Our heartfelt prayers go out to all those impacted by the barbaric invasion of Israel, and we are shocked by the unspeakable atrocities enacted by Hamas. If it is proper to measure people by their actions and not their words, it is clear that terrorists like Hamas, have no desire for peace but seek only to terrorize and control others. This should remind all Americans of the beauty of our Constitution, the purpose of strong borders, and the need to fight terrorism wherever it exists. We will never forget, and we pray for Israel and all those who believe in and fight for democracy and peace.

It is difficult to write about equities when the newswires are dominated by the war taking place in Israel. Particularly since Syrian shells, purportedly shot by a Palestinian faction, landed in Israeli territory on Tuesday and Israel responded by firing back. This points to the risk of the Gaza-Israeli war spreading in the Middle East, and as a result, it is currently overshadowing the Russia-Ukraine war, where again, a sovereign nation was invaded by Russia. Ironically, wars are not usually bad for equity markets, however, note that neither war has been good for the equity markets of any country involved. However, it is a positive for defense stocks, particularly for makers of bullets and missiles, and since both the Middle East and Russia are oil exporters, it has been good for energy stocks.

Israel has also pushed important news about China into the background. Country Garden Holdings Co. LTD. (2007.HK – 0.75) announced it had defaulted on a principal payment which sets the stage for one of the country’s largest debt restructurings. Simultaneously, China Evergrande Group (3333.HK – 0.265) failed to get regulatory approval for its offshore debt restructuring proposal which will likely lead to its liquidation at a hearing set for October 30. The potential debt defaults of China’s two largest property developers will have devastating impacts on stakeholders, customers, supply-chain vendors, China’s economy, financial creditors, and to a lesser extent, holders of China’s US dollar-denominated bonds. Therefore, we are not surprised that Fed officials are sounding more dovish this week. An unstable world is not the right environment for another rate hike, particularly since previous rate hikes are already having an impact on consumers.

Decoding Employment Data

September’s employment report was a huge surprise, Not only was the addition of 336,000 jobs nearly double the consensus expectation, but revisions added 79,000 jobs in July and 40,000 jobs in August. This means that employment was 119,000 higher than previously reported, which makes one wonder how rigorous government data really is. Moreover, September’s year-over-year job growth was 2.1% in the establishment survey and 1.7% in the household survey. These percentages are both well above their long-term averages of 1.7% and 1.5%, respectively. See page 3. September’s 336,000 new jobs also lifted the 6-month average by nearly 20,000 to 233,670 which is well above the 50-year average of 128,000 new jobs per month. Charts of the labor force and employment show that there has been a steady increase in both since the end of the Covid lockdown. See page 4.

From a historical perspective, the US economy is at risk of a recession whenever job growth turns negative. But since job growth in September was definitely robust, it appears that the US economy is not at risk of slipping into a recession any time soon. This could support those who are expecting the US economy to remain in a lengthy period of stagflation.

However, some details in September’s job report tell a slightly different story. Multiple job holders increased by 368,000 in the month, suggesting that holding one job is not sufficient for some individuals and households. Meanwhile, those working part-time for economic reasons fell by 156,000. It is unclear if part-time workers found full-time jobs or are now holding two jobs. See page 5.

In September, average weekly earnings rose 3.6% YOY for all private industries and increased 3.7% YOY for production and non-supervisory employees. These statistics raised concern that wage growth is now fueling inflation. However, since inflation has accelerated in recent months it means that real hourly earnings have decelerated. For example, average hourly earnings grew 4.5% in August and 4.3% in September. This means that real hourly earnings rose 0.8% YOY in August and potentially rose 0.65% in September — if inflation does not increase from August’s 3.7%. See page 6.

The CPI for September will be reported later this week, and we fear it may be disappointing. After eight straight months of year-over-year declines in oil, the WTI rose more than 14% YOY in September. This jump in energy prices could easily create a higher-than-expected headline number in the CPI. In short, the 5-month stretch during which earnings grew faster than inflation may have come to an end in September. This will be a handicap for consumers.

September’s ISM data was interesting, and it showed a switch in the normal pattern. The ISM manufacturing index displayed more upward momentum than the service index. Yet even though the headline index for ISM manufacturing rose 1.4 points in September, its reading of 49 remained below 50 for the eleventh consecutive month. The headline ISM services index fell 0.9 to 53.6. Production, or business activity, rose 2.5 to 52.5 for manufacturing and rose 1.5 to 58.8 for services. New orders rose 2.4 to 49.2 in manufacturing but fell 5.7 to 51.8 in services. Manufacturing could get a boost from the defense industry in the months ahead and this could help both the economy and employment. See page 7.

