The third quarter of 2024 may well be remembered for the dramatic shift in Federal Reserve policy. With a fifty basis-point interest rate cut, Chairman Powell made it quite clear that rising unemployment was more worrisome than inflation, which was gradually falling towards the Federal Reserve’s 2% goal. In addition, most market observers now believe that there will be two more policy cuts this year and several more in 2025. After an initial hesitation, the markets have responded positively to this change, in spite of significant risks such as the escalating war in the Middle East, a structurally imbalanced Chinese economy, and uncertainty around the U.S. presidential and congressional elections. We attribute this apparent contradiction to the wave of liquidity from elevated fiscal stimulus measures and central bank easing both here and abroad.

To say market forecasts have been subject to change is an understatement. Since the Fed’s policy change, past economic data has been revised to show significantly more robust growth than previously estimated, and the latest jobs numbers blew past economists’ projections. Rather than falling, the September numbers showed that non-farm payroll increased by 254,000—more than 100,000 above the consensus among economists—and the prior two months tally was increased by 72,000. As such, the unemployment rate, which was expected to rise, fell to 4.1% in September from the prior month’s 4.2%. These types of numbers make one want to question the perceived scenario of steadily falling interest rates through 2024 and 2025.

Despite evidence that low-wage earners in the U.S. are having a difficult time, overall consumer spending and confidence have held up remarkably well. In addition, the world economy may be getting a welcome shot in the arm from a just-announced massive stimulus program in China. While few details have been announced, it would appear to target not only China’s faltering housing market but also consumers themselves. 

With the popular equity indexes recently hitting record highs, earnings and earnings guidance become more important. Consensus numbers are for the S&P 500 earnings to rise 8% this year and 14% in 2025. While we believe a “soft landing” is possible this year, we also think 2025 earnings estimates are quite aggressive, and may leave the markets subject to a pullback early next year.                                   

October 2024

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While the major averages again performed well during the second quarter, breadth continued to narrow. In early June the number of stocks outperforming the S&P was at its lowest level since 1980. We believe this type of market action cannot continue, and is usually resolved by some sort of correction or at least consolidation in the current market leaders.

The Federal Reserve’s interest rate hikes have now begun to slow the economy. On July 5^th it was reported that the unemployment rate had climbed three months in a row to a fresh high of 4.1%. The last time the unemployment rate rose for three consecutive months was in 2016, when the Fed backed off from interest rate hikes. Payroll growth has slowed with the three-month moving average of nonfarm payrolls at 177,000—the slowest in over two years. The risks are in one direction, and the Fed ought to lean against those risks. It is questionable, given recent rhetoric, that the Fed will cut in July, but it can use the July meeting to strongly signal a cut is coming in September. We believe any further delay risks losing the Fed’s hoped-for “soft landing”.

While Federal Reserve policy and the direction of interest rates are paramount in our thinking, there are many reasons to believe this is still a decent environment for stock returns. Economic growth may slow in the coming quarters, but we are not looking for an economic contraction, and although the unemployment rate has ticked up, there are still 161.2 million people working in our country, close to the record amount of 161.8 million attained last November. There is also ample liquidity in the system with money market funds reporting a record $6.4 trillion in early June. Nor are we seeing any signs of stress in the banking system, with credit spreads acting well and the stock prices of most major banks near all-time highs. In addition, analysts are still projecting S&P 500 earnings growth of 9-to-10% this year and next.

We are at that time of year when some weakening can be expected in the popular averages, and recent winners in particular. But stocks have finished positively in every election year since 1944, with average returns of 16%. With the long-term drivers of stock returns, earnings and interest rates going in the right direction, we expect that any pullbacks will likely be a contraction in an ongoing bull market.

 July 2024

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U.S. stocks rallied in the first quarter of 2024 in anticipation of strong corporate profits and the Federal Reserve cutting interest rates. It is notable that the market’s breadth increased, something that was lacking for most of 2023. Towards the end of the quarter, however, some weaknesses developed as several Federal Reserve officials pushed back against the aggressive rate cuts many on Wall Street were predicting.

