As of market close July 21, 2023. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Volatility O

Where art thou? 2022’s average VIX of 25 is a distant memory. That reading implied a daily price range of 1.5%. Over the last two months, the VIX index has averaged 14.8, only a 40% drop from last year. When markets trend, volatility usually falls. In the S&P 500’s march higher, it has now posted 39 days without a -1% decline. Last time that happened? Well, that was the run-up to the index’s all-time high in November of 2021. 

The signs of imminent recession flash all around us, yet Mr. Market continues to push higher. April’s wandering around the 4,100 level made us worry that the top was in before the spring rally. Thankfully, that level is distant support now. Thursday and Friday were down days for most of the major indices, consistent with VIX option expiration on Wednesday and monthly options expiration on Friday. Those small red chart candles are not a trend change. 

There is a lot to like about this rally. The advance–decline line is rising, relative strength is near overbought, but rallies can stay overbought for longer than humans believe possible. The historical pattern in pre-election years is for stocks to take a breather around Independence Day. We are two weeks to the good versus history, but mindful of August’s poor track record. For now, our equity indicators are all shades of green. Even emerging markets are light green for the first time in months.

Back up

Fed meeting week again, and markets are primed for another quarter-point rate increase. Remember the Fed skipped raising rates at the June meeting. An increase of the Fed Funds range to 5.25%–5.5% would mark the highest level of short rates since June of 2007. An entire generation only knows “ultra-low” rates below 4%. Rates are headed back up to the “normal” world of 30 years before 2007. 

We have written ad nauseum about the Fed being too late and then raising rates too fast going too far (“TLTF²”). In Chair Powell’s June press conference, he mentioned the Fed would proceed at a “careful pace” of tightening. We are not entirely sure what pace that phrase entails but skipping every other meeting would fit at least one prior cycle path. 

Hedgers and speculators in the Fed Funds futures pit are betting that the Fed raises on Wednesday and not even a 20% chance of another increase. Odds of the first rate cut happening next March are better than 50/50. We take the futures with a grain of salt as they imply four cuts throughout 2024, pulling short rates to near 4% by the end of that year. Why? That implies that the Most Anticipated Recession Ever in 2024 (1) will be bad enough to cause the Fed to reverse course and rapidly lower rates and (2) will do so right before an election. Looking at prior rate cycles, up or down, the Fed stopped adjusting rates 11 months before an election. This is not a hard and fast rule, but if the Fed sticks with its historical pattern, then one would expect the last move to be at the December 13 or January 31 meeting. A pause would then be in effect through the November election. 

We do agree with the consensus that the Fed is about done with rate increases. One, two or three more? Recent strength in job numbers and a slight improvement in consumer sentiment could keep the Fed pushing short rates toward 6%. It’s a non-zero probability, especially if the MARE is already here and rolling lightly through the economy. Inflation is a lagging indicator and recessions are well under way when inflation finally breaks down. But, you counter, inflation has fallen from 9% last June to just 3% today! True, but that is a year-over-year comparison. Core components of CPI are still north of 4% and not coming down as fast as the Fed would like. If monthly CPI stays at June’s 0.2% growth rate, inflation should drift back into the low 4% area by the end of this year.

Happy time

We are now two weeks into the second quarter earnings season. Always our happy time of the quarter, we are only getting expectations. Through last Friday 18% of the S&P 500 have reported. FactSet states that earnings are beating estimates by 6.4% and revenues are beating by 1.4%. Both are in line with historical averages and nothing to write home about. 

Tesla and TSMC were the surprises of the week. Tesla handily beat earnings estimates, but the shares sank -7.6% last week. Tesla cut vehicle prices to move units out the door. This crimped margins. Regardless, Tesla did deliver 889,015 cars in the first half of the year. Nowhere near the Big 3, but a solid foothold. Tesla fans are looking forward to the Cybertruck later this year. The first one rolled off the line in Austin last weekend. 

We wonder about the market size for electric pickups. GM announced that it will deliver its all-electric Silverado in the fall. Rivian’s truck is now on the market. Ford sold out its first production year of F-150s, but word on the street is that depositors are not picking up the electric F-150s they ordered a year ago. 

TSMC, the Taiwanese chip maker, also slid -7.5% after its earnings report. TSMC is a key chip maker for Apple and Nvidia and produces over a third of the world’s chips in some product lines. The firm said orders were weaker than expected and cut its revenue outlook by 10% for the rest of the year. The cuts would suggest that smartphone demand may be softer than analysts realized. It also postponed production at a new factory in Arizona, citing a lack of trained workers. 

Consumer discretionary (think autos) and Financials are reporting year-over-year growth in revenues. Energy and materials sectors are reporting declines. Adding up the reports to-date with expectations, earnings are on track for a 9% drop from the second quarter of 2022. That would be the largest decline since the second quarter of 2020. A few weeks back we were reporting estimates of a 6% earnings drop. That -9% number is skewed by one healthcare company, and it is early yet. 

This week 166 S&P 500 and 12 Dow Industrials names will report. Stalwarts GE, Ford, Boeing, Union Pacific and Eastman Chemicals make this the industrials week. Southwest Air reports midday on July 27. Between pilot union negotiations, scheduling software and staffing issues, management will have a lot to talk about. In the tech world, Microsoft and Google report Tuesday and Meta (Facebook) on Wednesday.