THE LONG AND SHORT OF IT

August, 2023

By Dane Krich

WHAT YOU NEED TO KNOW

The following facts and statistics describe the situation from July 1 to August 17, 2023:

  • The S&P 500 is flat and is up 14 percent year to date.

  • The S&P 500 P/E ratio currently is at 25 (the historical average is 16).

  • The NASDAQ decreased by 2 percent and is up 28 percent year to date.

  • The NASDAQ is composed of higher beta, growth stocks.

  • Many of these stocks currently are trading at a premium to major indices.

  • The Dow Jones Industrial Average was flat from July to present and is up 4 percent for the year

RECENT STATISTICS AND ECONOMIC DATA THAT AFFECT INVESTMENT DECISIONS

The following statistics and data are important factors to consider when making investment decisions:

  • The Personal Consumption Expenditures (PCE) Price Index (an index favored by the Federal Reserve) is 3 percent in June -- a decrease of .8 percentage points from May.

  • According to ADP Employment 324,000 jobs were added in July with an annual pay increase of 6.2 percent. Nela Richardson, Chief Economist at ADP says, “The economy is doing better than expected and a healthy labor market continues to support household spending. We continue to see a slowdown in pay growth without broad-based job loss.”

  • Job openings decreased by .3 percent from 9.616 million in May to 9.582 million in June. Despite the slight decrease in job openings from May to June, there still is a noticeable increase in demand for employees across various industries and employers are facing challenges in filling all available positions. Before the pandemic (from 2013 to 2019), the monthly average of job openings was around 5.514 million. From the beginning of the pandemic up to the current time, average monthly job openings have risen significantly to approximately 9.486 million. These data suggest that the job market has experienced a notable shift with job openings increasing substantially during the pandemic compared to the pre-pandemic period. Despite the slight month-to-month decrease, the overall demand for employees remains high. This could indicate ongoing economic recovery or changes in the way businesses operate because of the pandemic.

  • The U.S. unemployment rate is 3.5 percent, a decrease of .1 percentage points from June’s 3.6 percent. The labor market remains strong.

  • The Employment Cost Index in June shows a 4.5 percent year-over-year increase in wages. This is the first time that wages have increased faster than inflation, showing real average earnings are up 1.3 percent.

  • The Consumer Price Index (CPI) is 3.2 percent (for the previous 12 months before seasonal adjustment); this is up .2 percentage points from June’s 3 percent.

  • Core CPI (excluding Food and Energy) is up 4.7 percent from the previous 12 months.

  • Month-over-month July retail sales increased by .7 percentage points when compared to June.

  • The yield curve between the 2-year and 10-year Treasury Bonds currently is -.64 and currently is in an upward trend. The last 6 recessions have happened after the 2-year and 10-year yield curve reversed and turned positive.

  • The Federal Reserve’s Balance Sheet currently shows $8.208 trillion in assets. The Fed’s Balance sheet was at its highest in April, 2022 at $8.965 trillion in assets. The Federal Reserve has removed 8 percent in liquidity, but still remains 97 percent elevated above its pre-pandemic assets.

QUESTION FOR CONSIDERATION

As economic data continues to come in favorable, the odds of a recession seems to lessen. In July, 71 percent of economists surveyed at the National Association of Business Economists see a 50 percent or less chance of a recession, and 1 in 4 put the recession chance at 25 percent or less citing a strong job market, lower inflation, and improved profit margins. Are we out of the woods and in the clear? No, far from it!

THE BOTTOM LINE

In May we witnessed the Federal Funds rate transitioning into restrictive territory, surpassing the inflation figure. This marks the initial instance of a restrictive rate since October, 2019, and its level of restrictiveness has not been observed to this extent since July, 2009. Furthermore, it is worth noting that there remains a portion of the interest rate — 2.8 percent to be precise — that has not yet undergone a full year of integration into the economy. Despite this, a significant number of individuals, including prominent economists, have expressed a sense of reassurance.

Given that all of these events have transpired within the past four months, certain investors and economists are predicting that the Federal Open Market Committee (FOMC) has concluded its series of interest rate hikes. Moreover, some are even projecting a potential rate reduction as early as 2024.

From the earnings data that have been reported for the second quarter of 2023, it becomes evident that specific sectors of the economy remain robust; however, arguments can be made that a few sectors may possibly be entering the initial phases of a recession. According to John Butters at FactSet: as of August 4th, eight out of the eleven sectors are disclosing year-over-year earnings growth. This growth is spearheaded by the Consumer Discretionary and Communication Services sectors. Conversely, three sectors (Energy, Materials, and Health Care) are revealing a year-over-year decline in earnings.

Furthermore, seven sectors are showcasing year-over-year growth in revenues, with the Consumer Discretionary and Financials sectors leading the way. However, four sectors are demonstrating a year-over-year drop in revenues, primarily guided by the Energy and Materials sectors.

For Q2 2023, S&P 500 companies are disclosing a year-over-year earnings reduction of -5.2 percent, primarily attributed to a significant earnings contraction of -51 percent in the energy sector. However, a year-over-year revenue growth of 0.6 percent is being reported. This revenue growth rate marks the lowest year-over-year revenue growth rate (-1.1 percent) reported by the index since Q3 2020.

When compared to other worldwide economies, especially those in Europe, the United States appears to be inching closer to attaining stability. This proximity to equilibrium is attributed to the U.S.'s position in the Federal Reserve's tightening cycle and to a discernible trend of disinflation. Nonetheless, this proximity is a relative concept, particularly because the precise conclusion cannot be predicted.

To effectively reduce core inflation (which excludes food and energy), a further decrease in earnings is necessary. This would compel employers to reduce their workforce, subsequently leading to an increase in the unemployment rate. As a result, wage growth would slow down. Despite the current robust labor market and positive real wage growth, I believe that the Federal Reserve still has some tasks ahead, including maintaining higher interest rates for an extended period. The market has yet to discount these considerations, even in light of the slight contraction observed this month -- and that is The Long and Short Of It!