Stocks slumped again on Friday ending their worst week in over a year. The decline was one part investor skittishness, one part the lack of corporate stock buybacks, one part fear of an Iranian attack on Israel over the weekend, and one part a poor reaction to Friday’s earnings reports by major banks. Futures are up modestly this morning after Israel and its allies thwarted most of the drone and missile attacks without significant damage, but nerves are still on edge.
Politics and warfare are beyond the scope of these letters. Simply said the options that Israel, Iran and the U.S. have today are many and range from standing down to military escalation. Logic comes into play but only in part. We should learn a lot more over the next several days and weeks. Until then, nerves will be on edge. As I note often, as far as equity investors are concerned, the focus is on dollars and cents. One place that is evident is the price of oil, which has been on the rise in recent weeks. Given that the worst of possible outcomes didn’t happen over the weekend, oil futures are modestly lower this morning.
Barring an escalation or immediate retaliation, the market’s focus this week should return to earnings. Friday’s reaction from the three major banks that reported is instructive. The numbers were generally in line. The warts within the reports were largely expected. Small business loan demand was weak as was demand for home mortgages. Deposits shifted money from low or no interest deposit accounts into alternatives like money market funds. All that was expected. Yet the stocks of all three major banks that reported fell. Does that mean meeting expectations but not raising future outlooks will trigger selling as others report earnings? That’s a question that will only be answered as additional companies report earnings.
When times are good, momentum is strong, and bulls have an infectious story to tell, stocks move higher. The November-March rally was all about a Fed pivot, a soft landing, and a brave new world where growth and productivity would be enhanced by artificial intelligence. At the time of the Fed pivot, inflation was declining at a moderate pace and 6-7 rate cuts were expected by the end of 2024. At the same time, recession fears continue to ebb. They haven’t disappeared; they never do. But they are certainly less today. As for AI, the promise is still there although the actual impact is still largely in the future.
What has changed over the past couple of weeks is the mood. A few days of sharp declines will do that. Skepticism has replaced euphoria. Trump Media’s stock has seen its value cut in half for no other reason than the hype that pushed it close to $80 per share was beyond all logic. It probably still makes no economic sense at today’s price. The FTC, the Justice Department and equivalent agencies in Europe are all becoming more active using their legal powers to make big tech companies behave. Washington over the past two weeks has sharpened its focus on health care insurers squeezing Medicare Advantage providers. One big difference between traditional Medicare and Medicare Advantage is that the former is completely funded and run by the Federal government while the other is funded and run in part by private enterprise. The ability of Medicare Advantage providers to control costs and utilization within a largely closed network allows them to charge less and yet make a profit. Now Washington wants to squeeze that profit opportunity, which will work to lower provided benefits and shift some Advantage users toward traditional Medicare. Needless to say, Medicare Advantage providers have had a bad few weeks in the market.
We can’t forget it’s election season and Washington will do as much as it can without the help of Congress to entice voters using the power of the purse, either by lowering user costs or by other means, such as student loan forgiveness. The events of this past weekend will put aid to Israel and perhaps Ukraine back on the front burner. Speaker Johnson clearly doesn’t have firm control of his conservative bloc but public opinion to do something could alter the balance. Given his tiny majority, it is likely that nothing can happen without Democratic help.
The question for investors now is when will the optimism return? Earnings season will give lots of answers. While first quarter results are likely to show only modest growth, the expectation is that earnings growth will accelerate as the year progresses. Management commentary that accompanies earnings announcements will impact that consensus in either direction. The return of corporate buybacks that will start for the early reporting companies over the next couple of weeks will also help. But perhaps the biggest hurdle rebuilding momentum will be valuation. The 10-year Treasury yield is now around 4.5%. That is incompatible with a market P/E over 20 times future earnings. That yield will come down for one of two reasons. Either growth will slow raising recession fears, or inflation will slow at a more accelerated pace than we have witnessed over the past 3 months. Without one or both, the valuation headwind is likely to slow the pace of advancing stock prices, create a choppy sideways market, or continue the correction that began this month.
Lower stock prices have created a few bargains. But it is too early to declare the correction over. Indeed, a correction of as much as 10% would be consistent within the context of a long-term sustainable bull market. In the investing world, patience is often a virtue.
Today, Seth Rogen is 42. Emma Thompson turns 65.
James M. Meyer, CFA 610-260-2220