The path to new all time highs

Posted by Jacob Radke
July 18, 2023

“As we move through this year… if things develop as expected, we’ll be normalizing policy, meaning we’re going to end our asset purchases in March, meaning we’ll be raising rates over the course of the year… At some point perhaps later this year we will start to allow the balance sheet to run off, and that’s just the road to normalizing policy.”

That was a quote from Jerome Powell on January 11th of 2022 stating that interest rate hikes may be necessary as soon as the March [2022] meeting.

That means we have been at this now for almost 20 months. It took ~10 months to reach the current bottom of the market, and now it’s been 9 months of pure stock market bliss.

The S&P 500 is near new all time highs

The S&P 500 is a mere 3.65% off of it’s all time highs, the Nasdaq Composite is off only 10.9%, much much closer to the top from the dismal 36% off it had been, and the Russell 2000 (small and mid cap index) is off around 19%.

This is a scenario that nobody thought was possible.

However companies have shown resilience, inflation has greatly subsided, and consumers aren’t feeling an overwhelming amount of pressure in the economy.

Those three, seemingly impossible to forecast, outcomes are what I believe to be the catalyst for our performance this year.

But any reasonable person should question that. Why should we be hitting new all time highs? Are there still significant risks to the market in general? After all it was me that said “this was all a sentiment driven rally” earlier this year.

While I do, now, believe that there is some backbone to this rally (namely rising earnings expectations, falling inflation expectations, and a notion of a semi-stable economy), there are also risks.

The yield curve has been greatly inverted for a very long time, but to be fair partly because of the fact that the Fed controls short term rates and both were at historic lows prior (the short end just outpaced, by a mile, the long term rates, because the Fed’s transparency).

Even though falling asset prices generally follow an inverted yield curve, we saw major price downs in 2022 in anticipation of what could be a worsening recession that now the market may be looking past.

Rolling 1 year stock returns and an inverted yield curve.

The S&P 500 companies continue to see earnings forecast improvements, but the future of margins may just be beginning.

While earnings expectations are improving the prices that business charge (producer prices) are steadily decreasing, signifying weakening demand on the purchasing side.

It may be hard to see the correlation between PPI (producer price index) and CPI (consumer price index) and why falling producer prices harm the business so I’ll give a brief explanation.

Falling PPI suggests that producers are facing declining prices for their goods and services. If businesses are unable to pass these cost savings to consumers, their profit margins may be squeezed. This can lead to reduced profitability and financial strain, particularly for industries with high fixed costs or tight profit margins.

And businesses experiencing falling prices may find it difficult to maintain or expand their workforce. Reduced profit margins can lead to cost-cutting measures, including layoffs and hiring freezes, which can negatively impact employment levels. Moreover, if businesses are struggling financially, they may be less likely to offer competitive wages or benefits to their employees.

Producer Price index over the last 3 years

The economy has remained rigidly strong through, a balance sheet adjusted, 7% in rate increases which is rather phenomenal. However, in the Fed’s own words “monetary policy works in long and variable lags.”

We may not see the full impact of that 7% of financial tightening until mid 2024 or 2025.

Earnings per share estimates improve.

The good thing, for now, is that the labor market is strong while average hourly earnings growth is slowing down with inflation, the consumer is still spending (70% of GDP), and real GDP only took a mild beat in early 2022.

There is far more to the economy, but the consumer is by far the most important.

Even with all of the concerns in the market right now I remain hopeful and cautiously optimistic.

Continued earnings forecast improvements, a Fed that is backing off, inflation that is now at target, and a consumer that is still healthy could continue to drive outperformance. But as always market participants like to look past the now, and may see some new storm clouds forming on the horizon, and while I may not see them now, it doesn’t mean they don’t exist.

As we head through the rest of the year remember to stay true to your strategy, remember to rebalance, stay diversified, and stay in the know.

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