeople in the Executive Branch. Perhaps more importantly, it implies an administration that will again focus on lower taxes, less corporate and small business regulation, more oil drilling (lower energy prices), and a stronger economy. All of these are good for small-cap stocks. The sharp gains in stocks this week are another positive sign that the stock market would welcome a Trump victory.

Liquidity Trumps Valuation

As we noted last week, even though the Federal Reserve is making progress on decreasing its balance sheet, liquidity in the banking sector is solid. Total assets at all commercial banks reached $23.52 trillion in early July, an all-time high. Near the end of June, demand deposits, retail money market funds, and small-time deposits were all at, or near, record highs. Only “other liquid deposits” at banks appear to be sensitive to the Fed’s balance sheet and have declined $3.5 trillion since their April 2022 peak. And since liquidity is the first necessity of a bull market (or bubble), this suggests stock prices could go higher.

However, this does not mean the stock market is cheap! The S&P 500’s trailing 4-quarter operating earnings multiple is now 25.5 times and well above all long- and short-term averages. The 12-month forward earnings multiple is 21.7 times and when added to inflation of 3.0% sums to 24.7. Note that this sum of 24.7 is higher today than it was a week ago despite the fact that recently released data showed that June’s headline CPI fell from 3.3% to 3.0%. The sum of inflation and the trailing PE multiple has been a simple but important standard of valuation during a wide variety of economic cycles and periods of low and high inflation. The current 24.7 level remains well above the top of the normal range of 14.8 to 23.8 and denotes an overly rich market. See page 9. 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. However, if this is a bubble, remember that bubbles are driven by liquidity and sentiment, not valuation. Right now, liquidity appears plentiful.

In the longer run, we are concerned about the massive amounts of debt accumulated by most of the developed nations since the COVID-10 pandemic. In our view, this will become a significant issue at some point in the future. It was an important factor in the recent UK parliamentary election. But in general, we do not believe federal debt will be a problem this year, particularly with the US debt markets single-mindedly focused on the timing of a first Fed rate cut. However, it could become a problem for the markets in 2025.

Economic data helps the Fed

July’s University of Michigan consumer sentiment survey showed a fourth monthly decline, falling from 68.2 to 66.0, down to its lowest reading since November. Consumer expectations led the weakness, dropping from 69.6 to 67.2 and current conditions fell from 65.9 to 64.1. This survey will be revised later in July and the Conference Board consumer confidence indices will be released at the end of the month. Both surveys have shown consumer sentiment declining since early this year. See page 3.

Total retail & food services sales were unchanged for the month of June on a month-over-month basis and up 2.6% YOY. This report was better than consensus expectations, however, after adjusting for inflation, real retail sales fell 0.7% YOY. This represented the 15^th year-over-year decline in the last 20 months. Historically, year-over-year declines in real retail sales materialize only during recessions. This has been one of those uncanny recession indicators that has not worked in 2023 or 2024. Nonstore retailers continued to provide a growing portion of total sales and increased 8.8% YOY. Food services were also strong, rising 4.6% YOY. See page 4.

As noted, headline CPI rose 3.0% YOY in June, slightly below the 3.1% seen in January with much of the improvement due to monthly declines in apparel, energy, and transportation prices. Still, inflation remains sticky in many areas, particularly in the service sector where the broad service sector index has shown prices waffling at roughly 5% YOY for the last seven months. See page 5.

This service inflation explains why, despite a steady decline in owners’ equivalent rent (OER), headline CPI has been stuck at the 3% to 3.5% level for the last eight months. Owners’ equivalent rent is said to be the main factor keeping the CPI index above 3%, but that does not appear to be accurate. Service sector inflation has been the problem in 2024, particularly in all areas of insurance. See page 6.

