The Week Behind

This week, the major indices experienced a ~1.5% decline as Jerome Powell testified to Congress at the Biannual Report on Monetary Policy. While some attribute the action to headlines from the event, I hold a different perspective. Powell’s testimony was consistent with the June FOMC Meeting; therefore, no new information was presented to impact stock prices. I believe the decline was a result of profit-taking as stocks had entered statistically overbought territory and anticipation surrounding upcoming inflation data grew.

Highlights 

• Housing starts and existing sales both exceeded expectations, canceling each other out in terms of housing inflation. The increase in supply via starts was offset by the growing demand via sales.
• The Services and Manufacturing PMIs came in below estimates, indicating that economic activity was softer than anticipated.
• Powell’s testimony at the Biannual Report on Monetary Policy has reinforced expectations that a 25 bps interest rate hike in July will likely be the last hike before an extended pause. 

Catch-Up or Catch-Down

As we enter the second half of the year (2H or 2H23), two distinct perspectives have emerged in the market. 

On one side, we have the bulls who have pitched their tents in the catch-up camp. They argue that the momentum observed in the Magnificent Seven will extend to the broader market, leading to further upward movement in stock prices. According to this view, increased market breadth will be a driving force behind the next leg up in the market.

On the other side, we have the bears who have established themselves in the catch-down camp. They believe that market expectations regarding earnings, inflation, and the Fed are overly optimistic compared to historical parallels. They contend that if incoming data indicates weaker earnings or more persistent inflation than what is currently priced-in, multiple compression will catalyze a broad sell-off.

The Week Ahead

There is a healthy balance of micro and macro this week.

On the micro front, Carnival, Paychex, McCormick, and Nike will be reporting their earnings. Carnival’s report will provide insights into the current state of the travel boom. Paychex’s results will offer hints on the health of small businesses that tend to rely on the now-distressed regional banks for financing. McCormick’s performance will inform the recession debate, as consumers often choose to cook at home to save money. The better McCromick performs, the louder the recession alarm. Nike’s earnings, particularly the performance of its Chinese segment following recent stimulus measures, will be closely watched.

From a macro perspective, there will be additional housing data with new and pending home sales reports on Tuesday and Thursday, respectively. On Wednesday and Thursday, Jerome Powell speaks with influential central bankers in Europe. PCE on Friday will be significant as it is the first major inflation indicator since the pause. With greater uncertainty surrounding the Fed’s next move comes increased likelihood of market volatility attached to the event. Analysts are projecting a 4.6% core PCE year-over-year, slightly lower than the previous month’s 4.7%.

Finally, it is worth noting that last week’s market weakness could mark the beginning of a 5-7% tactical pullback in the S&P 500 that I have been looking for. This kind of correction would alleviate the overbought condition and create a buyable dip. I want to see the dip bought because I view “dip-buyers” as an integral part of a healthy bull market. 

Bears Trapped

I am increasingly convinced that the current tightening cycle exhibits significant differences from historical analogs that the bear argument relies on. I know, I know… I essentially just asked, “Is this time different?”. Please, bear with me as I explain the two differentiating factors: employment and communication.

According to historical patterns, bears expect Fed tightening to lead to a rise in unemployment, resulting in a decline in corporate earnings as consumers have less disposable income. Bears need to witness this scenario unfold before transitioning to a bullish stance. However, this overlooks the unique, ahistorical circumstances of the current situation. During the pandemic, the largest companies in the S&P 500 retained their workforce while consumers received substantial stimulus from the U.S. government. As a result, contrary to a traditional tightening cycle, U.S. unemployment is at multi-decade lows and consumers have higher levels of discretionary income. Therefore, I anticipate that bears waiting for an earnings decline aligned with historical precedents will be disappointed.

Another distinguishing aspect is the level of communication from the Fed. Unlike previous years, the Fed now holds regular post-FOMC press conferences, and Fed speakers cannot go a week without making headlines. This increased communication allowed the bond market and corporations to adjust ahead of the actual tightening of financial conditions. Bond market rates, which affect real-economy debt pricing, have increased at a faster pace than Fed Funds, which moves on a meeting-to-meeting basis. Corporations have used this advanced notice to proactively prepare for a Fed-mandated slowdown. These factors indicate that financial conditions have been tighter for a longer relative to the bear’s historical analogs. Consequently, the “lag” time associated with Fed tightening is shorter, suggesting that the economy has already absorbed a significant portion of the “cumulative effects” of tightening. Consequently, bears waiting for the “lag” to catch up may be left waiting indefinitely.

In conclusion, I believe that bears who rely on historical models to maintain a bearish stance are basing their hopes on a premise that played out last year. In 2022, the potential for Fed-induced earnings recessions manifested through a 20% decline in the S&P 500 at the October low, which is undeniably a victory for bears. However, as it became evident that the earnings recession was not imminent, many bears failed to convert to a more bullish outlook. Now, they are trapped. While stocks may still revisit or breach the October lows (although it is not my base case), it would require a new negative catalyst because, holding all else equal, I do not think the typical bearish outcome will come to fruition the same way it has in the past.