Market Update

The S&P 500 fell 1.4% last week. It closed at 4,348.33. It was the first weekly decline after five weeks of gains. The Dow fell 1.7% and the Nasdaq declined 1.4%. The Nasdaq decline ended an eight-week winning streak.

We wrote last week that, “The S&P is short-term overbought though. It's due for some profit taking. A retracement to 4,300 is likely.” The S&P gapped down at the open on Tuesday. (Markets were closed Monday for the Juneteenth holiday). Buyers emerged. The low for the day was in by 10:30. The same pattern held for the other three trading days last week. The S&P gapped down each morning. Buyers quickly emerged to push the index higher by mid-morning. The S&P finished down three of the four trading days but well off the daily low each time. The buy-the-dip action means the pullback should be shallow. We may see a test of 4,200 but that level should hold.

The seven big cap stocks driving returns this year are up a market cap-weighted average of 25% since the Nasdaq started its eight-week run, according to Barron’s. Most stocks have not participated in this year's rally.

The U.S. manufacturing economy is in recession. The PMI has contracted for seven consecutive months. The longest period of contraction in the last 20 years was 11 consecutive months. That streak began in September 2008. The ISM Manufacturing report comes out Monday. It was 46.9% last month. A number below 50 shows contraction. The ISM Services index was 50.3% last month. That report is out on Thursday.

Earnings estimates for Q4 2023 and all 2024 are too high unless the economy avoids recession. Goldman Sachs recently lowered the odds of a recession to 25% in the next twelve months from 35%. Goldman Sachs economists cite the debt limit agreement as a positive. They think the regional banking difficulties will subtract about 0.4% from real GDP this year. They don't believe banking trouble will be enough to throw the economy into a recession though. GDP growth is getting a sizable boost from a recovery in real disposable income and stabilization in the housing industry, according to Jan Hatzius, head of Goldman Sachs Research. Goldman is forecasting 1.8% real GDP growth in 2023. The Goldman forecast is well above Federal Reserve and Conference Board estimates.

The Federal Reserve will need to hike interest rates several more times if Goldman is correct. The labor market is expected to be key. Wage inflation is too high. The Fed wants core PCE at 2%. Core PCE won’t decline enough if wage inflation remains near 4%. The latest U.S. JOLTS report showed 1.8 job openings for every unemployed person. Economists estimate that the ratio needs to fall to 1.0 to 1.2 to be consistent with a labor market that isn’t adding to inflation, according to Barron’s.

A recession might be delayed until 2024 if Goldman Sachs’ forecast is correct. But it will still come. There is too much debt for the economy to continue growing with the Fed funds rate pushing 6% (after two more hikes).

Economic Indicators

Housing is showing signs of life. A revived housing sector could help delay the next recession. The Home builder confidence index rose to 55 in June from 50 the prior month. It handily exceeded the forecast by economists. Housing starts rose to 1.63 million in May. The May number was well above the 1.34 million starts the prior month as well as the 1.39 million forecast. Existing homes sales in May rose to 4.30 million from 4.29 million. The forecast was for a decline to 4.25 million.

But U.S. leading economic indicators fell by 0.7% in May after declining 0.6% in April. The LEI for May dropped to 106.7 from April’s 107.5. It is the index’s lowest reading since July 2020 and the 14th consecutive monthly decline. That is the longest streak since 2009. The LEI fell in May due to a worsening of consumer expectations for business conditions, the ISM New Orders Index, the negative yield spread, and a worsening of credit conditions.

The Signal and the Noise

The Signal and the Noise: Why So Many Predictions Fail – but Some Don’t is about forecasting. I recommend the book by Nate Silver.

We live in an information age. It has resulted in information overload. The abundance of information leads people to believe they are well informed. In turn they believe they can predict what will happen next. Yet most economic and market forecasts are wrong. Two knowledgeable professional investors, with access to the same information, will often make very different forecasts.

Mott Capital Management has a blog that I follow. It is informative. Michael J. Kramer is knowledgeable about economics and the markets. He has over 25 years of experience as a buy-side trader, analyst, and portfolio manager. He looks at the current data and sees inflation as sticky and unlikely to fall to the Fed’s 3.9% year-end forecast. He thinks the Fed will likely raise rates in July. A second raise later in the year is a possibility also. Kramer is focusing on commodity pressures and the lack of progress with bringing down core PCE. He believes inflation will hang around for a while and that the Fed needs to continue to raise rates.

Danielle Park, CFA writes a blog that I follow. It is informative. Danielle thinks inflation is last year's problem. She wrote last week that, “Falling demand on credit contraction is a well-established disinflationary force.” And asks, “How long will central banks leave policy rates at 16-year highs to fight last year’s inflation problem?” Danielle points out that “U.S. monthly real retail sales have been negative year-over-year for four months. That hasn't happened since the 2008 recession.” She further points out that, dating from the 1950s, a contraction in U.S. Real Retail Sales led to a recession in all cases except 1967. Danielle thinks central banks need to stop tightening and start easing.

Both Kramer and Park have defensible points of view. Who’s right? We’ll find out. Does it matter for investors? Yes and no. The economy ends in recession in either case, but much sooner if Park is correct. Treasuries and cash, with a sprinkling of defensive issues, if you believe Park’s forecast. Commodity plays and other late cycle stocks while avoiding Treasuries if you think Kramer has the more accurate forecast.

For its part Norwood Economics will continue to look to buy good companies on sale. Our average holding period is between two and three years. We don’t base our buys on what might happen with the economy in the next few quarters.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist