Last week, we noted that we were about to enter Q2 earnings season.“Speaking of earnings, analysts have been extremely busy over the last 30 days, slashing estimates. In June, Q2 earnings estimates for the S&P 500 index were cut by $5/share to the lowest level yet. Interestingly, while Wall Street continues to boast confidence in rising asset prices, they have cut estimates from $214/share in March last year to just $193/share. Such suggests a dichotomy between expected market performance and the economy, which is where earnings come from.”
For a deeper discussion on Q2 earnings, read “Earnings Bar Lowered.”As noted, I am using Wednesday’s closing data for the current analysis before I head out for vacation. First, while markets hit an all-time high, I wouldn’t read much into it. Trading volume was light due to the shortening of the week for the Independence Day holiday week. Secondly, while the market did make a new high, it remains a marginal new high tracking along the 20-DMA, which continues to act as bullish support.The market remains overbought short-term, but the recent rally is close to flipping the short-term MACD “sell signal.” Such would suggest that while the overbought condition could limit the upside, the market will likely try to climb higher over the next two weeks. Continue to manage portfolio risk accordingly, but the bullish trend remains intact.
As noted, investors remain very optimistic about the market currently. Net bullish sentiment remains elevated, volatility is suppressed, and “bad news remains good news” for now.
Of course, the current “A.I.” driven rally based on Fed rate cuts seems eerily familiar.
Is 2024 Repeating 2023?As noted above, the market continues its bullish trend from the October 2023 lows. Of course, that rally has been the byproduct of the chase for anything related to “artificial intelligence,” the chase for performance (buy the “Magnificent 7”), and ongoing hopes for Fed rate cuts.In “Rising Bullishness,” we discussed how the performance chase has led to individual investors slashing cash and increasing household equity allocations to record levels.
At the same time, consumer expectations for higher stock prices in the next 12 months are at a record.
“This past week, the market pushed well past our previous price target and is moving well into 3-standard deviations above the 50-DMA. Furthermore, the market is very overbought on multiple levels. Lastly, the volatility index is at extremely low levels, which has almost uniformly preceded corrections of 5-10% during both bull and bear markets.“
Notably, that was June 2023, about a month before the market peaked in July. That market peak was followed by a 10% correction at the end of October.Interestingly, I can almost pen the same commentary with investors bullish, low volatility, and markets deviating well above long-term moving averages. As shown, the year-to-date price performance of the S&P 500 index is almost a mirror image of 2023. With the election approaching, the seasonal tendency of a market correction between August and October of election years suggests we may continue to see a repeat performance.
If the market does derisk pre-election, it will provide an opportunity to increase exposure as needed for the post-election rally into the year-end.Of course, much of this will depend on what the Fed does next.
Rate Cut In July?The Federal Reserve will meet at the end of this month to determine its next steps in monetary policy. While the market has been rallying on expectations of the Fed cutting rates this year, there is a very low expectation of a rate cut in July. However, could the Federal Reserve surprise the market with a rate cut? It is certainly possible, but much will depend on the data in the upcoming employment report and the core consumer price index.The Fed’s primary concern continues to be keeping the economy out of a recession while slowing the growth rate to bring down inflationary prices. It is a tricky tightrope, likely leading to significant policy-making errors. However, as of late, economic data continues to disappoint, with the Atlanta Fed’s GDPNow tracker for Q2 dropping from over 4% to 1.5%. Such suggests an unexpected deterioration in activity over the last two months.
Most notably, the Institute of Supply Management (ISM) Non-Manufacturing index turned sharply lower in June. As we explained previously:“While much of the manufacturing data has remained weak for quite some time, the services side of the data has remained somewhat robust. Services are essential to the economic outlook. While many looked at the manufacturing data and suggested a recession was likely, we argued previously that such was not possible as services now comprise 80% of the economy.“This isn’t the first time we have seen the manufacturing side of the economy contract, but services remained robust enough to keep the overall economy out of recession. As shown, when the economy’s manufacturing side contracts while services remain expanding, the economy has a “soft recession.” The 1998, 2011, and 2015 periods are the most recent examples.”
“This isn’t the first time we have seen the manufacturing side of the economy contract, but services remained robust enough to keep the overall economy out of recession. As shown, when the economy’s manufacturing side contracts while services remain expanding, the economy has a “soft recession.” The 1998, 2011, and 2015 periods are the most recent examples.”
While the ISM services index has been very volatile over the last few months, the latest reading showed a sharp contraction into contractionary territory and remains in a downtrend. Such continues to suggest the economy is much weaker than headline data suggests. While one month of a contraction reading is not meaningful, if the economically weighted index remains in contraction territory over the next several months, such will be another indicator that previously coincided with economic recessions.Furthermore, confirming the ISM readings, the Economic Composite Index (an index of more than 100 data points) has fallen to levels previously coinciding with recessions. Such suggests economic risk and a sharp deterioration in upcoming economic data will catalyze an initial rate cut. The Fed previously cut rates sharply, with the EOCI index at very low levels due to the onset of a recession.
Crucially, the financial markets are running well ahead of economic production. As shown, there is usually a reasonably close relationship between the ISM Composite Index and the annual rate of return of the S&P 500. That is because earnings are a function of economic activity. However, as shown above, and below, investors and analysts are incredibly ebullient about future growth far above what the economy produces.
How We Are Trading ItAs discussed above, 2024 has been almost a mirror image of last year, with market performance very close. Will the correlation continue, and we see a correction this summer, or will this time be different? I don’t know, but the similarity is eerie, and the risk of correction is elevated in the near term.For now, momentum remains king, keeping portfolios allocated towards equity risk. However, we are beginning to look into more “defensive” positions to add to or swap in the portfolio. We expect a correction this summer to provide a better risk/reward opportunity to increase equity exposure.While I have repeated the rules below over the last several weeks, reviewing your portfolio for opportunities to manage risk remains a good practice.
Notice, nothing in there says, “Sell everything and go to cash.”Just manage risk as needed to mitigate the impact of a sudden reversal.
7-2-24 Interest Rates Are A Function Of Inflation And Economic Growth
The Fed Funds Rate Is Too High
