Market Observations - July 2023
Observations Supporting Bullish Sentiment:
Some views suggest that the Federal Reserve's interest rate hike in July might be the last one as interest rates have reached their peak. This sentiment was widely adopted now and almost fully priced in by Interest Rate Swap traders. The next FOMC meeting is September 19 to 20.
Powell stated that the Federal Reserve will no longer predict economic downturns, and the second-quarter GDP, July consumer confidence, and the lowest initial jobless claims since February further support the likelihood of a soft landing for the economy.
The European Central Bank has shifted towards a more dovish stance, now making interest rate decisions based on data.
The record number of money market funds supports the possibility of higher equity allocations since there is still a lot of cash that may move into equities. However, there might be some regulatory headwinds from the SEC that are taking effect in 18 months.
The slowdown in inflation is becoming evident, with the growth of the core Personal Consumption Expenditures (PCE) index at its lowest since September 2021, and the Employment Cost Index (ECI) showing the slowest growth rate since 2021.
Second-quarter corporate earnings have been strong 1) 75% of S&P 500 companies have reported a positive surprise, 2)S&P 500 companies are beating EPS estimates by 6.4% in aggregate, and earnings guidance is more optimistic.
Consumer resilience has emerged as a significant theme for second-quarter earnings.
California Bank's acquisition of PacWest's regional banks is seen as a positive signal for the support of bank industry valuations. Sign of the passage of regional banking crisis.
Expert Views:
Jeremy Siegel (Wharton School) believes that the market will continue to rise. He pointed out that many companies appeared cautious in their earnings forecasts for the first and second quarters, but now their confidence has significantly improved, the market's underlying conditions are improving, and the economy is expanding. Additionally, he mentioned that Federal Reserve Chairman Powell's mention of the Employment Cost Index was lower than expected, leading to low inflation, a strong economy, positive guidance, and good profits. Therefore, the market will not stop its upward trend.
Tom Lee (Fundstrat) has great confidence in the resilience of companies, as he believes that many of them are prepared to face an interest rate hike cycle. He thinks this resilience will help support the stock market. He also believes that there might not be an economic recession in the next two years because there are many potential stimulus factors, such as potential reductions in loan interest rates that could drive economic growth.
Observations Supporting Bearish Sentiment:
During the Federal Reserve press conference, Powell did not explicitly state that the Fed would ease its tightening policy.
The prevailing market sentiment suggests that the US and Europe are on course for a “soft landing.” Skeptics might argue, not necessarily based on data, that significant geopolitical uncertainties exist: Trump indictments, Russia/Ukraine tensions, and US/China relations. Any one of these could significantly disrupt the current positive narrative. Unfortunately, it’s impossible to assign probabilities to any of these events occurring and the extent of the cost they will incur.
The market is experiencing overbought conditions, with nearly 70% of S&P 500 companies' stock prices trading one standard deviation above their 50-day moving average at the beginning of this week.
As the trend of rising product prices slows down and the sustained pressure of higher wages and input costs persists, companies face the risk of declining profits.
The slight adjustment in the Bank of Japan's easing yield curve control policy has driven up global government bond yields. While current data shows the US economy is performing well, if the Bank of Japan were to genuinely adjust its policies, it could have a significant impact on the market. Specifically, If the BOJ adjusts its yield curve control targets to stimulate economic growth or combat deflation(Japan’s current inflation is well below 2%, it may influence investors' expectations about interest rates in other countries, leading to changes in global bond yields. Moreover, changes in the BOJ's yield curve control policy could prompt responses from other central banks. In cases of significant policy divergence, central banks in other countries may adjust their own monetary policies to manage their domestic economic conditions and maintain currency stability, leading to potential changes in global bond yields. Therefore, careful observation and corresponding strategy adjustments are necessary.
Microsoft's annual report indicates a decline in profits, highlighting that artificial intelligence comes with considerable barriers and costs, requiring businesses to increase capital expenditures. This trend could also apply to the other 6 companies that drove a significant portion of the market returns this year because the prevailing market sentiment suggests that these 7 companies will benefit the most from the AI transformation.
Louis Vuitton's unexpected decline in Q2 sales in the United States raises concerns in the market about a slowdown in high-end consumption.(Page 51 of Q2 report shows an almost 50% decline of revenue from last Q4 to Q2 decline).
In Ford's financial report, the market observed pricing and profit pressures in the electric vehicle market.
Expert Views:
Mike Wilson (Morgan Stanley) believes that this year's stock market is mainly driven by valuation expansion, with the primary driving factors being the decline in inflation and cost-cutting, rather than accelerated revenue growth. He acknowledges that missing out on the upside opportunities this year is unfortunate but making further incorrect predictions could lead to permanent losses.
