Bad Data Fuels New Highs

Last week’s economic reports have been bad enough to send markets rallying to fresh all time highs. An unusual sounding statement, but true, nevertheless. Today’s financial markets care more about the monetary policy of the Central Bank than anything else. Ironically, that means investors are cheering pre-recessionary economic data, as the expected infusion of monetary accommodation should push stock prices to ever new highs.

Retail Sales for April came in unchanged despite rising gasoline prices, suggesting that the consumer continues to weaken. Inflation was slightly lower than expected. The Leading Economic Index (LEI) decreased by 0.6 percent in April 2024 after decreasing by 0.3 percent in March.

SPY set a fresh intraday all-time high on Thursday, briefly trading above $530. From a technical perspective, all previous resistance levels have been cleared, and the April correction is over. As long as overbought conditions persist, we wouldn’t be surprised by a decent pullback (-2% or -3%) to support in order to reset buying appetite. There is a large cluster where we would expect buying to occur on a drawdown: the $513 - $520 area, where the 20-DMA is crossing over the 50-DMA, while also coinciding with the March highs. On the upside, the way is clear to fresh record highs, since that’s the way bull markets work (and we’re clearly in one right now).

The MACD signal remains clearly elevated in the short term and suggests a pullback or consolidation is in order so that overbought conditions are resolved. Such a consolidation would give investors a better entry point should they require to add to their equity risk exposure.

Let’s dig in to why exactly the market rallied last week. As we’ve said in the intro, economic data was bad. For now, weak data translates into a projection of more accommodative economic policy, lower yields and higher valuations as a result. We can sum up the cause and effect relationship in an easy to understand way:

Weak economy -> Dovish Fed -> Lower Yields -> Higher Valuation Multiples -> Higher Stock Prices

As long as actual real-world devastation does not occur, this relationship will hold. However, it will come at a cost (but more on this later).

Retail sales in the US were unchanged month-over-month in April 2024, following a downwardly revised 0.6% gain in March and defying market forecasts of 0.4% rise, suggesting consumer spending have slightly eased. 7 out of 13 categories posted declines. Major falls were seen in sales at nonstore retailers (-1.2%), sporting goods, hobby, musical instrument, & book stores (-0.9%), motor vehicles & parts dealers (-0.8%), and furniture stores (-0.5%). On the other hand, sales were up at gasoline stations (3.1%), clothing stores (1.6%), and electronics and appliances stores (1.5%). Excluding food services, auto dealers, building materials stores and gasoline stations, the so-called core retail sales which are used to calculate GDP, edged higher by 0.2%. - source: U.S. Census Bureau

There are 2 issues to be aware of:

1. Retail Sales are not inflation adjusted, meaning that consumers spent the same amount of dollars to buy less “stuff” ;

2. The average household had less “discretionary” funds to spend, since gas prices went up

Consumers are beginning to reach a point where they are “tapped out” financially speaking. When looking at the levels of debt service, credit card and auto loans serious delinquency (90+ days), we find measures that are nearing 2008 GFC levels. Per the New York Federal Reserve report:

“The chart below shows a time series of non-delinquent maxed-out borrowers, with the blue line denoting their share among current borrowers and the red line showing the share they hold of aggregate current balances. Credit card borrowers made massive paydowns on their cards in 2020 and 2021, a time during which income rose from pandemic transfers and assistance but consumption opportunities were limited, resulting in a decline in the share of maxed-out borrowers. Since the economy reopened in 2022 and consumption was very strong in 2022 and 2023, credit card balances increased again, resulting in a rise in the share of maxed-out borrowers and their balances. These shares remain slightly lower than the pre-pandemic level but are edging back up.“

The data above consists only of borrowers who are not delinquent. When we account for all borrowers and extend the time horizon to 2003, this is what we get:

We can draw the conclusion that the consumer is bound to slow down and (despite headlines and various doomsayers on TV and social media), the risk going forward is disinflation, not reflation. Since consumption accounts for roughly 70% of GDP, economic growth and inflation will slow down as well.

Here’s the real problem for the stock market: there’s been very little EPS growth in the past couple of years as it is. Our Market Fundamentals Instrument measures reported median EPS data for companies in the S&P 500, equally weighted. This series actually trends flat to slightly negative since early 2022.

On a market cap adjusted basis, there has been some growth, but that growth was largely derived from just 7 stocks.

This chart from J.P. Morgan and Bloomberg confirms our findings. Absent the “magnificent 7”, since the beginning of this bull market cycle in Q4 of 2022, there has been ZERO earnings growth in the bottom 493 stocks of the S&P 500.

Eventually, EPS growth will be required in order to sustain historically elevated valuations. For now, markets are rallying on exuberance and speculation about rate cuts and monetary accommodation. The lag effect of higher rates, prices, and declining wage growth will undoubtedly translate into lower growth for companies’ bottom lines - which is what investors ultimately care for.

While the current bias is positive, we suspect “growth concerns” will come to the forefront once again before the year is over. Markets will most likely suffer another significant “sell-off” episode before the November elections. That sell-off might finally break the unusually high correlation between stocks and bonds, and signal a real regime change.

Our Trading Strategy

Record highs beget fresh new record highs, as momentum fuels rising optimism. We expect the market to maintain a positive and bullish trend in the months ahead. A slight pullback to the tune of -2% or -3% would be beneficial in the short term, as it would allow overbought conditions to cool a bit. This would allow investors to “buy the dip” and increase risk exposure up until late August / early September. Maybe NVDA’s earnings call on Wednesday will provide the downside catalyst for the move.

Eventually, recession fears will resurface, and “growth concerns” will make headlines. But that time is still further out, since Earnings Season has just about wrapped up. Buyback windows are re-opening and record equity market inflows are projected. With the help of added liquidity, we expect stocks to grind higher in the short term, meaning that there is no good reason to become too defensive at this juncture.

Going forward, the health of the consumer will become the main issue. We believe inflation to be yesterday’s problem. That’s why we will monitor the performance of Consumer Discretionary (XLY) closely and minimize exposure to this sector in our portfolio. There will be plenty of time (and technical signals) to reduce overall risk once the markets get “too hot” before the November elections. For now, dips will be bought.

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