What helped lower OER this year has been price declines in household furnishings and operations and fuels & utilities. More recently there have been signs of decelerating inflation in tenants’ and household insurance. But fuels & utilities pricing has been on the rise in recent months, which could become a problem. Plus, inflation has been accelerating in medical care, food at home, and other goods and services. See page 7. These are the factors that are a burden on many American households. Nevertheless, economists are focused on the trends in all the core inflation benchmarks – CPI, PPI, PCE – which are lower and favorable. This has led economists to shift back to forecasting two to three rate cuts this year. One factor on the Fed’s radar could be wages which grew 4% YOY in May and 3.7% in June. We believe the Fed would be more comfortable lowering interest rates if wages were growing below the inflation rate, or at least below 3%. This would eliminate the risk of built-in inflation, sometimes called a wage-price spiral. Import and export price indices were negative in 2023, due in large part to a strong stable dollar and a stable-to-hawkish Fed, and this helped tame inflation. This should continue to be true in the near term, but future Fed rate cuts could result in a weaker dollar and lead to higher import prices. See page 8.

Gail Dudack

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The S&P 500, the Nasdaq Composite index, and the Wilshire 5000 index all scored record highs this week, purportedly stirred by comments from Fed Chair Jerome Powell during his semi-annual testimony to Congress. This was despite the fact that Powell was clear during his testimony that he was not sending signals about any rate cut and that more good data was needed prior to any rate cut. Still, CME’s FedWatch continued to price in 50 basis points of easing this year and a 72% chance for a 25-basis-point cut at the September meeting.

In January, the consensus was expecting eight Fed rate cuts, and this dropped to two. In short, rate cut expectations have fallen well short of earlier forecasts, and in our view, it is evident that Fed rate cuts are not a driving force of the 2024 stock market. Earnings expectations linked to AI growth have been the catalyst for a number of technology stocks, and this has kept the popular averages moving higher.

Liquidity

The second quarter earnings season begins this week, and good earnings results may be a necessary factor for further gains. Shares of The Goldman Sachs Group, Inc. (GS – $472.83), JPMorgan Chase & Co. (JPM – $207.63), Citigroup Inc. (C – $66.55), and Wells Fargo & Company (WFC – $59.88) rallied ahead of earnings releases expected from the latter three later this week. Bank stocks may have been boosted by Powell’s comments to Congress indicating that regulators should seek additional feedback on the contentious “Basel III Endgame” proposal which would change risk guidelines and hike bank capital requirements. He added that a re-proposal was essential given the significant changes that would be imposed and that this would take time. Since Powell’s comments were in line with what the major banks had been asking for, this may have sparked the rally. Nonetheless, gains in banking stocks are always a welcomed factor since it is a favorable sign for the economy and the stock market. But if these gains are to be sustained, earnings results need to be in line with, or better than, expectations.

We noticed that liquidity in the banking sector is at record highs, which is a bit surprising since the Fed has been shrinking its balance sheet. After the mini bank crisis in March 2023, the Federal Reserve returned to its policy of quantitative tightening and since the April 2022 peak of $9.01 trillion, the Fed’s balance sheet is down $1.7 trillion to $7.27 trillion. This decline includes a $1.22 trillion decrease in US Treasury securities, a $404 billion drop in mortgage-backed securities, and a $115.5 billion reduction in loans. See page 3.

But despite this shrinkage in the Fed’s balance sheet, liquidity in the banking sector remains healthy. Near the end of June, demand deposits, retail money market funds, and small-time deposits were at, or near, record highs. “Other liquid deposits” appear to be most sensitive to the Fed’s balance sheet and have declined $3.5 trillion since their April 2022 peak. However, total assets at all commercial banks were $25.51 trillion at the end of June, an all-time high. See page 4. Liquidity is a necessary ingredient for any bull market, and it appears that liquidity remains robust despite the Fed’s tightening policies.

The Economy

June’s employment report was reassuring for investors since it was in line with the consensus. The establishment survey reported 206,000 new jobs and the household survey showed a small 0.1 increase in the unemployment rate to 4.1%. June’s total employment of 158.6 million jobs was a new record. The year-over-year growth rate eased to 1.67%, just under the long-term growth rate of 1.7%, but still healthy. Meanwhile, the household survey continues to be weaker than the establishment survey. Total employment of 161.2 million was below the record 161.9 million set in November 2023 and the year-over-year growth rate was 0.12% YOY, fractionally below May’s 0.23% YOY pace. Over the last six months, the growth rate in the household survey has been trending toward zero which could be significant and a negative sign for the overall economy. Year-over-year declines in total jobs have been one of the best predictors of an economic recession, as seen in the chart on page 5. Neither survey is there yet, but upcoming job releases will be important.

