Market Update

The S&P 500 rose 0.3% last week to finish at 4205.45. The Nasdaq 100 rose 3.5% last week as investors continue to crowd into a handful of big tech names. The S&P faces significant resistance at the 4,200 level. The index is expensive. It is trading at 19.1 times 2023 estimated earnings and 17.1 times the 2024 pie-in-the-sky estimate. Analysts are predicting $245.73 per S&P 500 share for 2024, growth of 11.7%. Any earnings growth at all for 2024 is unlikely if a recession appears. Rather, declining earnings of 15% to 20% is more typical during recessions.

Stocks are also expensive relative to bonds. Rising rates have made stocks less attractive to investors who can now get 5% in Treasury bonds. Stocks are as expensive relative to bonds as they’ve been since October 2007, according to Doug Kass of Seabreeze Partners.

The Federal Reserve is not going to cut rates in 2023. Investors were pricing in three rate cuts in 2023 until last week. Now they are pricing in at least one more rate hike. The Atlanta Fed is projecting 1.9% GDP growth for Q2. Unemployment is at 50-year lows. Inflation as measured by the Core PCE was 0.4% in April up from 0.3% in March. Year-over-year Core PCE rose from 4.6% to 4.7% in April.

Rate cuts in 2023 are a fantasy at this point. Rate hikes are a real possibility. The CME FedWatch site lists the probability of a quarter-point increase at the June meeting at 66.5%, up from 17.4% a week earlier. The probability of at least one hike by the July meeting stood at 78.9% by Friday, up from less than 20% a week earlier.

Rates are high and likely still rising. Credit tightening in the banking system is ongoing. Small banks—Nos. 26 to 4,500 in size—make up roughly 37% of all lending in the banking sector. Many of those banks are experiencing rising funding costs. Rising funding costs limit lending.

M2 continues to contract, falling 4.85% through April, the biggest contraction in money since 1932. Additionally, an unexpected source of liquidity is about to dry up. The Treasury is unable to borrow until the debt ceiling is raised. It has been spending down its account balances instead. The spending is a liquidity injection into the financial system. The Treasury can issue billions in bonds as soon as the debt ceiling is raised. Bond issuance will drain liquidity from the economy.

In short, the odds favor the S&P failing in the 4,200 area and retracing at least part of the rally off the October lows.

Market internals are supporting that forecast as well. “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names,” Bob Farrell frequently wrote. Farrell was the head of Merrill Lynch market analysis for 16 years and worked at Merrill for 45 years.

We’ve written several times recently about the current narrow rally. Deutsche Bank has calculated the impact of the handful of stocks pushing the S&P higher. Through Thursday year-to-date the S&P is up 8.1% versus a 1.2% decline in the equal-weighted S&P. It is a difference of 9.3%, the biggest difference since 1999. The spread between the two measures was also 9.3% in 1999, exceeded only by the 16.3 percentage-point spread in 1998.

The difference in performance is even bigger when comparing dividend-paying stocks to the Nasdaq 100. The iShares Select Dividend fund (DVY) is down 9% on the year. The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) is down 2%. Meanwhile, the tech-heavy Nasdaq 100 is up 30%. The bulk of the performance comes from a handful of stocks.

The highflyers might fly high a while longer, but history suggests they will eventually lose altitude. The rest of the stock market will need to start rising if the rally is to continue. An expensive market, sticky inflation and high-interest rates make that scenario less likely.

Economic Indicators

First quarter GDP growth was revised up to 1.3% from 1.1%. The Atlanta Fed GDPNow tool forecasts 1.9% growth in Q2, down from a 2.9% forecast a few days earlier. The S&P flash services PMI rose to 55.1 in May from 53.6. The manufacturing PMI rose to 51.0 from 50.2. A number above 50 shows growth. Personal income rose 0.4% in April, up from 0.3%. Personal spending rose 0.8%, up from zero the prior month. Consumer sentiment rose to 59.2 in May from 57.7.

Housing is perking up as well. Data on the number of new-home buyers, and home builder and home-buyer confidence are starting to move higher, according to Barron’s. New home sales rose to 683,000 in April from 656,000. Pending home sales were flat in April after declining 5.2% in March. The average number of offers received for a sold property is going up, according to Barron’s. A recovering housing market will impact the inflation numbers. Housing accounts for 40% of the consumer price index.

The data last week reflected an economy showing more strength than expected.

The Turn of the Century Stock Market

I was investing in small-cap value stocks in the 1990s. Small-cap value stocks have the highest long-term return. We had some good years heading into 1998. The stock market had had some good years as well following the early ’90s recession. We lost about 6% in 1998. The Russell 2000 small-cap index was down around 38% at one point in 1998 if memory serves. So, our 6% decline was strong relative to the small-cap market.

Meanwhile, the S&P 500 was up in 1998. It rose again in 1999. The dot.com bubble was in full swing. Jeremy Grantham was calling it a bubble and had positioned GMO accordingly. GMO was losing impatient investors in droves with billions in AUM leaving. Grantham wasn't wrong, just early. GMO did fine in the two-year bear market that followed the popping of the dot.com bubble. Many other fund managers couldn’t say the same.

My investors were getting a bit restless as 1998 unfolded. Why were we down when the S&P 500 was up so much? The answer of course is that we weren’t investing in the S&P 500. Our portfolio was a small-cap value portfolio, not a large-cap portfolio. We were down single digits while the Russell 2000 was down over 30%. It was a good year for us. The small-cap portfolio rose over 60% in 1999, which made the last years of the century even better for my investors. The gains in 1999 came in large part from the stocks bought in 1998.

The point of this walk down memory lane is that today’s market seems as split as that market 25 years ago. The Nasdaq is up 24.3% YTD. The S&P is up 10.3% YTD. Our stock portfolio is down about 2.5% YTD. It is down around 11.3% over the trailing 12-month period versus a gain of 7.9% and 2.9% for the Nasdaq and S&P 500 respectively. Of course, last year our stock portfolio was up mid-single digits with the S&P down 18% and the Nasdaq down 32%.

Our stock portfolio return looks better compared to the equal-weighted S&P 500 index ETF. Also, against the various dividend-paying ETFs. Those are more appropriate benchmarks for our stock portfolio than the market-cap-weighted S&P 500.

We’ll see if 2023/24 ends like 1998/99 did. The S&P 500 peaked in the spring of 2000. It lost 50% over the next two years as the dot.com bubble popped. A two-year bear market isn't my base case. Norwood Economics is expecting a 15% to 20% pullback in the S&P 500 sometime in 2023. It should be a nice buying opportunity for those with cash.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist