US Strategy Weekly: Liquidity Beats Valuation

Immediately after the Federal Reserve lowered the fed funds rate by 50 basis points last week, the debate shifted from when will the Fed cut rates, to what does a 50 basis-points cut mean? The table on page 3 shows all the easing cycles in Federal Reserve history that began with a cut of 50 basis-points or more. Of the 12 prior instances, five of these cuts occurred with a recession already in place (although that may not have been known at the time) and two other cuts preceded a recession by a few months. One 50 basis-point cut, in 1967, was a one-off, and the Fed soon returned to a tightening policy. In short of the 11 easing cycles that began with a 50 basis-point cut, seven, or 64%, were associated with a recession.

However, the current cycle is unique since the economy and inflation have been driven by a combination of trade disruptions and fiscal and monetary stimulus. With these external factors returning to normal, it is possible, perhaps even likely, that the economy will have a soft landing. But in our view, it is also possible that the economy falters badly once fiscal stimulus fades. The key to the economy’s next move will be the unemployment rate. As seen in the chart on page 3, if the unemployment rate continues to rise, the odds of a recession will increase substantially.

Nevertheless, the current backdrop for the equity market is promising. The Fed has begun to lower rates and its balance sheet, despite quantitative tightening, is $7.23 trillion, up 70% from the $4.21 trillion seen at the end of 2019. Plus, liquidity in the banking system remains high. For example, other liquid deposits are $10.58 trillion, down from a peak of $14.0 trillion, but assets such as demand deposits, retail money market funds, and small-denomination time deposits, have been increasing. As a result, banks held $18.8 trillion in liquid deposits for customers as of August 5^th, down only 5.5% from their April 2022 peak. See page 4.

This is good news since liquidity is a key ingredient for a bull market. At present, liquid deposits at commercial banks equate to 34% of total US market capitalization. This percentage is down from the 48% recorded in January 2023, but it is much higher than the 12% to 14% seen at the end of 2019. It is also well above the average seen over the last 30 years, or 22%. Total assets of commercial banks were $23.46 trillion as of September 11, 2024, more than 35% greater than the $17.7 trillion recorded at the end of 2019. See page 5. Overall, the banking system is awash in cash which supports equities, particularly since the Fed is, and is expected to continue to lower short-term interest rates.

What does not support equities is valuation, but if the current rise in stock prices is the start of a melt-up, or a bubble, valuation will not matter, at least in the short run. The S&P 500 trailing 4-quarter operating multiple is now 25.2 times, and well above all long- and short-term averages. The 12-month forward PE multiple is 21.5 times. When this multiple is added to inflation of 2.5%, it sums to 24.0, which is above the top of the normal range of 14.8 to 23.8. By all measures, the equity market remains richly valued and is at levels seen only during the 1997-2000 bubble, the financial crisis of 2008, or the post-COVID-19 earnings slump. But it is worth noting that those prior markets peaked when the 12-month trailing PE multiple reached a range of 27 to 31. In other words, if this is a bubble market, it could move higher. See page 6.

But this may depend upon the results of the upcoming third-quarter earnings season. The S&P Dow Jones consensus estimate for calendar 2024 is currently $237.26, down $0.44 this week, and the 2025 estimate is $276.62, down $1.05. The LSEG IBES estimate for 2024 had a typo this week, but the estimate for 2025 is $278.71, down $0.94, and the guesstimate for 2026 EPS is $314.37, down $0.52. The current pattern of equity prices soaring, while earnings estimates are falling for 2024, 2025, and 2026, is unsustainable and worrisome. This means third quarter earnings results, and corporate guidance, will be critically important for equity investors. See page 7.

Recent data on housing permits and starts for August were favorable and erased all of July’s declines. Existing home sales fell slightly in August and were down 4.2% YOY. The median price of an existing home fell to $416,700, but was still up 3.1% YOY. Months of supply of homes rose from 4.1 to 4.2. However, Moody’s Delinquency Tracker showed commercial delinquency rates are on the rise and in particular, the office sector delinquency rate rose to 9.18%, up from 5.5% in January.

September’s Conference Board consumer confidence survey showed the headline index fall from an upwardly revised 105.6 in August to 98.7, near the bottom of the range held over the last three years. The present conditions survey tumbled from 134.6 to 124.3, the lowest level since March 2021. The expectations index fell from 86.3 to 81.7, but remained above the 80 level for the third consecutive month. Consumers have become more pessimistic about the outlook for business conditions, the labor market, and future incomes. We reported University of Michigan data last week. That sentiment survey showed a small bounce in September, but all three indices — overall, present, and expectations — remained near recessionary levels. See page 8.  

This week China announced its largest stimulus package since the pandemic, which included, among other things, lower central bank rates, lower mortgage rates, minimum down payments on real estate transactions, and a 50 basis point decline in the RRR (reserve requirement ratio). Although analysts warned that the weakness in the economy would require more fiscal stimulus, China’s stimulus program was the catalyst for a global equity market rally. It also triggered a small increase in crude oil prices and a rise in US interest rates. With the 10-year Treasury yield currently at 3.74% and the 2-year Treasury yield at 3.49%, the yield curve inversion has been unwound. And inversions are unwinding in many parts of the world including the UK, Germany, and Canada. Some economists warn that the unwinding of a yield curve inversion represents the most vulnerable time for an economy. This may be true once more. If so, the unemployment rate will be key in the months ahead. See page 9.

The broadening participation in the equity market helped the Dow Jones Industrial Average reach a record high on September 24, 2024. Moreover, the DJIA gained 7.9% in the quarter to date versus the 5% gain seen in the S&P 500. See page 14. Stocks are responding favorably to the Fed’s rate cut and China’s stimulus program and this has resulted in much-improved readings in breadth data. For example, the 25-day up/down volume oscillator is 2.33 and was overbought for seven of the eight days ending September 19, and the last six were consecutive. With many of the indices at or near all-time highs, it is important for this indicator to confirm the advance with an overbought reading lasting at least 5 consecutive days. If the rally which began in October actually was a new bull market advance, it should also include several extreme overbought readings of 5.0 or better, which are typical of the first stage of a major advance. To date, the 4.07 reading is the best seen since December 2023 which is encouraging. This six-day overbought reading was not overly impressive, but it was the best demonstration of volume following prices seen since the end of last year. It is clearly positive for the near-term outlook. See page 11. In addition, the 10-day average of daily new highs is 600 and new lows are 44. This combination of new highs above 100 and new lows below 100 is positive. The NYSE advance/decline line made a new record high on September 24, 2024, confirming the rally. See page 12. In sum, for the first time in a long while, all the broad breadth indicators are uniformly optimistic.

Gail Dudack

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