Consumer credit growth slowed significantly in August. Overall credit balances grew 4.0% YOY versus 4.9% in July. Revolving credit grew 8.6%, down from 10.5% in July, and nonrevolving credit growth rose 1.8%, down from 3.1% in July. On a six-month rate of change basis, revolving credit contracted 0.2%, the first contraction since May 2016. It is not surprising to see credit card, or revolving credit, decline given that interest rates on credit card plans at commercial banks rose to 21.2% in August. However, it is important to note that sharp declines or contractions in consumer credit are signs of a recession. See page 8.

Technical Update

The Dow Jones Industrial Average and the Russell 2000 index are trading below their 200-day moving averages, the S&P 500 recently tested its 200-day average on an intra-day basis and Nasdaq Composite continues to trade well above its long-term average. Nevertheless, the major chart patterns remain characteristic of a long-term neutral trading range, best seen by the 1650-2000 range in the Russell 2000. If the Russell 2000 breaks well below the 1650 support, it would be bad news, but this is not our expectation. The 25-day up/down volume oscillator is at a neutral reading of negative 1.92 this week but has been oversold for three of the last five trading sessions with readings of negative 3.0 or less. This oscillator failed to confirm the July advance and we would not be surprised if it fails to confirm the recent decline with five consecutive oversold days. To date, the longer-term trend remains neutral.

Gail Dudack

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There were plenty of things for investors to worry about before the US House of Representatives voted to unseat House Speaker Kevin McCarthy on Tuesday. For example, Federal Reserve Chairman Jerome Powell has made it clear in recent weeks that there could be another rate hike in the near future and interest rates would not be coming down any time soon. This spooked the debt markets, and the 10-year Treasury bond yield broke above the 4.4% resistance level like a hot knife through butter.

The United Auto Workers strike does not look like it will be ending soon, and auto companies have begun to lay off workers. While the Writers Guild of America settled its strike recently, SAG-AFTRA, which represents 160,000 film and television actors, remains on strike. The 75,000 workers at Kaiser Permanente are set to go on strike this week and this would be the largest healthcare strike in US history. Meanwhile, big capitalization technology stocks are being sued by the Department of Justice and the Federal Trade Commission for monopolistic behavior and the goals appear to be to break companies like Amazon.com, Inc. (AMZN – $124.72) and Alphabet Inc.’s Google (GOOG – $133.30) into smaller pieces.

China’s property development sector continues to struggle and now Country Garden Holdings Company (2007.HK – 0.87), the largest company in the sector, is in default, following a similar pattern to that of China’s Evergrande Group (3333.HK – 0.41). Crude oil prices have surged to $89.44 a barrel and are now up 14% YOY. This will not be good for consumers, or for September’s CPI report. Perhaps more importantly, the rise in the dollar makes energy even more expensive for most non-US consumers. The triple-threat of higher interest rates, a strong dollar, and soaring energy prices will present problems for US consumers, but it could be even more damaging to emerging market economies. See page 8. Higher interest rates will also pressure regional banks since this could exacerbate deposit outflows and weaken balance sheets as Treasury bond prices fall. See page 4.

All the above makes previous concerns about the resumption of student loan payments and California personal income tax payments in October seem like child’s play. Nonetheless, these are all problems for equities. But the most immediate obstacle for equities is the 10-year Treasury yield which is closing in on 5%, and some people are beginning to think it could rise to 7% before the cycle is over.

Goldilocks or Recession

Nothing has really changed from our perspective. We were never advocates of the Goldilocks scenario which included a soft economic landing coupled with lower interest rates. We always expected interest rates to remain higher for longer and we also think that a recession is likely. Recessions are a normal part of an economic cycle and not all recessions are prolonged and systemic like in 2008. In fact, most recessions last for two to four quarters and are not even recognized as a recession until it is almost over. But historically, there has never been an inflationary cycle that has not been followed by a series of recessions. Hopefully, this cycle will see a slow steady slowdown that will bring inflation back in line with the Fed’s target of 2%. But it will take time. Meanwhile, we believe the equity market will continue to trade in a wide trading range.

