The Tipping Point… In The Stock Market?

It’s that time of year… beach, vacations, and fun in the sun… for most. That “May” be a contributing factor to the Wall Street adage “sell in May and go away”. The thinking… traders are less focused on the markets and more focused on vacations with their families. Oddly, this year has shown itself to be different… and possibly not in the best of ways.

Historically speaking, February is the second worst month of the year and yet this year it has been the best month. April is historically one of the best months of the year, and yet it was pretty bad. May is the time for vacation planning and yet a 0.01% drop in CPI caused the markets to rip higher +4%… If November to April is historically the best six months of the calendar year, and May to October is the worst six months, will this be “opposite year”?

This brings me to what I am calling “The Tipping Point”.

Just when I think the fight is over and the bulls have relented, a dovish FED and 0.01% decline in CPI gives the market the gasoline it needed to rally ~4%. In fact the zealousness of the rally even extended to “Meme Stocks” like Game Stop, AMC, Tupperware, and a couple others. And yet higher Weekly Jobless Claims, higher Continuing Unemployment Claims, downward GDP revisions, higher deliquency rates, higher bond issuances, poor bond auctions, higher spending on household goods, higher real estate prices (with lower home sales), and higher business bankruptcies had minimal effect on the US equity markets.

But why?

FED rate cuts. That’s it.

Last month I highlighted the “Great Debate”, citing the dual mandate the FED has to maximize employment while also pursuing a target 2% inflation rate. Finally, FED President Austan Goolsbee agreed stating “What everybody is trying to wrap their head around now … is are we back to the traditional tradeoff between employment and inflation?” This debate continues to plague the equity markets as weaker economic data gives rise to the belief the FED will cut interest rates sooner than expected. These assumed rate cuts (which were originally projected to be as high as seven this year) are now teetering on one, possibly zero, by year end. Yet the US equity markets, which rallied at the “FED pause” in November 2023, haven’t adjusted to the higher inflation and lower rate cut reality.

When the economic data (that I have been highlighting for eight months) is now becoming a snowball rolling down hill, does this mean the exuberance is at a tipping point?

In terms of our investment strategies, we continue to remain defensive. We continue to remain invested in the short maturity end of the yield curve (to earn 4% – 5%) on the fixed income side of the portfolio for Moderate Conservative and Moderate Aggressive portfolios. We also continue to look for new opportunities in undervalued names within the consumer brand space. While these names have strong international brand market share they have been significantly impacted by goods deflation, consumer spending, higher input prices, inflation, and more. Taking small positions (~1%) to assess market appetite has worked well.

With US equity indices priced at all-time highs, valuations stretched to record levels, bond yields continuing to climb toward 5%, and consumer companies (i.e. MCD, SBUX, TGT, HOG, KSS, LULU, ULTA, LVMUY) dropping 10% – 25% on earning misses… it’s time to prepare for class five rapids ahead – based on our research. For this reason, clients holding short positions in April saw a large increase – which was later given back in May. Headed into the summer months it is our forecast that goods companies continue to struggle with a weaker consumer, employment will continue to weaken, and a recession could be starting as early as now…

How Much Is Too Much?

In a prior Market Update I offered the analogy of riding roller coaster. In particular I mentioned the start of every roller coaster starts with a slow and steady ascent… until you reach the peak. With every escalator up there is an elevator down.

Today S&P 500 forward looking (2024) equity valuations are hovering at all-time highs of 20.5X earnings. For reference, according to Factset, the five year average is 19.2 and the 10 year average is 17.8. Of course the averages will adjust as price increases or decreases. This means, if the S&P 500 market cap weighted index dropped to 19x this year’s earnings forecast (245-250) then the S&P 500 market cap weighted index could drop to 4,655 to 4,750. However, should it drop to the 10 year average the S&P 500 market cap weighted index could decline to 4,200 to 4,400. In either case the S&P 500 would decline approximately (peak to trough) 14% to 26%.

So how do we know if the S&P 500 can power ahead or could decline? Let’s look at some interesting facts from Factset.

“Looking ahead, analysts expect (year-over-year) earnings growth rates of 9.3%, 8.3%, and 17.6% for Q2 2024, Q3 2024, and Q4 2024, respectively. For CY 2024, analysts are calling for (year-over-year) earnings growth of 11.4%.”

This means earnings are expected to significantly improve in Q4 of 2024. And yet…

“In terms of revenues, 61% of S&P 500 companies have reported actual revenues above estimates, which is below the 5- year average of 69% and below the 10-year average of 64%. In aggregate, companies are reporting revenues that are 0.8% above the estimates, which is also below the 5-year average of 2.0% and below the 10-year average of 1.4%.” Furthermore…

“For Q2 2024, 60 S&P 500 companies have issued negative EPS guidance and 41 S&P 500 companies have issued positive EPS guidance.”

While earnings guidance for Q1 2024 (ex-MAG 7) came in slightly below analyst expectations, it is difficult to see how earnings will power ahead WITHOUT cost cutting. With labor being one of the largest overhead costs it is not to far-fetched to see how the unemployment rate will need to increase.

But let’s try to look at this as glass half full… maybe input prices will offset the need to reduce labor. According to the FED New York, household spending continues to remain elevated, oil and gasoline prices continue to remain 10% higher than the start of the year, and borrowing costs are not projected to decline until the end of 2024 (if not into early 2025). Sooo… if labor is to remain intact, where do companies cut costs or will they be forced to pass prices on to the consumer (which will lead to higher inflation)?

Let’s bring this home with a compound question. If GDP for Q1 2024 was revised lower to 1.3% (from 3.3% in Q4 2023), business revenue is expected to continue to decline in Q2, inflation remains stubbornly high forcing the FED to keep rates higher for longer, and housing prices continue to increase 5% – 10% across much of the US… what would an uptick in unemployment mean for the economy? Weaker consumer spending? Higher bankruptcies for businesses? Increased foreclosures for homeowners? Higher defaults on credit cards and auto loans? This leads us to “The Bifurcation”…

The Bifurcation

If I hear about one more study or poll talking about how the consumer is “resilient” or “in good shape” I am going to scream. For example, recently the FED completed a poll about this topic. They found approximately 72% of Americans feel they are doing OK… which was last seen in April 2020, and families with children dropped to 64%. While much of the feedback was linked to inflation, it’s only a matter of time before the comments are linked to inflation AND employment. The poll went on to say “consumer spending has been resilient despite rising inflation, but the cracks are starting to show. In March, spending grew by 0.8% while income only grew by 0.5%, which suggests that Americans are spending beyond their means. This follows a monthly trend of overspending since late 2023.”

I know I have been shouting from the roof tops that the economy is deteriorating, but for the polls to only NOW show signs of weakness conveys a few important things. First, pundits have missed the underlying facts. Second, credit card delinquencies have increased more the 40% in the last six quarters. Third, auto loan delinquencies have increased more than 20% over the last six quarters – while the average car payment has remained at $1,000 per month. Fourth, people are saving less (approximately 3.2% or half of what it was pre-pandemic). Fifth, affluent consumers are trading down (i.e. spending more at Costco and Walmart).

In a prior Market Update I highlighted the fact that nearly 67% of American households make less than $100,000 a year AND they feel like they are living paycheck to paycheck. These are the people who typically have minimal investments in stocks, a large portion of these people are renting which means they continue to pay higher rents (based on higher Owner Equivalent Rent) at renewal times, these people feel the pain of increased housing expenses, and these people are more susceptible to changes in labor. Furthermore, this group has burned through most of their pandemic savings and are living on debt.

On the other hand, retirees with high fixed income or the households deemed “affluent” are living comfortably… for now. “The so-called “wealth effect,” whereby rising home and stock values give people confidence to increase their spending, is a big reason why the economy has defied expectations of a sharp slowdown. Its unexpected strength, which is contributing to stickier inflation, has forced a shift in the Fed’s plans.”

This bifurcation between the “haves and have nots” only future highlights the importance of the potential severity of a US recession. The longer the affluent prop up the economy — which in turn keeps inflation higher and in turn keeps interest rates higher — the more damage the US economy will experience. Higher debt (both consumer and government) will take longer to unwind.

For these reasons, along with geopolitical reasons, our outlook on the US economy continues to remain cautious. Our investment thesis will continue to remain defensive with a focus on EV/Infrastructure, Defense/Space, AI/Metaverse, International exposure, non-correlated asset classes, and a gradual transition to longer maturity fixed income options.

I will close with following charts that highlight a few key data points:

In each chart you can see that most of the underlying sectors have underperformed the S&P 500 over the last 12 months, consumer goods brands have cratered recently, and most of the positive performance has been experienced since the “FED pause” in November 2023. Furthermore, companies like Costco and Walmart continue to lead the “trade down” shift as more and more consumers struggle to meet their household expenses. With the expectations of rate cuts waning in 2024… it is only a matter of time before the US market catches up to the facts.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. You cannot invest directly in an index. Asset allocation is no guarantee of risk reduction. Past performance is no guarantee of future results.