The Consensus View

Stock markets may have their foundations built on fundamentals, but the short and intermediate-term moves are, more often than not, driven less by fundamentals and more by expectations and sentiment. And in our view, the expectations for the second half of this year are now a consensus that includes the following: 1.) the Federal Reserve will raise rates one or two more times and then pause; 2.) headline inflation will continue to decelerate to the 3.5% level or lower by year end; 3.) a recession is possible but the economy may instead suffer a rolling recession over the next twelve months; 4.) the housing sector is showing green shoots; 5.) interest rates are at, or close, to peaking all along the curve; and last, but far from least, 6.) earnings growth will rebound over the next four to six quarters.

The Media Plays a Role

However, we have noticed that the media is also playing a role in boosting investor sentiment. The National Federation of Independent Business (NFIB) released its Optimism Index for June this week. Reuters ran the story with the headline “Small business confidence reaches 7-month high in June, NFIB says.”  That is not what we read on the NFIB website. The NFIB’s headline was “Small Businesses Raising Prices Falls to Lowest Level Since March 2021.” And the NFIB’s opening text was “Small business optimism increased 1.6 points in June to 91.0; however, it is the 18^th consecutive month below the 49-year average of 98. Halfway through the year, small business owners remain very pessimistic about future business conditions and their sales prospects.” We were stunned at how different the Reuters story was from that of the NFIB. Reuters was clearly editorializing and not reporting. On page 7, we show charts of the NFIB’s survey, and you can judge for yourself which headline is more appropriate for the June report.

Too Optimistic Too Quickly

Perhaps the “optimism” we are reading in the financial press stems from the fact that the residential real estate market may, at last, be finding some sunlight. A recent Bloomberg headline states: “Homebuilding Set to Boost US Economy After Two-Year Contraction.” The NAHB housing index ticked up to 55 in June from 50 in May and it was the first time this index rose above the 50 benchmark in nearly a year. Condo sales rose in May, but single-family sales declined. A dwindling supply of single-family homes partly explains the housing market’s buoyancy. But to the extent that a lack of supply of single-family homes is due to the fact that homeowners are locked into their homes as a result of higher interest rates and higher home prices, this may not be a good thing. Right now, remodeling is cheaper than buying a new home for many households. Plus, recent consumer credit data shows that nonrevolving credit fell at an annualized rate of 0.4% in May. Revolving credit increased at an annualized rate of 8.5%, but this was down from 14.2% in April. In other words, a combination of tighter lending standards and higher interest rates are triggering a slowdown in consumer credit. This may make housing less affordable and as a result, the housing market bounce may be short-lived. Last, but far from least, one should not forget that the moratorium on student loans will end in October!

Investor Sentiment Warning

Nevertheless, optimism is spreading. Last week’s AAII sentiment readings produced a 4.5% rise in bullishness to 46.4% and a 3.0% decline in bearishness to 24.5%. This was the highest bullish reading in the AAII survey in 2023 and it was the highest since the 48% reading on November 11, 2021. In addition, bullish sentiment was above average for the fifth consecutive week, matching the streak last seen in October and November 2021. Unfortunately, in this case, sentiment is a contrary indicator. It is important to point out that current readings are similar to those seen in November 2021 and in this latter case, they appeared a month or two ahead of the January 2022 peak in equity prices. See page 13.

Inflation and Earnings

June inflation data will be released this week and many economists are looking for good news. Moody’s Analytics has inflation falling to 2.8% in the second half. That would be excellent news, but it may also be optimistic. The good news is that many areas of the CPI are seeing prices declining on a year-over-year basis, particularly since crude oil prices are currently down 33% YOY. Most energy-related and transportation-related areas of the CPI are seeing declining prices, and so are used cars, personal computers, and nondurables. On the other hand, the service sector showed prices rising 6.3% YOY in May.

The service sector is labor intensive and therefore, the Fed is also focusing on both service sector inflation and wage inflation in forming its monetary policy. Average hourly earnings rose 4.7% YOY in June, which is down nicely from the March 2022 level of 7% YOY; yet from the Fed’s perspective, this is still more than double its target of 2% inflation. Moreover, it means wages grew 70 basis points above May’s inflation rate which could create demand pull inflation. See page 5.

Average weekly earnings rose 3.8% YOY in June, quite a bit less than the average hourly earnings gain of 4.7% YOY, because hours worked dipped from a year ago. But after adjusting for inflation, real weekly earnings in dollar terms, have been declining since January 2021. Only recently have wages been growing faster than inflation. Again, what is good for consumers (real purchasing power) will be bad for employers (higher cost of labor) and this balance will impact consumption and margins in the second half of the year. Economists will be watching June inflation numbers to see how this impacts real earnings. See page 6.

Beating inflation is important. As we have pointed out, inflation erodes the purchasing power of consumers, it pressures corporate margins, and typically lowers PE multiples. Based upon the IBES Refinitiv earnings estimate of $219.14 for the S&P 500, equities remain overvalued at the current PE of 20 times. We define the market as being overvalued if the sum of the PE and inflation exceeds the top of the standard deviation range, or 23.8. The current PE of 20 and inflation of 4% puts the market above the standard deviation line of 23.8. See page 9. It also makes earnings season important. In terms of the second quarter earnings season, investors appear to have discounted a lot of good news in advance. One example of this is the rally seen in financial stocks this week, just ahead of their earnings releases later this week. Meanwhile, less heralded is the fact that consensus estimates continue to fall. The S&P Dow Jones consensus estimates for 2023 and 2024 are $216.59 and $242.80, down $0.29, and $0.26, respectively this week. Refinitiv IBES estimates for 2023 and 2024 are $219.14 and $244.88, down $0.38, and $0.58, respectively. S&P Global data shows that 18.4% of companies reporting first quarter earnings had a decrease of 4% or more in shares outstanding, which effectively boosted earnings per share, but not overall earnings growth. This pattern of lowering shares outstanding is not quality earnings. In general, this is a stock picker’s market. There are good companies to buy, but we see a pattern of bullish optimism that needs second quarter earnings to be outstanding. If they are not, the recent rally is in peril in our view.

Gail Dudack

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At the end of the first half of the year, the S&P 500 closed strong with a gain of nearly 16%, which was the best six-month performance for this index in forty years! Yet the S&P 500 was not the best-performing index year-to-date. The Nasdaq Composite gained twice as much with a 32% rise. Conversely, the DJIA only advanced 3.8%, or less than a fourth of the SPX’s gain. In short, large capitalization technology stocks were at the core of the performance in the first half, while the Russell 2000 index rose 7.2% and the Invesco S&P 500 equal weight ETF (RSP – $150.01) rose less than 6%.

Still, it was a better performance than most forecasters expected, including us. And earnings also surprised. But as we pointed out recently, S&P data shows that 71.4% of companies that reported first quarter earnings had a decrease in shares outstanding from a year earlier and 18.5% reported a decrease of 4% or more in outstanding shares. This effectively boosted earnings per share, even without any overall earnings growth. Nevertheless, given the first quarter’s results, our 2023 estimate of $180 is far too bearish and we are raising our forecast to $200 and simultaneously raising our 2024 estimate from $201 to $220. See pages 5 and 12.

However, even if we use the 2023 S&P EPS estimate of $219.52, equities remain rich with a PE of 20.3 times. This is well above the long-term average PE of 15.9 times. History shows that whenever the sum of the S&P’s PE and the rate of inflation is above 23.8, or one standard deviation above normal, the market is overvalued. At present the 12-month forward PE of 20.3 times and inflation of 4% equals 24.3 and is above the normal range. The S&P trailing PE is 21.5 plus inflation, equals 25.5 and is also above the normal range. Even when the 12-month forward PE of 19.5 times is added to the inflation rate of 4% the sum is 23.5 and just at the standard deviation line. In other words, the equity market is richly valued and is therefore at risk of earnings disappointments or any negative news.  

Student Loan Moratorium

At the end of June 2023, the Supreme Court blocked President Biden’s bid to provide $430 billion of student loan forgiveness to borrowers. This was not a surprising development since the Constitution states that the “power of the purse” resides in Congress, not the Executive branch of government. And even with a string of new proposals to circumvent the Supreme Court ruling, it is very likely that the three-year moratorium of debt payment for student borrowers will come to an end in October.

A Federal Reserve Board study estimated that most student borrowers improved their credit profiles during the moratorium and savings balances increased by $80 billion dollars. However, 44 million Americans will have to start paying back student loans in less than three months, with payments ranging from $210 to $320 per month. This will be a burden for many households and most economists expect that the resumption of student loan payments will generate a loss of roughly $70 billion in annual personal spending. While $70 billion may be a small number relative to nominal GDP of $26.5 trillion, it will be a major headwind for retail sales and some consumer-driven companies.

According to the Federal Reserve Bank of NY, total household debt increased $148 billion to $17.05 trillion in the first quarter of 2023. Mortgage balances climbed by $121 billion and were $12.04 trillion at the end of March. Auto loan and student loan balances also increased to $1.56 trillion and $1.60 trillion, respectively.

Credit card balances were $986 billion at the end of the quarter and flat on a quarter-over-quarter basis. However, while credit card balances did not increase much in the last three reported months, they grew 17% YOY. This was the largest increase in the 20-year history of the Fed’s data. And the fact that credit card debt did not increase in the first quarter of 2023 suggests that many consumers may have reached or may be reaching their credit limits. If true, this could be a concern for the economy, particularly since many of these same borrowers will soon need to restart paying their student loans. In sum, the start of the fourth quarter could bring about some surprising weakness in consumer spending.

We looked further into the Fed’s data to see how important student loans are to households and the economy in general. At $1.6 trillion, student loans are the second largest category of household debt and even though student loan borrowing grew the least of all debt categories in the last four quarters, it represents 9.4% of total household borrowing. However, sluggish growth and low default rates may be due to the moratorium, and we expect delinquencies and defaults will surge once the moratorium ends in October. Moreover, according to NY Fed data, student debt is not just concentrated in the 20-year-old to 30-year-old segment of the population; in fact, it is spread across all age categories and 23% of student loan debt is held by those 50 years of age or older. Keep in mind that at the same time debt payments will begin, the Fed is expected to be increasing interest rates. All in all, this will make the fourth quarter a very interesting time for the economy and the stock market.

Technicals: good and bad

The good news is that our 25-day up/down volume oscillator is at 3.78 reading as of July 3, 2023 which is the first overbought reading since April 28. It is important to see if this indicator can remain in overbought territory for a minimum of five consecutive trading days to confirm the recent advance. There have been other one-day overbought readings on April 8 and April 24; however, none of these one-day readings were sustained and none confirmed rallies in the averages. In general, this pattern reveals a lack of convincing volume in advancing stocks and the oscillator remains in neutral territory.

More importantly, NYSE volume was below the 10-day average for many days during the advance; conversely, the highest volume days in the last four weeks have taken place on May 31, 2023 when the DJIA lost 134 points, June 16 when the DJIA lost 109 points and on June 23, when the DJIA lost 219 points. These high volume down days suggest distribution, not accumulation, of equities. See page 7.

Last week’s AAII readings saw a 1.0% decline in bullishness to 41.9% and a 0.3% decline in bearishness to 27.5%. But it was also the fourth consecutive week of above average bullishness and below average bearishness. The last time this same combination was seen was October-November of 2021 when it persisted for five consecutive weeks. The market made a significant peak in January 2022. The technical patterns in the S&P 500 and the Nasdaq Composite index are bullish and explain why many strategists have now shifted to a more favorable outlook for 2023. But the DJIA is yet to break out and while it has a potentially positive pattern, it is currently ambiguous. We have put the Russell 2000 index and equal weight SPX ETF side by side on page 6 to show how similar these charts are for 2022 and 2023. Both have been in a trading range for over 12-months, and we believe this is a more accurate depiction of the equity market’s performance this year.

Gail Dudack

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According to Morningstar, US exchange traded funds saw a massive $40 billion weekly inflow for the week ending June 14, 2023. This was the sixth largest weekly amount on record and the flows, particularly into equity ETFs, appear to represent a significant shift in investor sentiment.

Meanwhile, according to the Wall Street Journal, bullish bets on artificial intelligence have been booming this month with more than 1.3 million call contracts on chip makers Nvidia Corp. (NVDA – $418.76), Intel Corp. (INTC – $34.10), and Advanced Micro Devices, Inc. (AMD – $110.39), changing hands on an average day. This burst of activity puts June on track for setting a record that would surpass the trading peak seen in November 2021. Keep in mind that November 2021 is quite memorable since the Nasdaq Composite index reached its all-time high of 16,057.44 on November 19, 2021.

And lastly, another example of extreme volume and extreme prices was seen in CBOE Global Markets data, where there has been record activity linked to S&P 500 index options, with one-day trading in calls surging and pushing up the prices of call options to extreme levels.

Couple this excitement with the $1.44 trillion sitting in retail money market funds (as of June 5), and one can see there is plenty of dry tinder on hand to move prices even higher. Market commentators on CNBC are suggesting it is “FOMO” – the fear of missing out – that is driving the surge in AI related stocks, some of which, like Nvidia have tripled in price in the last six months.

As I listen to analysts on CNBC talk about how artificial intelligence and ChatGPT will change technology as we know it, inspire trillions of dollars of investment and innovation, and disrupt companies that do not adapt, I cannot help but remember the excitement seen in similar times, like the Nifty Fifty era or the rally that led to the dot-com bubble of 2000. There is no doubt that there will be money invested and to be made in artificial intelligence; however, picking the right stocks at the right time will be crucial. Right now, it seems like patience and caution should be advised in view of the three-fold move seen in one of the best-positioned AI-related stocks – Nvidia.

Technicals

From a technical perspective, there are other signs of caution. The AAII sentiment survey has had three consecutive weeks of above average bullishness coupled with three weeks of below average bearishness. The last time this combination appeared, it lasted five weeks in October-November of 2021. This is another worrisome parallel to the November 2021 top in the Nasdaq Composite index. These parallels to the Nasdaq Composite are important since it is only a small number of technology stocks that are currently leading the June advance. News headlines are focusing on the 14% year-to-date gain in the S&P 500 index, but the Nasdaq Composite index has gained 29.5% to date, or more than double the S&P’s gain. Meanwhile, the Russell 2000 index has recorded a 5% year-to-date gain and the Dow Jones Industrial Average is up a mere 2.4%. It has not been a broad-based advance. However, if there is downside risk in the equity market today, we believe it is also concentrated in the Nasdaq stocks.

The 10-day new high and 10-day new low indicator is bullish averaging 193 new highs and 52 new lows. But our 25-day up/down volume oscillator remains neutral and reveals a lack of convincing volume in advancing stocks. More importantly, NYSE volume was below the 10-day average for many days during the early June advance and the highest volume days in the last four weeks have taken place on May 31, 2023 when the DJIA lost 134 points, June 16 when the DJIA lost 109 points and on June 23, when the DJIA lost 219 points. These high volume down days suggest distribution, not accumulation, of equities. See page 12 and 13.