The U.S. has appeared to be unique versus a more sluggish performance abroad, with several foreign countries entering recession. As a result, numerous global central banks are planning on cutting policy rates in 2024. The U.S. picture, however, appears much stronger. As an example, U.S. non-farm payrolls surged 303,000 month-over-month in March, a notable upside surprise. Average hourly earnings were up by 0.3%. The U.S. labor participation rate rose to 62.7% while the unemployment rate fell to 3.8%. Job growth has been expanding for over three years.

The Federal Reserve faces a core inflation stuck above 2% annually with increasing government deficits, and there have been well-documented historical mistakes of “stopping and going” monetary policy. Notably, the University of Michigan’s survey of long-run inflation expectations was 3.0% in early April. In the end, the Fed wants a soft landing, and recent Atlanta Fed data would keep this possibility as wage growth is slowing. While goods inflation is down significantly from COVID-induced supply chain disruptions, services inflation remains more persistent. So, a longer pause (before cutting rates) makes sense at this point.

The weaknesses in equity prices that showed up at the end of the first quarter has continued, and we believe it has further to go. We also have commented in the past about the uniqueness of the election year cycle, wherein stocks tend to bottom around Memorial Day and then rally into year-end. This scenario could be upset by international events—and there are enough uncertainties around to advise holding a near-term higher-than-normal cash position—but the bigger picture is one of stronger corporate profits and eventual falling interest rates.

April 2024

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Stocks performed well in the fourth quarter and for the year 2023, with the S&P 500 advancing more than 20%. However, practically all the action was in the so-called “magnificent seven,” a handful of primarily large cap technology issues. The remaining 493 companies in the S&P 500 appreciated 14% collectively. The number of stocks, or market breadth, substantially increased in the fourth quarter, a good sign for further progress in 2024.

While U.S. economic growth has been resilient, inflation staying well-anchored is the more important determinant for future Federal Reserve policy and the hoped-for soft landing. In December, the U.S. Consumer Price Index was a bit above expectations, but the Producer Price Index (PPI) was well below. We have now had three consecutive months of negative PPI readings. Separately, the New York Fed’s survey of one-year consumer inflation expectations fell to 3.0% and the three-year dipped to 2.6%. The domestic labor market appears to be overheating less, with fewer people leaving their jobs and better skills-matching at businesses. In sum, the U.S. labor market appears to be normalizing by cutting job openings rather than jobs.

At their most recent December meeting, Chairman Powell of the Federal Reserve Board hinted quite strongly that the Fed was finished raising interest rates, and the most likely path towards “normalization” would be rate cuts. This was greeted by some equity investors promptly penciling in five to six rate cuts during the course of 2024. We think this is excessive, and that three-to-four rate cuts are more likely. The last thing that the Fed wants is a repeat of the 1970s when they were forced to adopt a stop-and-go monetary policy due to reoccurring bouts of inflation.

Election years are generally good years for equity investors, but unique from other years in market patterns. We would not be surprised, therefore, to see weakness in the first half of the year, as investors muddle through the political process and its economic implications. We are optimistic, however, that with interest rates and inflation on a downward path and corporate profits increasing, 2024 will be a good year for both fixed income and equity investors. 

January 2024

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The S&P 500 lost 3.3.% for the quarter ending September 30th, and while positive for the year, this is entirely due to a handful of large-capitalization companies. On an equally weighted basis, that index is now negative for the year.

In our July commentary, we emphasized the importance of interest rates, and rising rates are the major problem today. It would be easy to blame the Federal Reserve for the market’s weakness, but the Fed has been signaling “higher for longer” for many months. U.S. consumer confidence has weakened but retail sales continue to surprise on the upside as jobs and asset values are still supporting consumer spending. It would appear that interest rates haven’t been high enough for long enough to fulfill the Fed’s aim of bringing inflation back to 2%. We would expect, therefore, that a “data-dependent” Fed will continue their restrictive policy until there is clear evidence that its objective will be met. The downside of this approach is, of course, that the economy could suffer a sharp slowdown.

