After a strong start following three sessions of losses, the Dow reversed course in early afternoon and fell sharply. All major averages fell at least 1.2%. It was the worst day for the Dow in a bit over a year. If there was a triggering event, it was a comment by a Fed President that it is possible that there will be no Fed Funds rate cuts this year. While that comment contributed to the decline in stocks, bond prices moved in the other direction.
A lot of Fed officials spoke this week, Of course, the most important was the Chairman, Jerome Powell. He reiterated that he expects cuts to begin later this year, probably starting in June. While comments of others seemed to spook the market, I don’t think equities are reacting to any sudden negative news this week. Manufacturing numbers have been strong while auto sales were weak. 10-year Treasury yields have anchored themselves a few basis points above their recent range, but you can’t go crazy about a few basis points change in yields. The most important economic report comes today. Trying to predict the exact change in monthly job totals is foolish given the big subsequent revisions. Lately, monthly employment growth has averaged close to 200,000 jobs. Any number today between 100,000 and 300,000 would violate recent trends which have already been discounted. There will be focus on the unemployment rate as well as changes in the average wage. Inflation doves will want to see modest wage increases. Last month’s spike in the unemployment rate was concerning but not worrisome by itself. Another similar spike, which would be accompanied by a contraction in the labor force, could suggest a tighter labor market than the Fed wants to see.
There is demographic downward pressure on the size of the labor force. Simply said, more boomers are retiring than the number of young Americans starting to work. But that leaves out two factors, the impact of immigration, and so-called retirees doing part-time work. Both are likely undercounted in the Labor Department’s statistics. Whatever. The market today will focus on the labor report because it has nothing else to focus on. But that report is unlikely to change the general trend of the economy toward continued growth and moderation of the pace of inflation.
Thus, what is likely happening in the market this week is simply an old-fashioned correction of an oversold condition. Stocks are up 5 months in a row. The first half of that rise was directly attributed to a decline in the 10-year Treasury yield from 5.0% to close to 4.0%. But this year-to-date, yields have rebounded a bit, something that logically should be a headwind to stocks. Economic strength has continued, but so far there have been only modest changes in earnings expectations. One must ponder whether a strong stock market pushed strategists to raise estimates for 2024 earnings or whether higher growth expectations pushed stock prices higher.
One factor that certainly helped was the expanding use by corporations of free cash flow to buy back stock. According to company filings and Goldman Sachs published estimates, American corporations are on track to buy back $925 billion of stock this year. That’s approximately triple what they bought back in 2010. The biggest buyers of their own stock are the members of the Magnificent 7. Their filings suggest they will buy back $215 billion alone, 30% higher than last year. The average market cap of the 7 is well over $1 trillion today. The average buyback is about $30 billion or approximately 3% of shares outstanding. That may sound trivial but it’s not. Think of the game of musical chairs. 19 chairs and 20 contestants will still get everyone to scramble when the music stops. A one or two percentage point change in occupancy rates can cause an outsized change in air fares.
Stock prices may be dependent on earnings and interest rates, but in the end, they are a function of the laws of supply and demand. Reduce supply by up to 3% and you have a nice tailwind to price. Right now, companies generally are forbidden to buy back their own stock. The first quarter is over, managements have a reasonably good idea what results will be, and they are, therefore forbidden to buy back shares until after earnings are reported. Among the Magnificent 7, only Nvidia# is not on a calendar quarter. Thus, there is logic to a correction starting April 1 as stock buybacks ended.
The absence of buyback activity isn’t the only cause of a correction. It’s just an accelerant. A day like yesterday gets accentuated by short covering. Traders who saw moderation in downward pressure Wednesday followed by a strong opening yesterday had to reverse course once markets tanked in the afternoon. Again, I wouldn’t read too much into yesterday afternoon’s freefall. If bond yields had spiked along with declining equity prices, I would have been more concerned.
But corrections, and by correction I mean a decline of at least 5%, don’t end without some elevation of fear and, ultimately, some capitulation by weaker hands disposing of stocks in fear of greater losses. I said Wednesday that I didn’t know if the Monday-Tuesday fall was simply a head fake or not. Yesterday’s losses say that barring a perfect employment report today with noticeably weaker wage growth, near term caution is warranted. The next big number is next week’s CPI report. Right now, the Fed is looking at higher-than-expected inflation readings in January and February numbers as an aberration. A stronger than expected March number would suggest a trend, not an aberration.
But the real bottom line is that nothing has changed from the macro conclusion that the economy continues to grow and inflation continues to moderate. What has changed, if only for the moment, is that trader euphoria has begun to ebb a bit. A correction of an overbought condition is a good thing. It replaces hype with value. A real correction is larger than 2-3%. One should also note that aside from the Magnificent 7, both earnings and margins for the rest of the S&P 500 were down in the fourth quarter and will likely be down again this quarter. If there is to be renewed upside momentum, companies this earnings season have to offer a pathway toward better margins and higher earnings later in 2024. We should see that in the tech sector and in core manufacturing. You will see it from the home builders and insurance brokers. Retail will be a mixed bag. Those appealing to consumers and gaining market share should do well. Others, squeezed by competition won’t. Weaker auto sales in February suggests caution of that sector. Higher oil prices are likely seasonal but will be an added cost to many. Note that while oil prices are at a multi-month high, natural gas prices in the Permian basin are now negative at the wellhead, meaning producers have to pay buyers and pipeline operators to take the gas away. Low gas prices are another economic casualty of climate change.
The bottom line is that long term investors should look at any correction as an opportunity to buy the dip. No one is likely to be able to predict the exact bottom. So, buying cautiously on the way down has merit. At the same time, downturns can be steep and frightening. No one wants to catch a falling knife. There is nothing wrong with letting a correction run its course, wait for two solid days of recovery, and then buy. Long term, if you are a few percentage points too early or too late, it won’t matter. But if a 2% correction morphs into a correction of 10% or more, it will be painful in the short term if you lack patience. The best program is to isolate what you want to buy, set a lower but realistic buy point, and don’t start nibbling until the market comes down to your buy target. Good hunting.
Today, Pharrell Williams is 51. If you are an old-time movie buff, I would note that Spencer Tracy, Bette Davis and Gregory Peck were all born on April 5.
James M. Meyer, CFA 610-260-2220