Jason Hunter (JP Morgan) thinks that overbought conditions might persist for a while. Stock market trading often exhibits asymmetry, with bottoms being events and tops being processes. Oversold conditions can be quickly resolved, but overbought conditions may endure for a period. He emphasizes that overbought conditions or investor optimism won't change immediately, and one needs to wait for the market's momentum to slow down and form a stable trend.
Bill Dudley (Former President of the Federal Reserve Bank of New York) suggests that the Federal Reserve might need to implement stricter monetary policies to control inflation. He predicts that the Fed may need to maintain a tight stance for an extended period. He expressed surprise at Powell's reconsideration of a rate hike at the next FOMC meeting(September) because, in the previous meeting, Powell mentioned the need to proceed cautiously due to the long and uncertain lags of monetary policy.
My Own $0.02
Based on the current earnings season, it appears that the U.S. economy has shifted from contraction(trough) to recovery. This conclusion is drawn from analyzing sensitive indicators such as advertising business, consumer spending, and hardware business. As the threat of inflation is receding, the Federal Reserve has many reasons to pause rate hikes after the September FOMC meeting.
Despite the impressive YTD returns (SPX price returns: 19.75%; IXIC price returns: 38.12%, underpinned largely by optimistic projections about AI's positive impacts and a soft landing), there are several observations suggesting bearish sentiment, akin to the prelude of another dotcom crash. However, it's crucial to acknowledge that traditional warning signs of a bursting bubble, caused by unsustainable valuations—like a rapid influx of overhyped IPOs and M&As, a general absence of profitability, and excessive speculative investments—are not as alarming when compared to pre-pandemic benchmarks. A significant portion of the YTD gains can be attributed to rebounding from pandemic-induced setbacks. A reliable measure of market valuation is the Shiller PE Ratio (CAPE) as outlined below. This metric establishes a relationship between a stock market's current price and the average of its real earnings over the past decade, adjusted for inflation. A lofty Shiller PE ratio might point to an overpriced market, while a diminished ratio could indicate an undervalued market. Presently, it appears the market hasn't yet fully recouped its pre-pandemic valuations.
CAPE dated 7/31/2023
Personally, I have a hunch that the pre-pandemic valuation is quite high but fair given many factors such as economic and productivity growth, monetary policy, and quantitative easing, etc. I do not have the hubris to claim to be an economist and build models to quantitatively and robustly reason whether the market valuation is right on the dot. But I do believe that assessing the M2 can give us some objective and high-level insights of market valuation. From 1959 to 2022, the growth of M2 since 1959, when M2 data is available, a wider range of assets that can be readily converted into cash has increased, was surpassed by the growth of GDP right before the 2008 Financial Crisis. At the height of pandemic when market valuation was in a trough in July 2022, we can see that M2 comfortably surpassed the same multiplier of GDP by 25 times.
FRED M2 and GDP data, dated 7/31/2023
Additionally, both GDP and M2 growth dwarfed the CAPE, which did not even double during the same trailing period. Knowing these indicators are not an apple-to-apple comparison, I sensed a high-level trend that the capital markets became the reservoir for the excess M2. Given the supply and demand relationship, money/capital has become increasingly cheaper, expressed academically in 1/CPI or intuitively in low-interest rates(for a long time until lately), thus pushing higher market valuation. This gap between GDP vs M2 growth could further grow when the Fed stops Interest Rate hikes and tapering of its balance sheet in fear of creating a self-fulfilling prophecy of recession when macroeconomic data and the labor market start to show cooling down signs. I think this is the underlying reason why the current market valuation is high but fair(returns are not as exorbitant if you look at purchasing power) and we will not see a crash like the dotcom bubble or 08 crisis, when M2 and GDP growth are largely in tandem, so long as the Feds do not reduce its balance sheet too much or exogenous events happen within the US causing massive capital flight outside of the US.
However, it's important to note that comparing the growth of M2 and GDP to market valuation might seem avant-garde to a more academic audience since this is purely a personal conjecture for high-level understanding, and it does not aim to provide investment decisions that require precision and robust backtesting. For this group, it's worthwhile to delve into works on the fiscal theory of the price level by authors like John H. Cochrane and Thomas S. Coleman. The fundamental premise is that unexpected inflation is driven by the perceived present value of future government surpluses and deficits, as well as outstanding bonds. The traditional quantity theory of money is viewed as too narrow, necessitating the inclusion of bonds and expectations for government spending to provide a comprehensive understanding.
All being said, I found myself in agreement with the bullish side more than with the bearish side. If I were an asset allocator, I would start positioning in economically sensitive stocks that exhibit the following characteristics: leading the recovery in the new economic cycle, having strong fundamentals, and either reaching or about to reach their earnings bottom. For bonds, I would increase the duration to capture the current high yields when the interest rates are stabilizing and potentially be cut next year, leading to expected capital gains from higher FMV of bonds.
In Chicago, 8/1/2023