US Strategy Weekly: Half Time

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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