A major shift took place in the stock market last week and money flowed out of the few popular large-cap stocks that had been the major drivers of this year’s market rally and into financial and a broad range of small-cap stocks that had been among the laggards. It was such a sudden and dramatic shift that it suggests this change was the result of professional traders using ETFs and futures to facilitate a major portfolio shift. Nonetheless, it triggered a major uptick in breadth data and produced a perpendicular breakout in the Russell 2000 index — well above the 2100 resistance level. Volume increased and the NYSE cumulative advance/decline line made a series of record highs confirming the gains in the indices. These are all technical confirmations of the advance. See pages 11 and 12.
This portfolio shift materialized prior to the assassination attempt on former President Trump on Saturday. However, this cowardly act by a 20-year-old man and the emotion that it unleashed in its aftermath, unified the Republican Party, and may have solidified Trump’s win in November. We mention this because a Trump win in November’s presidential election would put two businesspeople in the Executive Branch. Perhaps more importantly, it implies an administration that will again focus on lower taxes, less corporate and small business regulation, more oil drilling (lower energy prices), and a stronger economy. All of these are good for small-cap stocks. The sharp gains in stocks this week are another positive sign that the stock market would welcome a Trump victory.
Liquidity Trumps Valuation
As we noted last week, even though the Federal Reserve is making progress on decreasing its balance sheet, liquidity in the banking sector is solid. Total assets at all commercial banks reached $23.52 trillion in early July, an all-time high. Near the end of June, demand deposits, retail money market funds, and small-time deposits were all at, or near, record highs. Only “other liquid deposits” at banks appear to be sensitive to the Fed’s balance sheet and have declined $3.5 trillion since their April 2022 peak. And since liquidity is the first necessity of a bull market (or bubble), this suggests stock prices could go higher.
However, this does not mean the stock market is cheap! The S&P 500’s trailing 4-quarter operating earnings multiple is now 25.5 times and well above all long- and short-term averages. The 12-month forward earnings multiple is 21.7 times and when added to inflation of 3.0% sums to 24.7. Note that this sum of 24.7 is higher today than it was a week ago despite the fact that recently released data showed that June’s headline CPI fell from 3.3% to 3.0%. The sum of inflation and the trailing PE multiple has been a simple but important standard of valuation during a wide variety of economic cycles and periods of low and high inflation. The current 24.7 level remains well above the top of the normal range of 14.8 to 23.8 and denotes an overly rich market. See page 9. By all measures, the equity market is at valuations seen only during the 1997-2000 bubble, the financial crisis of 2008, or the post-COVID-19 earnings slump. However, if this is a bubble, remember that bubbles are driven by liquidity and sentiment, not valuation. Right now, liquidity appears plentiful.
In the longer run, we are concerned about the massive amounts of debt accumulated by most of the developed nations since the COVID-10 pandemic. In our view, this will become a significant issue at some point in the future. It was an important factor in the recent UK parliamentary election. But in general, we do not believe federal debt will be a problem this year, particularly with the US debt markets single-mindedly focused on the timing of a first Fed rate cut. However, it could become a problem for the markets in 2025.
Economic data helps the Fed
July’s University of Michigan consumer sentiment survey showed a fourth monthly decline, falling from 68.2 to 66.0, down to its lowest reading since November. Consumer expectations led the weakness, dropping from 69.6 to 67.2 and current conditions fell from 65.9 to 64.1. This survey will be revised later in July and the Conference Board consumer confidence indices will be released at the end of the month. Both surveys have shown consumer sentiment declining since early this year. See page 3.
Total retail & food services sales were unchanged for the month of June on a month-over-month basis and up 2.6% YOY. This report was better than consensus expectations, however, after adjusting for inflation, real retail sales fell 0.7% YOY. This represented the 15th year-over-year decline in the last 20 months. Historically, year-over-year declines in real retail sales materialize only during recessions. This has been one of those uncanny recession indicators that has not worked in 2023 or 2024. Nonstore retailers continued to provide a growing portion of total sales and increased 8.8% YOY. Food services were also strong, rising 4.6% YOY. See page 4.
As noted, headline CPI rose 3.0% YOY in June, slightly below the 3.1% seen in January with much of the improvement due to monthly declines in apparel, energy, and transportation prices. Still, inflation remains sticky in many areas, particularly in the service sector where the broad service sector index has shown prices waffling at roughly 5% YOY for the last seven months. See page 5.
This service inflation explains why, despite a steady decline in owners’ equivalent rent (OER), headline CPI has been stuck at the 3% to 3.5% level for the last eight months. Owners’ equivalent rent is said to be the main factor keeping the CPI index above 3%, but that does not appear to be accurate. Service sector inflation has been the problem in 2024, particularly in all areas of insurance. See page 6.
What helped lower OER this year has been price declines in household furnishings and operations and fuels & utilities. More recently there have been signs of decelerating inflation in tenants’ and household insurance. But fuels & utilities pricing has been on the rise in recent months, which could become a problem. Plus, inflation has been accelerating in medical care, food at home, and other goods and services. See page 7. These are the factors that are a burden on many American households. Nevertheless, economists are focused on the trends in all the core inflation benchmarks – CPI, PPI, PCE – which are lower and favorable. This has led economists to shift back to forecasting two to three rate cuts this year. One factor on the Fed’s radar could be wages which grew 4% YOY in May and 3.7% in June. We believe the Fed would be more comfortable lowering interest rates if wages were growing below the inflation rate, or at least below 3%. This would eliminate the risk of built-in inflation, sometimes called a wage-price spiral. Import and export price indices were negative in 2023, due in large part to a strong stable dollar and a stable-to-hawkish Fed, and this helped tame inflation. This should continue to be true in the near term, but future Fed rate cuts could result in a weaker dollar and lead to higher import prices. See page 8.
Gail Dudack
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