Investors are balancing between an earnings season, moderate economic growth, buoyant inflation and a fear-evoking fumbling of the real estate sector.
While the Nordics were marinating in May Day mayhem, in the US, the problem bank First Republic was dumped into the arms of the banking giant JP Morgan. Despite the problems in the banking sector, at least so far the impact on the economy seems mild and bank lending has continued (*knocks on wood*).
In this post, we talk about the development of critical results for equities and how so far the steps to a continued bull market seem to be hitting the mark. The past is no guarantee of the future, but so far things are looking good for the bulls.
This week, exceptionally, there will be only one What’s Up with Stonks, as I will be in Omaha this weekend for a certain annual general meeting. However, it should take weeks or even months for the content of this post to get obsolete. Next week is a bit busy because of the trip and the results, but I'll try to improvise something small towards the end of next week.
The right steps in a bull market
The results season has continued in a better-than-feared fashion. Last week saw practically the lion's share of the S&P 500 results. In particular, the index-driving mega-techs Microsoft, Amazon, Meta and Alphabet reported better-than-expected results, although, e.g., the value-generating growth of the cloud computing business of Amazon and Microsoft slowed significantly. Technology companies are generally more optimistic about the recovery in demand this year.
This year's 9% rise in the S&P 500 has been driven more by large companies anyway, as the index has risen several percent more than its balanced version where all companies regardless of size have the same weighting.
In an inflationary environment, the pricing power of companies is being properly tested, but it seems to be there. The average earnings beat relative to analysts' expectations has been a healthy 7% this earnings season - a level that has mainly been seen in good times.
It’s somewhat telling that consumer brands with strong pricing power, such as Pepsi and Coca-Cola, grew their sales in the first quarter by 14% and 12%, respectively. At the same time, tech giants such as Microsoft and Alphabet, which until recently were admired by investors, grew their sales by a more modest 7% and 3%. For investors, a situation where physical volumes don’t increase but price rises inflate profits seems to be a good one. Both Pepsi and Coca-Cola are at all-time highs.
Let's talk a little bit about the results and the economic development from now on.
This graph shows how the 2023 consensus earnings forecast has evolved over the last couple of years. The 13% fall from the summer 2022 peak is actually already more than the average fall in earnings in the recessions of the 2000s. Sure, 23 years is a fairly short time to look at averages, but this is a period that can accommodate really bad earnings collapses, as happened in the financial crisis and the COVID crisis. Because of these experiences, many investors seem to expect that earnings halving is the basic cure in downturns. This is not the case, however, even if the analysis is stretched beyond decades. Of course, this is not to say that performance expectations and the results themselves couldn’t fall a lot further. However, it’s good to be aware that the current downturn is already forecast to be deeper than average.
If the analysts' consensus forecast is spot on, which is a big question mark given the difficulty of predicting the future, the stock market is now behaving exactly as it should. Stocks tend to bottom out a few quarters before results. Here's a graph from a post from last fall titled Stock market bottoms out when it's darkest, showing the disparity between earnings, the economy, and wages. Usually stocks bottom before these others, which is why the start of a rise in particular looks illogical if the news continues to be bad. Sometimes the stock market guesses the bottom wrong, and the decline continues later. However, as a rule, the stock market is quite the forecasting machine, and the message it sends should be received with humility.
This Fidelity Timmer graph shows the stock market cycle performance of the average S&P 500 index. Unfortunately, it doesn't mention the period for which the average is calculated, but that seems to my reasonably well-trained graph-analyzing eye to be in the right direction, so I dare to share it here.
Average development in shares, valuation multiples and EPS is shown as a dotted line, while current development is shown as a regular line. As you can see, in the spirit of their historical precedents, stocks are anticipating the bottoming of results. Earnings will continue to fall for a while, which means that valuation multiples will stretch in the short term. If things continue to go well for equities, earnings should turn back up in the fall as forecast. In this case, earnings growth will again start to depress valuation multiples, assuming that stocks don’t run faster than earnings. That's what they can't really do in the long run. Ultimately, stocks are driven by fundamentals, of which earnings development is an important part. With equities now looking firmly on the rise, a worse-than-expected earnings miss or a deeper economic downturn could effectively spoil the party.
I have been asked what on earth could keep the engines of the economy running. One factor driving growth is wages, as I argued in a post a couple of weeks ago. In turn, good wage growth is underpinned by a strong labor market. The flip side of this is, of course, faster inflation, but the stock market so far seems to have adapted to the idea of a longer period of more buoyant inflation, which we will return to shortly. On top of that, the economy was mega-boosted in the COVID crisis and this good will be felt in the economy for a long time to come.
This graph shows the monthly evolution of real, or inflation-adjusted, income in the United States, the consumption engine of the world economy. Without transfers, incomes grow strongly, which means that even allowing for inflation, people's average spending power increases.
This shows the median weekly real wages of full-time workers over time. The median is the middle wage of the bunch if all wage earners were lined up. It's confused by the increase in super-earners’ salaries, which again distorts the averages a little. After the financial crisis, there was much talk of real wage stagnation, because purchasing power was practically at the same level in the early 2010s as in the early 1980s. But since then, real wages have been trending favorably, at least in this visual representation.
Strong wage growth is also reflected in an increase in real consumption, as can be seen in this graph. Strong demand encourages companies to keep people on the job and invest in additional capacity. Of course, high wage inflation also encourages more efficient production.
The US may be undergoing a veritable industrial renaissance, as it also seeks to break its dependence on China. After a decade of under-investment, industrial investment is recovering, and companies are talking much more about moving production home than before.
As for inflation, the Fed's tracking of core inflation as measured by PCE (Personal Consumption Expenditures), which considers inflation excluding energy and food, remained at 4.6% in March. This data lags a bit behind, but it has a lower weighting of shelter costs, so you can't cancel out a broad-based price increase with that card.
This graph shows annualized price developments excluding shelter. In practice, no progress has been made in curbing inflation and the level looks set to remain permanently higher than usual. We are still far from the Fed's 2% inflation target.
It should be noted here that after a sharp hiking spree, the Fed policy rate has reached the level of inflation, as can be seen in this graph. In general, the real interest rate has risen even more, and this week another 0.25% rate hike is expected.
It’s worth noting that the Fed policy rate is by no means the same rate that an ordinary consumer gets on their bank account. So far, interest rates on bank accounts remain low on average in the US. Monetary policy has the capacity to be transmitted to the economy in this way too. Even debt doesn't increase in value overnight, as most mortgages are fixed-rate mortgages.
However, common sense suggests that over time interest rate hikes should work, and inflation should at least not go back from its current trough. This seems to suit equities, as they no longer seem to react dramatically to inflation news. The most important thing is that the economy doesn’t drift into stagflation, a situation where prices are rising but the economy and results are eroding at the same time. This situation was feared last fall and that's why shares were quite cheap then. Not that stocks are very expensive now either, in general, especially on our home stock exchange.
One of the bears' standard arguments is that the current consumption boom is somehow happening because of debt. It’s true that in absolute terms households have a record amount of debt in absolute terms, but the debt-to-GDP ratio has actually been falling relative to the size of the economy for 15 years. In the economy, practically all things grow in absolute terms over time, which is why it’s better to look at their relative sizes to each other.
The savings rate has also rebounded, even though a decent buffer was built up during the pandemic. This graph shows the savings rate of Americans over 60 years. So far, the desire to save seems to be returning apace, which is exactly what the Fed's policy is aiming for. Saving is effectively cutting other people's income because your own spending is other people's income, and the less you spend, the more you cut other people's income. Of course, a jokester might point out that the savings rate tends to rise in a recession, but I would still argue that this is a normalization of savings after the exceptionality of the pandemic period.
Thus, the signs are there for the bull market to continue, but investors should also be aware of the risks. Because of the hammered results, valuation multiples are slightly elevated, especially in the US, although stocks are cheaper here on our home stock exchange and elsewhere in the world. If the recession started to take its toll on employment and services, the above-described strong wage and consumption growth would be under threat. And let's not forget the looming debt ceiling crisis in the US. Stocks also tend to underperform between May and October, so there may be some interesting places to buy.
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