The good news in June’s jobs report was the steady 4% YOY increase in average hourly earnings. This means real hourly earnings grew slightly more than inflation, which is currently at 3.3%. The same was true of weekly earnings, which rose 3.7% YOY to $1012.69. See page 6.

Last week’s ISM manufacturing indices showed broad-based weakness. The ISM service indices, released Wednesday, were surprisingly soft with seven of ten indices coming in below the breakeven 50 level, and nine of ten indices declining for the month. Only the imports index rose from 42.8 to 44.0, but this was still below the 50 neutral level. Business activity was one of the weakest segments of the service industry survey, falling from 61.2 to 49.6. A key takeaway from the ISM surveys was that both employment indices were below 50 in June. Another sign of possible job weakness. See page 7.

Technicals

The Nasdaq Composite index and the S&P 500 recorded all-time highs again this week led by big-cap technology stocks. However, the Dow Jones Industrial Average is 1.8% below its record high on May 17, 2024 and the Russell 2000 index remains 16.9% below its high of 2442.74 made on November 8, 2021. The Russell is still trading below its 50-day and 100-day moving averages this week and the DJIA is trading slightly above its two moving averages. This is not a broad-based advance. See page 10.

The 25-day up/down volume oscillator is minus 0.82, still in neutral territory, but retreating toward the uptrend in place in this oscillator since the October 2022 low. What this minus 0.82 reading means is that while the S&P 500 and the Nasdaq Composite index continued to score a series of all-time highs, over the last 25 trading sessions there has been slightly more volume in declining stocks than in advancing stocks. This is a bad omen for the market. Bull markets tend to stay overbought for long periods of time in this indicator – a sign of sustained buying pressure. The oscillator was last in overbought territory for four consecutive trading days between May 17 and May 22. 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. Conversely, the NYSE cumulative advance/decline line did make a new high on July 8, 2024. But while advancing stocks may define the trend of the market, advancing volume defines the strength of the trend. In short, the current rally is falling short of being confirmed. This is worth noting since at current prices the S&P 500 is trading at 25.1 times trailing and 21.3 times forward earnings. Both are extremely rich. See page 8.

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Global Elections

One in three Democrats think US President Joe Biden should end his reelection bid after last week’s cringe-making debate against Republican Donald Trump. However, Biden disagrees, and maybe he is right, because according to a Reuters/Ipsos poll disclosed this week, no prominent elected Democrat does better than Biden in a hypothetical matchup against Trump. Still, last week’s presidential debate may have been a turning point in the 2024 election. Not surprisingly, markets are looking at what a change in the Oval Office could mean for companies, stocks, inflation, and interest rates.

Most prognosticators are pointing to higher inflation as a result of a Trump victory. So, we checked. This view ignores the fact that during Trump’s presidency monthly CPI data averaged 1.9% from the end of 2016 to the end of 2020. More surprisingly, GDP growth averaged 2.44% in the same period despite, and including, the Covid-inflicted recession in early 2020. This growth rate was actually higher than 2.0% average quarterly GDP growth rate seen during the 8-year Obama administration. Surprised?

The reason many economists are worried about inflation is that Trump imposed significant tariffs on China during his presidency and “tariffs are inflationary.” Moreover, the Tax Foundation issued a report on June 26, 2024 on the impact of the Trump-Biden tariffs. They coined it the “Trump-Biden Tariffs” because Biden kept most of Trump’s tariffs in place during his term and announced $18 billion more tariffs on Chinese goods in May 2024. According to the Tax Foundation, “the Trump administration imposed nearly $80 billion worth of new taxes on Americans by levying tariffs on thousands of products valued at approximately $380 billion in 2018 and 2019, amounting to one of the largest tax increases in decades.”

