Again this letter is long but necessary in order to explain our current portfolio positioning. Please read all of this letter as it explains why we are managing your portfolio defensively.
The equity market declined over the course of last week as Chinese stimulus hopes faded and economic data came in better than expected, supporting the case for more Fed rate hikes in H2 ’23. Stocks fluctuated Friday after the jobs report, leaving the S&P 500 to close down 1.16% on the week.
Stocks began the second half of 2023 with very quiet trade last Monday during a holiday-shortened session ahead of July Fourth. Markets shrugged off sluggish manufacturing PMI data overseas before rebounding turning lower to end the day with a modest 0.29% loss.
This summer, I’ve spent a surprising amount of time answering these questions from friends and acquaintances at various summer activities such as neighborhood barbecues and parties: “What do you think of the market, and what’s going to happen with the economy?”
Most, if not all, of the people asking me these questions have money in the market, and they are concerned about a looming economic slowdown and are surprised (pleasantly) by the performance of the stock market. Their issue is this: They expect a slowdown to come, but they are trying to mesh that with a still-strong economy and rebound in stocks, and many of them are simply confused by the mixed signals. My explanation of 1) What’s happening and 2) Why the market is up has been well received, so I wanted to provide it here to potentially help you understand what is happening.
Investors started 2022 concerned about an imminent economic slowdown. We know that from the deeply negative sentiment indicators, and there was reason for this belief: The stock market was down sharply last year (investors often incorrectly extrapolate the stock market to be a leading indicator of economic growth), interest rates were way, way up, and the prognostication of a looming recession was seemingly everywhere.
However, so far, that economic slowdown hasn’t come. There is contraction in select parts of the economy (manufacturing, retail) but employment remains strong and the reality for most investors is their economy is doing just fine (no real change from last year).
The hangover from the 2022 stock market declines, combined with the aforementioned worries about a slowing economy led many professional and retail investors to underweight stocks at the start of the year. But when economic growth remained stronger than expected (the slowdown hasn’t arrived yet), inflation declined and Q1 EPS showed resilient corporate earnings, the reality was that stocks were underpriced. Put plainly, they were priced for a slowdown and earnings drop that did not appear, and combined with negative sentiment that pushed stocks higher through the first quarter and April.
Then, the “AI” craze hit markets and the super cap tech names carried the S&P 500 higher almost by themselves, making it appear the broad stock market was rallying hard and the worries about recession and corporate profit declines were gone. That caused more chasing and higher stock prices. Finally, in June resilient economic data led investors to embrace the idea that the U.S. economy will avoid this slowdown. That’s why we saw broad stock market gains in June (not just in tech).
Now the stock market is trading at one-year-plus highs on three assumptions (the new pillars of the rally):
- No economic slowdown (no landing or soft landing)
- A consistent drop in inflation
- Fed not hiking more than expected (one, maybe two)
As long as the economic and inflation data does not damage those pillars, then stocks can hold onto, and even slightly extend, the YTD rally.
To extend the gains meaningfully from here, however, it will take the introduction of something new. Specifically, either 1) Interest rates falling, 2) Economic growth further re-accelerating or 3) An increase in S&P 500 EPS. That’s what it will take to push the S&P 500 through 4,600 and towards old highs.
Now, importantly, while investor fears of a decline in growth and earnings have not materialized as expected at the start of the year, this is still a market that faces numerous risks, and we will cover that in tomorrow’s Report, where I’ll detail how I’m explaining the risks in the market to these same friends and acquaintances (I’m just out of room for today’s Report).
Notably, many of the same friends and acquaintances that have asked me about the outlook for the markets and economy have also revealed they are nervous about a looming economic slowdown. In these casual conversations, helping them understand which risks are likely (or possible) and which are remote helped to make them more comfortable with the markets, so I’m sharing that commentary below.
The easiest way I’ve explained the most pressing risks is this: Essentially, the major risk we all need to watch for is that everything investors were worried about at the start of the year happens, just later than expected.
Here’s what I mean.
At the start of the year, investors were worried about 1) A recession, 2) Stubbornly high inflation, 3) Too aggressive Fed rate hikes and 4) Earnings declines. Those risks never materialized in the first half of the year, and the S&P 500 rallied 15% as a result. But it’s important to remember that none of these risks have been eliminated, either, and they are all still possible and could materialize in the coming months.
Risk One: It’s Not Different This Time. Starting with growth, the point here is that, in the end, it’s not different this time: The dramatic Fed rate hikes cause a growth slowdown in the coming quarters. That, in turn, puts major pressure on the market multiple, which would fall from the current 19X to, optimistically, 17X or (most historically likely) 15X. That would result in either an 11% or 22% decline in the S&P 500 from here. Again, the performance of stocks in the first half and the large, positive swing in investor sentiment make the risk of a recession seem remote, but the reality remains that markets are still barely feeling the impact of rate hikes, and the longer they stay high, the greater the chance of a slowdown. How we’ll know: “Hard landing” will start to win the Hard Landing/Soft Landing scoreboard.
Risk Two: Stagflation. On the other side of the spectrum, what happens if inflation stops declining but growth slows? That’s what Friday’s jobs report hinted at, via the uptick in wages but deceleration in hiring. Now, to be clear, we’re a long way from a realized stagflationary threat, but if economic growth slows and inflation does not decline (due to ongoing supply chain issues, a still tight labor market, etc.) then that’s a near “worst case” scenario because stocks and bonds will decline, likely hard. How we’ll know: The decline in core CPI will stall in the coming months.
Risk Three: Disinflation hurts corporate earnings. The fact that earnings were so resilient in the first quarter was a major contributor to the 1H ’23 rally. But as we’ve seen with the retailers (and now it’s starting to spread to other industries) as inflation cools and prices drop, companies are seeing increasing margin compression and corporate profits may suffer. Here’s a practical example of why this matters: If 2024 S&P 500 earnings fall to $225 from the current $240, then even if the S&P 500 keeps a 19X multiple (which wouldn’t happen, but for illustration purposes say it did) then we should expect a 3%-5% pullback. If we combine that earnings decline with a drop in the multiple to 18X (still a high number) then we’re looking at a near-10% decline from current levels. How we’ll know: Guidance won’t be good this up- coming earnings season (for Q2) and Q3 earnings season (in October) will be downright bad.
Bottom line, the reality is that the risks still facing this market are essentially the same ones we had to start the year. The fact that these risks haven’t materialized yet has been interpreted by investors to mean the risks are no longer present.
But the reality is that these risks are still present, they just haven’t occurred (yet). But they still can occur and as such they need to be monitored and watched for, which is what we’ll be doing for you here over the coming months, because with the S&P 500 at 4,400 and sentiment bullish, there is zero cushion should one, or more, of these risks emerge—and it’s a long way down to fundamental value if they do.
As a result of the potential risks, I have decided not to move to growth with the portfolios. I hope you understand, that I am not happy with underperforming in the first half but I believe discretion is the path to better long term results. Be patient, as the positions we are in are undervalued and could be the beneficiary of a broad market downturn. If the best case scenario occurs, then I still believe that money will flow to small caps and dividend/value stocks simply because they represent more upside.
I will monitor this daily and keep you informed as to the direction of the economy and markets.
"This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. The information does not represent, warrant or imply that services, strategies or methods of analysis offered can or will predict future results, identify market tops or bottoms or insulate investors from losses. Past performance is not a guarantee of future results. Investors should always consult their financial advisor before acting on any information contained in this newsletter. The information provided is for illustrative purposes only. The opinions expressed are those of the author(s) and not necessarily those of Geneos Wealth Management, Inc."