Last week’s decline in the indices is barely perceptible in the charts of the SPX and IXIC, just like the June rally is not significant in the charts of the DJIA and RUT. The unweighted S&P 500 ETF is similar to the RUT and has been rangebound. See page 11. The Russelll 2000 index remains our main focus and it suggests the market remains in a long-term trading range.

Valuation

If we deconstruct the drivers of the 2023 equity market, we find that gains are due to a combination of earnings expectations and multiple expansion. A chart of IBES Refinitiv and S&P Dow Jones quarterly earnings expectations for the next seven quarters shows that analysts are anticipating solid straight-line EPS growth through to the end of 2024. See page 8. Unfortunately, PE multiples are currently above the standard deviation range, a sign that stocks are not cheap. And ironically, the 12-month forward PE is higher than the 12-month trailing PE, due to the deceleration in earnings growth seen in the first quarter. That is rare, and it is a pattern that often appears before an earnings decline. Moreover, if we look at the historic relationship between nominal GDP and S&P operating earnings, we find that earnings are, and have been, well above trend since early 2021. These outsized earnings gains could be due to margin improvements or post-pandemic stimulus; however, history suggests that this excess-earnings trend is not sustainable over time. See page 9. In sum, EPS expectations are robust, PE multiples are high, and EPS are rising faster than the underlying economy. It is a treacherous combination.

Economy

May’s inflation data produced good news, particularly headline CPI which fell 0.9% to 4% YOY. Yet, prices for food, housing, recreation, and services continue to rise faster than headline CPI. What helped May’s inflation data was a decline of nearly 12% year-over-year in energy prices. Still, inflation trends are generally decelerating, even for owners’ equivalent rent. See page 3. Although most of the deceleration in inflation is due to the dramatic decline in the price of crude oil — which was the initial catalyst for surging inflation in 2021 — the residual problem is now service sector inflation. Service inflation is driven by wage inflation, not energy prices. Unfortunately, the tightness in the labor market may make it difficult to reverse this trend quickly. See page 4.

Retail sales rose 1.6% YOY in May led by restaurants, drug stores, and nonstore retailers. But based on 1982 dollars, total retail and food services sales fell 2.4% YOY, the sixth negative month in the last seven. Typically, when real retail sales have been negative for more than a month or two it has been a sign of an economic recession. It might be different this time, but other data also suggest a recession is on the horizon.

The Conference Board leading economic indicators index declined again in May marking 14 straight months of declines. This is the first time the LEI has been down for 12 consecutive months or more without an economic recession being in place. In addition, the inversion in the yield curve is the greatest of any seen in over 42 years, and it too has historically predicted both economic recessions and bear markets. In our view, the missing ingredient for an all-out recession is negative year-over-year growth in jobs. A healthy post-pandemic labor market is sustaining the US economy. See page 5.

Consumer confidence surprised favorably in June. The Conference Board Consumer Confidence Index gained from an upwardly revised 102.5 in May to 109.7 in June — its highest level since January 2022. The outlook for business and the labor market improved in June. The University of Michigan survey was up from its May low, but it remains below January’s level and is stuck at a recessionary level. Similarly, May housing data included tentative signs that the decline in the residential housing sector could be bottoming. Nonetheless, assuming interest rates will move higher in the months ahead, it could be a tentative bottoming process, at best. We remain cautious.

Gail Dudack

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A Hostile Pause

The Federal Reserve is likely to pause at this week’s FOMC monetary meeting for a number of reasons, but none greater than the fact that this is precisely what the market has discounted and is expecting on June 14. To date, the Fed has been successful in molding sentiment for a rate hike well in advance of each meeting and therefore it has not shocked investors with its actions. This is done quite adeptly through presentations and speeches made by various Board Governors in the weeks preceding each FOMC meeting. However, while sentiment is currently looking for a pause, we do not think Chairman Powell is convinced that rate hikes are over. We believe he is being honest when he says that future policy will be driven by future data.

Right now, it is difficult to predict how weak or how strong future data and the economy will be in the second half of the year. As we pointed out last week, there were a number of weaknesses in May’s jobs report that were hidden by a strong headline number. Plus, no one can predict what will happen in October when the moratorium on student loans ends and 40 million borrowers will begin repayment for the first time in over three years. This will be an unprecedented event. What is certain is that it will dampen consumer spending.

Yet as the FOMC meets this week, a major discussion is likely to center on the impact of the debt ceiling resolution on the second half of this year. How the debt markets will respond to what is expected to be the issuance of more than $1 trillion in Treasury bills will be another unknown. This massive debt issuance is a double-edged sword since the increase in supply is expected to result in rates moving higher. And with so much of America’s debt on the short end of the curve, interest payments will also rise, increasing America’s overall debt load. This circular problem of higher rates and more debt issuance may not become a problem in the near term but barring a change in the trend of US debt and US interest rates, it will become a significant problem in the intermediate-to-long-term.

Nevertheless, investors have been celebrating the expectation that the Fed will pause in June and may or may not raise rates again in July. There is a growing consensus that a July rate hike is one and done, or that rate hikes are already done. But keep in mind that this has been what has been fueling the June rally. Recent equity gains are due to a shift in sentiment and not a result of good earnings. Yes, the first quarter’s earnings reports did generally beat expectations, but only because those expectations were already beaten down dramatically. What really matters is whether earnings are growing on a year-over-year basis. According to Refinitiv’s “This Week in Earnings” report, the first quarter earnings results are expected to show a rise of 0.03% on a year-over-year basis, and if the energy sector is excluded, earnings are expected to fall 1.7% YOY. According to S&P Dow Jones consensus data, which uses GAAP accounting, first quarter earnings are expected to rise 6% year-over-year, but from a much lower 2022 base. S&P Dow Jones data shows S&P 500 earnings per share fell 5.4% YOY in calendar 2022; whereas, Refinitiv had earnings rising 4.8% YOY in calendar 2022.

Equity prices have not been rising due to expectations of a stronger economy. According to data from the Mortgage Bankers Association, housing has become unaffordable for most Americans. In April the industry group’s Purchase Applications Payment Index rose to a record high of 172.3. Similarly, a recent report from the National Association of Realtors and Realtor.com states that over 75% of homes on the market are too expensive for middle-class buyers. In sum, a combination of inflation and rising interest rates is having a very negative impact on most households.

There has been some good news recently. The Fed’s balance sheet is contracting again following the liquidity boost in March done to offset the banking crisis. Although reserves are still $50 billion above the low level seen in early March, there is a sense that the banking crisis has eased. Meanwhile, a key liquidity benchmark – the 6-month rate of change in total reserves at the Fed – continues to be negative, indicating that the Fed is generally draining reserves from the system. This could become meaningful in coming months. While an increase in the Fed’s reserves tends to coincide with bull markets, the draining of reserves has been less predictive for the equity market; however, it tends to coincide with flat trends. See page 3.

Money supply (M2) continues to contract at a record pace as bank deposits and other liquid deposits leave the banking system in search of higher-yielding substitutes. This is not surprising, but it does hinder banks that need to borrow on the short end of the interest rate curve and loan at the higher end. It points to the fact that credit will be tighter in the months ahead. See page 4. And since the Fed has raised the fed funds rate nine times in the last twelve months, higher interest rates also impact borrowers. It is notable that the real fed funds rate is now positive for the first time since October 2019. See page 5.

If you wonder why there is a big debate among economists about whether a recession is at hand, or not, the charts on page 6 may help. It might be different this time, but history suggests a recession is on the horizon when we look at historical parallels. The current inversion in the yield curve is the greatest seen in over 42 years, and inversions have historically preceded economic recessions. Economic recessions produce bear markets in equities. The inversion of the yield curve may come early, but an inversion of this depth and length has predicted a recession in every case since 1954. We are of the view that history is a good guideline for defining risks in the equity market despite the fact that market sentiment is now tilting toward a mild recession or no recession. The one indicator that does not (yet) point to a recession is the year-over-year change in employment. That remains positive.

The acceptance of the current advance in stocks has been swift and dramatic and this is worrisome to us. Last week’s AAII sentiment survey resulted in a 15.4% surge in bullishness, now at 44.5%, and a 12.5% fall in bearishness, now at 24.3%. Investor bearishness is currently at its lowest level since November 11, 2021. Bullishness is now above average for the first time since February 2023 and at its highest level since November 11, 2021. Note that November 11, 2021 was less than two months prior to the major top in equities seen in January 2022. The Bull/Bear 8-week Spread remains in positive territory, but barely. See page 11.

Several technical indicators have improved this week including the 10-day averages of new highs, now at 172, and new lows, now at 60. This combination has turned positive with new highs above the 100 benchmark. But our 25-day up down volume oscillator remains neutral at 1.26 and is actually down from last week’s high. More importantly, the NYSE volume has been below the 10-day average for the last nine consecutive trading sessions and has not been impressive. The last high-volume day took place on May 31, 2023 when the DJIA lost 134 points. In sum, we would not chase this rally, particularly the large cap technology stocks that have been in the lead. If it is true that the real catalyst for the advance is the expectation that the Fed will pause in June, the wisest thing may be to follow the Wall Street adage “sell on the news.”

Gail Dudack

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Regional Banks

Last week’s passage of a bi-partisan debt ceiling bill extended the worrisome debt ceiling debate to January 2025. This bill resolved a major crisis that could have triggered a default on US obligations and crushed the US dollar and economy. However, the aftermath of this bill could result in different unintended circumstances. And while some investors may be celebrating these consequences, we believe the short-term positives may not outweigh the longer-term problems.

The balance in the Treasury General Account dropped from $140 billion in mid-May to under $23.4 billion last week and the lifting of the debt ceiling means the Treasury can and must refill its coffers in the coming months. Analysts at Deutsche Bank have estimated that a whopping $1.3 trillion in Treasury bills will be issued over the remainder of 2023, bringing total issuance for the full year to about $1.6 trillion. This massive issuance of Treasury bills will almost certainly drain liquidity from the financial system and could also steepen the yield curve.

The problem with this is that a further rise in short-term interest rates and a further steepening in the yield curve will make the environment even more difficult for the banking system and for the regional banks in particular. Banks borrow on the short end of the yield curve and lend on the long end and a steep yield curve is not a profitable situation. Regional banks are already suffering from a serious exodus of deposits as account holders seek higher-yielding investments found in the Treasury market and/or money market funds. And as deposits continue to leave the financial sector, credit conditions will continue to tighten, and this will slow economic activity.

Adding to the pressure on the banking sector is the fact that regulators are currently planning to increase capital requirements for all banks with $100 billion in assets or more (down from $250 billion in assets) and this could mandate increases in capital cushions for some banks by as much as 20%. Again, this would add another burden on regional banks.

Last, but far from least is the potential for a crisis in commercial real estate and the ramifications on the commercial real estate debt market. According to the Wall Street Journal, in the next three years an estimated $1.5 trillion in commercial mortgage loans will come due. Data provider Trepp indicates that interest-only loans as a percentage of newly issued commercial mortgage-backed securities have represented 65% or more over the last ten years but this increased to 88% in 2021. And while borrowers typically pay off these mortgages by selling real estate or getting a new loan, falling real estate prices, and rising interest rates make neither of these options attractive in the current environment.

Given all these pressures on the real estate and financial markets, we find it curious that regional bank stocks have rallied in recent trading sessions. However, it may be that investors have viewed this from a short-term perspective and have concluded that the Federal Reserve is unlikely to raise interest rates next week. Given the fact that the Treasury market will already be dealing with a significant increase in supply in the month of June and is faced with an unknown amount of demand, this may prove to be true. In fact, it is questionable whether the Fed can continue with its quantitative tightening policy in the face of record debt issuance. Therefore, we are less convinced that the Fed will raise rates in June. But while the Fed may choose to pause next week, this is not great news, and it does not make us bullish. 

Labor Markets

The BLS establishment survey indicated an increase of 339,000 jobs in the month of May, which was stronger than expected. However, the accompanying household survey suggested that employment fell by 310,000 jobs and that unemployment grew by 440,000. This discrepancy explains the increase in the unemployment rate from 3.4% to 3.7% for the month, but it also raises questions about the real strength of the job market. Job trends are important since one of the best leading indicators of a pending recession is a year-over-year decline in jobs. From this perspective, neither BLS survey suggests the economy is on the verge of a recession. See page 5. And the household survey showed other cracks in the data. Permanent job losers as a percentage of all unemployed was 26% in May, up from 21% in October. Of job losers and those completing temporary work, 36% were permanently laid off in May. The number of workers no longer counted in the labor force, but who indicated they want a job, increased from 5% to 6%; while discouraged workers increased 93,000 in the last 2 months to 396,000 in May. See page 6. Overall, the headline 339,000 job increase with upward adjustments to previous months was just not what it seemed. There were signs of weakness beneath the surface.

The Stock Market

Tesla Inc. (TSLA – $221.31), Alphabet Inc. C (GOOG – $127.91), Amazon.com (AMZN – $126.61), Apple Inc. (AAPL – $179.21), Meta Platforms, Inc. (META -$271.12), Microsoft Corp. (MSFT – $333.68), Netflix Inc. (NFLX – 399.29) and Nvidia Corp. (NVDA – $386.54) , represented about 22% of the S&P 500’s market capitalization at the start of the year, and now account for more than 30%. These stocks have been investor favorites this year which helps to explain why the equally weighted version of the S&P 500 (.WEGSPC – $5842.49) is up just 1.1% this year, the DJIA is up 1.3%, and the Russell 2000 index is up 5%, while the SPX is up 11.6% and the Nasdaq Composite has gained nearly 27% YTD. The recent rally clearly generated breakouts in the SPX and the Nasdaq Composite but is not visible in either the DJIA or the Russell 2000. See page 11. And despite the drama of a 701-point gain in the DJIA on June 2, 2023, there was no meaningful change in our 25-day volume oscillator or the NYSE cumulative advance/decline line in recent days. Moreover, the 701-point move materialized with NYSE volume that was below the 10-day average and volume continues to trend below its 10-day average. See pages 12-13. These are not impressive breadth statistics. We remember the Nifty Fifty and Dot-com eras, so we know narrow markets can be sustained longer than many expect. But we are not chasing this rally and believe the broad market will remain in a wide trading best seen in the Russell 2000 between 1650 and 2000.