At least some explanation for the economy’s resilience lies with the wealth of American households, which are estimated to have increased by some $40+ trillion since the start of 2020. We can thank a good stock market and booming housing market for a substantial part of this increase. The downside is that this was all made possible by unrealistically low interest rates and massive government deficit spending.

While interest rates are beginning to normalize, government spending continues and deficits continue to rise. This latter factor is important for bond investors as they will demand a higher interest rate for holding a longer-duration instrument.

As we enter the fourth quarter, we are optimistic that we will see a year-end rally, and historically the third year of a presidential cycle is the strongest. There is increasing evidence, moreover, that the Federal Reserve may be done raising interest rates, at least for this year. For the market to move appreciatively higher, however, we must see increasing corporate profits and a decreasing cost of money.
October 2023

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Contrary to many predictions at the beginning of the year, stocks have advanced nicely for the first half of 2023. While gains in the second quarter were still concentrated in large technology companies, market breadth broadened. On an equally weighted basis, the S&P 500 total return was 7% for the first half of the year.

Financial markets react not only to the level of economic data, but also to the direction and rate of change—and a lot has improved in the U.S. this year. To date, the percentage of people employed increased by 1% to an all-time high of 156 million, while unemployment hovers near the multi-decade low of 3.5%. With inflation falling, real disposable income increased 2.5% through May. Contributing to the current robust employment situation are many areas of the economy that are thriving, including fossil fuel production, new homes under construction, reshoring of manufacturing, and the beneficiaries of the $280B CHIPS Act and the $437B Inflation  Reduction Act.

There are risks this current economic strength could diminish. The U.S. Bureau of Labor Statistics reported 209,000 jobs were created in June, which fell short of estimates. More importantly, the rate of growth in private sector job creation continues to slow, reaching 159,000 in June. This figure has consistently slowed for the past 12 months. The U.S. labor market does not appear to have rolled over enough to remove concerns about wage inflation yet, and the Federal Reserve has forecast additional interest rate increases.  Price inflation likely peaked in mid-2022, however core inflation was still 4.8% on a year-over-year basis in June.

For these and other reasons, aggregate earnings expectations for both fiscal year 2023 and 2024 have been revised significantly lower since early 2022. The U.S. Treasury yield curve remains inverted, and the Conference Board’s Leading Economic Index has been in decline for 14 consecutive months, all while interest rates have been rising.

We believe the stock market is trading at one-year highs based upon the assumptions that there will only be a mild economic slowdown, a consistent drop in inflation, and the Fed will not hike rates more than expected. To extend the gains meaningfully from here, however, we think we will have to see interest rates falling, economic growth re-accelerating, or an increase in S&P 500 earnings estimates.  As to earnings and interest rates—both continue to matter.

July 2023

                                                                                                                                                

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The year 2022 was not a good year for the markets. The Dow Jones Industrial Average, S&P 500, and NASDAQ all had the biggest annual declines in fourteen years. Bonds, traditionally a source of stability, faired almost as poorly. A 60/40% portfolio, consisting of equity and debt, lost 17%—the worst performance in over 50 years. The primary reason for these terrible results was the rapid rise in interest rates as the Federal Reserve, recognizing that inflation was an escalating—rather than a temporary—problem, suddenly reversed course from quantitative easing to quantitative tightening.

