A recession is overdue
Market Update
The S&P 500 rose 2.35% and finished the week at 4450.38. It rose 16% in the first half of 2023 after falling over 18% in 2022. The average S&P stock is up 6% year-to-date. The Dow Jones and Russell 1000 Value index are up less than 4% on the year. The Nasdaq is up 32% in the first six months of 2023 after falling 32% last year. It is the Nasdaq’s best start since 1983.
The S&P is still 368 points away from its all-time high of 4818 set in January of 2022. The S&P is trading at 19x forward earnings, up from 15x in October of 2022. The long-term average 12-month forward P/E is 15.5 times. The S&P is trading 23% above fair value. It might surpass its all-time high before the year is out anyway. Expensive can get more expensive after all.
Expensive means lower than normal returns over the next 10 years though. It’s unlikely the S&P 500 will return anywhere near its long-term average of 9%-10% over the next decade. Instead, the S&P is priced to return around 2% per year. More risk, less reward over the next decade argues for caution.
The stock market’s advance since last fall has come as earnings estimates have fallen. Deutsche Bank strategist Parag Thatte expects a modest selloff soon, according to Barron’s. The S&P index hasn’t declined by more than 3% since March. That’s unusual, putting the duration in the 90th percentile for rallies without at least a 3% pullback since World War II, according to Thatte.
A 5% - 10% decline could happen at any time. Traders have profits to protect, with the S&P up over 27% in the last eight months. It wouldn’t take much to trigger selling. It would be surprising if the market didn’t trade down to at least 4,200 in the next few months. A retest of the October low could happen if the economy falls into a recession.
The consensus earnings estimate for the S&P continues to decline. Earnings are now expected to reach $219.70 in 2023. Third quarter earnings are expected to decline. It would be the third quarter in a row of negative earnings growth. Fourth quarter earnings are expected to grow 8.5%. It wasn't too long ago that the consensus was for growth of more than 11%. A fourth-quarter surge in earnings seems unlikely given tighter credit conditions. The earnings growth forecast for 2024 is falling also. Yet, it is still too high, especially if the economy slips into recession in the next 12 months.
Mike Wilson of Morgan Stanley is forecasting earnings of $185 for the S&P for 2023, according to a note last Monday. Wilson sees a 16% drop in profits in 2023 versus the consensus 0.7% increase. Wilson does expect a bounce back in profits to $239 in 2024, an increase of 23% from his 2023 earnings estimate. The consensus estimate for 2024 is $245.73 per share. The S&P is trading at 24 times 2023 earnings and 18.6 times 2024 earnings based on Wilson’s estimates. It is trading at a still expensive 18.1 times 2024 estimates based on consensus. Again, more risk less reward, not just for the next decade but in the short-term as well.
It’s hard to see the S&P advancing much over the next 12 to 18 months given its P/E and earnings estimates. Sideways for the next year or so seems the most likely scenario. A new bear market with the S&P 500 trading into the low 3,000s seems plausible as well. A continued strong advance to new all-time highs seems least likely. The high probability of a recession in the next 12 months argues against that last scenario.
The New York Federal Reserve places the odds of a recession in the next 12 months at 71%. It’s basing its estimate in part on the 3-month/10-year Treasury spread. An inverted yield curve has preceded every recession since 1950. Dow Jones Market Data says inversions of two-year and 10-year yields have preceded recessions by as little as seven months or as much as two years. The yield curve inverted in March of 2022, which puts us at 15 months and counting. The Conference Board LEI has declined 14 months in a row. On average there is usually 10.6 months between a peak in the LEI and a recession. The last LEI peak was 17 months ago.
A recession is overdue. Earnings estimates are too high. The stock market is expensive. The S&P is likely to trade sideways to down over the next 12-18 months. Norwood Economics is looking forward to buying good companies as they go on sale.
Economic Indicators
The housing market continues to improve, sort of. New home sales rose to 763,000 in May, up from 680,000 the prior month. But pending home sales declined by 2.7% in May. They were flat the prior month. Home prices fell nationally. Declining prices may be helping stimulate sales. Declining prices also indicate weaker demand. The S&P Case-Shiller home price index fell 1.7% in April after declining 1.1% the prior month.
Consumer Confidence increased in June. The confidence index rose to 109.7, up from 102.5 the prior month. Retail inventories rose by 0.8% in May from 0.3% in April. Rising retail sales can be an early warning of a decline in consumer spending. Initial jobless claims fell to 239,000 from 265,000 the prior week.
Personal income growth slowed to 0.3% in May from 0.4% the prior month. Personal spending growth slowed to 0.2% in May from 0.8% the prior month. The core Personal Consumption Expenditure index (PCE) rose by 0.3% in June. Core increased 4.6% year-over-year. The Fed expects core PCE to be at 3.9% by year end, well above the 2% target.
The Fed is expected to raise the fed funds rate this month. Odds are at 86.8%, according to the CME FedWatch tool. Odds are at 69.1% that the Fed holds in September. There are no longer any rate cuts priced in for 2023. Interest rates higher for longer seem to be priced into the bond market. Higher for longer is not priced into the stock market.
Dividends and Taxes
I had a conversation with a client last week about taxes. She had gotten a notice from the IRS about tax year 2021. It was a proposed payment notice, which the IRS sends out when they find a mistake in someone’s taxes. There was a $53,000 discrepancy in reported income. The IRS was proposing total payments of over $14,000, including interest and a penalty.
We looked to see if she’d taken any distributions from her qualified accounts. She hadn’t. Next, I pulled up her Composite 1099 for 2021. The amount of missing income matched the ordinary dividends paid for 2021. Turns out my client’s accountant hadn’t included ordinary dividends in the tax return.
Problem solved; I asked if she had any more questions. She responded that she had “just one question…. what are dividends?”
I explained that dividends were paid to owners from company profits. Stock is ownership in a company.
Profits can be used for only four things. Profits can be paid as dividends to owners. They can also be used to buy back stock, pay back debt, or be invested in the company to grow earnings.
Owners must pay taxes on dividends in taxable accounts. Buying back stock is more tax efficient. Unfortunately, company executives tend to buy when their stock price is high. It’s a pro-cyclical phenomenon. Times are good, cash flow is strong, and the stock price reflects it. Executives buy high. Times are bad, cash flow is weak, and the stock has fallen. Executives usually don’t buy even when their company is clearly undervalued. So buying back stock is more tax efficient, but not necessarily better than paying dividends.
Likewise, company executives often do a poor job of allocating for growth. They get paid to grow revenues and earnings. Options packages are skewed to aggressive growth goals. Growth for growth's sake often leads to poor investment decisions and wealth destruction. Again, it is often better to return profits to investors and let them decide what to do with the money.

It should be noted that dividends have made up most of the return for stock investors over the last 150 years.
Regards,
Christopher R Norwood, CFA
Chief Market Strategist
