As August winds down, stocks show a better tone. Yesterday, it was the NASDAQ that led the charge, rising by more than 1%. At a time when both economic and corporate news is sparse, equity investors take their lead from the bond market. 10-year yields fell almost 2% yesterday and stocks followed suit.
This morning, yields have rebounded a touch and stocks are directionless in early pre-market trading. Again, the news calendar is light with only a few remaining earnings reports. Friday we will see the August employment report, potentially a market moving event. As everyone is aware, August is a relatively quiet month economically with so many around the world on vacation. Most economic data is seasonally adjusted. Seasonally adjusting sparse data often leads to the wrong conclusion. Whatever employment numbers we see Friday, I would take them more seriously if I look at 3-month trends. July saw some weakening in employment growth, more than some if I pay attention to revisions of prior months’ data. There is no logic to expect a resurgence in August, nor is there any logic to expect material weakness. As always, when fighting inflation, a lot of attention will focus on employee cost numbers. While the rate of growth is coming down, it has stayed too high for comfort for those battling inflation (i.e., the Federal Reserve). Both labor employment numbers and the pace of change in wages are lagging indicators. One lays off workers after business starts to decline, not before.
Speaking of inflation, the Case-Schiller home price index rose for the fifth straight month, another sign that inflation hasn’t disappeared. The futures markets are basically split as to the need for yet another increase in the Federal Funds rate in November. November is simply too far away to make any sort of intelligent guess now. With that said, markets will always look ahead and guess. Friday’s data will change the odds of a rate increase in November. Given the sparse amount of data to digest, any outlier move within Friday’s report will have an outsized impact. Judging only by yesterday’s market action, traders are betting early that employment growth will be modest and that wage rate increases will moderate.
August is a month when earnings reports are dominated by retailers. The 800-pound gorilla in the room is Wal-Mart and it reported strong results. Its performance is testimony to good management, but also shows consumer purchases emphasized staples (half of its sales are groceries) and value. While some higher priced retailers had OK results, there were a lot of misses within the August reports. More importantly, virtually every retailer warned of tougher times ahead. The reactions on Wall Street varied. Best Buy# had lousy numbers that still fit within the range of expectations and its stock rallied about 5%. At the other extreme, Foot Locker’s results were well behind weak expectations. Its shares fell 20%. Overall, it was a tough month for retail. Since consumer spending accounts for close to 70% of GDP, what retailers say warrants our attention.
With that said, I want to step back and try to better understand the impact of inflation. Inflation data measures the immediate-term change in prices. An inflation reading of zero means prices last month were the same as the month before. Most of the time, when inflation is reported, we look at year-over-year changes. But we also need to note that peak inflation readings happened in mid-2022. We have now anniversaried those numbers meaning anything that happened before August 2022 is now forgotten. As least it is forgotten by data watchers.
But we consumers cannot forget so easily. Forecasters who are bullish on spending point out that accumulated savings today are still higher than they were in 2019 before the pandemic. That’s true. But the purchasing power of savings today has to be adjusted for interim inflation. In July 2023, the CPI was 19.5% higher than in August 2019. In many cases, (e.g., restaurants) the rate of change is significantly higher. While in recent months, as wages rose and the pace of inflation receded, Americans are finally making real headway. But that hasn’t erased the pain of inflation in 2020-2022. In round numbers, the buck in your pocket today will buy you 20% less than it could have bought you in 2019.
Few think about this. But we all feel it. We spend what we have after paying the rent and filling up the gas tank. But when we lose purchasing power, we end up asking ourselves, “where did all the money go?”. That’s why recessions often come upon us suddenly. At the surface, we hear the bad news. Intuitively, we suspect that at some point it might affect us. But as long as we have a comfort cushion, life goes on. That happens until the comfort cushion goes away.
If it goes away. Right now, there is debate whether we face a soft landing or a recession. It all comes down to whether the comfort cushion disappears or fades to the point where our behavior changes. There are signs of changing behavior. Lower income Americans are starting to fall behind on debt and credit card repayments. The levels of default are still not alarming but the rate of change raises yellow flags. Gasoline prices have been rising again. That starts to take money away from discretionary spending. Higher interest rates mean more money has to go to service debt including new mortgages. Mortgage purchase applications are at a 2+ decade low. Despite all this, Americans are still traveling and they are still spending. Unemployment remains very low. If we all have jobs, the collective thinking suggests we will muddle through.
As for the stock market, it’s still all about earnings and interest rates. Earnings have fallen modestly so far this year and should continue to decline through year end. 2024’s outlook is a bit cloudy, dependent on whether there is a soft landing or recession. As for interest rates, stocks relate to the 10-year yield as the most competitive. For months, it has vacillated between 3.3% and 4.3%, a fairly narrow range. Long-term, 2% real growth plus 2% inflation suggests a yield close to where it is today. Combining earnings and interest rates, as we have done so often, the logical conclusion is that without any major change in either long-term rates or earnings, there is little reason to expect a big move in stock prices. With that said, 2023 has been a year when stock prices rose while rates crept into the upper end of their trading range. That suggests any bias at the moment should be to the downside. Given that September and early October are historically weak times for equities, I would be more interested in buying dips here than chasing rallies.
With that said, momentum money is still chasing. Modest dips in the prices of the high-profile tech names bring buyers back quickly. As long as the buy the dip mentality stays in place, momentum remains to the upside. The risk is that at some point, buying the dip fails to work either because stocks become too overpriced or the economy sinks toward recession. Picking short-term moves is hazardous. Thus, I still say, near-term, stocks are likely to take their cue from the bond market.
I want to end on a different tangent. Yesterday, the government announced the first 10 drugs that will be subject to price negotiations between CMS (Medicare) and the drug manufacturers. Of course, you hear a lot of political shouting. Conservatives yell price-fixing and the diversion of future research dollars. Progressives pound their chests saluting their support of the poor and frail. I will stay out of the politics. We will find out over time how the development of new drugs may or may not slow. But one thing is clear if you look at Medicare spending trends. If we continue down the path we have been traveling for years, there won’t be enough money to pay all the bills. Private insurance found a solution by raising co-pays and increasing deductibles. Medicare could do the same. It could also negotiate lower drug prices (or set them monopolistically as some charge). Or it could raise the Medicare tax, but it has to do something. The stark reality is that entitlements have been out of control for years. Politically, no one wants to touch either Social Security or Medicare. Seniors vote, the young don’t. It’s that simple. The steps being taken relative to drug prices are a small step. The While House claims close to $100 billion in savings over the next decade. That actual number likely will be less. That’s less than $10 billion per year. That’s a tiny number compared to the annual growth in Medicare spending. But it’s a start.
While the stocks of drug producers have been among the worst performers this year so far, they barely moved on yesterday’s news. It had already been discounted. Drug companies have been the scapegoat because we all see the prices when we go to the pharmacy. But drug price inflation has been modest for years. In most cases, there are generic alternatives that work fine. Cholesterol drugs today are a fraction of the price they were years ago, for instance. Most of the drugs subject to price negotiation announced yesterday only have a few years of patent protection left anyway. What will be important is the political reaction. The negotiated price for the 10 drugs announced yesterday won’t even go into effect until 2026. The list will expand throughout the rest of the decade. It’s a grand experiment. How well it is received over the coming years will determine whether elected officials in Washington have more or less will in the future to tackle the escalating costs of Medicare.
Today, Cameron Diaz is 51. Warren Buffett turns 93. Former tennis star Vic Seixas reaches 100 today.
James M. Meyer, CFA 610-260-2220