Below are two expert opinions that fall in line with what I shared with you this past Tuesday. It is a warning to not be tempted to chase returns. The first article is from renowned economist, Brian Wesbury, chief economist of First Trust…I will summarize his statements this week:
Since the financial panic of 2008, and the introduction of Quantitative Easing, the Fed has flooded the system with reserves. Reserves are so abundant that banks no longer borrow or lend them. The Fed pays banks to hold them. As you can imagine, the Fed would like to pay almost nothing to banks, as it did for nine out of the last fifteen years. Under the new system there is no direct link between interest rates and the money supply.
Instead, the Fed just decides what rates should be. And this explains why market expectations about interest rates jump around with every piece of economic data. It’s all about what the Fed “might” or “might not” do. Earlier this year, the market was pricing in multiple rate cuts in the second half of 2023. (Principle reason the markets were up 8 -10% in January)
But after last week’s employment report, which showed continued solid job growth, the futures market finished the week with the odds of a July rate hike at almost 90%. We think the market is underestimating the odds that the Federal Reserve will raise short-term rates again this year, after July. Recent economic reports have been stronger than expected, and inflation remains stubbornly high around the world.
The Fed pays close attention to the labor market and average hourly earnings rose 0.4% in June and are up 4.4% from a year ago. We think the Fed needs to focus on actual inflation and the money supply, but its models tell Fed policymakers to focus on the labor market. Given a 2.0% inflation target and slow productivity growth, we think the Fed would like to see average hourly earnings grow at more like a 3% annual rate, not 4.4%.
Meanwhile, the unemployment rate is now 3.6% versus the 4.1% the Fed projected for the fourth quarter (back in June). Low unemployment is another reason the Fed is likely to be aggressive. Remember, back at the June meeting, two-thirds of Fed policymakers (twelve of eighteen) thought the Fed would raise rates at least two more times this year, so the flow of data on the economy and inflation would have to be generally weaker than expected to suggest only one rate hike is on the table for the remainder of 2023.
In turn, this bolsters the case that equities are overvalued. If the Fed ends up raising rates more than currently expected, long-term interest rates have some more risk to the upside in the months to come. Our Capitalized Profits model, which uses a measure of nationwide profits from the GDP report, discounted by the 10-year US Treasury yield, suggests that with the 10-year Treasury yield at 4.00%, the S&P 500 index is fairly valued at about 3,350. All else equal, a higher 10-year yield would drive this measure of fair value even lower. Currently the S&P 500 is 4,495!
Apparently, investors aren’t worried about that because they think the Fed will cut rates. And we would not be surprised if 2024 brought more aggressive rate cuts than the market is currently pricing in. However, our model says that if the 10-year yield fell to 3.00% but profits fell 15%, the S&P 500 would have a fair value of just 3,800.
In other words, the Goldilocks future, where the Fed manages everything perfectly, is likely too optimistic. Some stock valuations have become too high in our opinion. More defensive strategies are appropriate at this juncture.
Another article in Apple News: Business Inside:
Stocks have rallied in 2023, but it isn't a new bull market yet, Wells Fargo says.
That's because the market faces three barriers to a sustainable rally.
Stocks historically bottom after the economy enters a recession and the Fed begins to cut rates, the bank said.
Despite the strong performance of equities through the first half of this year, stocks aren't in a new bull market yet, Wells Fargo warned.
The bank's strategists pointed to the S&P 500's strong rebound since bottoming at 3,600 in October, with the benchmark index now 23% higher than its October low.
Those gains have caused the index to officially cross the threshold of a new bull market, some commentators say, who have made the case that stocks could even notch new highs in 2023 on the hype around artificial intelligence.
"We are less optimistic," Wells Fargo warned in a note on Monday. "With stock valuations full, we believe prices are unlikely to sustain recent highs as the economy rolls over. In our view, equity markets should continue to reside within this wide trading range that has been in place since April 2022," strategists later added.
The bank pointed to three factors that are preventing stocks from entering a true bull market – and suggest that investors could be in for more downside in the months ahead.
1. The Fed hasn't cut interest rates yet
The Fed likely isn't done raising interest rates, and markets are still a long way from a rate cut that would boost equities.
Central bankers have raised interest rates aggressively over the past year to lower inflation, though high rates have weighed heavily on asset prices. Stocks fell 20% last year as financial conditions grew tighter – and Fed officials have warned monetary policy will continue to tighten as inflation pressures linger.
Investors are now pricing in a 92% chance the Fed will raise rates another 25 basis-points at their July policy meeting. That would lift the Fed funds rate target to 5.25%-5.5% – the highest rates will have been since 2007 – a move that will likely weigh on equity prices.
2. The US hasn't tipped into recession yet
High rates also threaten to push the economy into a downturn. And though a recession hasn't been officially declared yet, there are warning signs flashing in different areas of the economy, from falling RV sales to cardboard box demand, more Americans are pulling back on spending.
That spells trouble for equities, as stocks historically have bottomed after the economy enters a recession and after the Fed begins to cut interest rates. Neither of those events have happened yet, strategists said, suggesting more downside was on the way for investors.
3. Only a narrow portion of the market has rallied meaningfully
Most of the S&P 500's gains have been driven by a small group of large-cap tech stocks, the excitement for AI leading investors to plow their money into the tech sector. Other sectors, meanwhile, have lagged. Small-cap, mid-cap, and large-cap indexes that aren't tech-heavy, like the Dow, have posted just a 3-8% gain from the start of the year.
Those returns are meager compared to those of the "Magnificent 7" tech stocks, with Nvidia the group's best-performing member, gaining 195% since the start of the year.
"The market cap weighted S&P 500 index has so far outperformed the smaller-cap indexes as well as the equal weighted S&P 500 Index because this rally has been driven almost entirely by a small number of large companies. This has not been a characteristics of a durable bull market," strategists said.
As you can see from these two articles, our defensive posture is warranted. I still believe our positions will get the lion’s share of the money flows before the end of the year. If the markets do drop 5% to 15%, we will be insulated from that downturn and the beneficiary if the market moves to a recession. Time will tell as the economic numbers give us a clue of what is next.
Sources: Apple News Business Insider 7-13-23; First Trust Economics Blog 7-10-23
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