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If the S&P 500 is going to materially extend the rally, then...

July 18, 2023

Stocks powered higher last week with the major U.S. equity indices rising to fresh YTD highs on Goldilocks economic data that showed falling inflation and stable growth. The S&P 500 rallied 2.42% on the week and is now up 17.34% YTD. 

Equities began the week with a modest gain Monday as the Mannheim Used Vehicle Index dropped sharply while the NY Fed’s consumer inflation expectations dropped to 3.8% from 4.1%. Both data points further reinforcing the idea of Immaculate Disinflation, and that strong rallies last week, continuing a trend that started in early June whereby economic data refuted the trifecta of fears of: 1) Hard landing, 2) Stubbornly high inflation and 3) Significantly more rate hikes. 

Those fears were the foundation of the negative outlook at the start of 2023, and since June economic data has undermined them, and that’s been responsible for the broadening out of the rally since then (remember, up until June it was just the mega-cap tech stocks that rallied YTD while the “rest” of the market was little changed YTD). 

However, while it’s undeniable that fears of a hard landing, inflation and hawkish Fed have not materialized, the reality is that the current level of the S&P 500 largely factors all of that in, so last week’s CPI and PPI reports didn’t provide the market with a new positive catalyst, but instead just reinforced what was already widely assumed. Now, the good data did create further “chasing” from underinvested managers, but with sentiment bullish and the financial media (and most economists) dismissing the chances of a future recession (despite yield curve and other warnings), most of the “chasing” that’s going to happen in this market already has, so don’t expect that to push the S&P 500 materially higher (momentum could get the S&P 500 to 4,500-4,600). 

If the S&P 500 is going to materially extend the rally, then it’s most likely going to be driven by one of the three following events: 

1) Treasury yields fall sharply. If the 10-year yield and the 2-year yield drop sharply, say down towards 3% and 4%, respectively, and 10s-2s continues to rally (say back towards -50 bps) then that will ease valuation constraints and we could see markets push for a 20X multiple on earnings, if economic data stays Goldilocks. That equates to 4,800 in the S&P 500 (absolute best case). 

2) Earnings are stronger than expected. 2024 S&P 500 EPS estimates are $240/share. They were close to $270/share a bit over a year ago. If Q2 earnings season is better than expected and guidance is raised, then a bump in 2024 S&P 500 EPS could push the S&P 500 higher (say towards 4,700, if EPS are increased to $250/share and we keep a 19X multiple). 

3) There’s another round of AI tech driven enthusiasm. AI was the reason stocks rallied out of the March regional bank crisis, but it created very thin market breadth, with five-seven tech stocks accounting for basically all the market gains. If we see another round of AI mania, the weighting of these tech stocks could push the S&P above reasonable valuation levels, although our concern about the sustainability of that rally would be extreme. Nonetheless, it could punch SPY higher. 

Bottom line, at current levels, the S&P 500 has priced in 

1) No hard landing, 

2) Falling inflation and 

3) A Fed that won’t be raising rates much longer (and possibly cutting soon after). 

That’s basically the best outcome anyone could have hoped for at the start of the year, and that means the gains in stocks are legitimate, but also likely exhausted in the near term and it’ll take something else to push stocks materially higher from here. 

Meanwhile, I will continue to point out that the biggest risk to this market over the medium term, namely a hard landing or recession, has not been totally vanquished. In fact, hard landings and recessions usually don’t appear until after the Fed has stopped hiking rates, so it really isn’t a surprise one hasn’t materialized yet, and it does not mean that it won’t appear, either. Additionally, falling inflation is a macro-economic positive, but it could negatively impact corporate earnings starting this quarter (although more likely in Q3) and at these levels, the S&P 500 is vulnerable to earnings disappointments. Bottom line, the macro-economic environment is as positive as anyone can hope for, but don’t confuse that with a “risk-less” environment. It is not! 

Through last week, according to FactSet Research, we have seen 6 percent of the component companies in the S&P 500 post results with the overall blended earnings growth rate currently standing at -7.1 percent. As of June 30th, the estimate for the earnings growth rate of the S&P 500 for the quarter was -7.0 percent so the results that have come in so far have been slightly below expectations when looking at earnings, even after the strong results from the big banks. Earnings season really gets rolling next week as we have a pickup in the number of companies reporting their results. 

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