The Silent Tightening Cycle

The equity market responded rather dramatically to the Fed’s statement that the fed funds rate would remain higher for longer; however, the real problem may be that monetary tightening is occurring on multiple levels, not just with the fed funds rate. The Fed continues to reduce the size of its balance sheet which means it is no longer a major buyer of US Treasury securities or mortgage-backed securities. This downshift in demand is part of the reason why Treasury bond yields and mortgage rates are rising. And it is also why the money supply, as measured by M1 and M2, has been contracting at a historical rate. See page 4. In addition, as the long end of the yield curve moves higher, this adds to the tightening process by making auto loans, mortgages, and consumer loans far more expensive. It is important to note that August’s personal income and expenditure data shows that interest income rose 8.5% YOY, but interest payments increased 47.5% YOY! See page 5. This is just one example of how higher interest rates will lower consumption in the coming months.

Much is being made of the fact that China’s ownership of US Treasury securities has been declining, and China is part of the reason that interest rates are on the rise. First, foreign official investors tend to buy and sell US bonds at a slow and deliberate pace and rarely make sudden shifts in supply or demand unless it is needed to support their own economy. In other words, it is unlikely that China is the cause of last week’s surge in rates (even though China is clearly lowering its exposure to the US). In fact, Federal Reserve data shows that foreign official and international holdings of US Treasuries have remained fairly constant since 2013. See page 3. We believe the real catalyst for last week’s surge in bond yields was that money managers and hedge funds came to a sudden decision that the consensus view of falling interest rates was an error.

Congress

This brings us back to the US Congress, the unseating of Kevin McCarthy as Speaker of the House, and the burgeoning US deficit. The chaos in the House of Representatives could not have come at a worse time. With interest rates rising, the risk of a third downgrade of US debt by Moody’s on the horizon, and analysts expecting the supply of federal government debt will be $2.5 trillion this year, the debt markets are under extreme pressure. Since the House of Representatives is crucial in terms of budgetary issues and the debt ceiling, this week’s historical ouster of the Speaker of the House adds to the uncertainty surrounding the debt markets. History shows that financial markets can deal with good news or bad news, but they do not deal well with uncertainty.

Technical Update

As we indicated last week, with the Dow Jones Industrial Average and the Russell 2000 trading below their 200-day moving averages, it is likely that the S&P 500 and Nasdaq Composite will have a similar test in the days ahead. Nevertheless, the major patterns remain characteristic of a long-term neutral trading range, best seen by 1650-2000 in the Russell 2000. If the Russell 2000 breaks well below the 1650 support, it would be a major negative for the chart, but this is not our expectation. See page 10. The 25-day up/down volume oscillator is at a negative 2.90 reading this week, down from last week and closing in on an oversold reading of negative 3.0 or less. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1, but it never confirmed July’s advance in the averages. Strong rallies should have at least one extremely overbought day and overbought readings that last at least five consecutive days. If, or when, this indicator becomes oversold, the same will be true – five consecutive trading days in oversold are needed to confirm that the decline is more than a normal pullback in prices. All in all, the market appears vulnerable, but the trend remains long-term neutral. See page 11.  

Gail Dudack

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

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

Higher for Longer – Inflation and Interest rates

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

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

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

The Impact on the Economy and Earnings

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

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

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

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

Technically, Still in a Trading Range

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

Gail Dudack

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

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

Is It Different This Time?

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

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

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

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

On the Horizon

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

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

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

Technical Changes and Review

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

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

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

Gail Dudack

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

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

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

Inflation Matters

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

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

Household Haves and Have Nots

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

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

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

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

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

Gail Dudack

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

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

Narrow is Not Noble

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

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

August Payrolls

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

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

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

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

Watching oil

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

Technical Update

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

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

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

Gail Dudack

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US job openings in July dropped to the lowest level in nearly two and a half years and equity investors rejoiced. The news triggered a 292.69-point gain in the Dow Jones Industrial Average, carrying the index just 5.3% below its all-time high of 36,799.65 high and to a gain of 5.1% year-to-date. The JOLTS report also showed that the number of people quitting their jobs fell to the lowest level seen since early 2021, which implies jobholders feel that switching jobs has become more difficult. More importantly, the employment report for August will be released at the end of this week and it too could be a market-moving event, particularly if it confirms a below-consensus increase in jobs. However, we would be wary of being bullish about bad economic news since bad news inches the economy closer to a recession and a recession has never been good for corporate earnings or for equity prices.

We have often noted that high inflation has a debilitating impact on consumer purchasing power, corporate profit margins, and price-earnings multiples. It erodes the value of the dollar and of savings. In short, it is bad for all parts of the economy. And this is why we believe the Federal Reserve is likely to be more hawkish than dovish for all of 2023. In our opinion, the Fed understands that an inflation target of 2% will not be that easy to achieve without slowing the economy down. And while Fed Chairman Jerome Powell has danced around the question of whether a recession or no recession is part of the inflation solution, slowing inflation without a recession would be like threading a tiny needle … possible but difficult. 

