Last week was a disjointed holiday week that resulted in many people more focused on enjoying a four-day weekend rather than following economic data. But, last week was very important in the story of this market and I want to make sure the holiday doesn’t mean people miss the message, namely that economic growth is now clearly losing momentum, the question is how much does it lose?
Throughout 2024, there have been anecdotal reports of the economy losing momentum, whether it’s from sporadically soft economic data or corporate earnings results or commentary. But in recent weeks, those occurrences have been much more frequent on both a micro and macroeconomic front. Numerous earnings updates from consumer related companies have cited reduced consumer demand and spending (NKE and WBA the most-recent examples).
Last week, the “big three” monthly economic reports all signaled varying degrees of economic weakness. The ISM Manufacturing and Services PMI fell back below 50 and the Services PMI dropped to the lowest level since late-2021. Both PMIs dropping below 50 hardly even happens, and when it does for several months in a row it is a clear warning of a looming economic slowdown. Put differently, it’s a hard landing warning, not a soft landing confirmation.
Be aware that hasn’t happened yet (both PMIs have been in contraction two of the past three months so we need another month or two below 50 to truly confirm the weakness) but the bottom line is these numbers are not going in a good direction. Additionally, while the job adds number was fine, unemployment now is at 4.1%. That’s a near-three-year high. Again, it’s not a disastrous number, but it’s not going in a good direction.
I realize I’ve been beating the drum cautioning about complacency regarding an economic slowdown but again there’s a simple reason for me to do it: An economic contraction will end this bull market and could reverse it.
First, stocks are trading at 20.4X 2025 S&P 500 EPS of $270. A stagnant economy warrants a multiple lower than that, and if I want to be generous, it’s between 17X and 18X. That’s 4,590-4,860 in the S&P 500! If it’s a contracting economy, it’s a 15X-16X multiple (4,050-4,320). But stagnant economies aren’t theoretical events. They hurt earnings. So, if the economy is worse than currently expected, it will reduce the $270 2025 expectation and put even further downward pressure on stocks.
To be very clear, I am not saying this is going to happen. Right now, it is not happening. But what I am saying is the market, at current valuations, is not acknowledging the possibility it can happen, and that’s what makes me nervous because I’ve seen this movie twice before, and both times it didn’t end well. To return to the “Hard Landing/Soft Landing” analogy of our economic airplane, data last week shows that we are clearly descending, the question is whether we’re descending to a soft landing or is this the start of a crash/ hard landing. We won’t know for several more months, but the fact that markets seem to be pricing in virtually zero chance of a hard landing exposes a real vulnerability in this historic and impressive bull market. Also, I am not saying that the election could change a lot of this rhetoric, to a positive view of the future under a new president. Remember 2016, the economy and markets were on the verge of a tailspin until the election and then the markets went up 14 months in a row.
Broadly, I am not saying to raise cash here. I am, however, saying to continue to monitor volatility and be aware there are economic storm clouds gathering on the horizon. That doesn’t mean a storm will hit, but it does warrant monitoring.
Bottom line, I want to make sure that all of us are aware the economic plane has started its descent and while sentiment and spirits are running high (along with the S&P 500) we are entering perhaps the most important several months for this bull market.
In the next several weeks we will see how the earnings reports for second quarter fair. My guess is that we will see a small slow down and an above average share of positive surprises. The markets will move in the next two months on the earnings reports for that week. I remain optimistic until I see clear signs of a reversal…not yet!