Market Update

The S&P 500 added 0.4% this past week and the Nasdaq rose 0.1%. The S&P closed the week at 4,298.86. The index broke above 4,200 two weeks ago. We wrote last week that the next resistance is 4,325.28. The S&P didn’t test 4,325.28 last week but consolidation above 4,200 is a positive sign for more advances. Expect the S&P to test 4,325.28 this week.

An expected test of 4,325.28 is a forecast based on technical analysis. The S&P 500 has been in a clear uptrend since its October low. The S&P will need to surpass 4,325.28 before the long-term trend turns up. Lower highs and lower lows are the definition of a downtrend. The S&P has been in a long-term downtrend since it peaked at 4,818 in early January 2022. A move above 4,325.28 shifts the S&P into a long-term uptrend. The rising 200-day moving average is already indicating as much. A failure to climb and maintain above 4,325.28 means a trading range market at best. It means a resumption of the long-term downtrend at worst. Trading range markets often visit the downside of that range if they can’t break out to the upside.

The fundamental picture argues for a failure at 4,325.28. At least a partial retracement of the rally from the October 2022 low would follow. But the technical picture points higher. The American Association of Individual Investors’ survey shows bears outnumber bulls by almost eight percent. Bulls usually exceed bears by 6.5 points, according to Barron’s. Also, leveraged funds are as short as they were during the pandemic. Maintaining an elevated short position means leveraged fund managers are pessimistic. And a recent Bank of America survey of portfolio managers shows high levels of cash holdings. Portfolio managers are almost 6% in cash, near the average peak for holding cash. All these are contrarian indications pointing toward a higher market.

Offsetting the technical picture is a fundamental setup that urges caution. Earnings estimates have been falling. S&P 500 earnings-per-share estimates for 2023 are down almost 12% in the past year, according to FactSet. Morgan Stanley strategist Mike Wilson sees further declines. He believes that earnings could suffer a 16% decline this year, to $185 a share. Wilson points to profit margins as the culprit. Companies will struggle to raise prices to keep up with cost inflation, he predicts. And the stock market is already expensive. The index trades at 18.6 times 12-month forward earnings, down from 21.5 times at the end of 2021. It is still above its 20-year average of 15.7.

Marko Kolanovic is J.P. Morgan’s chief global markets strategist. He sees the U.S. and global expansions lasting longer than expected. Kolanovic points to the compression in profit margins and tightening credit conditions as evidence that the U.S. will still see a recession. It will only be delayed, not avoided. “These data suggest that the seeds for an end to expansion are being sown,” he writes.

And of course, there is the sharp rise in the federal funds rate. The trip from zero to 5% was the fastest on record. The impact of the rate hikes is only now being felt. More hikes are likely. The FOMC is going to pause this week, according to the futures market. Powell is expected to emphasize the potential for further hikes during the news conference though. It is being dubbed a “hawkish pause”. Another hike or two is likely because the core PCE isn't falling very fast. Core PCE was up 4.3% annualized for the most recent three months. It was up 4.7% over the last 12 months.

The BofA strategy team led by Michael Hartnett writes that the biggest “pain trade” for the next year is for fed funds to rise to 6%. That is much higher than most forecasts. He thinks it could well happen because bringing inflation down to 3% will require a jobless rate over 4%. A jobless rate over 4% will in turn require the economy to slow further.

Fundamentals are pointing toward recession, although maybe not until 2024. Technicals favor a continuation of the current rally, at least for a while longer. We will see which will prevail into the year end.

Economic Indicators

It was a quiet week for economic reports last week. The CPI is out on Tuesday, in time for the Fed meeting Wednesday. The data that did come out last week indicated an economy that is growing slowly. The jump in weekly jobless claims was notable. Claims rose to 261,000 from 233,000. The trend has been higher for the last six weeks or so. Long gone are the sub-200,000 jobless numbers. It might be that the Fed rate hikes are finally starting to get some traction with the labor market.

The Economy, Earnings, and Stocks

I had a client email me on Friday. He was writing to me about one of the stocks we own. He wrote, “You have to wonder what really moves the market.” It is a worthwhile question. What does move the stock market?

Earnings and interest rates move the stock market over ten-plus year periods. The correlation is high. It should be. Stocks represent ownership in a business. The more profitable the business the more valuable it is to stockholders. Investors are willing to pay more for a company whose earnings are growing faster. The current earnings yield plus the expected earnings growth rate represents the expected return. Buying a stock with a P/E of 12 means owning a company with an 8.5% earnings yield (P/E is the inverse of earnings yield). Earnings growth of 5% means a total return of 13.5% (add the earnings yield and the earnings growth rate together).

Future earnings must be discounted to present value though. The present value of the future earnings stream changes with interest rates. Higher interest rates mean future earnings are worth less. Lower interest rates mean future earnings are worth more.

Also, earnings and economic growth are correlated. Earnings grow at the same rate as the economy over the long run. Profit margins are stable. Capitalism works. Excess profit margins attract more capital, more competition. Excess profits are competed away in a functioning marketplace. Earnings can’t grow faster than the economy over the long run. Stock prices can’t grow more rapidly than earnings over the long run either. At least they can't unless investors are willing to pay more and more for each dollar of earnings. There are limits to how much an investor is willing to pay for a business. Those limits are tied to owner's earnings and interest rates.

So, what moves the stock market in the long term? Earnings and interest rates. What moves the market in the short-term is everything else. Momentum, greed, fear, a shift in consumer confidence, and mutual fund window dressing can all contribute to stock price movements in the short term for instance. None of those influences determine the value of a business. None of those things impact the stock market over the long run. They may push stocks up or down in the short run though. Best to ignore the noise. Focus instead on the future stream of owner's earnings. Focus on how much you're willing to pay for those earnings today.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist