Beneath the surface
Equity market's new highs mask issues lurking underneath.
Investors away for vacay must love the relaxing, good-vibe headlines—grinding new equity highs, a continuing bond rally and a VIX fear gauge that indicates nothing to worry about. The view beneath the surface is murkier. While the Nasdaq 100 was gaining 1% on Monday, decliners outnumbered advancers nearly 2.5 to 1 on the NYSE and the percentage of S&P 500 issues above their respective 50-day moving averages remained south of 50%. Rail, airline and other reopening stocks that popped this spring are deteriorating. Utility and other defensive stocks remain laggards even with declining yields. Since reaching a high in May, Value is down 16% relative to Growth, dragging the equal-weighted S&P down with it. With recent big rally in Big Tech, it’s no wonder the cap-weighted S&P continues to see record after record (34 new highs so far this year and counting, with the second-best first half ever). This is to take nothing away from Apple, which is on the fresh breakout list and is a monster in cap, as it tries to emerge from a multi-quarter consolidation. But individual new-high data has been rather anemic (just 8% of issues traded to a 20-day high Wednesday) as, in reaction to a less-dovish Fed, investors have pushed market leaders over the past seven months to the rear. This reversal ranks among the largest short-term moves Empirical Research can recall following any Fed meeting of the last 70 years. Crosscurrents!
But, but … looking at returns after prior Fed surprises, Empirical found a year out, performance moved opposite the initial reaction two-thirds of the time. With investors flushing out cyclical names, Strategas Research believes another leg up is likely as the recovery high in rates or cyclicality is not yet in. Bank of America thinks the S&P could break 4,400 this summer. The key is picking the right stocks. Value stocks have tended to rebound strongly as expansions proved durable, as was the case after their sharp reversal in 2000, when they renewed a dramatic multiyear run. Wolfe Research thinks the recent setback in non-Growth sectors (Industrials, Materials, Financials and Energy) simply reflects their typical seasonal pattern—an early June peak, followed by a few months of churning, before a year-end rally. Unprecedented stimulus, massive savings, pent-up demand, happier consumers (more below) and accelerating capital expenditures (capex) represent strong underpinnings for the economy—and cyclical value stocks. Several cyclical indicators Bank of America tracks are unwaveringly strong, including global confidence, trucking activity, inventories and luxury demand. And the cyclical message being sent by oil is hard to ignore—it was the star performer in Q2 and the first half, with crude prices rising a respective 24% and 51%. Even as fiscal support fades (no more stimulus checks and extra jobless benefits are phasing out), surging private-sector activity already is boosting federal receipts without tax hikes. Fundstrat expects GDP to surge above consensus forecasts that already have this year’s economy growing at its fastest pace in at least 40 years and, 2021 aside, next year’s growing at its fastest pace in 20 years.
Much as with GDP, the consensus on earnings seems to be the consensus is too low. UBS expects the Q2 season, which starts in earnest after the July 4th holiday, to beat estimates by 15% or more. Then all eyes will be on margins, which so far have been expanding despite rising cost pressures. The S&P’s 12-month forward operating margin hit a new high of 16.6% this week, and the forward profit margin set a record high of 12.8% in mid-June. We may be at peak earnings growth but the S&P typically doesn’t peak until earnings do, and that appears years away. Earnings are expected to rise nearly 40% this year and 12% in 2022, dwarfing the average 6% compound growth rate since 1950. One of the most important cyclical questions is whether the current runup in productivity can continue. The next several quarters, when service jobs that historically are less productive flow fully back into the economy, should be telling. Worker shortages, rising material costs and supply chain disruptions already have companies accelerating productivity-enhancing capex. With depressed interest rates widening the gap between the return on capital and the cost of capital to near a record high, businesses have all the more reason to expand their assets, especially with the age of the U.S. capital stock at an almost 6-decade high. Beneath the surface, one can find things to worry about. Sentiment is at extremes. And the market rarely goes this long without a 5% to 10% correction. Approaching late-summer seasonality could be a catalyst. But, but … until the Fed goes full bore into tightening, macro and market fundamentals continue to suggest pullbacks are opportunities. That much seems clear to me.
- Job growth surging again June nonfarm payrolls jumped by 850K, well above consensus, and ADP payrolls rose more than expected, too, pushing the monthly Q2 average to its highest level since last August. June’s job gains were driven by leisure and hospitality industries, as more restaurants reopened, more Covid restrictions were relaxed and Americans emerged from their Covid caves. Jobless claims also fell again, and Challenger’s tally of layoffs stayed very low while hiring plans were elevated.
- Consumers are pumped Conference Board confidence jumped in June to a 14-month high as both the present situation and expectations components surged. The perception of the labor market (jobs plentiful minus jobs-hard-to-get) surged to the highest reading since July 2000.
- Housing is stronger than you may think Pending sales unexpectedly jumped in May, a sign sales declines may be starting to reverse. Home prices keep soaring. Case-Shiller prices hit a new high, as did the FHFA’s price gauge, and, year-over-year existing home sale prices rose at their fastest pace in 42 years. The runup may be blocking some but the first-time buyer’s share of activity is at a 20-year high, as mortgage rates still near historical lows make it easier to digest the price increases.
- Peak growth likely behind us While still very robust, June ISM and Markit manufacturing indexes dipped slightly, suggesting growth could be peaking. Notably, ISM prices paid jumped to their highest level since 1979. Historically, turns in the PMIs have tended to signal turns in the broader economy. By the way, companies with a history of raising dividends have tended to outperform the broader market after PMIs peak.
- ‘Transitory’ can last a long time The 3-month annualized CPI trend is running close to 8%, a number that fails to capture the simple lack of availability of so many products or large delays in delivery. Credit Suisse believes this suggests inflation can’t dissipate until supply chain and other post-pandemic disruptions resolve themselves, an outcome it doesn’t see occurring before Labor Day or even Christmas.
- The Europeanization of the U.S. Births are declining, deaths are rising and baby boomers who had been working longer to make up for the shortfall of younger participants are retiring in droves and showing little interest in coming back. The nut: the shrinking working-age population that has befuddled Europe is rapidly becoming a U.S. headwind, too, threatening future growth and the ability to fund entitlements that could soar even more if progressive Dems have their way.
More pay equals more spending While rising wages feed inflation worries, the potential benefits for increased spending shouldn’t be overlooked. The biggest increases are occurring at the lower end of the income scale, where the propensity to spend is highest. Added to an estimated $2.3 trillion of excess savings, the wage increases could lift consumer spending by almost 5% a year, ISI estimates. A bonus: with margins expanding, a growing top line helps the bottom line, too.
Hopefully, way below the surface On his final day as Bank of England’s chief economist, inflation hawk Andy Haldane warned that he expects U.K. inflation to be nearer 4% than 3% at the end of the year, increasing “the chances of a high inflation narrative becoming the dominant one, a central expectation rather than a risk. If that happened, inflation expectations at all maturities would shift upwards, not only in financial markets but among households and businesses too. We would experience a Minsky Moment [a market collapse brought on by reckless speculative activity that defines an unsustainable bullish period for monetary policy], a taper tantrum without the taper.”
Millennials are just entering their prime income years Bank of America shares that nearly half of millennial millionaires have at least a quarter of their wealth tied up in cryptocurrencies.