Market Update

The S&P 500 fell 0.1% last week to finish at 4,105.02. The Nasdaq fell 1.1%. The S&P pushed higher on Monday and Tuesday, peaking at 4,133.13 in early trading Tuesday. The index drifted lower until early Thursday morning when it bottomed at 4069.84. It was a holiday-shortened week with light volume.

Companies will begin reporting first-quarter earnings this week. JP Morgan, Citi, and Wells Fargo will be among them. The big banks may shed some light on how much rising funding costs are impacting earnings. We may also learn if there are more regional banks with insolvency problems as earnings season progresses. Bank earnings will falter as the economy slips into recession, which makes them a leading indicator of sorts.

Earnings estimates continue to fall. First-quarter earnings are expected to decline by 7.5%. Second-quarter earnings are expected to decline by 6.4%. It’s not just analysts forecasting a tough couple of quarters. There have been 81 negative preannouncements for the first quarter among S&P 500 companies, according to Barron’s. There have been only 26 positive preannouncements. The more than 3 to 1 ratio of negative to positive exceeds the average of 2.5 to 1, according to Refinitiv’s data, which goes back to 1997. Earnings for 2023 are estimated at $220.45, an increase of 1.1%. Earnings estimates are too high if the economy falls into recession in 2023. Forecasted growth of 12.3% for 2024 is too high if the economy falls into recession in 2024. Growth of 12.3% is likely too high by half even if the economy avoids recession in 2024.

Earnings estimates are too high if inflation continues to fall. Falling inflation means slower nominal revenue growth. Slower nominal revenue growth means compressed margins. Companies would need to cut costs to maintain margins. It is unlikely companies can cut costs fast enough to keep pace with reduced revenue growth because cost-cutting typically occurs after revenue growth starts to slow. There is a lag during which margins compress. Revenue growth slows further once widespread cost-cutting does begin because one firm’s cost savings is another firm’s revenue.

Labor is the biggest cost for most companies. Expect unemployment to rise as inflation falls. Rising unemployment will reduce nominal revenue growth further. Consumers can't spend as much when unemployed.

The S&P is expensive at 18.6x 2023 earnings and 16.6x 2024 earnings. The Fed will likely raise at least one more time in May, putting the fed-funds rate at 5.0% to 5.25%. Financial conditions are tightening further as banks reduce lending. Banks are tightening lending standards because of large unrealized losses on their balance sheets. They don't have to declare the losses, but they impact lending, nevertheless.

Leading indicators continue to point toward recession. Coincident indicators are hinting at recession. And the stock market rally has been narrow. Narrow rallies don’t tend to last.

The S&P 500 returned 7.5% in the first quarter. Technology contributed 5.4% of the 7.5% return. The S&P 500 equal-weighted ETF rose a mere 2.9% in the first quarter by comparison. It appears as if investors are chasing the big tech stocks that did so well from 2017 through 2021. New bull markets rarely have the same leadership as the previous bull market. It’s unlikely that big tech will lead when the new bull market does get underway.

It is unlikely that the new bull market is already underway. The bond market certainly doesn't think so. Bonds continue to signal a slowing economy and possible recession. Stocks disagree. Bond investors have the better track record when the two markets are at odds.

Economic Indicators

The jobs report was front and center last week. A strong 236,000 jobs were created. Job growth was down from 326,000 the prior month but in line with expectations. The unemployment rate fell to 3.5% from 3.6%. Average hourly earnings rose by 0.3%, up from 0.2% the prior month. Initial jobless claims were 228,000, down from an upwardly revised 246,000 the prior week. It looks as if jobless claims are starting to trend higher. It is too soon to tell for sure, though. Job openings fell to a still strong 9.9 million from 10.6 million. There are 1.67 job openings for every unemployed person. The job market is still tight

Manufacturing is showing contraction. The March ISM manufacturing index fell to 46.3% from 47.7%. Construction spending fell 0.1% in February after rising 0.4% the prior month. The service economy is growing, but less robustly. The ISM services index was 51.2% in March down from 55.1% the prior month. The service index number was below expectations. Economists had expected a reading of 54.3%. The service index is close to joining the manufacturing index in contraction.

Fallacy of Composition

The economy is a complex system with many variables. The economy is always changing as new technologies produce new goods and services. Economic cycles are never the same as a result. Economic cycles are never alike as well because people adapt. Learn one lesson and fix one problem. New problems arise. The learning process continues, and the economy evolves. The capital markets are continuously evolving as well. There was a time when junk bonds were a minor part of the bond market for instance. Michael Milken pioneered their use in leveraged buyouts (LBOs) in the 1980s. Original-issue high-yield debt provided corporate raiders with enormous amounts of capital for hostile takeovers. Financiers took it too far leading to the junk bond market crash and the bankruptcy of Drexel Burnham Lambert in 1990. Drexel was a bulge bracket bank at the time and the fifth largest bank in the U.S. 

Economic forecasting is difficult because the economy is evolving. Investing well is difficult because the capital markets are evolving. Neither is made easier by the firehose of misinformation at our fingertips. The media gets much wrong much of the time. Financial services firms are configured to earn profits. The information they put out has an agenda behind it. The agenda biases their forecasts.

Fallacy of composition is a logic fallacy. It occurs when someone assumes something is true of the whole because it is true of some part of the whole. Money managers and investment strategists fall victim to the Fallacy of Composition all too often. Cost cutting is an example of a fallacy of composition in economics.

An example:

“The market is set to see a substantial acceleration in earnings growth on better-than-expected operating leverage,” Morgan Stanley’s Mike Wilson wrote in a note to clients in February of 2021. Wilson predicted that cost-cutting would dramatically improve corporate America’s bottom line. Cost-cutting can improve an individual company’s bottom line. It cannot improve everyone’s bottom line at the same time. Wilson’s claim that the market is set to see a substantial acceleration in earnings growth because of cost-cutting can’t be true. Why?

Because one company’s cost is another company’s revenue. Some companies can increase profits through cost-cutting. Their vendors, however, will see a decline in revenues because of that cost-cutting. What is true for one is not true for all. Corporate America cannot cost-cut its way to prosperity.

Money on the sidelines is another example of a false claim. Market strategists often point to "cash on the sidelines" as a source of buying power. It's a matter of when not if investors will deploy it. Strategists are making a false claim to get investors to buy. Of course, there is no fresh cash sitting on the sidelines.

All securities issued must be already held by someone. Savings must equal investment. People buying stocks are offset by people selling stocks. People are exchanging securities, nothing more. The same amount of cash continues to exist in the economy. The amount doesn't change when one person buys a stock because someone else is selling that stock. No big slug of “(new) cash on the sidelines” exists to send the market higher. The market goes up when buyers are more eager to own stocks than sellers. It goes down when sellers are more eager than buyers.

Financial services firms use the “cash on the sidelines” claim to whip up enthusiasm. But it just isn’t true. There is no cash sitting on the sidelines. It has already been spent. The same is true of cash on corporate balance sheets by the way. Nevertheless, Wall Street trots out the untruth repeatedly. Why?

Wall Street makes more money when stocks are rising. Everyone always has an agenda. The information surrounding us, drowning us, is shaped by that agenda.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist