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.

 [AC1]Add comma after “week”

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

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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

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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

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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

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The Wall Street Journal article entitled “Wall Street’s Favorite Recession Indicator is in a Slump of its Own” caught our attention this week. The writer asks the question of whether there is still value in the idea that an inverted Treasury yield curve can predict a recession. The yield curve, typically measured as the spread between the 1-year or 2-year Treasury note and the 10-year note, has currently been inverted for 23 months and since 1968, an inverted yield curve has been followed by a recession in the subsequent nine to 24 months. So, by historical standards, we should be in or entering a recession right now.

But there are no signs of a recession on the horizon, particularly with monthly employment statistics showing job growth averaging 242,000 over the last three months and there are no signs that the yield curve inversion will end any time soon. Therefore, it is valid to question whether there is still value in an inverted yield curve or if the current environment is the beginning of a “new normal.”

We believe the inverted yield curve is a valid indicator and we do not think this is a new normal. Recessions and expansions might be muted by monetary and fiscal policy, but in our opinion, they cannot be eliminated. And we admit that we count ourselves among those who were looking for a recession last year. This was not due just to the inverted yield curve, but also to the string of months of negative year-over-year real retail sales, the Conference Board’s leading economic indicator signaling a recession for 22 consecutive months (ending in February 2024), and suspected weakness in the housing market. The one recession indicator that did not appear was perhaps the most critical and that is weakening job growth. Whenever the year-over-year change in employment in the establishment and household surveys turn negative, it is an excellent forecaster of a recession. That signal did not materialize. Was it because there was a massive catch up in employment after the Covid–19 shutdown? Or was there some underlying driver of the economy that was not being measured? In retrospect, it seems quite clear that it is due to a historical level of fiscal stimulus.

The Federal Reserve had been too dovish for too long in the face of rising inflation, but the inverted yield curve was a sign that this stimulus was being unwound. What was not being unwound was fiscal stimulus. And even though the pandemic stimulus passed by Congress was slowly fading into the background, it was followed in August 2022, by President Biden’s Inflation Reduction Act (which should have been named the Clean Energy Act) which the administration described as “one of the largest investments in the American economy, energy security, and climate that Congress has made in the nation’s history. In short, the stimulus continued well after the pandemic was over.

More recently the administration has shifted to boosting the economy through government agencies. This is best seen on www.whitehouse.gov website which currently lists in its press releases the following statements: May 21, 2024 – 1 Million PACT Act Claims Approved and Benefits Delivered to Veterans in all 50 States and US Territories; May 22, 2024 – Statement from President Joe Biden on $7.7 Billion in Student Debt Cancellation for 160,000 borrowers; May 22, 2024 – Biden to Release 1 Million Barrels of Gasoline to Reduce Prices at the Pump Ahead of July 4; May 24, 2024 – Statement on the Signing of the Recruit and Retain Act (COPS – Community-Oriented Policing Services); May 24, 2024 – Meeting with Community Lenders Expanding Capital for Underserved Communities; May 28, 2024 – Biden-Harris administration Launches Federal-State Initiative to Bolster America’s Power Grid. Over the past week there have also been various federal disaster relief programs for West Virginia, Nebraska, Maine, Iowa, Oklahoma, Arkansas, Kentucky, and Texas, which have suffered from tornadoes and other weather-related disasters.

We are not making judgment on any of these spending initiatives; however, it is clear that there has been a steady stream of fiscal stimulus over the last four years. Moreover, the White House website reveals that it continues on a near-daily basis.

This spending is liquidity and liquidity is good for financial markets. But spending also results in deficits and at some point, it will have to stop, perhaps abruptly. We wonder how many of today’s investors remember the Greek debt crisis that materialized shortly after the financial crisis of 2008-2009. It crushed the Greek economy, and it should be mandatory reading for all investors and all politicians. But for now, the US debt market appears complacent and that is good news for equities.

May’s Conference Board consumer confidence indices improved from upwardly revised levels in April; nevertheless, the indices remain in the lower half of the range seen over the last 18 months. Revised numbers for May’s University of Michigan consumer sentiment indices were up slightly from initial estimates, yet again, indices remain well below January’s peak. In general, sentiment indices improved from April’s lows, but remain below recent peaks and well below 2019 peaks. See page 3.

New home sales were 634,000 units in April, down 5% for the month, down 7.7% YOY, and negative for the first time in 12 months. Existing home sales were 4.14 million units, down 1.9% for the month, down 1.9% YOY, and remain in the negative year-over-year pattern seen since August 2021. In both cases, sales are well below the peak levels seen in January 2021 for new home sales and below the October 2020 peak in existing home sales. See page 4.

All the same, the median price of a new single-family home was $433,500 in April, down 1.4% for the month, but up nearly 4% YOY. This is just 6% below the record new home price of $460,300 set in October 2022. The median price of an existing home was $412,100, up nearly 4% for the month, up 5.6% YOY, and close to the record $415,700 price set in June 2023. See page 5.

Residential construction and housing prices have remained strong despite a slowing sales trend due to limited inventory. The months of supply of existing single-family homes reached a record low of 1.6 in January 2022, and while it rose to 3.4 months in April, up from 3.0 months in March, the supply of homes remains historically low. It should be noted that an assortment of home price indices indicate prices are rising again, after a slump from February 2022 to April 2023. See page 6.

Existing home sales are currently six to seven times larger than new home sales and would probably be higher if inventory were greater. However, many households are finding it difficult to move or trade up in a housing market with both rising prices and higher interest rates. Still, there are signs that the housing market is improving in 2024 and if the Fed cuts interest rates later this year, the residential real estate market should improve significantly. This is just one example of why Fed policy has been a major focus for investors. See page 7. Right now, financial markets are complacent that cuts are ahead. The PCE deflator reported later this week will therefore be an important release. And finally, technical indicators are supportive of the current rally. The one laggard is our 25-day up/down volume oscillator, which despite being overbought for four consecutive days recently, is yet to confirm the advance.

Gail Dudack

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