Market Update Summer 2023

History shows that a strong first-half with gains of ten percent plus have been followed by additional 8% gains in the second half 82% of the time since 1945 according to CFRA research. Moreover, S&P 500 forward returns are positive after inflation has peaked as widely reported by news outlets such as Bloomberg. Inflation has clearly peaked and is moving lower. Lower future inflation allows for higher stock valuations. That is exactly what happened in the first half. Price action has discounted improving inflation numbers, an end to rate hikes coming soon, and now a possible economic soft landing. Investors are looking beyond seasonally weak third quarter to a re-acceleration in earnings over next twelve months. A softer economic landing would be required for fundamentals to support the Bull case. An end to the Fed tightening cycle this quarter could support this kind of outcome.

In the past, when the Fed stopped its tightening cycle, the S&P 500 Index rose over the next 12 months 92% of the time since 1950 according to Bank of America. The forward returns for the S&P have been above average over a 12-month period. My view is twelve months from now the US economy and earnings should be accelerating not decelerating like now.

Will there be smooth sailing ahead? That depends on core-inflation’s path and the Federal Reserve’s reaction. Core -inflation is moving lower, however it is significantly above The Fed’s target rate that the Fed obsesses about. Further tightening that is unnecessary could bring about the much-anticipated recession. Something investors should keep in mind is that Bear markets usually bottom mid-point in a recession. That should make investors cautious if a recession is coming our way. Widely circulated research shows that an inverted yield curve has preceded every U.S recession since 1950. Today’s yield curve is steeply inverted. Last time it was this inverted was in the 1970’s, another period of high inflation and recession according to DOW Jones Market data. Recession warnings have not completely gone away. Those calling for a recession are venerable institutions such as The New York Federal Reserve. Yet the stock market is signaling a soft landing. Which one is it? I side with a softer landing if the Fed does not continue to tighten after July.

Historically a fast-tightening cycle resulted in a recession, particularly ones that had five hundred basis point increase in rates like this one. Leading Economic Indicators (LEI) have been down for 14 months in a row – another red flag. Global PMI index sending recession warning messages. Credit spreads widened but have backed away from recession levels as talk of a credit crunch disappeared from headlines. Anyone professionally managing money had to take heed and be concerned about monetary lag effects on the economy. I see the economy slowing down the rest of year along with inflation indicators.

My view is any slowdown will not be as pronounced as in past tightening cycles because unemployment is not expected to rise as much as in past slowdowns. Why? For one, there is a shortage of workers. Secondly, corporations and households seized on the opportunity to borrow long term at historically cheap rates. The economy has had time to adjust somewhat to a normalization of interest rates. Fed Funds Rate rose from zero to short term rates associated with an economic expansion. Lastly, the Federal Government is still stimulus spending with the Inflation reduction act, etc.

Corporate profits have declined a lot less during recessions in times of high inflation according to research by Credit Suisse. Inflation indicators are steadily declining. Wholesale inflation, as measured by Producer Price Index, is falling faster than it rose and is at its lowest level in three years. Business profit margins have held up because of lower commodity input costs.

Earnings reported better-than-expected results last quarter. FactSet reports that the second quarter has seen the highest number of S&P 500 companies issuing positive earnings guidance for a quarter since Q3 2021. CFRA research reports that census operating earnings are projected to bottom this quarter, and gradually rise over the next twelve months. If correct, the Stock market bottom is in because past patterns show prices bottom before earnings bottom. It may take a couple of quarters for earnings to re-accelerate because of the lag effect on monetary policy on economic growth. Earnings acceleration allows higher stock valuations.

Presently, the S&P 500 Index is trading at 20.3 forward earnings (year-end). That is lofty unless the economy is heading for a soft landing. The odds of a soft landing characterized by flatter economic growth are rising, which would benefit corporate earnings. Stable consumer consumption and lower levels of unemployment, thanks to structural labor shortages, are also supportive of corporate earnings. AI is another tail wind for profit margins. It is an offset to wage inflation hit on profit margins. Lastly, corporate profit margins remain robust compared to historical metrics. The latest decline in Producer Price Index continues to support higher profit margins.

The time to overweight equities is early cycle when the Fed is done hiking. We are so close to an end to this tightening cycle. The speed, magnitude, and duration of tightening cycle suggest the Fed should be done in July. The lag effect of monetary policy has already hit "goods", "commodities", and into year-end “services” should feel it. The market is in the third year of the presidential cycle, which is the best year for stocks in its cycle. Typically, there is third quarter weakness followed by a strong fourth quarter. Inflation data clearly shows peak inflation. Historically, S&P 500 index returns are usually positive after inflation peaks. I am overweighting stocks this summer by dollar-cost-averaging into cyclical sector and Mid-Small cap stocks. Many areas of the stock market are overbought with stretched valuations. In the short term it does not matter. Finally, the Investment Company Institute reported a record level of cash is sitting on the sidelines parked in cash-equivalents such as Treasury Bills- plenty of dry powder is a bullish indicator.