So much for the normal summer doldrums this year. The S&P 500 stock index rose almost 10% in the June – August period, and is now up 9.8% through the end of August.
The rally in August was a textbook example of what the bulls want to see. Cyclicals led the way, breadth was strong, long-term Treasury yields declined, and volatility plunged. Small caps came to life and were up 7% as measured by the Russell 2000 index. It was more about rotation within the market rather than rotation out of it.
Seasonality seems to be the biggest headwind for stocks. This week starts what has historically been the weakest month of the year with an average decline of 1.51% over the last 25 years (source: Bespoke Investment Group). Once we get through September, seasonal headwinds shift. The last quarter is typically the strongest period for stocks.
Economic growth hasn’t been particularly strong but is still positive. Overall economic momentum turned positive in June and stayed positive in July. Here are a few takeaways from recent data:
– For the second month in a row, manufacturing showed positive momentum but the Chicago PMI and capacity utilization still show contraction.
– Employment data continues to be skewed to the downside. Although jobless claims took a sharp leg lower, growth in non-farm payrolls and average hourly earnings over the last four months were the weakest since 2021. This Friday non-farm payrolls for August will be released with an expectation of 75,000 new jobs created.
– Housing is finally starting to show signs of improvement. As long as home prices don’t collapse (not expected), people should remain in good shape. Homeowners have built up massive equity in their homes that can be tapped if needed. Current mortgage debt in the U.S. is less than one-third the value of the housing market – the lowest level since the 1950s.
– If we were starting to see serious cracks in the economy, we would expect it to show up in the health of the consumer. Household debt service ratios are lower than pre-COVID levels despite higher rates. And delinquency rates for credit cards have been stable.
– Productivity growth is also solid. Over the past two years real output per worker hour has risen 2.0% annualized. This is quite fast for any period not directly after a recession. This growth rate may increase in the future due to further adoption of artificial intelligence.
– Inflation has been showing signs of upside momentum in the last three months. This is probably the biggest risk to the bull market.
In summary, economic indicators are mixed but not sputtering by any means. The economy should be strong enough to produce solid corporate profit growth (see main section).
THREE CATALYSTS FOR THE RALLY TO CONTINUE
Stocks don’t typically go up in a straight line although it may seem that way after the tremendous run we have had this year off the April lows. A drawdown is overdue and, of course, could come at any time. But the fundamentals are still solid and point to higher prices ahead, in our view. Here are three reasons why:
1) Earnings. One way to gauge the success of an earnings season is how they influence the longer-term earnings and sales growth estimates. This past earnings season pushed up expected future growth rates. Revisions over this earnings season raised forecast EPS growth for the next 12 months by 2.4% with sales revised up 1.5%. Earnings are now expected to grow 12.9% over the next 12 months which seems possible given high profit margins. Sales are expected to grow 7.7% over the next 12 months. Rising guidance often results in higher share prices.
2) Lower interest rates. At Jackson Hole, Fed Chairman Powell strongly hinted at a rate cut at this month’s meeting. For the underlying economy, a single cut will not make much difference. Investors are hoping for a series of cuts. Lower rates are good for stocks except when they are the result of recession fears.
The “neutral” rate is an arguable number. (The neutral rate is the rate at which the Fed is neither too easy or overly restrictive.) Most economists project a neutral Fed funds rate around 3.5%, or 75-100 basis points below the current funds range. Hence the expectation for multiple rate cuts this year and next.
3) Cash reserves. As we mentioned in a previous commentary, there is approximately $11 trillion in U.S. money market funds. This is an enormous amount of potential future demand for stocks.
The financial media claim this is the most hated bull market of all time. Of course they say that about most bull markets! Many investors cashed out of equities in March and April of this year out of fear. Will they gradually come back to the market? At what point does FOMO consume them (fear of missing out) and prompt them to re-enter the market? They have plenty of cash to do so.