History shows that whenever inflation has had a rapid rise or has been more than a standard deviation above the norm (6.5%+), like the 9% seen in June 2022, it has always been followed by a recession. A recession is most often the result of tighter monetary policy which has generally ended with a real fed funds rate of at least 400 basis points. Perhaps it will be “different this time” but that is a risky view, in our estimation. See the historical charts on page 3.

For the real fed funds rate to reach 400 basis points today, with a 3% inflation rate, means the fed funds rate would rise to 7%. We are not predicting a 7% rate, but we do believe the fed funds rate is likely to move higher in September and this would be a negative surprise to the consensus. It could also be a dampener to economic activity in the months ahead.

Is Bad News Good News?

In line with the JOLTS report, the regional Federal Reserve activity reports were a mixed bag. The Kansas City Fed Manufacturing Survey was at zero in August, but up from negative 11 in July. The Philadelphia Fed Nonmanufacturing Survey was negative 0.5 in August, down from 2.0 in July. The Richmond Fed Manufacturing Survey was negative 7.0 in August, up from negative 9.0 in July. The Chicago Fed National Activity Index was 0.12 in July, up from negative 0.33 in June. The Texas Manufacturing Outlook Survey was minus 17.2 in August, up from minus 20.0 in July. All in all, these surveys were not a recessionary package, but neither were they a sign of strength.

As interest rates rise the biggest impact may be seen in the housing and auto sectors, two areas that have been a source of strength since the pandemic. New home sales rose 4.4% in July to 714,000, an increase of 31.5% from a year earlier. The median price of a single-family home rose 4.8% in the month to $436,700, but this was down nearly 9% YOY. Home prices and sales have been relatively stable, but primarily due to a lack of inventory. The supply of existing family homes rose fractionally in July to 3.2 months, nevertheless, this is a historically low level. While low supply has been what has supported the residential market, we worry that demand may eventually fall as a result of high prices and interest rates. See page 4. Rising mortgage rates are already hurting housing affordability, which is currently at its lowest level since 1985. This is a concern since housing typically represents 15% to 18% of GDP. See page 5.

The auto industry is also hurt by higher prices and rising interest rates. The post-pandemic auto-buying surge is over, yet vehicle sales rose in July to 16.3 million units. See page 6. However, this remains well below 17-18 million units consistently seen between 2014 and 2020. Autos, along with housing, have been the most unwavering drivers of the US economy. We will be watching closely to see if higher financing rates slow auto sales.

Consumer sentiment can be a guiding indicator of the economy at both peaks and troughs, so it is worth noting that August’s deterioration in sentiment surveys follows months of steady improvement. The University of Michigan consumer sentiment index fell in August, dragged down by future expectations due in large part to rising gas prices. It was the first month-over-month decline since May for this survey. The Conference Board consumer confidence index fell from 114.0 to 106.1 in August as both present conditions and expectations fell significantly. See page 7. We had been hopeful that the improvement seen in real wages in recent months would give a boost to investor sentiment and consumption, however, we may have been too optimistic.

Important economic news will be released this week including the Fed’s favorite inflation benchmark, the personal consumption expenditure deflator. It will be released alongside personal income and real personal consumption for July. Pending home sales may give an insight into whether higher mortgage rates are taking a toll on home buyers. And the week ends on Friday with the employment report, the ISM manufacturing report, and vehicle sales for August. This should give good insight into economic activity and the health of the consumer.

Technical Indicators

The Dow Jones Industrial Average, the S&P 500 index, and the Nasdaq Composite index have all tested their 100-day moving averages and are rebounding. This is favorable. The Russell 2000 index tested its 200-day moving average and is also rebounding. We would rate these tests as tentatively positive; but even if successful, the longer-term pattern remains characteristic of a long-term neutral trading range. See page 9.

The 25-day up/down volume oscillator is at a negative 1.10 reading this week, relatively unchanged from a week ago, and at the lower end of its neutral range. This oscillator generated overbought readings in 10 of 22 trading sessions prior to August 1. However, none of these overbought readings lasted the minimum of five consecutive trading days required to confirm an advance in the averages. Strong rallies should also include at least one extremely overbought day which was also missing. However, it is also important to note that the recent rally did not generate new highs in the indices. In short, the recent rally is, to date, an advance within a larger neutral trading range. That is what this indicator has been implying for over twelve months. In our view, this trading range is a substitute for a bear market, and it is likely to persist until inflation is under control and/or earnings growth becomes more predictable and stable.

