Market Update

The S&P 500 rose 2.6% last week to close at 4,409.59. We wrote in our last newsletter to, “expect the S&P 500 to test 4,325 this week.” The test came on Monday. The market had no problem blasting through 4,325.

The prior Friday’s action peaked at 4,322.62. The market spent several hours Monday trying to break through that level. It finally punched through in the last hour of trading. Monday’s high of 4,340.13 surpassed the 4,325 August high. The market closed above the August peak as well. Breaking above resistance is step one. Maintaining above resistance (now support) is step two.

It is not uncommon for a rally through resistance to run into selling. Sometimes the selling overwhelms buyers, knocking the market back below the key level. In this case, the S&P maintained the important 4,325 level. In fact, it closed higher three days in a row following the initial breakout. The market's technical action last week was strong and foretells further upside.

The S&P is short-term overbought though. It's due for some profit taking. A retracement to 4,300 is likely. It's even possible we'll see a pull back to 4,200. Any test of 4,200 would likely hold. Expect higher highs in the next month or so.

The Fed’s “hawkish pause” on Wednesday was not unexpected. The Fed’s updated dot plot signaling two more quarter-point hikes wasn’t enough to derail the rally. The S&P has climbed five weeks in a row. It hit a new 52-week high of 4,448.47 on Friday. The next resistance isn’t until 4,637.30. It is clear sailing until then.

But the S&P 500 is already trading at 19x 12-month forward earnings. It is expensive. The long-term average 12-month forward P/E is 15.5x. The equity risk premium has fallen to a new cycle low. The risk premium is at its lowest level in two decades, according to Roth MKM market strategist Michael Darda. The market is even more expensive if forecast earnings growth fails to materialize. Second quarter earnings are expected to fall by 8.1% before rising 0.4% and 9.1% in the following two quarters. Earnings are expected to grow 1.2% for all 2023 and leap 11.7% in 2024. Double digit 2024 earnings growth is unlikely.

There is a 74% chance that the Fed will raise rates in July, according to the CME FedWatch Tool. The FOMC lifted its year-end projected fed-funds rate to 5.6% in its latest Summary of Economic Projections. That is a half-point higher than before. None of the 18 panel members are projecting an interest rate cut this year. The market was expecting reductions of a half-point or more until recently, according to Barron’s. The Fed’s year-end estimate of the core personal consumption expenditure (PCE) deflator was raised to 3.9% from 3.6%. The unemployment rate is now expected to rise to 4.1% by year end, down from the previous 4.5% projection.

The Federal Reserve doesn’t expect to cut rates this year. It does expect inflation to be higher than previously forecast. It does expect unemployment to be lower than previously forecast. Higher rates for longer will impact demand. A reduction in demand will reduce earnings growth. The stock market is likely more expensive than the 19x P/E estimate suggests. The earnings component of the ratio is going to shrink, pushing the actual P/E higher.

Actual earnings will come in below forecast earnings for the rest of 2023 and 2024. Monetary policy analysis suggests as much. A higher cost of money for longer means less consumption. Less consumption means slower economic growth. Slower economic growth means lower earnings growth.

Fiscal policy will also play a role in earnings disappointment. The Federal government’s fiscal stimulus in response to Covid led to over $2 trillion in excess savings. Research by the San Francisco Fed indicates excess savings will be gone in the next few months. Meanwhile, real wages are 4% lower than they were at the end of 2020. Consumption will slow because excess savings are about gone, and real wages are lower. More restrained government spending will further pressure GDP growth. The Fiscal Responsibility Act is a fiscal headwind.

Last week we wrote that technical indicators pointed higher. They still do, although a short-term pullback is likely. We also wrote that fundamentals were pointing toward recession. They still are. Technical indicators prevailed last week. The stock market continues to rally. It is only a matter of time though until fundamentals begin to matter. The economy will slow and fall into recession by 2024. Earnings growth will stall, giving way to declining earnings. The market will begin to decline once again. But it might be 2024 before that happens.

Economic Indicators

M2 is falling by 4.85%. The velocity of money has risen by 10% over the last year. The pertinent equation is MV = PQ. The left side of the equation has risen approximately 5.15% (10% minus 4.85%). PQ must also equal approximately 5.15%. The core CPI year-over-year rose 5.3% leaving Q (quantity) unchanged. The 12-month PCE trimmed mean inflation number as of April was 4.8%. The numbers suggest a no-growth economy with a slight upward bias. Of course, there is plenty of noise in the numbers. Precision isn't present.

The point though is that the real economy is likely still growing, albeit barely. Nominal GDP is likely to grow somewhere around 5%. The growth comes mostly from price increases. Nominal GDP grew 7.4% in December 2022 down from 9.2% in September of 2022. Nominal GDP growth is slowing which means so will earnings.

The economic indicators out last week were consistent with flattish real GDP growth. The Atlanta Fed GDPNow tool is currently reading 1.8%. The GDPNow is a running estimate of real GDP growth, according to the Atlanta Fed. The estimate is based on real time economic data. The GDPNow Q2 forecast will likely fall given changes in money supply, the velocity of money, and price.

Excess Risk-Adjusted Returns

I had a conversation with a friend of mine a few weeks ago. He had a meeting with his wife’s financial advisor that left him frustrated. And rightly so. The financial advisor was making excuses for a poor track record. The portfolio in question averaged 2.5% per year over the trailing five-year period. The Bloomberg US Aggregate bond index averaged about 1% per year over the last five years. The S&P 500 returned a little less than 13% per year over the last five years.

The advisor insisted that the portfolio was based on his client not wanting to lose money. Not losing money was his performance goal. The advisor also refused to compare his results to an appropriate benchmark. He deflected the effort to benchmark the portfolio. Instead repeating that his client didn't want to lose money. He was doing what his client wanted him to do.

There are several problems with the advisor's response. First, he is being paid to provide advice to his client. It is his job to explain to his client how much she needs to earn to meet her spending goals in retirement. A goal of not losing money is only appropriate if the client can still meet spending goals in retirement. Most people need to earn a real rate of return above zero to meet spending goals. It is the advisor’s job to do the necessary financial planning to determine the needed real rate of return.

The second problem with his response was his refusal to benchmark the portfolio. Benchmarking a portfolio is important. It allows us to determine whether we are meeting our real return goal with the least risk possible. A portfolio that earned 2.5% per year while investing in stocks wasn't efficient over the last five years. Remember, the S&P 500 rose 13% per year over that period. A portfolio that earned 2.5% per year investing in investment grade bonds was efficient. Remember the Bloomberg bond index earned about 1% per year over the last five years. It’s the advisor’s job to construct a portfolio that meets the performance goal while taking the least amount of risk. Benchmarking the portfolio allows us to see how he did.

Financial advisors should know what real rate of return a client needs to meet spending goals in retirement. They should also know how to create diversified portfolios that produce the needed return with the least risk possible. Advisors who aren't willing to discuss portfolio construction and performance in those terms should be avoided.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist