After what seemed like an eternity, stock prices rebounded nicely in July, rising 9.1% for the month as measured by the S&P 500. The surge lifted stock prices up from their bear-market lows, and nearly halved the year-to-date loss from -22.5% on June 16 to -12.6% at month end. According to JP Morgan Asset Management, the average intra-year drop in stock prices is -14% over the prior 42-year period. While on one hand we’ve reverted to the mean, on the other we’re seeing a huge technical improvement in many market segments and some much-needed emotional relief in what has otherwise been a miserable year.
The change in tone for the market began mid-June. The big difference maker is the growing view that inflation pressures may have peaked and that the Federal Reserve may be preparing to scale back its plans for future rate hikes. Pundits refer to this as the Fed pivot: the point at which the Fed no longer needs to raise rates (tighten monetary policy).
Though the economic backdrop is difficult to read, some things are evident: gas prices are falling, oil (measured by WTI) is below $90 per barrel and its 200-day moving average, and commodity prices (copper, aluminum, lumber, wheat) are falling. Lower prices at the pump and lower food prices will go a long way toward repairing consumer sentiment, as inflation has been the most worrisome issue for investors. We may have seen the peak in interest rates, as evidenced by the 2.7% yield on the US 10-year Treasury now well off its mid-June high of 3.48%. Many borrowing rates, particularly mortgage rates, are set off the 10-year. This ought to temper the spike in mortgage rates and optimistically allow supply and demand in the housing market to normalize. It will also provide a valuation boost to growth and tech stocks as their valuations are typically more interest rate sensitive. While the Federal Reserve is expected to raise rates again by 0.50% in September, bringing the Fed Funds rate up to 3.0%, the market appears to expect this to be it and for rates and consequently the US$ to level off.
The drop in price for the S&P 500 this year has been entirely due to multiple compression (the P/E ratio has fallen from roughly 22x at the start of the year to 17x today). This in turn was largely caused by rising interest rates. In fact, earnings have increased since the start of the year, but that positive was obviated by the multiple’s free-fall. Currently, earnings expectations are roughly $240 per share for ’23 and $260 a share for ’24 and both the P/E ratio and the dividend yield are within a fraction of their long-term averages.
We have been encouraged by the reported results and forward guidance from the majority of the companies we own in our models this earnings season. Several of the largest growth and technology companies have reported stronger than expected results and have indicated reassuring forward guidance, helping to boost those segments of the market. Our research is also indicating a turn in the equity style the market is favoring, from value to growth. These positive signs are reinforced by the recent behavior of small cap growth stocks (IWO – iShares Russell 2000 Growth) which have recently reversed a nearly 12+ month downtrend.
Without a doubt, there is a lot to worry about. Investors’ fears are amplified by the abysmal price performance during the first half of the year. We don’t know if this is a bear market rally (a dead cat bounce) or whether stock and bond prices are discounting better times ahead. Our approach is to use the current lift in share prices to re-set cash levels for the remainder of the year. Cash is the “insurance”, if you will, that allows us to patiently wait for the markets to normalize. We are still finding fixed income that is attractive, but I’m afraid the window of opportunity has begun to close. Finally, we are working to minimize your realized capital gains so you may see increased activity as we exercise some tax-loss selling.
Our newly renovated office is open, and we happily invite you to stop in if you are in the area. If we have not spoken recently, we would love to catch up with you. More communication is better than less when we are working through challenging time in the markets. Please don’t hesitate to call and take good care.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.