Gail Dudack

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Fitch downgraded its credit rating for long-term US government securities from AAA to AA+ on August 1, 2023, citing an erosion of fiscal governance and rising general government deficits. Moody’s cut the ratings on 10 mid-sized lenders on August 8^th. The Fitch Ratings service warned of a downgrade on more than a dozen banks on August 15^th and S&P Global Rating downgraded five regional banks on August 21^st, focusing on lenders with commercial real estate exposure. All these rating agencies indicated that some banks face a future risk to their balance sheets due to potential bad debts in the commercial real estate area, but all banks are dealing with liquidity pressure since many portfolios are drawing interest income of 2.5% to 4.5%, while needing to pay depositors 4.5% to 5.5% in savings and money market accounts. This may seem like an isolated problem within the banking sector, but it is not. Although there is no immediate crisis in the banking sector, there are strains in the system that are likely to continue longer than some expect. More importantly, the US economy cannot do well if the banking sector is not doing well. It never has. So, in our view, with this backdrop, it is not surprising that stock prices have been in a correction in August.

Trading Ranges Defined

The last year has produced a series of issues that have chastened both optimists and pessimists. From a longer-term perspective, the last 18 months have been frustrating for both the bulls and the bears. Our long-held view is that the stock market is in a broad sideways trading range, best defined by the Russell 2000 between support at 1650 and resistance at the 2000 level. The other indices have less obvious trading ranges, although it is clear that price action has been contained by resistance at the January 2022 peaks and support at the October 2022 lows.

Long-term trading ranges are not unique in equity history, but they have not materialized in a while. Since the March 2009 low, equities have been in a relatively consistent uptrend. In short, for most of the last 14 years, stock prices have been “trending” and as result, new investors might be unfamiliar with rallies that have limited leadership and declines that lack follow through. However, trading ranges are not unusual, and in our view the current trading range is a substitute for a more dramatic bear market.

Classic bear markets are often triggered by an unexpected event that shakes investors’ confidence and this event becomes the catalyst for an unforeseen earnings decline. A dramatic bear market ensues and produces a relatively sudden but quick repricing of risk. A trading range is simply another way of repricing risk and can be a subtle substitute for a bear market.

In the current environment, a trading range is a way for earnings to catch up with prices. Earnings for the S&P 500 declined on a year-over-year basis during the second, third, and fourth quarters of last year. Earnings are now expected to grow modestly from these much-reduced levels; nevertheless, the outlook for earnings growth remains uncertain.

If we look at S&P Dow Jones operating earnings data, it shows that the four-quarter sum in earnings peaked in March 2022 at $210.16. The S&P Dow Jones consensus estimates show that four-quarter earnings could reach a new high by the end of the 2023 third-quarter earnings season, with earnings of $212.89. However, these are estimates and data shows essentially no earnings growth for most of 2022 and 2023. In sum, prices moved higher in 2023, but the fundamentals did not. The recent trading range is a way for earnings to eventually catch up with stock prices. In our view, the catalyst needed for stocks to break out of this trading range is for the Fed to successfully tame inflation and this will take more time. In the interim, we believe focusing on stocks with reliable earnings streams and reasonable PE multiples will be the best way of managing through this environment. 

FOMC September 20

One reason to believe the Federal Reserve will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 3, in previous cycles, the fed funds rate typically increased ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend, and this allowed inflation to become ingrained in the service sector. Since service sector inflation is less commodity driven and more salary driven, it is more difficult for the Fed to control. It also explains the Fed’s attention to service sector inflation. Meanwhile, it is important to note that the real fed funds rate usually reaches 400 basis points in a tightening cycle, and though the real rate has been rising, it is now only at 230 basis points. In short, we believe another rate hike is likely on September 20 and we do not believe this is discounted in stock prices.

The path of interest rates is important to the economy since it will impact both the auto industry (see page 4) and the residential housing market. The National Association of Home Builder Confidence index fell from 56 to 50 in August, which is not surprising, since the June NAR Housing Affordability index fell from 93.7 to 87.8, the lowest level since January 1984. This decline in affordability was before the Fed’s July rate hike! The June decline was attributed to a combination of median family income ratcheting down to $91,319, the median price of a single-family home rising to $416,000 and the NAR mortgage rate increasing 28 basis points to 6.79%. See page 5.

