As of market close June 16, 2023. Returns in percent.

 Investment Insights

 — Steve Orr 

Swim

Time to jump in the rally pool? The NASDAQ and S&P 500 waters look great. A 3%+ return last week and 8%+ since April show the traditional spring rally is running ahead of expectations. We challenged Mr. Market to prove itself worthy of a new Bull cycle a couple of weeks back. Since then, participation has broadened among Large Cap stocks. The percentage of stocks above their 200- and 50-day moving averages is moving higher. The short-term version of that indicator, the percentage of stocks above their 10-day moving average, touched 84% earlier in the month. Not quite to the rally threshold of 90%, but in the neighborhood. Bear market indicators such as negative price momentum and falling moving averages are nonexistent at the moment. 

Our asset quality rankings focus on valuation, trend and sentiment. Valuations remain a concern for the headline indices. We are struggling to remember a long-lived Bull that began with P/E ratios above 19 times like we have today. The median P/E of the S&P 500 is 24, well above its longer-term average of 17. All of the rally this year has been in the Price of P/E. Earnings estimates have ticked up and down the last few weeks but have yet to make a lasting turn higher. The equity risk premium, or earnings yield minus the Treasury 10-year yield, is now below 1.5%. It is within sight of its 20-year low of 1%. Usually, it’s this low coming out of a recession, not before. Mid- and Small-Cap P/Es in the mid 13s are about two points below their averages, consistent with a recessionary outlook and rising rate environment.

“The trend is your friend” goes the old saw, and every stock index has some level of positive trend. The major indices from NASDAQ to the Dow Transports are overbought in relative strength terms and in uptrends. The S&P 500 and NASDAQ both touched new 52-week highs during Friday’s trading. Small- and Mid-Cap stocks are actually performing better than the S&P 500 this month but need to rally another 6% to reach their 52-week highs. Sentiment is back up to frothy levels and reminds us of a bit of the “FOMO” (Fear Of Missing Out”) times of 1999, ’18–’19 and ’20–’21 melt-ups. 
 

Deflating

The Fed skipped raising the overnight lending rate last Wednesday. After 10 straight meetings of rate increases, the FOMC rationalized a pause as a break to see the effects of prior increases. At 5% to 5.25%, the overnight Fed Funds range is now above last month’s 4% headline consumer price index and close to the CPI’s core reading of 5.3%. 

We would suggest several better reasons for the Fed to take a break. First, the Fed is continuing to wind down its holdings of Treasury and mortgage bonds. As the bonds leave the Fed’s balance sheet, excess reserves are drawn down from the banking system. Second, bank officer surveys show that lending and credit extensions for businesses are declining. Combined, these forces mean money supply growth has turned negative for the first time since World War II. Let’s repeat that thought — growth in the U.S. money supply usually happens at about the rate of the economy. It has never shrunk in the modern era. The economy, stock and bond markets run on liquidity and credit. Money (M2) growth is paramount to a healthy economy. So, the Fed may be taking a short break to see if the deflating money supply will amount to another rate hike. We believe it will. 

Never Quit

The Fed remains committed to fighting inflation. Other Central Banks are doing their part. This month the Royal Banks of Australia and Canada and the European Central Bank all raised their rates. FOMC members raised their year-end forecast for our short-term rates to 5.625%, a full half of a percent higher than March. Get your car loan now. 

Each quarter the Fed staff and FOMC members issue their projections on the economy. Let’s look in detail at the Fed’s view of the world. Over the next year they think the following:

• GDP growth will slow to 1% this year and 1.1% next year (down from last year’s 2.6%).
• Inflation will moderate to 3.5% to 4% by the end of this year. (Wrong last three years.)
• Unemployment will rise from today’s 3.7% to 4.1% by year-end and 4.5% by the end of 2024. In other words, about 1.5 million workers will lose their jobs. 
• Short-term rates will drop from 5.6% at the end of this year to 4.6% at the end of 2024. 

The Fed is so focused on inflation that a recession or at best, flat growth, will occur next year and cost 1.5 million workers their jobs. They also think the recession will be serious enough that they will have to cut interest rates by 1%. Perhaps not raising rates further would be an easier step? 

Minus signs

The bond market is finally getting on board with higher rates. The two-year Treasury has resumed its quest for 5%, finishing last week at 4.71%, up from its March banking worries low of 3.5%. Ten-Year Treasuries remain stuck in the middle of their recent range of 3.5% to 4%. Why lower than short-term rates? Bonds are telling the Fed you have raised rates too high, and those levels will deflate future growth. Rising yields equal negative performance for bonds — a big reason why a portion of our bond holdings is in short-term money markets earning near 5% annually. 

Parts of the yield curve have been inverted (short rates above long) since last July. There are a number of versions of curve inversions (just had to say that), but all have common traits. First, they occur as short rates are pushed higher than future economic growth can sustain. Second, they are eight for eight in the modern era for calling a recession. Finally, on average the recession starts 311 days from the start of the inversion. A rundown: 3 months to 18 months forward and the 3-month to 10-year curve both inverted last November. The 10-year to 2-year curve inverted July 5 of last year. 

Place your bets — does the recession start in July or sometime around Halloween? Will this time be different? There are a few economic Bulls out there. We will examine their narrow path to avoiding a recession next month.