Unlike the January-through-May advance in the S&P 500, the rally since June hasn’t been driven primarily by too-bearish sentiment or the impact of seven stocks on the S&P 500 (while the other 493 did nothing). Instead, the rally since June has been quite logical: Solid growth, falling inflation, looming end of Fed rate hikes. I call these the “Three Pillars” of the rally: Soft/No Landing, Disinflation, and Fed Done (or Almost Done) with Rate Hikes, and as long as these pillars stay in place and are confirmed by the economic data, the outlook for stocks is positive near term.
Logically, then, it’s going to take actual news to break that positive mantra and cause a real pullback in this market, and that didn’t happen last week (so stocks drifted slightly higher). So, our focus from a risk management standpoint is to identify, as early as possible, any events that could damage those three pillars. And, just like economic data has driven this rally since June, data that’s “Too Hot or Too Cold” can also undermine or end this rally, and we want to explain that here.
Generally, if economic data is Too Hot (meaning too strong) then that damages two of Three Pillars: 1) Disinflation and 2) Looming end of Fed rate hikes. That’s because a strong economy 1) Puts upward pressure on inflation and that will cause the Fed to 2) Reconsider hiking rates more. That’s why stocks dropped Thursday following the decline in jobless claims. As we look ahead, this week we’ll be monitoring ISM Manufacturing and Service PMIs, Jobless Claims, Wages and the Unemployment Rate in the jobs report. If any of those are “Too Hot” it’ll be a headwind on stocks.
Conversely, and, if economic data is “Too Cold” (meaning much weaker than expected) that damages one pillar of the rally: Soft/No Landing. Of the Three Pillars, that’s the most important one, because if data suddenly drops off (and this is our main concern as we move into the end of the year) then 1) Valuations in stocks are much, much too high and 2) The Fed has raised rates too high, and they’ll never be able to cut fast enough to forestall a recession and 3) Earnings will drop. This is the No. 1 candidate to reignite a bear market (and the complacency of markets around this risk is a vulnerability, in our opinion, not near term, but in the coming quarters).
Bottom line, we and others said at the start of the year that economic data would drive this market in 2023, and that’s what’s happened. The data has been Goldilocks, inflation has fallen, and the Fed isn’t worse than feared. But just like those were positive surprises YTD, they can also turn into negative surprises.
For now, the outlook for stocks remains positive and we continue to think cyclicals, small caps, Value can continue to close the performance gap with tech. But it’s important to remember that this isn’t a serendipitous rally—it’s been driven by data, and if the data turns more negative, there’s nothing to support stocks, especially at these valuations. That’s why we’ll continue to closely watch the data, because if it does turn, we will tell you so you can move before the rest of the market. For now our defensive positions in small caps and value stocks have been benefited from money flowing to those positions since the end of the quarter.
For the past two weeks, economic data has been Goldilocks enough to support the rally in stocks, and that largely continued last week as data was mostly solid (in some cases slightly too good) while the Fed decision met expectations that last week’s hike is likely the last one.
Starting with the Fed, it met expectations and hiked rates an additional 25 bps and made no change to forward guidance, leaving the door open to another hike between now and year-end, possibly at the September rate hike. But Fed Chair Powell also was clear that it’s possible this hike was the last one, and for a market that does not believe the Fed will hike again, that was enough. Going forward, the market does assume the Fed is done with hikes, so anything that counters that and implies another hike is coming will be a new negative.
Through last week, according to FactSet Research, we have seen 51 percent of the component companies in the S&P 500 post results with the overall blended earnings growth rate currently standing at -7.3 percent. This is a notable improvement from the -9.0 percent that we saw this time last week and more in line with the -7.0 percent that was expected at the end of the second quarter. According to FactSet, 84 percent of companies have either met or beaten market expectations when looking at earnings while 16 percent have missed. When looking at revenues per share, 64 percent of companies have met or beaten expectations while 36 percent have fallen short. Earnings season continues to roll next week in what will be the second busiest week for earnings.
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