Although the housing market has been in a slump for almost two years, it is possible that housing is about to slow further as interest rates rise and remain high. This risk can be seen in the fact that both existing and new home prices have stopped increasing and in recent months have registered year-over-year declines. Also interesting is the fact that home prices and retail sales have been highly correlated over the last 60 years, and both appear to be on the cusp of a negative cycle. See page 7. Some may think that these are reasons for the Fed to pause, but underlying these risks are a tight labor market and wage growth that recently has exceeded the pace of inflation. We believe the Fed will remain higher for longer in order to be confident that inflation will reach its target of 2%. 

Technical Update

As a result of the recent weakness in the equity market, all the popular indices are currently trading below their 50-day moving averages and are about to test their 100-day moving averages. However, the Russell 2000, is about to test its 200-day moving average which is now at 1843. We would not be surprised if all these moving averages were broken in the near term since this would be typical of a long-term neutral trading range environment. See page 9. 

The 25-day up/down volume oscillator is at negative 2.05 this week, which is at the bottom of the neutral range. It is close to registering an oversold reading of negative 3.0 or less, which would neutralize the recent unsustained overbought readings. Meanwhile, the 10-day average of daily new highs is 54 and new lows are 111. This combination turned negative this week since new highs fell below 100 and new lows rose above 100. All of the above is normal for a trading range market.

Gail Dudack

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In last week’s US Strategy Weekly (Things to Ponder; August 8, 2023), we wrote “we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.” In truth, there was not a big reaction to last week’s CPI report. See page 3. But the PPI report, which showed intermediate service sector inflation rose from June’s 4.4% YOY to 4.6% YOY, seemed to make investors anxious. And in a market priced for perfection, any unpleasant or unexpected news will make equities vulnerable.

There were a few other developments this week. Chinese economic reports for industrial production, retail sales, and property investment were weaker than expected. More importantly, the combination of this data reflected an economy that is potentially faltering. The PBOC responded by lowering key interest rates by 15 basis points. Yet the real concern is China’s real estate sector, which is estimated to represent as much as 30% of China’s GDP, and which has already weathered a string of defaults by residential property developers. This week the focus is on Country Garden Holdings Co. Ltd. (2007.HK: 0.81), a giant Chinese real estate developer that is expected to deliver nearly a million apartments in hundreds of cities throughout China. Unfortunately, Country Garden has not been paying its bills, indicated it would report a loss of as much as $7.6 billion in the first six months of the year, and in August skipped two interest payments on loans. A default is possible in September. The big concern is the exposure of China’s $3 trillion shadow banking sector to this potential real estate risk, as well as the risk to the broader Chinese economy.

Separately, Russia’s central bank raised its key interest rate from 8.5% to 12% to help stop the slide in its currency which has lost more than a third of its value since the beginning of the year. The ruble passed 101 to the US dollar earlier this week and continues to weaken due to capital outflows, big government spending on the Ukraine war, and a shrinking current account surplus as a result of Western sanctions on Russian oil and gas. Inflation reached 7.6% over the past three months, and according to Russia’s central bank, inflation is expected to keep rising, noting that the fall in the ruble is adding to the inflation risk.

Closer to home the Fitch Ratings service warned that the agency could downgrade more than a dozen banks, including some major Wall Street lenders. Fitch already lowered the score of the “operating environment” for banks to AA- from AA at the end of June – although this went largely unnoticed. And Fitch’s warning comes weeks after Moody’s cut the ratings of 10 mid-sized lenders, citing funding risks, weaker profitability, and increased risk from the commercial real estate sector.

Retail Sales

Advance estimates for July retail sales showed a month-to-month gain of 0.7% and the May and June estimates were revised from up 0.2% to up 0.3%. This acceleration in retail sales concerned investors who had been expecting a Fed pause, since economic momentum opens the door for a rate hike in September. On a seasonally adjusted basis, retail sales rose 3.2% YOY in July; on a non-seasonally adjusted basis, sales were up 2.5% YOY. However, when adjusting for inflation, real retail & food service sales, based on 1982 dollars, fell 0.1% YOY. See page 5. In other words, despite a month-to-month acceleration in sales, real YOY retail sales declined and have been negative for nine of the last 10 months. This pattern is a classic sign of an economic recession, not strength. See page 6.