S&P Earnings As the first quarter earnings season ends, the S&P Dow Jones consensus estimates for 2023 and 2024 were $218.69 and $244.70, up $0.77, and $1.03 for the week, respectively. Refinitiv IBES earnings estimates for 2023 and 2024 were $220.89 and $246.70, up $1.54, and $1.63, respectively. But note that last week’s big increases effectively erased the declines seen in estimates over the prior three weeks. We did not see any major earnings release to account for this big change and therefore believe it is due primarily to positive forward guidance. However, it is also important to note that S&P data shows that 18.4% of companies reporting first quarter earnings had a decrease of 4% or more in their shares outstanding. This decline in shares outstanding boosts earnings per share but does not represent a significant change in overall earnings growth. In sum, earnings are not all that it seems. See page 9.

Gail Dudack

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If you are focusing on the recent gains in the S&P 500 and the Nasdaq Composite index, you might think a major equity rally is underway. However, with the exception of seven technology stocks, the S&P 500 is unchanged this year as seen by the SPX equal-weighted index which is down 0.35% year-to-date. Viewed another way, the Nasdaq Composite is up 24% year-to-date, while the Dow Jones Industrial Average is down 0.3%. Our favorite index for monitoring the market is the small-cap Russell 2000 index which is up 0.3%, or essentially flat. In short, the 2023 stock market is all icing, no cake.

Most of the recent excitement in the stock market comes down to one stock — Nvidia Corp. (NVDA – $401.11) – up 30% in the last three trading sessions as a result of the billions of dollars expected to be invested in artificial intelligence in coming years. We have no doubt that there will be a lot of investment dollars directed at AI in the years ahead, but a mania seems to be the best description of the action in NVDA this week.

Volmageddon

And there are other interesting market trends that should be noted. A recent Wall Street Journal article titled U.S. Stock Market Stays Calm With Help From Quant Buying, suggests that the equity market remains calm in the face of the debt-ceiling debate due to demand from quant funds. The article states: “At the end of March, quant-focused hedge funds held about $1.13 trillion in assets, according to research firm HFR, hovering just below last year’s record high. That represents about 29% of all hedge-fund assets.”

“It’s rules-based trading,” said Charlie McElligott, a managing director at Nomura Securities International. “There’s no emotion involved.” Data from McElligott shows quants tend to move together quickly when volatility strikes. Take, for example, the stock market selloff of May 2019, when the S&P 500 slid some 7% as investors panicked about U.S.-China trade tensions. McElligott estimates that CTAs unloaded $35 billion worth of equities over the course of a month.”

However, rather than being a calming influence on the equity market, we believe this concentration of quantitative investments could prove to be risky down the road. It is reminiscent of another memorable event in equity history – Volmageddon — which is a blend of the words volatility and Armageddon. Volmageddon refers to the unusual activity that occurred on February 5, 2018. On this day, after about a year of rising stock prices and low stock market price volatility, the CBOE Volatility Index (VIX – 17.46) soared from an opening value of 18.44 to 37.32 at close. Unfortunately, the low volatility that characterized the 2017 stock market had generated huge demand in leveraged short volatility trades, especially in the Velocity Shares Daily Inverse VIX Short-Term note, whose ticker was XIV. The XIV (no longer traded) shrank from $1.9 billion in assets to $63 million in one day due to the jump in the VIX. The SPX only fell 5% on February 5, 2018, but February 5, 2018 proved to be just the beginning of a volatile year that ended in a large December sell-off, a 6.2% decline in the SPX and a 12.2% loss in the Russell 2000 index.

In short, this big increase in quant-based investment can have a calming impact on equity prices today, but if sentiment changes, it can also trigger a lot of volatility, illiquidity, and serious damage to stock prices in the future. In sum, we would not chase this rally and remain focused on recession resistant stocks with predictable earnings streams.

Economics review

After hitting cyclical lows in June or July of 2022 and rebounding to 12-month highs in February 2023, both the University of Michigan and the Conference Board sentiment surveys dropped in the month of May. The declines were across the board including the overall index, present conditions, and future expectations. May employment will be reported on Friday, and it will be interesting to see if these declines in sentiment are a leading indicator of job market weakness. See page 3.

June’s FOMC meeting is only two weeks away. Another month of inflation data will be available in early June, but April’s inflation data could support another rate hike. Both headline and core CPI were relatively unchanged at 4.9% YOY and 5.5%, respectively. Service sector inflation fell from 7.3% to 6.8%, services less rent fell from 6.1% to 5.2%, services less medical care fell from 8% to 7.6%, while other services rose from 4.4% to 4.7%. Nevertheless, all service sector inflation data remains high and well above the Fed’s 2% target. See page 4.  

However, small declines in inflation are helping households. April’s personal income rose 5.4% and CPI rose 4.9% which means real personal income is improving. Moreover, disposable income rose nearly 8% as tax payments fell and this produced a 3.4% YOY gain in real disposable income. April became the fourth consecutive monthly gain seen in real personal disposable income. See page 5. Personal consumption expenditures (PCE) rose 6.7% in April. Although expenditures are positive on a year-over-year basis, there are clear signs of deceleration in all categories including durable goods, nondurable goods, and services. See page 6. 

Several financial commentators have stated that the current savings rate is “average”, but this is far from accurate. The current savings rate of 4.1% compares to the historical average of 8.8% or the 22-year average of 6.6%. In short, savings are well below average. And while the savings rate did soar to 33.8% in April 2020 as a result of pandemic stimulus checks, that buffer has been depleted. Therefore, it is not surprising that personal consumption expenditures are also decelerating. See page 7. 

Retail sales rose a mere 0.15% YOY in April and real retail sales fell 3.2% YOY. Much of this was due to a decline in auto sales which fell 5.8% in the month and 3.4% YOY. However, a lack of motor vehicle inventory has hampered auto sales due to supply chain disruptions; but auto sales face a new hurdle from rising interest rates which will increase the cost of leases and auto loans. See page 8.

Technical Indicators The charts of the S&P 500, DJIA, and Nasdaq Composite are technically positive, but the SPX and DJIA failed to better critical resistance at SPX 4,200 and DJIA 34,500. The Nasdaq bettered the 12,500 resistance, but this was due primarily to Nvidia Corp. (NVDA – $401.11). The Russell 2000 remains our favorite guide for the broader marketplace and it remains well within a defined range with support at 1,650 and resistance at 2000. See page 12. The 10-day average of daily new highs is 94 and new lows are 109, making this combination negative since new highs are below 100 and new lows are above 100. See page 14. With the debt ceiling vote still incomplete, the Russian/Ukraine conflict escalating, Chinese GDP expected to slow from the first quarter’s 4.5%, Friday’s job report, and the FOMC meeting on June 14, there are many ways sentiment could change. Note that there was renewed weakness in crude oil and gasoline prices this week which implies fear of an economic slowdown may be increasing. We remain cautious.  

Gail Dudack

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Economic Mish Mash

One could build a case today for either a strong or weak economy based on recent data releases or from financial headlines. And it could be difficult to say who is right or wrong. In terms of economic strength, financial headlines noted that the US consumer is strong and resilient as seen by April’s total retail sales which rose 0.4%, the second month-to-month increase in the last six months. Industrial production increased 0.2% YOY in April led by a 16% YOY increase in auto and truck production. In terms of housing, the NAHB/Wells Fargo Housing Market Index (HMI) rose to 55 in May, a 10-month high. This NAHB survey of homebuilders is designed to take the pulse of the single-family housing market and it appears that housing may be on the mend. In general, economic activity appears healthy.

