Stocks were resilient again last week and the S&P 500 broke above 4,300 for the first time since August 2022, not because macroeconomic news was good, but in- stead because news wasn’t bad enough to make inves- tors doubt that a Goldilocks’ scenario of 1) Rapid disinflation, 2) End of central bank hawkishness and 3) Soft economic landing is the most likely outcome.
And, we know that because markets ignored actual evidence to the contrary: Economic data (ISM Services PMI and jobless claims) pointed to an economy losing momentum while two significant global central banks (Reserve Bank of Australia and Bank of Canada) surprisingly hiked rates 25 bps and both
cited sticky inflation for the surprise hikes! But, none of that was enough to break the optimism in markets, as evidenced by the CNN Fear/Greed Index hitting “Greed” levels, and the AAII Investor Senti- ment Index becoming the most bullish and least bearish since November 2021.
Looking forward, we know what can push this market higher: More of the same (evidence of accelerating disinflation, not hawkish Fed, solid economic data). Specifically this week, that looks like 1) CPI (and especially Core CPI) solidly under expectations, 2) The Fed pausing rate hikes and markets not believing threats to hike in the future and 3) Solid economic data from Philly Fed, Empire Manufacturing, Retail Sales, Jobless Claims and Industrial Production.
But even if we get that outcome from the data and news, the S&P 500 is facing a real valuation constraint. At 4,300, the S&P 500 is now trading at a 19.4X multiple if we use the 2023 S&P 500 EPS estimate of $223, and a 17.4X multiple if we use the 2024 S&P 500 EPS estimate of $247. Those aren’t “best case” scenario multiples, but they aren’t that far off, either, and even with the bullish momentum currently helping stocks ignore any news that doesn’t fit the bullish narrative, it’s hard to see investors pushing the broad averages materially higher from here (any more than 5% or so). What is undervalued is the stocks we are in: Dividend stocks/value, small stocks and international. I believe these markets are poised for a dramatic upturn going forward.
Regional bank crisis (not over), earnings declines (but not as bad as feared), clear softening of economic momentum (but not a hard landing) and more rate hikes than expected at the start of the year (the market expected one in 2023, then a pause). And it’s the respect of the market’s ability to do that very thing that kept me advocating staying long stocks throughout (albeit in more defensive and lower-volatility sectors) rather than raising cash.
But the reality of 1) High rates for longer, 2) A slowing economy, 3) Pressure on corporate profits, 4) Contracting lending and 5) Slowly rising unemployment can’t be totally ignored, either. So, while we enjoy this resilient market, please keep in mind that under the surface, things aren’t quite as good as the AAII Sentiment Index would imply. Thus our defensive posture.
Economics: Starting with the data, the most important report last week was the ISM Services PMI, and it showed a slowing of activity and inflation. The headline reading fell to 50.3, which was the second lowest reading since the pandemic, while New Orders, the leading indicator in the report, dropped to 52.9 from 56.1. Prices also fell to a three-year low, declining to 56.2 from 59.6. Looking at the data unemotionally, this report implies the U.S. economy is indeed slowing, as the service portion of the economy has been the engine of growth for years and it is slowing. That slowing is causing prices to fall, but that’s not “Immaculate Disinflation,” and instead just a good, old-fashioned economic slowdown causing reduced demand and lower prices. Markets largely ignored the report as it wasn’t damning enough to counter act the strong bullish momentum in stocks, but I do want to make clear that this report, which is basically the third most important economic report of the month, did point more towards a hard landing.
Now, stocks didn’t care as momentum is higher, a new “bull market” apparently started, and people are chasing. But I do want to make it clear that beyond the short term, last week’s actual data wasn’t positive.
To say this week is busy would be an understatement because by Friday, we will learn 1) If the Fed is truly pausing rate hikes, 2) If disinflation is accelerating and 3) If economic growth is holding up so far in June, and the answers to those questions will determine if the S&P 500 can extend last week’s gains or give them back.
The most important event this week is Wednesday’s FOMC decision. At this point a pause is widely expected (a hike would be a big surprise) and the key will be how forcefully the FOMC threatens to hike rates in the future (and how much the market believes them).
The second most important event this week could make that Fed rate hike more likely, because the May CPI report (Retail inflation report) comes out on Tuesday and will be the first big inflation number since hopes of accelerating disinflation boosted stocks throughout May. Specifically, markets will want to see Core CPI fall much closer to, and ideally below, 5.0% y/y and that could help bolster the idea that disinflation has taken hold and it’s just a matter of time until inflation is back under control (and it’d make a Fed pause all but guaranteed).
Finally, after CPI and the FOMC, we get a series of important economic reports on Thursday. First, we get the initial look at June economic activity via the Empire and Philly manufacturing indices, and markets will want to see stability in the data (both are negative and if they get worse that will increase hard landing worries). Second, jobless claims will be of particular interest given the spike from last week, and markets will want to see that increase undone or at least partially reversed to ease any concern the labor market is weakening. Then, and just as important as the other two reports, May retail sales will be released. Markets will want to see stability in consumer spending because with manufacturing weak and government spending flat, consumer spending is the key to keeping this economic landing “soft.” Here’s why this data matters so much.
If CPI drops sharply and confirms accelerating disinflation, and the Fed pauses rate hikes and markets think they’re done, and we get a run of bad economic reports on Thursday, then worries will bubble up that it’s all too late, and that Fed has hiked too far, that inflation is dropping because growth is slowing, and that a hard landing is much more likely. Moreover, markets will think that the Fed’s pause came too late and now they can’t do anything to help the economy. That’s the major worry for stocks, and that’s why economic data this week is as important as CPI and the FOMC decision.
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