These are imputed tax increases estimated by the Tax Foundation that assume Chinese tariffs would be passed on as price increases to US consumers. But actual history shows that in many cases, they were not, and the Chinese government subsidized their exporters. The Foundation also estimates there would be a loss of consumer choices, a loss of jobs, and a loss of trade as a result of tariffs. But we disagree. What did happen is that other Asian countries such as Viet Nam, Thailand, and Cambodia, became new sources of goods for US consumers and this buoyed these Asian economies. They also underestimated the fact that small US businesses picked up the slack when Chinese imports became more expensive for US consumers. What is also being ignored is that the revenue from these Chinese tariffs go straight to the US Treasury which helps to balance the budget and could therefore lower the need for revenue (i.e., new taxes). And to the extent that tariffs reduce Chinese imports (which is a negative to GDP), it would thereby increase GDP. In our view, the Tax Foundation is only looking at one side of the coin, ignoring that we live in a dynamic global economy, and is making assumptions that simply did not occur. And finally, most tax-payers would agree that taxes were lower under the Trump administration. In short, we suggest you do not believe everything you read, even from the “experts.”

In Europe, Marine Le Pen’s National Rally (RN) far-right anti-immigrant Euroskeptic party scored historic gains to win the first round of France’s parliamentary election this the weekend. This means that President Emmanuel Macron’s gamble on calling for a snap election backfired since his centrist camp came in at a lowly third place behind the RN and a hastily formed left-wing alliance. Pollsters calculated after the first round of voting that the RN is on track for anything between 250-300 seats in a race in which 289 seats are needed for a majority. However, that was before the tactical withdrawals and cross-party calls for voters to back any candidate that is best placed to defeat the local RN rival. In short, politics is chaotic in France. Moreover, the RN party has very different opinions on European politics, and this could put the Eurozone, and the European economies, in turmoil.

The UK also has a parliamentary vote later this week, and if polls are correct, the ruling Conservative party will be replaced by the centrist Labour Party, currently led by Keir Starmer. Starmer is running on a platform of economic stability, which is an attractive concept to British voters after Conservatives ran through five prime ministers in eight years. The disastrous six-week premiership of Liz Truss demolished what was left of the Conservative party’s claims to competent economic management. More importantly, Britain’s economy continues to struggle in the aftermath of Brexit and Covid. But financiers in the City of London are said to be privately optimistic about a change of administration since a large majority will allow Starmer to make necessary long-term decisions and resist pressure from his party to boost government spending. It is worth noting that the issues driving elections in Europe are immigration, the economy, and soaring federal debt, just like at home.

The US Economy

We review recent releases on housing, personal income, wages, personal expenditures, the PCE deflator, and the ISM indices this week. The standout data for us in housing was the pending home sales index, which fell 1.5 points to 70.8, in May, the lowest level since the index began in 2018. This is not good news for the future of residential construction which fell 19.3% YOY in May, to 1.277 units. Single-family housing starts were marginally better, falling only 1.7% YOY. New permits for housing also fell 9.5% YOY, but single-family housing permits rose 3.4% YOY. Overall, these are signs that the housing sector is slowing. See page 3.

Despite the fact that new home sales were down 16.5% YOY in May and total existing home sales also fell 2.8% YOY, home prices were strong. The average price of a newly constructed home was $520,000 in May, up 2.2% YOY and the median price was $417,400, off slightly by 0.9% YOY. The median price of an existing single-family home hit a record $424,500 in May, up 5.7% YOY, or 6.8 times disposable income per capita. The record for home prices to DPI per capita was 7.55 times set in June 2022. See page 5.  

Personal income increased 4.6% YOY in May. Disposable income increased 3.7% YOY and personal consumption expenditures increased 5.1% YOY, or slightly above the long-term average of 5.0%. The recent strength in consumption appears unsustainable over the longer term. See page 6.

We noticed an interesting trend in consumption and inflation. Healthcare represented less than 5% of PCE in 1960 but has grown to be the second largest expenditure after housing (17.8%) and now is 16.6% of PCE. In 2023, healthcare pricing was negative or benign. But in May, healthcare, which represents nearly 8% of the CPI, saw prices rise 3.1% YOY. More importantly, healthcare prices tend to rise in the fourth quarter of the year when healthcare insurers set pricing for the upcoming calendar year. This could be a handicap for the CPI and consumers in the second half of 2024. See page 8. The ISM manufacturing index for June fell from 48.7 to 48.5; however, all but one category of the index was above 50 (prices paid 52.1) and all but one category of the index declined in June. New orders rose from 45.4 to 49.3 in the month. Employment fell from 51.1 to 49.3. See page 9. The ISM service sector survey will be reported later this week[AC1]  and it will be important since services represent 70% of consumption, and housing and manufacturing appear to be slowing.

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