Broker Check

Now, to be clear, I am trying not to sound like a permabear, because I’m not...

June 20, 2023

If you followed the Fed last week, you know that they paused another rate increase. They indicated that they had two more quarter point moves before the end of the year. That is consistent with my projection that they need to get to 5.6% Fed funds rate. It is currently just over 5%. I have been writing about a more aggressive move in the portfolios at mid-year, assuming the Fed was done with interest rate increases. Well, that does not appear to be the case. The Fed is determined to get inflation down to 2%, but that means the economy has to slow even more.

With the S&P at 4,400, the market is trading on an 18.3X valuation, which given the macroeconomic reality is about as “best case” as one can get. That said, bullish momentum and chasing can continue to push the S&P 500 higher from here, but at these levels (and above) it’s important to realize that stocks are reflecting a future economic and market “nirvana” where 1) Immaculate disinflation occurs, 2) Growth remains solid and 3) 2024 S&P 500 earnings expectations of $240 not only stay solid, but actually rise.

Anything is obviously possible, and it’s entirely true the market and economy have performed better than most expected (including me), but at 4,400 the S&P 500 is aggressively pricing in a lot of good things occurring, and virtually zero negative surprises.

Now, to be clear, I am trying not to sound like a permabear, because I’m not. I am long stocks (albeit primarily defensive sectors and low volatility ETFs given my general cautious outlook, so I’m participating in the rally but relatively underperforming). And I do not enjoy consistently warning of risks to the markets when 1) Those risks don’t materialize in the near term or 2) When the market ignores those risks. But I do view it as one of my jobs to make sure you understand the other side of sentiment. That’s true when stocks were dropping hard in 2022 and many analysts became more negative than the facts implied, and it’s true now when, suddenly, many analysts that were bearish to start the year are upping price targets.

The truth is the outlook for the economy and stocks is more balanced than the price action would imply. On a macro level, the economy is just now starting to feel the impact of 5%of rate hikes. Yes, a re- cession hasn’t started yet. Yes, it’s possible the economy doesn’t slow. But that is not what history implies will happen. It is also not what the bond market has been saying, incredibly consistently, for the past year. And, while those signals haven’t been correct, I do think they still warrant consideration.

On a micro level, corporate America is facing a more challenging environment. The margin expansion that inflation gave companies will partially reverse as disinflation takes hold. Meanwhile, there has been no economic slowing to impact earnings yet—as it’s just starting now.

Bottom line, I’m happy the S&P 500 is at 4,400. I hope it keeps going. Bull markets are better for everyone in our business than bear markets. But my job is to stay focused on facts and ensure you understand them as they are, not as we hope them to be. That’s why we’ll continue to talk about risks to this market, because they are real.

Finally, I also appreciate the momentum in this market and this rally can keep going as long as data supports the “Immaculate Disinflation” narrative. But given valuations across sectors, I’d prefer to continue to allocate to value stocks (dividend stocks) and small caps.

Economic data last week was mostly Goldilocks and that offset the hawkish FOMC “pause” for one simple reason: Investors know the data will dictate future Fed policy, not the “dots,” and the data last week showed a further decline in inflation (disinflation) and stable enough economic growth.

Starting with inflation data, both CPI and PPI showed further disinflation. Headline CPI declined to 4.0% y/y vs. (E) 4.1%, but more importantly the “super core” CPI (which is CPI less housing) dropped to 4.6% from 5.3%, and the Fed will welcome that as a positive sign that consumer driven inflation is declining. Similarly, PPI dropped to 1.1%, confirming that goods inflation also continues to ease.

Now, none of these numbers are where the Fed wants them, but they don’t have to be for the markets. Instead, the data just has to not refute the market’s expectation that disinflation is accelerating, and last week’s inflation data was good enough to further that expectation, and again that’s why the markets largely ignored the more hawkish dots.

Turning to growth data, virtually all the notable reports came on Thursday and while they weren’t “great” in an absolute sense, they did point more to a soft landing than a hard landing.

Retail sales were slightly better than expected on the headline and solid in the details and while not especially strong reports, they implied the consumer remains largely healthy. The first data points for June, Empire and Philly manufacturing, were both better than expected and Empire turned positive, while Philly was still modestly negative but both well off the recent lows. Now, these surveys are volatile and that’s especially been true this year, but overall they show that economic activity didn’t suddenly drop so far in June.

The only “soft” reading last week was jobless claims, which remained elevated at 261k. That’s not a “bad” number historically speaking, but it does point to some potential softening in the labor market, and if that gets worse quickly (say a quick move towards 300k over the coming weeks) that will increase hard landing worries, but for now the labor market remains generally tight.

Bottom line, investors have embraced the positive scenario: That disinflation accelerates and declines enough that the Fed won’t need to raise rates much higher than current levels, and that the economy will enjoy a soft landing. To be clear, the economic data doesn’t confirm that will occur, but it didn’t do anything to damage that expectation, either, and stocks rallied as a result.

We will stay the course for now.

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