Strategy and Positioning written by Steve Orr, Chief Investment Officer; and Essential Economics written by Mark Frears, Investment Advisor

As of market close July 29, 2022. Returns in percent.

 Strategy & Positioning 

 — Steve Orr 

Best so far

July is in the books, and we enjoyed the fireworks. The S&P 500’s 9.1% gain was its best since November of 2020. The NASDAQ Composite, heavily weighted toward tech, jumped 12.3%, its best month since April 2020. How about a repeat in August? 2022’s first half says, “no way.” But we remind ourselves that this is a midterm election year and that markets took the Fed rate increase in stride. Markets climb a wall of worry. The start of August finds us staring up at more bricks than ever. Let’s put that aside briefly and review July. 

Most of July’s negative price action was confined to the second week. The S&P 500 and Dow Industrials declined more than 3% as fears of a 1% Fed rate rise were in force. That week’s lowest price was well above the low of June 16. Higher lows are an encouraging sign. In the eleven trading days that followed, only two had negative returns. That was the best run since an 11% rebound in late March. 

Grades

Second quarter earnings get a lot of the credit. Last week was Big Tech’s turn. Apple CEO Tim Cook said that the only negative in iPhone sales was the strong dollar. Microsoft’s chief Satya Nadella was bullish on future sales, saying, “as a percentage of GDP, IT spend is going to increase because every business is trying to fortify itself with digital tech.” Amazon posted better than expected operating income and raised guidance. So, the big three got bigger. 

On the raw material end of tech, Exxon and Chevron both beat estimates with some of their strongest ever free cashflow numbers. No one should be surprised when crude prices jump 49% year-over-year. Exxon caught our attention because they guided capex spending at a $22.5 billion midpoint, well above Wall Street expectations. Most energy companies have lowered capital spending due to regulatory concerns.

Over half the S&P 500 (279) has reported as of this morning. To date, 73% have beat earnings and 66% have beat revenue estimates. Earnings growth over last year’s second quarter is running at 6%. If 6% holds through the next couple of weeks, 2022’s second quarter will have the lowest earnings growth since 2020’s fourth quarter, according to FactSet. Despite the 9% rally last month, earnings growth has kept the forward P/E for the S&P at a very reasonable 17.1 times. Strip out the eight largest companies and the remaining members price out at 15 times.

About those bricks

The Ukraine war continues to drag on. We are not sure it is possible to calculate the human toll. We are confident that between the war and depressed natural gas supplies, fertilizer production will be lower in the next several years. This will depress crop yields worldwide, pressuring food prices higher. 

The Fed is not finished raising rates. Despite Chairman Powell’s bullish assertion that rates are near neutral, expectations are for rates to rise at least another 1% this year. The Fed’s favorite inflation gauge, the Personal Consumption Expenditures index, is running at 6.8%. We think we understand algebra; and 6.8% – 2.25% Fed Funds rate sure looks a long way from zero neutral. This is the fastest set of rate increases since 1994 and its effects have yet to fully ripple through the economy. Over the last several weeks, five-year inflation indicators moved higher, suggesting that traders fear the Fed stopping too soon — and not tamping down inflation. 

Earnings from the second quarter are coming in above expectations. June early data suggests the slowdown continues and third and fourth quarters will need to be marked down. Walmart just issued its second profit warning in 10 weeks. Amazon cut its earnings guidance for the rest of the year.

Any lights?

What is that light in the tunnel? Bulls will say it’s the sunshine on the other side of a mild slowdown. Supporting their case are peaking Fed Funds futures, commodity prices, valuations, technicals and, of course, sentiment. 

Fed Funds futures, while peaking at 3.5% near the end of this year, show increasing odds of the Fed cutting rates next spring. Futures are telling the Fed, “Hey, you may be going too far and inflation is not that big of a problem.” Certainly, that is a message one could infer from commodity prices. Iron ore, steel, copper and even crude oil buyers have responded to high prices by lowering demand. China’s struggles with their real estate industry are also cutting into demand.

Stock valuations are not cheap, but well below the nosebleed levels of the last two years. Call them reasonable, and more so if rates continue to slide. Technicals are slowly rebuilding — most of the U.S. indices are well above short-term moving averages. The advance-decline line has turned higher and the percentage of stocks above their 20- and 50-day moving averages continues to climb higher. Expected volatility over the next month as measured by the VIX index continues to fall. Sentiment remains near the bottom of the Gulf of Mexico, which is a bullish signal.