Market Update

The S&P 500 rose 0.7% last week to finish at 4,536.34. The Nasdaq fell 0.6%. The S&P is up 18.2% in 2023 after falling 19.4% in 2022. The all-time high of 4818.62 is within reach as the rally continues. The last meaningful resistance is at 4,637.30.



But the S&P is overbought. The 200-day moving average is at 4050, almost 11% below Friday’s close. The Relative Strength Index (RSI) peaked Wednesday in overbought territory. The stochastic oscillator flashed a short-term sell signal on Wednesday as well. The MACD is close to a sell signal also. On the other hand, On Balance Volume (OBV) hit a new high for the rally that began in October 2022. Traders use technical indicators. They base their trades on technical indicators. Technical indicators help with short-term timing in large part because traders use them. They become self-fulfilling prophecies. Technical indicators can and often do drive the market’s short-term direction in the absence of fundamental news.

We’ve written about the leading indicators that are signaling an impending recession. The Consumer Confidence leading economic indicators index, for one. It has fallen for 15 consecutive months. That kind of decline has always resulted in a recession. The yield curve has been inverted for almost a year. A 3M/10Yr curve inversion has always correctly signaled a recession. “We have a persistent signal in the yield curve,” says Roth MKM’s chief market strategist Michael Darda. “It would be unprecedented not to have a recession.”

Yet the Chicago Fed’s National Financial Conditions Index (NFCI) loosened again the week ending 14 July. The index edged down to -0.37. Risk indicators contributed -0.18, credit indicators contributed -0.12. Leverage indicators contributed -0.06. Also, the ICE BofA US High Yield Index fell to 3.90%. The spread between high-yield debt and Treasuries is smaller than normal. The spread’s long-term average is around 5.5%. Tight spreads mean bond investors aren't afraid of defaults rising. And that means bond investors aren't worried about corporate cash flows covering debt. It also means high-yield bond investors aren’t worried about a recession, at least not yet.

Equity investors are also showing optimism about the economy. The consensus forecast for earnings continues to decline. The forecast is down to $217.28 for 2023. The consensus was closer to $224 at the start of the year. Yet optimism reigns for 2024. The consensus forecast is $244.74, a 12.6% bounce year to year. The S&P won’t produce anywhere near that level of earnings if a recession comes knocking. In fact, it is unlikely to reach $244 even without a recession.

Technical indicators point to a continuation of the stock market rally. The market will need to work off its overbought condition first though. The market may move sideways in the coming weeks or correct outright. A 5% decline would be normal given how far and fast the stock market has risen in 2023. The longer-term uptrend is unlikely to come to an end though, at least not before the fall.

Fundamentals will eventually exert themselves and put an end to the rally. A recession is by far the most likely scenario heading into 2024. Aggregate demand will decline as the Fed’s rapid rate hikes and Quantitative Tightening do their work. A continued decline in earnings in concert with falling demand should send the S&P back into the mid-3000s. Perhaps sometime in the next few quarters but possibly not until the first half of next year.

Risk management remains the priority. Avoiding big losses is more important than participating in big gains. The tortoise and the hare come to mind.

Economic Indicators

Friday is a big day for economic reports. The PCE comes out before markets open. The core PCE year-over-year is 4.6% and is forecast to fall to 4.2%. Likewise, the employment cost index comes out before the market Friday. Labor cost is a particular focus of the Fed’s given that wage growth is too high to accommodate a 2% inflation rate. Friday is likely to be a volatile day in the stock market.

Last week saw economic weakness. U.S. retail sales were weaker than expected. Industrial production was weaker than expected. Capacity utilization was weaker than expected. Housing starts and building permits were weaker than expected. And U.S. leading economic indicators fell again and by more than expected.

The LEI fell for the 15th month in a row. It dropped 0.7% in June. Seven of the ten indicators fell. The coincident indicator was flat, as was the lagging indicator. The Consumer Conference Board continues to forecast a recession. It believes it will start in Q3 of 2023 and last into Q1 of 2024.

Meanwhile, the labor market continued to show strength. Weekly jobless claims of 228,000 were better than expected. Economists had forecast 240,000. The stronger jobs number was unwelcome given the Fed’s focus on slowing wage growth. The Fed would like unemployment to rise to 4.5% or so. It needs higher unemployment to reduce wage growth pressures.

Irrational Decision-Making

We are not rational. Not even close. There is a whole subsection of economics that deals with irrational decision-making. Behavioral economics studies how people make decisions. Behavioral economists have found some surprising biases that lead to suboptimal decisions.

We chase performance. In 2023 that has meant more of our clients wanting to invest more in the S&P 500 index. The S&P is up over 18% year-to-date. That means the companies in the S&P are priced 18% higher on average than they were at the beginning of the year. Does anybody feel the urge to buy the house down the street because the price has gone up? Yet rising stock prices trigger the urge to buy in stock investors. Rising stocks are like catnip.

We sell losing investments because they didn’t do well the prior year. A diversified portfolio guarantees holding some poor investments. Own ten investments that move together and you have no diversification. A diversified portfolio will always have some poorly performing investments. Low correlation between investments is necessary to provide diversification. Getting rid of the “losers” concentrates your portfolio. You may earn a higher return for a while, but the lack of diversification will lead to more volatility and bigger losses eventually.

Stocks that are going up are good stocks. Stocks that are not going up are bad stocks. I had a client tell me a few months ago that I’d sold all the good stocks and kept the bad stocks. She was complaining about having to pay taxes. We’d sold five oil companies in 2022 along with a couple of drug companies and a defense contractor. It was a lot of selling for us as our holding period is in the two-to-three-year range. But the companies were no longer undervalued. Having a sell discipline is important. Taxes are the cost of doing business. We value tax efficiency. We aren’t willing to hold overvalued companies to avoid paying them, however. None of the companies we sold are currently above our sales price. They haven’t been “good” stocks since we sold them.

Recency bias is pervasive. We forget about the more distant past and focus on the recent. Last year the S&P 500 lost over 19% and the Nasdaq was down over 32%. Those large losses are forgotten this year as people rush to buy both indexes. Gone is the fear of a market crash, replaced with the fear of missing out (FOMO). Forgotten is the fact that the Nasdaq is down since it peaked in November 2021. Forgotten too that the S&P 500 has lost money since it peaked in January of 2022.

People are irrational. Investors need to understand their biases. Understanding our biases can help us avoid them, leading to better investment results.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist