Market Update

The S&P 500 fell 4% last week to finish at 4057.66. It fell 3.4% on Friday after Fed Chairman Jerome Powell talked tough about interest rates. The Nasdaq fell 4.4% last week. High price-to-earnings tech stocks were hit especially hard. We wrote last week that the stock market was likely to fall if it didn’t receive good news. No good news surfaced. Instead, Powell was hawkish.

Powell told attendees at Jackson Hole that the Fed needed to bring inflation down to 2%. He told them it would take time and that another large interest rate hike was likely in September. Ed Yardeni of Yardeni Research characterized Powell's speech as short and hawkish. “He quashed any lingering expectations that the Fed would pause its tightening and might lower interest rates,” Yardeni wrote.

Inflation is the problem of course. It is difficult for the Fed to stop hiking with inflation readings still near 40-year highs. The numbers are heading in the right direction, which is the reason investors have been so upbeat. The most recent CPI number of 8.5% year-over-year is still far above the targeted 2% rate though. The Fed’s preferred measure is the personal consumption expenditure index (PCE). It slipped to 6.3% in July from 6.8% in June. The core PCE, which eliminates food and energy, fell to 4.6% from 4.8%. Sticky inflation is still rising. It will take time for the core PCE to fall to 2%. It may not happen until 2024.

Housing has a much different weighting in the PCE than in the CPI. The PCE index doesn’t weight housing as much. Housing is 16% of the headline PCE and 18% of the core PCE. The CPI housing weight is approximately 40%. Home prices are expected to rise almost 20% when the June S&P Case-Shiller U.S. Home Price index is released this week. Rental prices follow home prices with an approximately 12-month lag. Expect the CPI decline to lag the PCE decline. The public looks to the CPI. Expect the publics estimation of future inflation to be higher than the Fed’s. Remember, inflation expectations matter as they influence inflation.

The odds of a full-blown recession beginning in the next two to three quarters is high. The most likely path for the U.S. stock market is down in September. The short-term trend is already down after last week. The 50-day at 4,000 is support. We should get a small bounce early in the week, but a test of the 50-day is likely later in the week, if not immediately. A test of the June low this year or next is likely as well. A decline in the S&P 500 to 3200 is possible. Norwood Economics’ base case is a trading range market between 3200 and 4800 over the next few years. It will be a good market for stock pickers if that scenario comes to past. Mutual fund investors are likely to be frustrated with a sideways market though.

Economic Indicators

The economy is growing slowly based on last week’s economic data. The Chicago Fed national activity index (CFNAI) was 0.27 in July up from -0.25 the prior month. It is composed of 85 separate indicators. A number above zero indicates growth above trend. The S&P U.S. manufacturing PMI was 51.3 in August down from 52.2 the prior month. A number above 50 indicates growth. The services PMI fell to 44.1 from 47.3. It is the sharpest contraction since May 2020 during the pandemic. Inflation and rising interest rates were cited as reasons for dampening customer spending. New orders contracted at the steepest pace in over two years. The data is collected in a survey of over 400 private sector companies.

The housing market also showed signs of weakness. New home sales in July were 511,000 down from 585,000. It was the lowest level since January 2016. The pending home sales index dropped by -1.0% in July after falling -8.9% in June. The housing market is one of the most interest rate-sensitive economic sectors. It will continue to struggle with the Fed continuing to raise rates.

There were several positive signs for the economy last week as well. Real GDP for the second quarter was revised upward to -0.6% from -0.9%. Real final sales were revised to -0.2% from -0.3%. Consumer income and spending numbers are holding up. Real disposable income rose 0.3% in July after falling 0.2% the prior month. Real consumer spending rose 0.2% in July after being flat in June. The consumer makes up 70% of economic activity. Consumer confidence was better in August than first reported. The UMass consumer sentiment index was revised to 58.2 from 55.1. It’s an improvement but still at levels associated with recession.

How to Know If a Company is On Sale

Last week we wrote about what makes a good company. A good company is a profitable company. A good company has an edge that will keep it profitable. Strong balance sheets and high dividend payouts are also desirable.

Good companies make bad investments if you pay too much for them. Price is the most important determinant of returns. No matter how good a company is you’ll experience poor returns if you pay too much.

Norwood Economics relies heavily on how the market has valued a company in the past. We look at the price of the stock relative to sales, book value, cash flow, and dividends primarily. We calculate the yearly low and high going back a decade. We look at five- and ten-year average lows and highs for those measures. We’d like to buy companies trading at the low end of their average price multiples over the last five and ten years. We want to own companies trading cheaply, but with long-term prospects intact.

There are three sources of return for any company. The first is the current earnings yield, which is the P/E inverted. The earnings yield is how much return an investor receives for buying the stock today. The second is earnings growth. The earnings yield plus earnings growth is the return an investor receives over time. Buying a stock at 12 times earnings means getting an 8.5% earnings yield. Your return will be 10% annually if earnings growth is 1.5%. The 10% return assumes the price-to-earnings multiple doesn't change. Of course, it does over time. The change in the price-to-earnings multiple is the third source of return.

Changes in sentiment result in changes in price multiples. A company trading at 12 times earnings can fall to 10 times earnings if investors become more pessimistic. Likewise, the company can move to 14 times earnings if investors become more optimistic. A rise from 12 to 14 times is a 16.7% increase in the P/E multiple. A stock with an 8.5% earnings yield growing earnings at 1.5% will return 10%. The return rises to 13.3% if the P/E rises to 14 times over a five-year period. The return still rises to 11.7% if it takes ten years for the P/E multiple to increase.

Norwood Economics looks for good companies that can beat the S&P 500’s long-run return of 10% on a risk-adjusted basis. Contrarian investing works because stock multiples are more likely to rise than fall with out-of-favor stocks. Investors overreact to both good news and bad news. High P/E multiples will eventually contract as earnings growth slows. Low P/E multiples will eventually expand as the bad news becomes less bad.

Norwood Economics seeks to buy good companies when they are on sale. Much less needs to go right for those companies to provide above-market rates of return. Buy good companies when negative news temporarily surrounds them. You'll be rewarded over the long run.

Regards,

Christopher R Norwood, CFA



Chief Market Strategist