We cannot overemphasize the importance of Fed policy, which determines the amount of money available and, hence, economic activity. Earnings are driven by the direction of economic activity and, over time, the equity markets correlate to the direction of earnings, or earnings per share. The debate among economists and strategists now seems to focus on when the Fed will ease its monetary stance and how badly earnings will be affected. We think the Federal Reserve has made it quite clear that interest rates will remain higher and monetary policy tighter for longer than most observers expect. Key to their thinking is that a monetary policy of stop-and-go, similar to that which resulted in a severe recession in the 1970s, must be avoided at all costs. As of November, wages for part-time and full-time workers were 6.2% higher than in 2021, and Chairman Powell has gone on record as saying that wage growth of 3.5% would be consistent with the Federal Reserve’s 2% inflation target.

Leading Economic Indicators, published by the Conference Board, have declined year-over-year to levels consistent with the onset of recession. The Treasury yield curve is deeply inverted, while on the inflation front the ISM Backlog, the ISM Manufacturing Prices Paid, and the Chicago PMI Prices Paid indexes remain in contraction. All of these indexes lead the Consumer Price Index (CPI), which is one reason to expect the CPI to fall significantly over the next year. Earnings will follow suit.

The remarkable thing about today’s economy is the strength of consumer spending, which has been fortified by government subsidies and a tight labor market. This strength is not what the Fed wants to see in its fight against inflation. We expect, therefore, that it will be difficult for the markets to mount a sustainable advance until there is tangible evidence that the Fed believes that their intended results are successful.

January 2023    

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Stocks continued to fall in the third quarter with September, true to form, once again proving to be the most difficult month of the year. For the quarter, the S&P 500 fell 5.3%, the Dow Jones Industrial Average lost 6.7%, and the NASDAQ dropped 4.1%. The NASDAQ 100 (QQQ), populated with mega-cap growth companies, broke below the key technical level market watchers were eyeing, the June 2022 lows, and may be signaling another leg downward.

The two primary issues facing investors remain the central bank’s efforts to arrest inflation and a deterioration of the corporate earnings outlook. These come as the FOMC remains committed to taking the benchmark interest rate to at least 4.25%, and perhaps higher. With the Conference Board’s leading Economic Index now in contraction for six consecutive months, shipping rates and orders in free fall, commodity prices well off the high and many now at pre-COVID levels, investors are becoming increasingly concerned about both faltering growth and the Fed hiking too aggressively into a recessionary economy. The most recent Chicago PMI, a bellwether for economic activity, came in at 45.7, firmly in contraction and far below economists’ estimates.

On the positive news front, the Atlanta Fed, in a surprise move, upgraded the outlook for the third quarter for the U.S. economy, sharply revising real GDP growth estimates from 0.5% to 2.4%. The main driver for the revision was the strong uptick in personal consumption expenditures. Clearly, the consumer has exhibited some firepower, but it remains to be seen whether this is temporary. With weakening leading economic indicators and a deeply inverted Treasury yield curve, we should remain skeptical.

The Federal Reserve has made it quite clear that fighting inflation is its number one priority and, we think a Fed “pivot” towards easier money is premature. The jobs market remains strong, with initial claims for unemployment at record lows, and hiring consistently above 300,000 per month. As long as jobs remain widely available, it is unlikely the Fed will ease its policy stance on interest rates.

With the twin headwinds of further tightening and earnings estimates falling, it is too early to declare the end of the bear market. We believe, however, we are getting closer to that end rather than the beginning. While high-quality growth companies should remain long-term holdings, our position continues to be that a higher-than-average cash level and allocations to short-term investments is a sound tactical strategy in the current environment.                                                                                                                                  October 2022    

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The S&P 500 declined 21% in the first half of 2022, the worst showing since 1970. More persistent inflation than the Federal Reserve had forecast is forcing it to tighten monetary policy into a slowing economy. Russia’s invasion of Ukraine has been an additive to inflationary pressures, especially in energy and agricultural commodities. COVID lockdowns and fiscal responses in the past two years distorted supply chains and consumption patterns throughout the global economy. The repercussions are profound. Workers left the energy and many services sectors. Durable goods consumption was pulled forward at a time factories remained supply constrained. These distortions lead to a lagged inventory build now present at precisely the wrong time as consumers are tightening belts in response to food, rent and energy inflation. With the Fed fighting to catch up to inflation, these stresses make it likely the US will experience a recession in the coming months, and indeed may already be in one. The actual timing and severity will only be known with hindsight.

Inflation is pressuring corporate margins and forcing consumers to curtail discretionary spending, reducing aggregate demand. This, in turn, will flow through to negatively impact corporate earnings. So far analysts’ estimates of forward earnings have remained resilient, and the market’s decline to date has been largely a compression of the multiple investors are willing to pay for those earnings. The final market lows will likely be accompanied by a reduction in earnings estimates.

Regardless of whether a recession occurs or not, the stock market is unwinding a liquidity-driven run-up from the extraordinary monetary policies enacted during the COVID crisis. Market bottoms are emotional and take time. While the tell-tale characteristics of a final market capitulation are not evident yet, we are well into the process of forming a bottom.

Investors should not lose hope, as there are some silver linings. Strong earnings and shareholder returns—in the form of dividends and buy-backs—have propelled the market in the past two and a half years. The S&P 500 finished the first half of 2022 17% higher than the end of 2019, before COVID, however second quarter trailing twelve-month S&P earnings are estimated to be 43% above pre-COVID levels. While the pace of growth should decelerate from current expectations—and may pause—growth will resume again. A variety of secular growth areas from batteries and electric vehicles, to hydrogen and solar, to genetics and big data (to name just a few) will continue to provide ample growth opportunities for companies in many industries.

Historically, markets bottom in the midst of recession, not at the end. The market is a discounting mechanism and the decline in the market to date has discounted a lot of the dour news cited above. This year marked the sixth time in history that the S&P 500 declined over 15% in the first half.  On each of those occasions the market rallied in the second half.  It is too early to say the low is altogether in, but we are significantly on the way.

                                                                                                                          July 2022

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The first quarter of 2022 will probably be remembered for two seminal events: the Federal Reserve’s pivot from quantitative easing to quantitative tightening, and the start of hostilities in Ukraine. While either of these events in and of itself would probably give the markets pause, the combination resulted in a 4.6% decline for the S&P 500. The NASDAQ lost 8.9%.

As expected, in mid-March the Federal Open Market Committee (FOMC) raised its federal funds target rate by one quarter of a percentage point to 0.25%-0.50%. At the same time, the Committee unveiled economic projections with sharply higher inflation and federal funds expectations, while lowering anticipated economic growth for 2022. The numbers were in sharp contrast to those released in December when Omicron, rather than Ukraine, topped the list of worries.

The war in Europe, which so far has proven to be a stalemate and is unlikely to be resolved any time soon, has disrupted activity on a number of fronts. These include upheavals in the markets for energy, food grains, and a number of key materials, all the while further disrupting already stretched global supply chains.

Inflation in the U.S. and in Europe is now above 8%, a 40-year high and well in excess of what was expected as recently as December. More troubling, especially in the U.S., are signs that the underlying drivers of inflation have broadened from goods to services, exacerbated by tight labor market conditions. Inflation psychology has shifted significantly, and while longer-term inflation expectations have not yet become unhinged, they are increasingly at risk of doing so.

The Federal Reserve, now finding itself well behind the curve, has given clear signals that it is shifting to a more aggressive tightening mode, to include more rapid and larger rate hikes as well as balance sheet runoff. The U.S. consumer is still in good shape, but recent wage gains have been overtaken by inflation. Most analysts are still forecasting decent economic and corporate profit growth, both this year and next. We question, however, whether these projections will be realized, given tightening monetary policies, continued conflict, and emerging weakness in other parts of the world. Mortgage rates in excess of 5% are already having an effect on the U.S. housing market.

We ended our January letter with this sentence: “As a practical matter, this outlook requires increased allocations to defensive quality equities and higher cash cushions.” We continue to believe this is the case today. 

                                                                                                                            April 2022

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