Historically, a negative trend in retail sales is tied in with a decline in nominal GDP and that is true in this cycle as well. On page 7 we show a table that highlights, in red, all the months since January 1968 that have experienced below average retail sales. This table is important because a string of below average sales has always defined a recession and negative real retail sales in any year has also characterized recessions. The current string of “red” is the longest since 2008-2009, and to date, real retail sales are averaging negative 1.3% in 2023. Nonetheless, GDP continues to grow. It is uncanny. Still, we would not describe July’s retail sales report as strong.

However, one reason to believe the Fed will keep interest rates higher for longer is that they were so late to address the inflation problem. As seen on page 4, the fed funds rate typically increases ahead of, or in line with, the level of inflation. In this cycle, the Fed was 12 to 18 months behind the inflationary trend. This suggests more work needs to be done. Moreover, while the real fed funds rate has increased to 200+ basis points, it usually reaches 400 basis points in a tightening cycle.

Earnings

The second quarter earnings season is close to ending and as is usual, retail stocks are the last to report. Home Depot Inc. (HD – $332.14) beat the consensus estimate for quarterly earnings per share, and though same-store sales fell 2% YOY this was less than the expected 3.5% decline. The company announced a $15 billion share repurchase program and it reiterated its muted forecast for the year. The company noted caution on the part of consumers towards big-ticket items. Walmart Inc. (WMT – $159.18) is expected to raise its full-year earnings forecast this week when it reports quarterly results. A research report by Stifel, Nicolaus & Company estimates more people plan to shop at Walmart compared to Costco and Target, even though they expect to spend 16% less on back-to-school purchases compared to a year ago. Retail is a sector of winners and losers in this environment.

All in all, earnings season has gone better than expected and the S&P Dow Jones consensus estimates for 2023 and 2024 are currently $219.41 and $244.06, up $2.31, and $1.00, respectively. Refinitiv IBES estimates for 2023 and 2024 are $219.09 and $245.55 up $0.41, and down $0.25, respectively. What is notable is that S&P Dow Jones and Refinitiv IBES are both showing a $219 estimate for this year. These two surveys tend to diverge in the second half of the year. Nevertheless, based on this year’s earnings estimate of $219.41, equities remain overvalued with a PE of 20.2 times. The 12-month forward operating earnings PE is 19.0 times, and the December 2024 PE is 18.1 times. When we add inflation of 3.2% to these PE multiples, we get 23.2, 22.2, and 21.2. All of these sums hover just under the 23.8 range that defines an extremely overvalued equity market. This is what explains the market’s nervousness.

Technicals are Slipping

The S&P 500, Nasdaq Composite, and Russell 2000 are all trading below their 50-day moving averages, a key level for some traders. However, the RUT, a useful benchmark for the last 18 months, failed to break above the 2000 resistance level in July, implying that the recent rally was simply part of a much larger neutral trading range. See page 9. The 25-day up/down volume oscillator is at a negative 0.51 reading this week and neutral. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1, but failed to remain overbought for the minimum of five consecutive trading days required to confirm the advance. This week the 10-day average of daily new highs fell to 88 and new lows rose to 75. This combination turned positive on June 8 when new highs rose above 100 and new lows fell below 100 but it turned neutral this week with both averages now below 100. In short, upside momentum appears broken.

Gail Dudack

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More Credit Rating Risks

Last week Fitch stunned the financial sector with its downgrade of US Treasury debt. This week Moody’s surprised investors by cutting credit ratings on 10 small- to mid-sized US banks. In addition, Moody’s put six banking giants, including Bank of New York Mellon (BK – $45.72), U.S. Bancorp (USB – $40.23), State Street Corp. (STT – $72.73) and Truist Financial Corp. (TFC – $32.41), on review for potential downgrades. Moody’s indicated there is no immediate crisis, but “banks will find it harder to make money as interest rates remain high, funding costs climb, and a recession looms. Some lenders’ exposure to commercial real estate is a concern.”

Several financial analysts suggested these warnings were unwarranted, however, rating agencies are paid to point out risks and there is no doubt that an unbridled federal debt burden is a long-term hazard, particularly as interest rates rise. For most banks an inverted yield curve combined with the potential of commercial real estate defaults are real risks that should not be ignored.

Although stocks sold off on both credit rating warnings, the pushback from some analysts and even the Biden administration are more disturbing to us than the actual agency warnings. The gains in equity prices this year have been primarily multiple expansion, not earnings gains. According to IBES Refinitiv, earnings in the last two quarters of 2022 and first quarter of this year were 4.4%, negative 3.2%, and 0.1%, respectively, and estimates for calendar 2023 show an S&P 500 earnings growth rate of a measly 1.2%. According to S&P Dow Jones, the last three quarters of 2022 had year-over-year declines in earnings, and though a modest rebound in growth is forecasted for coming quarters, it is coming from a diminished earnings base. Perhaps this lack of earnings power is why investors are flocking into generative AI stocks and looking far into the future for earnings growth. But after massive price gains, these stocks now have extremely high PE multiples and even fans feel the stocks are richly valued.

