Market Update

The S&P 500 rose 0.51% last week to finish at 4455.48. The gain snapped a two-week losing streak. The advance came despite a drop of more than 1.5% on Monday. The decline was probably driven by computers. The S&P closed below the 50-day moving average a week ago Friday. Algorithmic trading formulas kicked in driving the profit-taking on Monday. At one point the market was down almost 3% before recovering to a 1.7% loss for the day. Dip buyers pushed the S&P 500 fifty-five points higher in the last 45 minutes of trading to pare the daily loss. Likely those same algorithms calculated an oversold condition, triggering buying near day end.

The rest of the week saw sideways and up days. The S&P 500 did make it back above its 50-day moving average by Friday. The close above is an important milestone. It increases the possibility of a continued rise in the coming week. The S&P bounced off its 100-day moving average at its lows Monday. The last test of the 100-day was in late October 2020. Momentum is still declining. The market is still vulnerable to a larger correction.

The 10-year Treasury bond rose to 1.46% last week after an extended period near 1.30%. The rise in the 10-year Treasury came as the Federal Reserve talked taper before year-end. The Federal Reserve is buying $120 billion in Treasuries and mortgage-backed bonds monthly. The $1.44 trillion in annual liquidity has kept interest rates low, the Fed’s intention. Interest rates are likely to rise as the bond-buying comes to an end. The Fed expects to stop buying completely by the middle of 2022. The Fed’s dot plot shows 9 of 18 FOMC members expect to begin rate hikes by the end of 2022.

Rising interest rates are a threat to the stock market. The cost of money is important to the economy. Tapering starts the clock ticking on the stock market’s advance. Most rate hike cycles end in bear markets. It can take years though.

Earnings season starts in earnest in a few weeks. Wall Street is anticipating excellent earnings. The stock market has priced in strong earnings growth already. Earnings disappointments will put more downside pressure on the stock market. Fed-Ex stock was hit hard when it reported disappointing earnings mid-week. The company pointed to margin pressure as the culprit. Input costs continue to rise. The producer-price index for intermediate goods was up 23% in August. The PPI for finished goods was up 10.5%. The CPI last month was up 5.3%. Companies take earnings hits as producer prices rise faster than consumer prices unless they raise prices. Raising prices results in lower unit sales, which can cause less top-line growth as well. We will see if analyst’s earnings forecasts have taken margin pressures into account. Earnings season starts in a few weeks.

Economic Update

Building permits rose to 1.73 million in August from 1.63 million the month prior. Building permits are a leading indicator. Housing starts also rose from 1.55 million to 1.62 million. Existing home sales were down to 5.88 million from 6.00 million. New home sales were higher at 740,000 in August from 729,000 the prior month. The housing market seems to be strengthening once again. It is a good sign for near-term economic growth. Leading economic indicators rose 0.9% in August from 0.8% the prior month. Another good sign for near-term economic growth.

The economy is likely to continue slowing for the rest of this year and next. Expect 2.0% to 2.5% economic growth next year. A recession is unlikely before late 2023. Tight monetary policy could pull it forward. Loose monetary policy could extend the economic expansion by several years.

Corrections are Normal:

I had a friend tease me last week about my predictions of a market crash. He isn’t the only reader who’s told me I’m always bearish and calling for a crash. The funny thing is I’m not calling for a crash, nor have I since the fall of 2007. Even then it wasn't a crash I was expecting, rather a bad bear market. My friend was teasing me, but he was also expressing his interpretation of my forecasts at the same time.

Norwood Economics does expect a 10% to 15% pullback in the S&P 500 sometime in the next few quarters. A 10% to 15% pullback is far from a crash. It is also quite normal. We wrote a few weeks ago that, “Corrections occur about once every 17 months, according to Dow Jones Market Data. A correction is a pullback in the market of at least 10%. Bear markets are pullbacks of at least 20% or more. Either a bear market or correction happen about once per year. We haven’t had a correction since the stock market bottomed in late March of 2020.”

In other words, we’re due. It is only a matter of the catalyst. EverGrande is a possibility. It will take contagion in the emerging debt markets for it to have any real impact on the U.S. stock market though. Rising interest rates around the world are a real possibility for the catalyst. Major central banks have indicated that super-easy monetary policies are coming to an end. Only the European Central Bank (ECB) hasn’t announced it yet. Another real possibility is inflation. It is currently working its way through the supply chains around the world. There are estimates of it taking another year or more before supply chain log jams are cleared. Rising input prices can impact earnings as margins compress.

We are due for a pullback, but that doesn’t mean it will come anytime soon. It does increase the likelihood though. There are three broad buckets of potential catalysts: an exogenous shock (Evergrande), interest rates (central bank tightening), and earnings (margin pressures). The one thing I can guarantee is that earnings, interest rates, or an exogenous shock will eventually trigger a correction.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist