Stocks fell yesterday amid profit taking. While many attributed the decline to a consensus that the Federal Reserve will keep raising interest rates, a 25-basis point increase at the end of July had already been priced in. Beyond that, while Fed officials warned of further increases, history tells us that what might happen in September is still far from a foregone conclusion. Nevertheless, rates continued to increase as 2-year Treasury yields crossed 5% and 10-year yields passed the 4% barrier.
To understand why stock prices fell by more than 1% yesterday, one has to explain why they rose over 6% in June at a time when interest rates were still rising. As June began, optimism increased that there would be no more Fed Funds rate increases. But strong economic data in June increased concern that the battle to reduce inflation toward a 2% target was far from over. Bond and stock markets compete for investor dollars. It is rare for one to rise and the other to fall for a sustained period. While there was nothing really new in what Fed officials have been saying in recent weeks, markets have become more attentive as economic data remains solid.
Let’s look at the overall economy. To start, it is still growing, although there have been persistent pockets of weakness over the past year. In particular, consumers continue to spend. During the early stages of the pandemic, they spent on necessary goods including what they needed to support changes in lifestyle, like working from home or doing home repairs. Later, as the pandemic faded, they switched toward experiences. That meant everything from Taylor Swift concert tickets to family vacations at Disney World. The urge to get out and about was accelerated by money accumulated during the pandemic when one couldn’t spend on experiences and thus banked trillions handed out by the Federal government. Collectively, we are still spending those handouts.
Hotels and restaurants employ lots of people. No wonder the number of employed keeps rising. As long as the urge to travel and eat out keeps increasing, the number of those with jobs will keep rising. We will learn this morning the picture for June. Advanced forecasts predict another healthy increase. A healthy construction market adds demand for jobs. New home construction is surprisingly strong despite the fact that mortgage rates are now well over 7%. The supply of existing homes for sale is extremely low thanks to the same high rates. Who wants to sell a home that carries a 3% mortgage to buy another with a 7%+ mortgage? In addition, the non-residential construction market is starting to benefit from the $1+ trillion infrastructure package.
Thus, while the Fed continues to tighten in order to create economic slack necessary to defeat and control inflation, spending fueled by Federal government actions continues to push in the opposite direction. With that said, Congress is not agreeing to more handouts, and students are going to have to start paying back their debt beginning in October. Home building activity is likely to remain solid and the reshoring of manufacturing will continue. GDP grew close to 2% in the first half of 2023. It could moderate in the second half, but a recession now appears to be a 2024 event, if it happens at all.
For equity investors this has two primary implications. First, interest rates are likely to be higher for longer. The key to stock prices is the yield on 10-year Treasuries and other long dated maturities. One anomaly is that the spread between high and low grade bonds has actually shrunk in recent months, hardly what one would expect if a recession was pending. That doesn’t mean one won’t happen. But it does mean one isn’t priced in yet. With that said, a 4%+ yield on Treasuries and a yield of close to 7% for the highest quality junk bonds, suggests a P/E of close to 15. Currently, the S&P 500 P/E is close to 20 on forward earnings while the P/E on the Dow (less dominated by technology names) is around 16. Simply said, stocks are overpriced relative to current bond yields. That imbalance can remain in place for months. But the farther apart it spreads, the more likely some correction will become necessary in the future.
The other part of the valuation equation is earnings. Earnings season will start at the end of next week as the biggest banks start reporting. Given the economic strength we have seen recently, there is room for some upside surprise, particularly for those companies impacted by ongoing consumer spending. However, as noted earlier, there are many pockets of weakness within today’s economy. Oil prices are less than they were a decade ago and far below peaks reached shortly after the Ukraine war began. Inventories are building thus reducing manufacturing demand. The health care industry is undergoing major changes related to the end of the pandemic and lack of funding for new biotech startups. In the stock market, in sectors where stock values are closely correlated to dividend yields, pressure from higher interest rates is pushing prices down. Overall, however, there are more pockets of strength than weakness. That has propelled overall improvement in the economy and helped to keep earnings forecasts stable.
Using logic, not often useful to predict short-term market behavior more dominated by momentum, the P/E outlook should be lower for longer while earnings forecasts might be a smidge higher. That doesn’t sound like the ingredients for a major move in stock prices in either direction. The key economic numbers to watch are today’s employment report and next Wednesday’s CPI number. In the employment report this morning watch both the employer and household figures. They are not always in synch. Second, watch average hourly wages. There should be a downward bias to this number as high paid retirees are replaced by young Americans entering the labor market. In addition, job growth is concentrated within lower paying industries (e.g., waiters and hotel desk clerks).
With all this said, yesterday’s correction was quite orderly, reaching lows early in the session following weakness overseas. Notably, the two largest stocks, Apple# and Microsoft# both rose yesterday, hardly a condition leading to a significant correction. After the CPI report, the focus will move to earnings. The late July Fed meeting will garner some attention but a 25-basis point increase is almost certain and any forward-looking forecasts should be treated with a grain of salt, given the Fed’s proven inability to predict future trends. Right now, I expect good numbers. Corporate managements have proven their mettle recently, not by boosting sales in a slow economy, but by controlling costs. While U.S. employment continues to grow, many larger companies have been resizing to a slower growth world. Thus, margins continue to expand. That won’t happen indefinitely. Cost cutting can carry only so far but it is earnings and margins that dominate stocks. Higher margins suggest control of one’s destiny. Lower margins mean macro pressures are overwhelming. Leadership companies continue to sustain or raise margins. They still have pricing power, at least for now. Markets may have gone too far too fast in June but I don’t expect a major correction any time soon.
Today, comedian Jim Gaffigan is 57. Shelley Duvall turns 74. Ringo Starr is 83.
James M. Meyer, CFA 610-260-2220