The End — Week of August 30, 2021

As of market close August 27, 2021. Returns in percent.

The End

Just another week in a Bull market. Low volume and the start of the all-important high school football season did not prevent major and minor indices from reaching new highs. The S&P 500 has gained about 2.5% since the release of the Fed’s meeting minutes on the 18th. Recall that stocks traded lower that day on the prospect of tapering sooner rather than later. The one blemish in the string of new highs was due to last Thursday’s terrible bombing in Kabul.

Heading into the home stretch, we are impressed with August’s performance. Pouring through our trusty Stock Trader’s Almanac, over the last 33 years the Dow Industrials and S&P 500 have had positive returns in only 18 Augusts. The NASDAQ has only done one better, gaining in 19 of 33 Augusts. At this writing every major U.S. index and sector is positive for the month, even utilities. Overseas, developed international (mostly Europe) is higher and emerging markets are flat. Starting with Memorial Day, the S&P 500 has gained over 6%, on track to post one of its best summers since 2000. Small cap’s 5% performance last week has us wondering if markets are gearing up for Round 2 of the Recovery trade. 

The second quarter earnings season has come to an end. Will we see such gaudy numbers again anytime soon? Likely not. Year over year, the net growth in the S&P 500’s revenues per share finished at 18.5%, or more than four times greater than the five-year average of 4.5%. Revenues beat analysts’ expectations by an average of 5.2%, the highest beat on record. The bottom of the income statement is where our dividends are paid out, and what’s left over is net income or earnings.

Earnings per share for the second quarter grew 87.7% over a year ago for the S&P 500. Refinitiv’s I/B/E/S database shows that is the second biggest in history after 2009’s fourth quarter jump of 198.9%. Note that both jumps occurred after recessions. Consumer discretionary (autos) had the biggest earnings leap, rising 356%, followed by the energy sector’s 244% gain. Utilities earnings, dependent on the weather, brought up the rear at 13%.

Operating margins, or what is left over after paying employees and buying materials, have hovered in the 8% range over the last two decades. With all the supply chain and labor issues in the news, one would expect margins to be crimped. In the second quarter operating margins hit a record of 14%. Company guidance leads us to believe that operating margins will come down in the coming quarters. If in the aggregate, S&P members can keep margins above that 8% trend, then we would mark our earnings and GDP estimates higher.

Down a Hole

Fed Chairman Powell’s much anticipated Jackson Hole speech last Friday did give a strong hint on tapering: “this year.” Traders are back in wait mode – will it be at the Fed meeting in September, or November, December? Tapering refers to the Fed’s scaling down its monthly purchases of Treasury and mortgage bonds. Since March of last year, the Fed has purchased $120 billion of those securities per month, pushing its balance sheet past $8.3 trillion last week versus $3.8 trillion at the end of 2019.

Powell stated that “substantial further progress” has been met on inflation, but not enough progress on employment. Reading the lines and between the lines, we think the Committee is split on tapering. Several regional Fed presidents have called for tapering to begin, others want to wait. Powell made the trigger official: there must be more job gains. He did note that the job picture has “brightened.” By the November meeting, the Committee will have two more job reports in hand. The September report, released on October 8th, should show teachers back in school and the end of unemployment stimulus. If the job gains satisfy the Committee, then we can expect an announcement on tapering later this year, with the purchase reductions beginning in Q1 2022. Powell has said in the past that the playbook from 2013-14 would be the template. That means a gradual reduction in buying over 10 months, and then another 14 months until the first-rate increase. Note that the rates markets are pricing a first interest rate increase in late 2022 or early 2023, well ahead of the 2013 timeline. Powell also reiterated that no hikes would occur before the economy reaches “maximum employment” and inflation is on track to “moderately exceed 2 percent for some time” (check!).

His speech also made clear that he still believes inflation is transitory. While noting that the current levels are “concerning,” he listed several areas where inflation measures have recently peaked. We agree that several items may have peaked in terms of price gains. Their prices are still rising, however, just not as fast (negative second derivative, positive first derivative for you calculus folks. We know who you are). We are curious as to the date of Powell’s future conversion from “transitory” to “permanent.”  

