Trees Don’t Grow to the Sky
A large tree ring exhibit sits near the entrance to Muir Woods in northern California. The exhibit is a cross-section slice of a coastal redwood that was over 1,000 years old when it fell in 1930. The historic display features key tree rings that are labeled with major world events, such as the Battle of Hastings (1066), the signing of the Magna Carta (1215), the discovery of America (1492), and the Declaration of Independence (1776). Tree rings show yearly growth, with wide rings indicating wet, rainy years and thin rings representing dry, tough climate conditions. During the last 250 years, the U.S. economy has similarly weathered many cycles, including periods of strong growth led by population expansion and technological advances, but also lean years and disruptions from major international conflicts. The overall trend, however, has been toward long-term economic expansion.
Like the rings of growth on a tree cross-section, markets have been displaying a strong period of annual growth in earnings and stock returns this year. Markets do not mirror the economy exactly, and are generally forward-looking, but there is some correlation to corporate earnings growth and interest rate changes. The current bull market is about 4 years old, generating a doubling of the S&P 500 Index since 2022. The historical average upward trend in equity markets has been about 3-5 years in length, although bull markets can last more than 10 years if the conditions are right. It is easy to forget that the average correction during any given year is a pullback of about 14%, and we witnessed a 9% pullback earlier this year. While strong performance from a minority of highflying artificial intelligence names has helped to limit losses at the index level, over 40% of stocks in the index are trading at least 20% below their 52-week highs. That means that a large number of the constituents in the S&P 500 are technically trading in bear-market territory.
Pruning the Branches
The bond market is close to signaling that interest rate hikes may cause the US economy to stall out as the yield curve “flattens.” The extra yield on 10-year Treasuries over two-year notes shrank to less than 0.2% last week. If short rates move higher than long rates, that has historically preceded each of the last eight recessions going back to the 1960s. While the predictive power of yields proved faulty a few years ago, the outcome has broad implications across financial markets, particularly for stocks trading near record highs.
The Federal Reserve is attempting to prune the lower branches and make sure inflation remains contained. However, the short-term impact on interest rate sensitive sectors, such as housing, is causing some real pain. Mortgage applications to purchase a home are down about 14% from the prior year as mortgage rates have risen. Meanwhile, fiscal spending continues to stretch skyward. Yields on the US Treasury’s 30-year bond rose for a sixth straight day, crossing another key threshold amid a deepening selloff across global debt markets. The 30-year rate surpassed 5.6% on Tuesday to touch a level last seen in 2002 as inflationary angst and hefty corporate-debt supply have weighed on markets. The current rate hiking cycle is expected to be relatively short and shallow, and expectations are that the Fed will hike just over one percentage point through next year. Today’s inflation report came in lower than expected, which helps, and markets are reacting positively.
Reading the Tea Leaves
Right now, economic growth remains strong. The latest U.S. GDP growth forecast for the third quarter is at 5%, adjusted for inflation. The unemployment rate hovers around a relatively low 4.1%. Earnings forecasts for the S&P 500 for the third quarter call for 23% growth on 14% revenue gains. For 2027, forecasts call for 15% earnings growth on a 12% revenue increase. However, there are some storm clouds forming on the horizon. Consumer confidence, both current conditions and expectations, have been trending lower. The JOLTS jobs report out yesterday showed less job openings were available in August. AI has tremendous potential for enhancing productivity, but also raises threat concerns that could impact capital spending plans. Higher interest rates are the fly in the ointment for consumers and businesses, along with elevated energy prices. Despite sticky inflation and energy market disruptions, the S&P 500 is up 12% year to date, besting a number of international markets and near all-time highs. As Warren Buffet noted in the 2021 Berkshire Hathaway# shareholder letter: “Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.”
Formula 1 Red Bull Team race car driver Max Verstappen corners 29 today, actor Kieran Culkin succeeds to 44, and actress Fran Drescher turns 69.
Christopher Crooks, CFA®, CFP® 610-260-2219