Stocks moved sideways yesterday with very few changes in the major averages. This outcome was despite negative reaction to earnings reports from Dow components Johnson & Johnson# and Goldman Sachs#. Bond yields continued to move higher with the 2-year Treasury yield now back above 4.25%.
I was speaking to one of my partners yesterday who voiced optimism. The notion that new generative artificial intelligence (AI) software could have a positive impact on future productivity and India’s possible emergence as an economic power, combined with lower inflation suggested a bullish outlook despite the risks of near-term recession that has been well advertised and already priced in. While I agree that the potential of AI to boost productivity is exciting, and accepting that India might be an emerging economic power, I still believe the combined weight of pending economic decline and high interest rates are too big a near-term burden for equities.
Look at the reactions so far to the major companies that have reported. Names like United Healthcare, Johnson & Johnson, and Netflix all reported fine results. Yet their stocks dipped. Very rarely do companies report quarterly results so good or so bad that the inevitable reaction is obvious. For big complex companies, that likelihood is even less. When investors are in a good mood, they latch onto the favorable news and outlook driving prices higher. In times when the mood is sour, they nitpick and let the negatives dominate. What you saw in the three names above was an example of the current pessimistic mood. There weren’t any real surprises in the results of any of the three. There was plenty of good news to latch onto. The negative aspects could or should have been well anticipated.
There are a few exceptions. I was drawn to the action of Charles Schwab since it reported earnings. Schwab has been in investor crosshairs for weeks after the recent bank failures. Its earnings are going to be hurt by the fact that its customers are moving cash rapidly into money market funds. That hurts its interest margin spread. This is a fact everyone knew before the company reported earnings Monday. Even though results, like the three I mentioned above, were generally within the realm of expectations, analysts generally refine their estimates and price targets after earnings are reported. I saw that at least eight brokerages lowered price targets on Schwab’s stock. Despite that, the stock rose. Could that be a sign of seller exhaustion? The answer is yes, assuming fundamentals don’t deteriorate further. In a bear market, seller exhaustion is exactly what you want to see.
Schwab and perhaps the regional banks set to report this week, are simply a small part of the overall picture. The reality is that the Fed may be winding down its plan to raise the Fed Funds rate to 5%, but the impact hasn’t been completely felt within the economy. The first industry to be hit was housing. The impact was immediate. Starts dropped sharply. Resales dropped even more. The combination of high prices and high mortgage costs saw sales tumble. However, the actual earnings impact is only starting to impact the economy. Resales don’t impact GDP. They are a transfer of assets, not a sale of goods and services. New home builders still had large backlogs to work off even as demand was falling. 2022 was a record year for most of the major homebuilders. This housing correction was far different that 2008. There are few foreclosures and few forced sales. While high prices and mortgage rates have scared away buyers, weak demand and lower prices have signaled sellers that now may not be the time to put homes on the market. Thus, inventories of homes for sale are down. Activity is way down. That impact feeds through the economy. Less turnover means less furniture sales. Fewer new TVs and lawnmowers.
Look at the auto industry, another that is impacted by higher rates in normal times, but 2020-2022 weren’t normal. Supply chain constraints meant empty dealer lots. A year or two ago you couldn’t find a new car to buy. So demand was pushed out until inventories started to arrive. They are just now arriving. Catchup demand overcame the impact of higher rates, but the catchup period is winding down and rates are still high. Thus the impact of higher rates, which in normal times should have been felt last year, is now likely to be felt later this year.
How about technology? Growth there at times is so strong that the impact of varied economic cycles has less impact. Aha! But this time is different. Covid moved us back into our home offices. Companies had to scurry to be able to serve customers from anywhere. We soon found out that while front line workers couldn’t work from home, millions could. So, there was a surge in demand for computers and all that tech gear to support networking and cloud development. At the same time, tech sectors that emerged and surged in the first two decades of the 21st century were maturing. Who doesn’t use Amazon? Or Google? Who doesn’t own a smartphone? And, by the way, our phones last longer. The new ones don’t offer enough incremental features that has buyers lined up outside stores the day of introduction. Thus, instead of more growth, we got more layoffs.
All these slowdowns, are now coming home to roost. Unemployment claims are rising. Home sales continue to fall. Car sales will follow soon. Manufacturing activity is falling. Demand for commercial real estate is soft. Even apartment rents are starting to fall with a record number of new apartments coming to market.
Reported economic data is backward looking. What we still see is resilience lifted by catch up demand for experiences like travel and rock concerts. Layoffs aren’t pervasive yet. Your lifestyle when you are employed changes once you lose your job. I think the message of this earnings cycle is that the worst is yet to come. Backwards data doesn’t show that. Most assume weakness in the second half. When a storm approaches us, we know that we have to pay attention, but the reality of the impact often can exceed expectations.
So, let me go back to the earnings reports I mentioned earlier. The reactions to Johnson & Johnson, and Goldman Sachs suggest more negative adjustments ahead. However, there are exceptions, like Schwab, that say at least for some, most of the bad news is priced in. So I will leave you with one last name, ASML Holding NV. This is a Dutch company that absolutely dominates the high-end lithography market for semiconductors. If you make high end chips, you use ASML’s products. They had a great quarter and a tepid outlook. We all knew that going in. Its stock is down 2.5% this morning nonetheless. Simply said, the worst isn’t fully discounted yet.
That doesn’t mean the market is headed for new bear market lows. It means the idea of an upside breakout near term isn’t high. We are approaching that time of year when “sell in May and go away” is the message often in vogue. It may be apt this year. I haven’t mentioned higher interest rates yet, but as yields climb into the middle of recent ranges, the likelihood that rates will decline sharply from here is reduced, eliminating another positive tailwind for the bulls. I still see 3800-4200 as a trading range for some time until we start to hear of “green shoots”, early signs that the weight on the economy is starting to dissipate. Historically, bull markets don’t begin before a recession starts. Yes, as my partner noted, this time could be different. It could be. But I don’t think so.
Today, Kate Hudson is 44. Artist Fernando Botero turns 91.
James M. Meyer, CFA 610-260-2220