Stocks managed to eke out a small gain after trading lower for much of the session. With the next FOMC meeting less than two weeks away, the yield curve has flattened a bit reflecting investor optimism that lower rates could spur economic growth and a slight increase in the rate of inflation.
This week has been mostly about earnings. What economic data we saw was mixed-to-negative. The highlights were a decline in leading economic indicators, a harbinger of a slower economy ahead, and weaker than expected housing data. Those items are almost sure to reinforce the Fed’s likely decision to cut interest rates. It is even possible that it could cut rates by 50 basis points instead of 25. That, however, is still a long shot. While it definitely would give the economy a shot in the arm and would be cheered by equity investors, it also could send an unintended message of excessive concern over the state of the economy.
As for earnings, most of the reports to date have come from banks. Generally, the numbers have matched expectations or even been a bit better. The highlight was solid loan growth, a sure indication of a stable and growing economy, albeit growing slowly. Bank stocks have performed decently over the past few months but have been consistent laggards over the past several years. They are thought of as early cycle stocks, equities that outperform at a time when the central banks are stimulating aggressively to help lift an economy out of recession. Late in the economic cycle bank stock outperformance is unusual.
But a curious thing seems to be happening in this market. Banks aren’t the only early cycle group coming alive. A few homebuilders (e.g. Pulte) are at 52-week highs. Ford and GM are acting well. While the performance of brick-and-mortar retailers is spotty, those that have solid growth are also doing well. Why are these stocks suddenly coming alive late in an economic cycle?
The answer may be that we are, in fact, entering a new cycle as the central banks once again start to ease in an effort to lift inflation and, secondarily, stimulate more economic growth. We aren’t talking about fierce rate cutting or the massive purchase of bonds by the Fed in the open market. We are talking about modest steps to reenergize an economy that was showing signs of old age. Thus, in a sense, we are potentially entering a new phase of an aging bull market, one that will see some acceleration fed by lower rates. That is exactly the catalyst that classic early cycle stocks need to reinvigorate themselves. Will these stocks become true market leaders? Maybe not. But most sell at low P/E ratios, sport healthy dividends, and have improving balance sheets. Many are actively buying back stock. And a company can buy back a lot more stock when it sells at 8-10x earnings than when it sells at 20x or more.
Away from banks, a few key technology companies reported. IBM# surprised many with a nice improvement in gross margins. After so many disappointing quarters, this was a welcome surprise. Microsoft#, which has almost always exceeded expectations in recent years, did so again last night. One can hardly describe its stock as cheap but when a company is able to beat expectations consistently, it usually attracts buyers.
Overall, so far, earnings season is about as expected. Companies are beating analyst forecasts by a few percentage points and look forward to the second half of the year with cautious optimism. When the dust starts to settle a couple of weeks from now, what looked to be a down quarter going into earnings season may turn out to be flat or even up a tad.
The next two weeks will hold the key as the vast majority of S&P 500 companies report. The fact that there have been few big misses so far and few preannouncements may be a harbinger of better than expected results.
The one notable miss this week was Netflix. After reporting smaller than expected subscriber growth and an actual decline in the U.S. on the heels of a price increase pushed some to disconnect. With major new services, like Disney Plus, getting ready to roll out and others, like Hulu and HBO Max gearing up for major expansion, the competitive landscape is only going to become more fierce. At the same time more services are fighting for the same subscribers, programming costs are climbing as the various channels bid for top talent. Time will tell how this will all shake out. Netflix will stay a leader, but whether it can earn enough money to support today’s stock price was brought into question this week.
Today, former Starbucks Chairman Howard Schultz is 66. Queen guitarist Brian May turns 72.
James M. Meyer, CFA 610-260-2220