Investment Insights

 — Steve Orr 

Flip script

The all-time highs in late March were a scant six weeks ago. Stock indices dipped 5% to 8% lower in a classic spring consolidation. We were comfortable with sitting at those lower levels and letting earnings catch up to price. A magical swing toward cheap valuations was not in store, as this cycle’s drivers (aka “LIFT” below) appeared and lifted us back to within 1% of the highs. Those new highs now serve as fairly strong resistance for the S&P 500, NASDAQ and Dow Industrials.

Breadth is still reasonable by a number of measures. Nearly 80% of the Dow and S&P 500 are above their 200-day moving average. The advance-decline for all three indices is trending upward. Relative strength is rising but not overbought. More than 80% of the 47 All-Country World markets are in upswings. The bounce from mid-April lows is waving two yellow flags. One is that daily volume is very low. The low volume manifests itself in a morning rally, followed by markets drifting lower through the trading day. Not August everyone-at-the-Hamptons low, but low enough for us to question the durability of the recent move. Second, there’s a wholesale move into defensives. After receiving less love than a UT grad in College Station for the past two years, the XLU Utilities ETF has run a torrid 13% higher since mid-April. Consumer staples and Financials are up more than 5% in the same span, doubling big tech’s 2.3% move. Truly a flip of the leadership script from the past several years. Question: If defensives are leading a low volume rally, is it a lasting rally? 

LIFT

Let’s examine four pillars of the current Bull cycle. Liquidity, inflation, the Fed and Treasuries play an outsized role in stock returns since the Bear low in October 2022. We are awash in banking system liquidity. Yellen has more than $200B in available cash after tax filings to push back into the economy in the coming months. Borrowing spreads remain tight, and credit is available to quality borrowers. No asset class is starved for money.

Inflation remains a worry. The Fed’s magic 2% goal will remain elusive over the next year. Wall Street economists are almost unanimous in their belief that the consumer price index will drift lower over the next several months toward 2.5%. Not 2%, but enough that Bulls will be braying for a rate cut that is not needed.

Consumer sentiment has ground slowly lower as inflation hits pocketbooks and depletes shutdown savings. The University of Michigan’s one-year-ahead expectations of inflation nudged higher last month from 3.4% to 3.5%. We note that number is the median, not the mean. Both numbers trend tightly together in this series over time. That is, until the past three years. The mean, or average of the survey respondents, has trended higher than the median. Last month, consumer respondents’ average inflation a year from now hit 6.1%. Hello, Fed.

This Wednesday’s CPI release should show prices rising at a 3.4% clip over last year. The CPI does get modifications and upgrades from time to time. One of the reasons you are cutting back to one latte a week at Starbucks is that their raw material costs have gone nuts (pun alert). Coffee bean futures are up 32% since last fall. The statisticians at the BLS are revising coffee’s contribution to the CPI as of this Wednesday’s release. The smaller sample size of bean prices will likely lower CPI’s caffeine level. Looking ahead, we think inflation edges back up in the fall to its present mid-3% level.

Wall Street continues to believe the Fed will cut short-term rates twice this year. Never say never, but we think the chances are slim. We wonder why they are so focused on lower rates. The S&P 500 usually performs well between the last rate increase and first rate cut. Usual performance is in the high mid-teens. The Fed last raised the overnight lending range on July 26 last year. The S&P 500 has returned 15.7% since then. The Fed usually does not lower rates until something breaks or they panic. Strategas Research reports that from the first rate cut through the next 12 months, the S&P 500 declines around 10%. As a rule, we do not approve of negative returns.

In recent speeches, no less than five Fed officials have countered Powell’s rate cut stance at his press conference. Dallas Fed President Lorie Logan said it’s still too early to consider lowering rates. Fed Governor Bowan said she doesn’t see “rate cuts warranted this year” per Bloomberg. We think they are on the right track. Consider that liquidity conditions are already very easy. A rate cut would spur more activity, pressuring inflation higher. How would more inflation sit with those living paycheck to paycheck?

Powell buying Treasury bonds artificially suppresses supply at the margin. That should help rates stay close to present levels. Steady rates are relatively helpful for stock valuations. Any further slowing in the economy would bring more cries from the Street for rate cuts, and long bonds would likely rally. U.S. bonds have fallen about 2% this year and will likely end the year flat if the economy continues along in second gear.

Weak finish

Walmart puts an unofficial bow on the end of the first quarter earnings season this Thursday. Retail and restaurant reports have listed consumer weakness and increased promotions. Translation: Inflation is getting to consumers, and they are guarding their wallets. Home Depot is the only other large retailer reporting this week. Further confirmation of consumer sentiment will have to wait until next week. TJX, Lowe’s, Dollar Tree and Target all hit the tape with earnings and management reports.

Earnings are running 5.3% ahead of last year’s first quarter, ahead of analyst estimates of around 3%. A nice beat for members of the S&P 500 but a word of caution. Most of those earnings increases were from “expense management” — i.e., reducing headcount, delaying orders and other cost-cutting measures. Gone are the heady days of a year ago when companies could easily pass through inflation to their customers. The road ahead will be slower for earnings growth unless something breaks lower on the inflation front.