However, if one unpacks the April retail sales data it is easy to see that total retail & food services rose 1.6% on a year-over-year basis, a deceleration from the 2.4% YOY gain seen in March. Moreover, this 1.6% YOY increase was well below the level of inflation, which rose 4.9% YOY in April. In other words, real retail sales are negative and are decelerating which does not suggest the consumer is improving. In addition, a deceleration in sales implies corporate margins could be squeezed as consumption declines. What was notable in April’s report is that the standout segment of retail sales was, and continues to be, food services and drinking places, which rose 8.3% YOY before adjustments and 9.4% YOY after seasonal adjustments. See page 3. But in our view, this is not a broadly encouraging picture for an economy that is consumer driven.

Plus, offsetting the nice rebound in homebuilder sentiment was the University of Michigan consumer sentiment index for May. The headline consumer sentiment index tumbled to 57.7 from 63.5 in April. The decline was led by expectations, which fell a sizeable 7.1 points to 53.4. Current conditions also fell 3.7 points and as a result, each component is in recessionary territory. See page 5. In our view, the University of Michigan sentiment indices could be a warning for the homebuilders, since this survey is for May and the homebuilder survey was for April.

In terms of being either strong or weak, inflation data for April was also a tale of two cities. Headline CPI was 4.9% YOY in April, down only slightly from 5% in March. Core CPI was 5.5%, nearly unchanged from the 5.6% reported in March. More importantly, core service CPI was 6.8% versus 7.1% in March and remains stubbornly high.

The producer price index data was much the same. PPI for finished goods was 2.6%, down from 3% in March and final demand PPI was 2.4%, down from 2.8% in March. However, final demand PPI for the service sector was 3%, up from the 2.8% reported in March. Core PPI was also down from the 6.4% YOY pace seen in March, but it nonetheless remains high at 5.4% YOY. See page 4.

The importance of the stubbornly high inflation seen in the service sector is that it gives the FOMC a reason to worry about the embedded inflation in the economy, and to possibly raise rates again in June. This has not been the consensus view, but it has been something that several Federal Reserve governors have hinted at in recent discussions.

Earnings and Valuation

As earning season nears completion, and with over 91% of the S&P 500 companies having reported results, the S&P Dow Jones consensus estimates for 2023 and 2024 are $218.86 and $244.26, which rose $1.15 and fell $0.59, respectively, this week. Refinitiv IBES earnings estimates for 2023 and 2024 are $220.09 and $245.83, falling $0.78 and $0.60, respectively. See page 7.

We match our historic estimates to the S&P Dow Jones estimates since they have the longest historical database and because S&P is careful to see that estimates are uniform and reflect GAAP standards. [GD1] Nevertheless, our 2023 forecast of $180 for the S&P 500 is currently well below both the S&P Dow Jones consensus estimate of $218.86 and the IBES Refinitiv consensus estimate of $220.09. But this does not change the basic valuation standing of the market.

On page 6 we show two versions of our valuation model, one with the S&P Dow Jones estimate of $218.86 for this year and one with our $180 forecast. Surprisingly, there is little difference between these various estimates in terms of whether the equity market is currently overvalued, fairly valued, or undervalued. With both estimates, equities were overvalued prior to the surge in inflation in 2021 and became even more overvalued as interest rates rose in the last twelve months. The only difference is how much the fair value range increases, or not, by the end of the year. In both cases, our other model inputs for 2023 include an inflation target of 3.6% at year end and a fed funds target of 5.25%. We can envision scenarios in which inflation is better or worse in the second half of the year, but we believe our estimates are relatively sensible.

Still, the bottom line is that the equity market appears quite overvalued at current prices when using both the S&P estimates and our forecast. The main difference is that with S&P estimates the midpoint for the 2023 year-end fair value range rises from the year-end level of SPX 2700 to SPX 3235. Using DRG estimates, the midpoint of the fair value range falls from the year-end level of SPX 2700 to SPX 2660. We may be too pessimistic in our earnings estimate; but it is worth pointing out that even with the S&P estimates of an 11% increase in earnings this year and a 12% increase next year, coupled with inflation falling to 2.4% by the end of 2024, our model shows the midpoint of the fair value range to be SPX 3860 at the end of 2024.

In sum, this exercise shows that many things would have to go much better than expected for the stock market to move significantly higher from current levels. This is one of the reasons we remain cautious and would focus on companies and stocks with the most predictable earnings and reliable dividend payouts.

Technical Update

The charts of the S& P 500, Dow Jones Industrial Average, and Nasdaq Composite are technically positive, but each has failed to better critical resistance just above current prices. These levels are: SPX 4,200; DJIA 34,500; and Nasdaq 12,500. The Russell 2000 remains our favorite guide for the broader marketplace since it remains well within a defined range with support at 1,650 and resistance at 2000. See page 9. The 25-day up/down volume oscillator fell to a negative 1.99 reading this week but it is still in neutral territory. The oscillator recorded one-day overbought readings of 3.0 or higher on April 18, April 24, and April 28, but was unable to maintain an overbought reading on a rally. These failed overbought readings revealed a weakness in underlying buying pressure, i.e., demand. See page 10.  

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Gail Dudack

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At the May meeting of the Economics Club of New York, the New York Federal Reserve President John Williams said it is too early to say if the central bank is done raising interest rates. He added that “officials have not yet decided what lies ahead in terms of possible increases in short-term borrowing costs and if more action is needed policymakers won’t hold back.” This is not in line with the consensus which shows a 78% chance that the Fed is likely to pause rate increases at the June meeting. More importantly, fed futures now reflect a 45% chance that interest rates will actually be cut 25 basis points at the September meeting.

Keep in mind that while FOMC just raised the fed funds rate 25 basis points last week and the next FOMC meeting is only five weeks away on June 13-14. Nevertheless, we believe there is a good chance that the consensus could be disappointed, and the Fed could raise interest rates again. This explains why the CPI and PPI data reported this week will be so important. It could have a big impact on sentiment.

Inflation Math

Yet from a purely mathematical perspective, the peak rate of inflation of 9.1% was recorded in June of last year, and this means it could, or should, be easier for the year-over-year inflation rate to move steadily down as we approach mid-year. When we checked our database, we found that if the headline seasonally adjusted CPI data remained unchanged on a monthly basis for April, May, and for June, headline inflation would fall to 2.4%. This would be a very pleasant surprise for most economists. Either way, new inflation data will be crucial in the coming months.

But first, it will be important to see what headline and core inflation were in April and if there is any moderation in service sector pricing. Inflation data for May will be reported prior to the June FOMC meeting, which means the Fed governors will have several new data points on inflation before their next meeting.

The controversy surrounding the May FOMC meeting was whether the Federal Reserve should raise interest rates in the wake of a banking crisis. However, the crisis appears to be fading. Loans on the Fed’s balance sheet rose by $339 billion at the onset of the March banking crisis, but loans have been on the decline and by early May fell $36.4 billion from the March 22 peak of $354.2 billion. From a broader perspective, the Fed’s total balance sheet has been contracting, which means that quantitative tightening has been reinstated. This is good news since it lowers the risk of inflation in the broad economy, nevertheless, it does remove the positive bias that quantitative easing has for equities. See page 3.

Recession Math

April payrolls increased by 253,000 and the unemployment rate fell 0.1% to 3.39%. This decline in the unemployment rate now matches the low last seen in 1969, or 54 years ago! This robust growth in jobs and a historically low unemployment rate reflect a resilient job market and unfortunately for the Fed, a strong job market will only make its inflation goals more difficult to achieve. The bottom line is that it adds credence to the possibility of another rate hike in June.

Rising interest rates usually increase the risk of a future recession, however, there is another interesting math equation worth pointing out about recessions. The data series we have found to be the best lead indicator of a recession is a year-over-year decline in total employment. In fact, in the eleven recessions recorded since 1950, each was immediately preceded by a decline in total employment. Given that job growth has been robust, the US economy does not appear to be at risk of slipping into a recessionary state in the near future. However, this may also be one reason the Fed will continue to raise rates further than expected. The strong job market should give them a safety blanket, at least in the near term. See page 4.

On the other hand, small business owners are not optimistic about their future. The NFIB optimism index slipped to 89 in April. This was the 16^th consecutive month below the long-term average of 98 and it leaves the index at levels typically associated with a recession. Twenty-four percent of business owners indicated that labor quality was the top business problem. Inflation was in second place by one point at 23%. Plans for capex, employment, or to increase inventories have been declining for much of the last twelve months. Expectations for real sales, economic improvement, and better credit conditions also fell in April. See page 5.

Earnings Math

The economy may not be on the brink of a recession, but earnings are already experiencing their own recession. According to IBES, first quarter earnings for this year are currently $438.1 billion, down 0.7% YOY and down 0.4% month-over-month. This marks the second consecutive quarter of negative growth. Earnings declines are expected to continue into the next quarter when estimates suggest a 4.7% YOY decline. See page 7.

Using S&P Dow Jones earnings estimates on a 12-month trailing basis, earnings turned negative in April. When looking at reported earnings, the 12-month trailing earnings stream has been negative since October 2022, i.e., for the last two quarters. See page 6. In short, while the job market may not suggest a recession is in sight, earnings are already experiencing a recession. This is apt to continue since the consumer and small businesses have been crippled by high inflation and rising interest rates this year. All in all, this explains why the stock market has been stuck in a trading range for most of the last twelve months. See page 10.

Technical Roundup

The charts of the S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite are all technically positive, but each faces a critical level of resistance near current levels. These levels are SPX 4,200; DJIA 34,500; and Nasdaq 12,500. The Russell 2000 remains our favorite guide for the market since it remains well within a defined range with support at 1,650 and resistance at the 2000 level. It is worth noting that the Russell 2000 has been underperforming the larger capitalization indices and this is a cause for concern. And even though the index is moving toward the bottom of its range, we remain cautious. Our main near-term concern centers on our lack of faith that the debt ceiling negotiations in Washington DC will be done in good faith and if we are right, it will have a negative impact on the dollar and the securities markets. Most other technical indicators are neutral and inconclusive. The 25-day up/down volume oscillator is at negative 0.62 this week. This is in neutral range, but only after being unsuccessful at sustaining an overbought reading. In sum, we remain cautious and continue to focus on recession-resistant stocks where both earnings and/or dividends are most predictable.

Gail Dudack

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Bank Turmoil

Equity investors turned cautious ahead of this week’s FOMC meeting and we are not surprised. For one thing, regional banks continue to be under pressure despite the fact that over the weekend, in a relatively smooth transition, the FDIC stepped in, seized control of First Republic Bank, and sold its assets to JPMorgan Chase & Co. (JPM – $138.92). Yet, this buyout is no guarantee that the banking industry has stabilized. In fact, the stocks of many regional banks continue to suffer from intense selling pressure. There are multiple reasons for this.

Even though the 2023 banking crisis has been managed relatively well so far, it is not a “small event.” The three US banks that collapsed this year (First Republic, Silicon Valley Bank, and Signature Bank of New York) had more combined assets under management than all 25 federally insured lenders that failed in 2008. According to the New York Times, this year’s three failed banks held a massive $532 billion in total assets versus the $526 billion in combined assets of the 25 banks with FDIC insurance that failed in 2008.

Meanwhile, deposits continue to leave the banking industry. In the twelve months ending in late April, commercial bank deposits fell by $960 billion, with $464.0 billion exiting the banking system since the early March banking crisis. And unfortunately, it is questionable if the banking system has stabilized since loans in the Fed’s new Bank Term Funding Program rose to a new high of $81.3 billion on April 26, 2023. This is a sign of illiquidity in the system. At the same time, the Fed’s balance sheet contracted $171 billion in the 5 weeks ended April 26, 2023. See page 3.

In short, the Fed has resumed its monetary tightening at the same time that money is leaving the banking system for higher yielding assets. Confirming this trend is data from Refinitiv Lipper which indicates that investors purchased a net $42.68 billion worth of money market funds in the week ending April 26, which makes the cumulative money market fund inflows for the year $427.4 billion.

And the commercial banking industry faces the risk of rising bad debts later in the year. The Wall Street Journal recently reported that a 22-story glass and stone tower at 350 California Street in San Francisco, worth about $300 billion in 2019, is now for sale and expected to see bids come in around $60 billion! More surprisingly, life-sciences buildings, typically less vulnerable to the remote-work movement since lab work requires specialized equipment and mechanical systems that can’t be replicated at home, are also coming under pressure. A deluge of new supply in industry hubs such as San Diego, South San Francisco, and the Boston-Cambridge region, is generating a rise in life-sciences vacancies, according to commercial real estate services firm CBRE Group. In short, we expect banking will continue to be under duress from a combination of dwindling deposits, an inverted yield curve, and potential defaults. And note, short-term interest rates have not yet reached their peak.

This week’s FOMC is expected to result in an additional 25-basis point increase in the fed funds rate to a range of 5.00% to 5.25%. However, important information will be found in whether the vote was unanimous for this rate hike or not, and whether or not the Fed’s comments suggest a pause in rates will follow the May increase. Equity investors expect the Fed to be more accommodating in the second half of the year, which means anything slightly hawkish in Chairman Jerome Powell’s comments would be a negative surprise for the market. We expect Chairman Powell will try to be as vague as possible about future monetary policy and will resort to being “data dependent.” And economic data is quite a mix at the moment. Keep in mind that the Fed’s meeting will be followed by expected rate increases by the European Central Bank on Thursday and the Bank of England next week, which means credit conditions are contracting globally. This means equity markets no longer have the wind at their back.

Economic Data Jumble

The March JOLTS report showed 9.6 million job openings, down 2.5 million over the last year and now at the lowest level since April 2021. In another sign that the labor market is cooling, the quits rate edged lower to 2.5%, the lowest point since February 2021.

GDP grew at 1.1% in the first quarter of the year, disappointing consensus expectations, but it is worth noting that personal consumption rose a fairly healthy 3.4%. It was the drag from inventories which contracted 2.3% that lowered GDP. See page 4.

However, the drag from inventories may not be over as seen in recent ISM data. The ISM manufacturing index rose from 46.3 to 47.1 in April but for the sixth consecutive month it remained below the 50 level that shows a contraction in activity. Nine of the 11 components rose in April, and surprisingly two of these, employment and prices paid rose above 50. This is not a good sign for the Fed since it is looking for weakness in both inflation and employment. The major drag on the April ISM index was inventories, which means second quarter GDP is starting on a weak note. See page 5. The ISM services index will be reported later this week.

Personal income rose 6% YOY in March and wages rose a more robust 7% YOY – a sign that wage inflation continues. But after being negative for 19 of the 21 months between April 2021 and December 2022, real personal disposable income increased 4% YOY in March for the third consecutive month this year. This shift is an indication of a gain in purchasing power and it is good news for the consumer. As a side note, March disposable income benefited from a 7.3% YOY decline in tax payments. The savings rate rose from 4.8% to 5.1% in the month and now exceeds $1 trillion. See page 6.