Things to Ponder

There are three things that we often wonder about although they are not part of our official forecast. The first is a risk that the stock market is on the verge of a bona fide bubble. This thought emanates from the excitement surrounding generative AI, estimates that the AI market will grow to $126.5 billion by 2031, and the massive runup that these stocks have had. AI has created a two-tiered market with the Nasdaq Composite up 33% year-to-date while the DJIA is up only 6.5%. This divergent price action is very reminiscent of the Nifty Fifty era that led to the January 11, 1973 peak and the Dot-com bubble era that ended on January 14, 2000. We have also thought about the fact that there were 27 years between those two market bubble peaks, and we are now 23 years past the 2000 peak. Since bubbles tend to be generational, we are in the right time frame to be on the lookout for a bubble. And the pattern we see of analysts ignoring fundamentals only adds to this worry.

Second, is the fact that bullishness is now consensus and the bears on Wall Street have been converted. Many sentiment indicators, particularly the AAII sentiment indices, are showing extremes last seen between February and May of 2021. The stock market did not peak until January of 2022; however, this is how sentiment indicators work. Sentiment are not timing indicators, rather they tend to be early warnings systems and only point out that risks are rising. See page 13.

Our last consideration is COVID, and the global pandemic it sparked. COVID resulted in an unprecedented manmade global recession in 2020 produced by many government leaders who decided to shut down their economies. It was not a normal economic recession. The subsequent recovery was also unusual, manmade, and manufactured with monetary and fiscal stimulus. This fiscal stimulus continues to drive many segments of the US economy to this day. History is often an excellent guide for economists and equity strategists, but there is no rule book for what has transpired over the last three years. Therefore, perhaps the typical signals of a recession such as an inverted yield curve, the 15-month decline in the Conference Board’s Leading Economic Index (the longest streak of decreases since 2007-2008), and the 7 months of negative real retail sales, are not applicable today. This seems strange to us. Nonetheless, the years of monetary and fiscal stimulus have kept the US economy afloat and it also provides the liquidity that could set off a stock market bubble. Thus, we ponder and worry. However, we do believe the recent rally is fragile since it has been driven by the new consensus view that the economy will have a soft landing or no landing. This view is coupled with the belief that there is no interest rate hike in September. We think the Fed will hike in September, unless economic data becomes very weak in the interim. What is clear is that this week’s CPI and PPI reports will be center stage and could be market moving.

Household Debt: the Good and the Bad

Total household debt rose by $16 billion in the three months ended in June and increased $909 billion in the prior 12 months. In short, household debt rose 5.6% YOY in June versus the 7.6% YOY increase seen in March. Of the $909 billion increase, $627 billion (or 69%) was in mortgages and $144 billion (or 16%) was in credit card debt. Credit card debt grew 16.2% YOY in June exceeding $1 trillion for the first time. As a result, credit card debt now represents 6.0% of total debt versus 5.5% a year earlier. See page 4.

A broader look at household debt shows that debt grew fairly rapidly in 2021 and 2022 but grew at a slower pace in 2023. A large part of the increase in household debt occurred in the under-40 age group and was likely linked with a period of significant increases in new credit card accounts. Note that the 2021-2022 period overlaps with the moratorium on student loan payments and a healthy trend in personal consumption. While the number of credit card accounts grew, the number of outstanding auto loans, mortgages and HELOC loans remained fairly stable in the same period. See page 5.

The good news in household debt data is that delinquencies have not had much of an increase from the low recorded last year. However, there are two big changes on the horizon. First is the massive increase in financing rates seen for revolving credit lines over the last year. This will make credit card debt less viable for many households. Second, the end of the moratorium on student loan payments which begins in October will also reduce liquidity for some households, particularly for middle class borrowers. See page 6.

Fundamentals The current S&P 500 trailing PE multiple is 21.5 times and above all historical averages; in short, the market is priced for perfection. The forward PE is 19.3 times, and when added to inflation of 3%, sums to 22.3, which is just below the standard deviation line of 23.8 denoting an overvalued equity market. In sum, earnings growth is pivotal to the market’s intermediate and longer-term trends. See page 8.

Gail Dudack

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