Market Update

The S&P 500 fell 1.2% last week to finish at 4,398.95. The index bottomed for the week Thursday morning, hitting 4,385.05 after the market gapped down at the open. The weekly low was just above the 20-day moving average. Commentators pointed the finger at the ADP jobs report as the cause of the early selling on Thursday. It came in stronger than expected. Buyers stepped in around 11 a.m., pushing the index up to 4,415 by the end of the day.

The S&P continued its climb on Friday as the government jobs report came in weaker than expected. Buyers couldn’t push the S&P above 4,440, although they tried for almost 45 minutes. Having failed to advance past 4,440, the S&P started falling around 1:30 p.m. Friday and closed near its low for the day. Closing near its low on Friday means the selling is more likely to continue Monday.

We wrote last week that, “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.” The strong ADP jobs report triggered some selling Thursday and Friday. Whether traders continue taking profits ahead of earnings season remains to be seen.

Earnings season starts Friday with the big banks reporting. S&P earnings are forecast to decline by 8.6% for the second quarter. Earnings are expected to continue falling in the third quarter, but only by 0.1%. It would mark three straight declines in quarterly earnings if forecasts are correct. Fourth quarter earnings are expected to grow 8.5%. Management guidance is likely to have a greater impact on near-term market direction than actual Q2 earnings. The market is still overbought and expensive. The odds favor more downside in the next few months unless management guidance is strong.

Economist David Rosenberg described the last six months as a sentiment-driven rally while appearing on CNBC last week. He went on to say that the rally was “devoid of fundamentals”. He expects continued rate hikes to “break the back of something” in markets. Rosenberg believes the next 12 months will be “really tough” as the lagged effects of Fed tightening kick in. He pointed to declining corporate earnings as evidence that a recession has already hit US corporate profits. Rosenberg is the former Chief North American economist for Merrill Lynch. He has one of the best economic forecasting records on Wall Street.

Rosenberg is hardly alone in his bearish views. Last week we wrote that Mike Wilson of Morgan Stanley is forecasting $185 per share for S&P profits in 2023. It would be a better than 15% decline from 2022 if he's correct. The consensus forecast for 2023 is $219 per share.

Both Rosenberg and Wilson are focused on corporate profits rather than unemployment. They know that unemployment is a lagging indicator. It doesn’t peak until after a recession has ended. For instance, unemployment kept rising until October 2009, four months after the official end of that recession. Meanwhile shrinking corporate profits are a better real time gauge of economic distress. Other leading indicators are pointing to recession as well.

We’ve mentioned the Conference Board LEI repeatedly over the last few months. It is a reliable leading indicator that is signaling a looming recession. We’ve also pointed at the inverted yield curve as another reliable leading indicator. Rising bankruptcies are yet another sign that the real economy is struggling.

There were 286 publicly traded companies in bankruptcy by the end of May 2023. The spike in bankruptcies has already exceeded the 2000-2002 period. It is approaching the magnitude of the spike seen during Covid. It does not bode well that more than 30% of Russell 2000 companies are unprofitable. Rising interest rates will make it hard for these “zombie” companies to get financing as current debt comes due. Credit spreads don’t yet reflect the unfolding credit crunch, but it's only a matter of time until credit spreads widen. High-yield bonds are likely to underperform beginning in the next few quarters.

Economic Indicators

The manufacturing sector remains in recession. The ISM manufacturing index fell to 46.0% in June from 46.9% the prior month. Readings below 50 indicate contraction. The forecast was for 47.3%, which made the actual number weaker than expected. Factory orders came in weaker than expected as well, rising by 0.3% in May. The forecast had been for a 0.6% increase.

Offsetting manufacturing weakness, the ISM Services report showed continued growth. The June number was 53.9% up from 50.3% the prior month. Services make up almost 80% of the U.S. economy. The economy is unlikely to fall into recession until the service sector does.

The jobs market remains strong. But it is a lagging indicator. U.S. nonfarm payrolls rose by 209,000 in June. It was down from a 306,000 job increase in May and below the 240,000 forecast. The U.S. only needs around 100,000 jobs created monthly to absorb new entrants. Higher job growth than that means a tightening labor market. Job openings remained high with 9.8 million open positions in May. That’s down from 10.3 million the prior month but still well above normal. Hourly wages grew by 0.4% in June ahead of the 0.3% expectation. Hourly wage growth year over year was up 4.4%, too high to accommodate the Fed's 2% inflation goal.

The Fed will hike the fed funds rate by 0.25% when they meet on the 26th. Futures put the odds at 93.0%. The CME FedWatch tool has the odds at 30.6% for a second hike by year end. The bond market is pricing in one hike, as evidenced by the 2-year Treasury’s better than 5% yield. It is not pricing in a second, at least not yet. Rising rates will pressure both the economy and the stock market.

Risk Premium

The stock market is expensive. Asserting that it is expensive isn’t the same as predicting a decline. The stock market can remain expensive for years. Still, it is expensive by most of the measures used. Price-to-book, Market Capitalization to GDP (reportedly Warren Buffet’s favorite measure), Replacement Cost, Price-to-Sales, and Cyclically adjusted Price-to-Earnings are five of the most used metrics. None of these measures are helpful in predicting short-term price movement. All are helpful in estimating returns over a decade or longer. We wrote last week that the S&P 500 is priced to return about 2% per year over the next decade (excluding dividends). We were using the above metrics as our guide.

Risk premium is another measure of valuing stocks, this time against Treasury bonds. It is a relative measure, comparing different types of assets, but still useful. The concept stems from the commonsense notion that risky investments should offer a higher return than risk free assets. Stocks should return more than Treasury bonds in other words. And they have over the last 150 years of U.S. investing. The equity risk premium has been around 4.5% since the late 1800s. It has been between 3.0% and 3.5% over the last 20 years.

Now the risk premium is about 1.1%, using the S&P 500’s forward P/E and the 10-year Treasury bond. The S&P is trading at around 19.1 times 12-month forward earnings. The earnings yield (inverse of P/E) is 5.2%. The 10-year Treasury yield ended the week at 4.1%. Not much added reward for the higher risk taken when buying stocks.

The S&P would need to fall to 13.6 times 12-month forward earnings for the risk premium to rise to 3.25% (the mid-point for the last twenty years). A decline to 13.6 times earnings using the next four quarters of earnings estimates would put the S&P 500 at 3,141. A 29% decline is a typical bear market. It's possible we'll see such a decline if the economy does slide into recession in the next few quarters. But only if investors demand an equity risk premium more in line with the last 20-years. Otherwise it’s more likely that the S&P will bottom in the mid-3000s should a recession come calling.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist