Stocks surged ahead again yesterday. Three days of strength wiped out the damage done by Monday’s sharp drop. One day reversals have little meaning without follow through. While investors had reasons to be scared by the rapid rise in speculation, it wasn’t sufficient to derail the current rally.
This week Fed Chair Jerome Powell spent two days in Congress and stayed pretty much on point, saying inflation is moving in the right direction but the Fed can afford to wait a few more months to start cutting rates. Once it does, look for it to move slowly, making sure the rate cuts don’t reignite inflationary pressures. From a GDP perspective, higher short-term interest rates seemingly have done little damage. While the resale of existing homes has been soft, new home sales, which count in the GDP arithmetic, have stayed strong as buyers choose a fresh problem-free home over a 30-50 year old structure that could become a money pit. Auto sales did well for a period while car dealer lots refilled. Consumers, flush with cash handed out during the pandemic, spent despite the cost of credit.
Meanwhile, inflation eased. On the surface, the obvious question is how could the economy grow, new jobs get created at a healthy pace, and inflation come down all at the same time?
There are three good answers.
First, there was a spike in productivity almost certainly related to the easing of supply chain problems. Workers are more efficient when they don’t have to wait around for the one part needed to complete the project. No dozens of ships waiting offshore to unload. Homes could be built in 12 months instead of 16 months without waiting for components delivered to the job site.
Second, immigration, legal and illegal, added over three million bodies that needed jobs and had mouths to feed. While the front pages show the rogue immigrant who does wrong, busses unloading in New York City, or politicians parading along our southern border, these immigrants are working and contributing to economic growth while relieving some of the tightness in the labor market. How many of the 200,000 new jobs every month are being filled by immigrants?
Third, China is struggling economically. One solution is to ramp up manufacturing and send the goods overseas. Import prices are down helping to reduce inflationary pressures. While Chinese exports are sharply higher and the price of U.S. imported goods is down, both China and the U.S. are trying to become more self-sufficient, distrusting the other to use goods sold on foreign soil to spy on the other. It reminds me of the old Mad Magazine Spy versus Spy cartoons in every issue. How much is real and how much is false fear is for others to decide. Whatever the answer may be, it certainly impacts economic activity in both nations. Sometimes, the paranoia spills over into the world of absurd. For example, last year when Covid breakouts caused massive lockdowns in China, the damage was probably exacerbated by an unwillingness to use U.S. made vaccines. How is a vaccine a tool of foul play?
Of the three, a surge in immigration continues but will likely slow over the next year as Washington somehow takes steps to slow the flow across the southern border. Supply chain snarls have largely been unraveled. That could slow future productivity gains. As for cheap foreign imports, they will continue although manufacturers will make sure they have the flexibility to withstand future supply chain disruptions.
Thus, in two days before Congress, Powell said what needed to be said. While allowing for various members to use their time at the podium to issue their own screed about anything and everything, Mr. Powell stayed on point, noting that economic statistics supported lower rates over time. He just wants to be careful that all the hard work of the past two years isn’t disrupted by too hasty a move to spur more growth. After all, no one should complain about GDP growth of 3%.
Powell’s presence on Capitol Hill was followed by President Biden’s State of the Union address last evening. It was less a speech outlining where our nation stands today than a kickoff to a Presidential campaign. To combat the cries of old age, Mr. Biden chose to be unusually feisty. Angry. Combative. Whatever it took to look energetic. Without mentioning Donald Trump by name, he tried to skewer him and his policies at every opportunity. Nothing wrong with politicizing the speech. It might be Mr. Biden’s biggest audience in months. But from a market perspective, there were no new ideas, nothing to digest, and likely nothing that will move markets today.
The big economic news today will be the monthly employment report. As usual, the focus will be on the number of jobs created, and the pace of wage growth. It will take an outlier number (greater than 300,000 new jobs or less than 100,000) to move markets.
Bond yields have remained within a narrow range for weeks. At this juncture, only sudden moves will spill over and impact equity markets. For now, the path of least resistance remains higher. With that said, the uniformity of bullish forecasts is a reason for caution. Some minor correction is overdue, but it can stay overdue for months. Fundamentally, there is little news to support any significant correction. The upside is only limited by valuation, which remains high by any historic standard. One must realize that the entire rally over the past four months is P/E driven. Earnings have been rather flat, especially when one looks beyond the handful of major AI beneficiaries. While the earnings outlook is improving, that alone doesn’t justify a 15% rise in equity prices. Nor do nominal changes in interest rates. At some point there will be reversion to the mean. What causes that remains unknown. But buying at peak valuations is rarely a secret to investment success. There will always be individual bargains, but they get tougher to find when valuations are high. One can ride the AI train and hope it continues to ride upward for a while longer. But probably the better places to look today are in pockets of the market and the economy that will experience solid growth this year and next at valuations much more reasonable. Ideas? The success of weight loss drugs has helped to create a new resurgence in drug development. Flat-to-lower interest rates are keeping housing demand strong. There is still a nationwide shortage of quality homes. Infrastructure spending is finally starting to percolate. And there are always new hot products and ideas. Keep searching. We will.
Today, Mickey Dolenz, the drummer for the Monkees, is 79.
James M. Meyer, CFA 610-260-2220