Roughly 75% of the time, stocks go up. They go up because earnings rise. They don’t go up in a straight line for obvious reasons. Interest rates fluctuate. Central bank actions are impactful. With that said there are periodic bear markets. While occasionally they represent a correction of a severely overvalued market, most bear markets coincide with recessions or some other form of financial crisis.
What we have today doesn’t seem to be the ingredients for a bona fide bear market but rather an elevated level of uncertainty. The yield curve remains inverted. Some key indicators are sending out alarm signals. Unemployment rates are rising, the labor market is softening, and that triggers a certain amount of angst. We also face a Presidential election between two candidates whose economic positions are not entirely clear. Trump favors lower taxes and less regulation but he also wants to impose tariffs on all imports, deport hundreds of thousands if not millions of immigrants, and shoots from the hip in a very unpredictable fashion. Harris is even more of an unknown factor. On the surface she is a California liberal closely tied to President Biden’s economic agenda, but wanting to act more of a centrist at times, reaching out for moderate votes. Both agendas, as vague as they are, seem on a path to escalating deficits at a time when Federal debt service is already greater than defense spending and approaching what is spent on Social Security.
The Fed itself is at the cusp of a major change, morphing from a laser focus on reducing inflation toward its 2% target, to ensuring that economic growth is stimulated enough to avoid a recession. Given the Fed’s past track record, assuming total success is a dicey assumption.
Despite all the ups and downs this year, earnings estimates for both 2024 and 2025 have changed very little. S&P earnings forecasts of $245 for 2024 and $275 for 2025 haven’t changed much. In addition, while the Fed will almost certainly lower the Fed Funds rate rather persistently through 2025 at a pace yet to be determined, given consensus growth assumptions, it is hard to see the 10-year Treasury yield moving very far from its current 4.0% return. By not very far I mean plus or minus 50 basis points.
The earnings estimates for both this year and next seem to indicate growth rates close to 10%. But that paints a distorted picture. Almost all the gain is concentrated within the technology sector where rapid spending related to an expected surge in artificial intelligence activity is leading to billions of dollars being spent developing the necessary infrastructure. Some may argue that too much is being spent. Some may argue that AI isn’t all it’s cracked up to be. But in a disruptive technological revolution, while the path upward isn’t a straight line, AI is for real. With that said, away from AI, we see cracks in the economic picture. Inflation has made housing unaffordable to many, even taking into consideration the recent decline in mortgage rates. Retail sales appear to be weakening a bit as consumers exhaust their excess Covid savings and start to build credit card balances. Inventories start to pile up as the pace of growth slows. That impacts manufacturing activity. Truckers are in a near recession state already.
I like to think of the image of a saucer, high around the edges and lowest in the middle. If the economic outlook bears any resemblance to a saucer, the key question is, where is the bottom? Above the zero-growth line (a soft landing) or below (a recession)? No one has the answer, not me, not the Fed, and not the brightest economists.
Thus, we are in a state of transition, one involving monetary policy, employment outlooks, the state of the consumer, the outcome of an election, and, most importantly the path to future earnings growth. If the economy decelerates into recession, the $275 S&P 500 earning estimate for next year won’t be achieved. If, however, we pass the bottom of the economic saucer early in 2025 and growth begins to reaccelerate, markets will respond and stocks will move back to record highs.
One of the key questions facing our economy is why the impact of higher rates has been so muted during this cycle, leaving the yield curve inverted for a very extended time. The answer lies with Fed policy before it began to raise rates in 2022. Prior to that rates were near zero for a very extended period. Many millions owned homes with very low mortgage rates and weren’t going to move. Rising rates may have held them back from moving, but they didn’t increase the cost of staying put. Similarly, those who bought or leased cars at ultra-low rates, either bought out their lease at termination or simply held onto their cars longer, rather than financing a new purchase with higher rates. As for the impact of high rates on credit card balances, consumers paid down their balances with the extra cash given to them during Covid. And those with excess cash now got paid 5% to keep money in money market funds versus zero prior to 2022.
People eventually have to sell their homes. They move, someone dies, family size dictates change, etc. At some point cars wear out and have to be replaced. Once excess cash is used up, consumers start to feel the pain of higher rates on their credit card balances. We have been at the cusp, finally, where those higher rates are starting to hurt, more than two years from the time the Fed began to be restrictive.
I said at the start that most of the time, stocks go up. Even if a modest recession occurs, it shouldn’t become a serious one. But even a mild recession can cause a 20% decline in stock prices from peak to trough. At last Monday’s close, markets were almost halfway there. We will see hints of consumer behavior this week as the big retailers begin to report second quarter earnings, starting with Home Depot# tomorrow. Wal-Mart, the 800-pound gorilla, reports on Thursday. What we are looking for is any commentary that leads to a change in attitude by the consumer and, by extension, a change in attitude on Wall Street toward consumer spending. There will be economic reports this week on retail sales and consumer prices, but I think that what the retailers say overall may carry more weight. Next week the Fed holds its annual Jackson Hole conference. Most likely, comments will set the table for an initial Fed Funds rate cut in September, the size of which will be determined by economic data between now and the September FOMC meeting.
Over the next several months, a lot of today’s uncertainties will be resolved or come into clearer focus. By early November, we will know who will be the next President, the Fed will have initiated its rate cutting program, and more data will give us a better picture as to whether a soft landing or recession is more probable. Wall Street hates uncertainty. When uncertainty is elevated, that often leads to elevated volatility. I expect the next two months to be more volatile than the first half of this year. Last week saw an enormous spike in volatility only to end almost exactly where it started. Until some of the key uncertainties are clarified, that sort of behavior may be more common than one would like to see.
Today, Pete Sampras is 53. George Soros turns 94.
James M. Meyer, CFA 610-260-2220