Personal consumption expenditures continue to increase on a year-over-year basis, but the trend is decelerating. Spending on services is highest with an 8% YOY increase, while nondurable spending is growing at a modest 2.6% pace. What surprised us in the data was that personal outlays rose 6.9% YOY in March whereas personal consumption expenditures rose only 6% YOY. Digging through the data we found that interest payments rose a stunning 52% YOY in March, which helps explain the differential. In other words, wages are rising, inflation is moderating, and real personal disposable income is improving. But at the same time, a steady increase in interest rates and interest expenses are eating up a good portion of these gains. In sum, higher interest rates are clearly hurting household consumption. See page 7.

Technical Update

The combination of falling crude oil and gasoline prices, coupled with the relatively positive performance of gold this week, implies that investors have become increasingly worried about a recession. The dollar has been stable in recent sessions despite its weakness since early March, but this is not surprising given that interest rates are expected to rise this week. See page 9.

This year’s equity gains have been concentrated in the most depressed stocks of 2022, the high PE growth stocks. And with interest rates headed higher this week it is not surprising that the April rally hit a roadblock. The Russell 2000 remains the best guide for what we believe is a trading range market as it trades between support at 1650 and resistance at 2000. See page 10. We would point out that the 10-day average of daily new highs is 87 and new lows are 87. This combination is neutral since neither new highs nor new lows are above 100; but the combination is also turning negative as the number of daily new highs declines. See page 12. Although we focused on the risk in the banking industry this week, the looming debt ceiling debate may be the biggest problem for investors in coming weeks. Friday’s employment report is another potential market-moving event. Plus, this is the biggest week for first quarter earnings reports. In the long run, it is valuation that will strengthen or weaken equity prices. We remain cautious.

Gail Dudack

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President Joseph Biden announced his reelection campaign for president this week, even though 44% of registered Democrats say the 80-year-old president is too old to run. Biden’s current leading Republican rival, Donald Trump, who is 74 years old, is not supported by 34% of registered Republicans. Although Biden’s announcement could be the first step toward a rerun of the 2020 presidential election race, the political polls indicate it is a scenario most Americans do not want to see. Still, a lot can happen in the next 18 months and the early leaders do not always make it to the finish line, particularly since both of these candidates are hampered by legal issues and Congressional investigations. All in all, we do not expect the presidential election to impact the equity market this year, or any time prior to when the parties confirm the selection of their candidates and their platforms at their respective national conventions.

Watch Over the Dollar

However, domestic politics is not tabled. The pressing political issue on the horizon is the all-important debt ceiling and this could prove to be more serious than any election outcome. Treasury data for the days following the April 18^th deadline when most Americans file federal income taxes, suggests that the tax windfall for the Treasury is falling short of expectations. This shortfall could have several sources. There is a postponement of the tax filing deadline for disaster-area taxpayers in California, Alabama, and Georgia from April 18 to October 16.

In addition, the Congressional Budget Office forecasts that capital gains tax receipts could be as much as 17% lower on a year-over-year basis. This is directly due to the performance of the stock market in 2022 versus 2021. Nevertheless, the tax shortfall has major implications for the debt ceiling debate on Capitol Hill. Most economists were expecting the debt ceiling standoff to take place in August; however, it may become an emergency as soon as June. Failure for both parties to come together to address the debt ceiling and spending would be a disaster. The dollar and US Treasury securities have always been the world’s global currency and the world’s safe-haven investment. To change that would weaken not only the US economy, but the global financial balance that has existed for decades. And this comes at a time when the dollar is already under pressure related to challenges from China, Russia, India and Brazil, countries that have been pushing for settling more trade in non-dollar units. Even French President Emmanuel Macron has recently warned against Europe’s dependence on the greenback. A French multi-energy conglomerate, TotalEnergies SE (TEF – 58.31 €) and China’s national oil company, CNOOC Ltd. (12.42 HK$), recently settled a major liquified natural gas transaction in the yuan. According to Bloomberg, Malaysia has initiated talks with China on forming an Asian Monetary Fund in a bid to decouple from the dollar. A weaker dollar could have many ramifications, but the most immediate one would be higher inflation.   

Earnings Season

Meanwhile, the first quarter earnings season is filled with surprises. First Republic Bank (FRC – $8.10) plunged nearly 50% after reporting that more than $100 billion in deposits left the bank during the quarter. Deposit flight has been at the center of investor concerns as clients continue to move capital out of regional banks and into money market funds where higher returns are available or to larger ‘too-big-to-fail’ institutions. However, First Republic is not the only bank suffering from deposit flight. The decline in commercial bank deposits reached $979 billion in mid-April, and only 25% or $251.8 billion exited the banking system since, or due to, the March banking crisis. See page 8. In short, the banking system has been suffering from disintermediation since the Federal Reserve began to raise interest rates a year ago. This trend is apt to continue throughout the year. And in our view, there is no guarantee that a 25-basis point hike in May will be the last rate hike. In other words, the banking system will continue to suffer from a decline in deposits and a painful inverted yield curve. The banking crisis of March will only add to the pressures and credit crunch that began months ago. 

Still, the banking system appears to be stabilizing from the March panic and loans from the Fed’s new Bank Term Funding Program fell modestly from the April 5, 2023 high of $79 billion to $73.8 billion on April 19, 2023. This is a ray of sunshine. But it is worth pointing out that now that the banks are no longer in crisis, the Fed’s policy of quantitative tightening has been reinstated. As seen on page 8, the Fed’s balance sheet contracted by $140 billion in the 4 weeks ended April 19, 2023. In short, the stimulus put into the banking system in March was temporary and is slowly reversing. This means that equities no longer have the wind at their back from this temporary liquidity boost. And this fading liquidity is beginning to show up in some technical indicators.   

Employment and Recession

A simple way to predict a recession is to monitor the year-over-year growth, or contraction, in jobs. See page 3. This indicator is simple, but useful, because the main characteristic of a recession is a decline in jobs. In the post-Covid recovery period job growth has been positive as people went back to work after the shutdown. And the year-over-year growth in both the employment and household surveys has been positive. The household survey has been the weaker of the two surveys recently and it decelerated to an “average” growth rate of 1.5% YOY in March. The interesting thing about job growth in the second half of this year is that comparisons will become more difficult when compared to 2022, and it is quite possible that job growth will stagnate of decline. We will be monitoring this in the coming months.  Meanwhile, consumer sentiment, which is normally a good indicator of a recession, has been extremely weak.

The Misery Index, which is the sum of inflation and unemployment, hit 12.7% in June 2022, a sign of household stress, but it dropped to 8.5% as inflation eased to 5% in March. However, March employment data included a small warning. The number of permanent job losers has been rising and was 26.6% of those unemployed in March. This is the highest percentage since December 2021. In sum, employment data could get weaker in the months ahead and job data will be the key to whether a recession appears in 2023 or 2024.

Technical Update

It has been a difficult equity market in which to maneuver and this can be seen by the year-to-date performances of the indices which are currently: S&P 500 up 6.1%, DJIA up 1.2%, the Nasdaq Composite up 12.7% and the Russell 2000 index down 0.9%. In other words, gains are concentrated in large-cap growth stocks this year, and we fear many of these large-cap favorites, with high PE multiples, may hit a major hurdle as interest rates continue to rise. See page 11.   The 25-day up/down volume oscillator is at positive 1.94 this week and neutral after recording one-day overbought readings of 3.0 or higher on April 18 and April 24. The inability of this oscillator to sustain either overbought reading reveals a weakness in underlying demand. We remain cautious.

Gail Dudack

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