What the Chair did not mention is that inflation travels in waves. The food, rent and wage waves have yet to hit. Food prices should rise this fall thanks to droughts and uneven rain in the Midwest. Rents will adjust in the CPI later this year. Finally, the Amazon effect: $20 per hour is literally pulling workers from other industries into Amazon warehouses around the country.  Small businesses were already struggling and now will have to raise wages to compete for bodies. We have thought most of this year that a 3% level on CPI would last through 2022. We are considering raising that level.

Where o’ Where

The delta surge is starting to show in consumer sentiment and business surveys. Most that have reported in the last two weeks are below peak levels from the last few months. Make no mistake, we are in no danger of slowing to 20teens' 1.5% growth in the next couple of quarters. But we caution readers to be on alert for August data to be not as strong. Markets are betting on continued strong earnings and supply issues getting worked out. The idea that supply chains would be cleaned up by fall 2021 has now slipped to fall 2022 in many industries. We are hearing that some microchip lines will not catch up for several years just because of demand growth.

Consumer spending, which accounts for two-thirds or more of GDP, slowed from June’s 1.1% to 0.3% in July.  Travel and dining out are still increasing but not enough to offset the drop in major goods and automobile purchases. We think product shortages are creating pent-up demand that could last well into next year. As in January, the virus is the throttle on retail sales and spending. If the delta variant did peak on August 20th, then we would expect the fast metrics such as RedBook weekly sales and foot traffic to turn higher in the coming weeks.

Where are we in this compressed business cycle? Recovery activity has peaked with the summer surge in retail sales. Any additional jump would have to come from additional stimulus from Congress or a jump in employment. Certainly, the jobs are out there; the BLS Job Openings data series sits north of 10 million openings. We expect over the second half of the year to see continued strong growth, but at slower rates of increase. GDP estimates for the third quarter are being marked lower and now sit in the high 5% area. We do not think the delta or lambda variants will cause shutdowns in Europe and the U.S. that would derail growth.

One-Two

History says August and September are the one-two punch to lower returns. Facing good odds to hold gains in August, we must turn to miserable September. The ninth month ranks dead last in monthly performance over the last 70 years, but since 2003 the S&P 500 has dropped six times and risen 11 in the month. Post-election years September ranks a bit higher, only eighth or ninth worst of the year. 

September traditionally sees house cleaning by portfolio managers and lots of activity in D.C. This year is no different. For those who like to watch sausage being made, here is our scorecard:

1. September 27^th: Pelosi’s tentative deadline for passing the $1.2 trillion infrastructure bill and taking up the $3.5 trillion social spending bill. Today odds favor $1 trillion in infrastructure plus a scaled down social bill, perhaps $2 trillion and some tax increases.
2. September 14t^h: California recall election. Not D.C. but California affects a lot of national policies and trends
3. September 21-22^nd: Fed meeting. Probably too early to announce tapering, but a third month of over 800,000 new jobs may make for lively debate. Quarterly updates to the Fed’s economic outlook will get scrutiny, especially the “dot plot” of future interest rate changes.
4. In September: likely full approval by the FDA of Moderna and J&J COVID vaccines. May help vaccination rates.

D.C. machinations could be a trigger for a possible correction as traders try to handicap effects on the economy and stock valuations. The summer rally has pushed valuations and sentiment to high but not frothy levels. Interest rates have risen slightly after taper became an acceptable dinner topic but will remain low. Most commodities remain below their May peaks. Lumber futures have given up all their 2021 gains and now sit at last October’s levels. Still elevated over 2019, but no longer headed for the moon. Oil remains below its mid-70s peak back in July but has recently broken its down trend.

Wrap Up

Purchasing Manager Index reports from Markit and ISM this week will show August activity downshifting from Amazing to just Strong. This Friday’s Non-Farm payrolls report has a lot of analysts guessing. Seasonal adjustments by the BLS pushed results far from estimates in June and July. As a result, estimates for August results range from gains of 375,000 to 1 million. The median estimate of the 57 analysts polled by Refinitiv sits at 750,000. Do not be surprised if the number is closer to 500,000.

The coming month can be slip and slide for traders as opposed to dancing in September. While the short-term picture keeps us cautious, our intermediate indicators suggest the recovery and rally are still in gear. We continue to favor stocks over other asset classes. 
 

Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary's University School of Law. Follow him on Twitter here. Greg Kalb is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts from The University of Texas at Austin.

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