Market Commentary: July 2023
At a Glance
- Moderating inflation and still strong economic growth boosted investor confidence in July
- Equity market returns broadened beyond the mega cap US leaders
- The Fed resumed interest rate increases, reaching a 22-year high
- Rising stock prices reflect optimistic earnings expectations, but valuations are stretched
A Solid Start to the Second Half
Markets continued their upward march to begin the second half of the year. Investors were encouraged by continued signs of moderating inflation despite the Fed raising interest rates again.
- Equity markets rose solidly with gains continuing to broaden.
- The Fed raised interest rates 0.25% on July 26th as expected, but reiterated the commitment to its 2% inflation target.1
- Inflation eased further in June with the key Core Personal Consumption Expenditures index now up 4.1% from a year earlier.2
- Initial Q2 earnings results were mixed, but forecasts suggest steady improvement for the rest of the year. 3
- Valuations for the S&P 500 remain high despite strong earnings expectations.
Equity Returns: July and Year-to-Date 2023
Stocks continued to rally in July
- Economically sensitive emerging markets and small cap stocks led the way in July as expectations for economic growth improved.6
- Gains were seen across the board, with all indices posting returns above 3%.7
- The Dow posted a 13 day positive return streak, one day less than the record 14 day streak in 1987.8
- Equity returns outside the US strengthened in July.9
- All economic sectors posted positive returns for the second consecutive month, led by a rally in energy stocks and continued strength in communication services.10
Fixed Income Returns: July and Year-to-Date 2023
The Fed Resumes Rate Hikes
As expected, the Fed ended its short-lived pause in interest rate increases by raising the target rate by 25 basis points at their meeting on July 26th. The comments after the meeting suggested continued vigilance in bringing down inflation to the Fed’s 2% target, but also that monetary policy going forward would take into account a “wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments”.11
- Fixed income returns were mostly positive in July with returns for equity-like instruments (preferred stocks and high yield bonds) again leading the way while longer-term treasuries fell for the month.12
- The rise in short-term rates in July helped lower the “inverted yield curve” measure (10-year treasury yields less 2-year yields) by 15 basis points.13 A negative spread on this measure has historically been associated with a high risk of recession, so the reduction in that negative spread in July, while still troubling, is moving in the “soft landing” direction.
Earnings and Valuations
Over time, the earnings generated by a company are the key driver of the value of the company’s stock. The stock's return is related to these earnings and the price paid for the stock. When company earnings decline, it is usually a bad sign for stock returns. The historical data shows that company earnings (for the S&P 500, for example) and their stock prices tend to move together. When earnings weaken, stock prices tend to fall. When investors expect strong earnings, stock prices tend to rise. The chart below illustrates this relationship for the S&P 500. The shaded areas on the chart represent periods where the earnings of S&P 500 companies have declined, so called “earnings recessions”. In these periods, S&P 500 returns have also typically fallen.
Inflation Adjusted S&P 500 Prices and Earnings
In the current period, we see that the S&P 500 companies have been in an “earnings recession” since the start of 2022. That peak in earnings also closely matches the peak in S&P 500 stock prices in November 2021. Earnings have continued to decline through the first quarter of this year. However, stock prices have rallied since October 2022. This is not too surprising, since stock prices will often rise in advance of earnings hitting bottom as investors position their portfolios for a recovery from the earnings recession. We can see the expectations for earnings recovery in the path analysts forecast for earnings for the rest of 2023 (the red line). It is important to note that analysts are often overly optimistic about company earnings and may be again in the current environment. The debate in the market now is how robust will company earnings be for the next several quarters. So far, the few Q2 earnings released to date have been mixed, with several important companies suggesting slower earnings growth ahead. When those negative earnings reports come out, we have seen stock prices adjust lower, sometimes sharply.
Source: Yardeni Research16
The relationship between company earnings and prices can also be expressed as a “valuation” ratio of the stock price to the earnings measure. Valuation ratios can help gauge whether stock prices are high (overvalued) or low (undervalued) relative to earnings. In the first chart, we showed trailing earnings reported by the company, but there are other earnings measures that are helpful in assessing the market’s valuation. The chart above shows prices for the S&P 500 relative to “forward” (or forecasted) earnings. It is useful as a more forward looking indicator which may be especially relevant at potential turning points in the earnings cycle. With the rally in the S&P 500 this year relative to modest expected earnings, the price-to-forward earnings ratio has risen steadily. It is not at all time highs, like during the tech bubble or Covid, but is still elevated relative to history. The S&P 500 valuation is also very high relative to the mid and small cap indices, reflecting the exceptional strength of the large cap growth stocks so far this year.
The expectations that the current cycle of earnings weakness has bottomed underlies the strength in equity markets, especially the S&P 500, this year. Valuations, while stretched historically, are in line with those expectations. Still, any weakness in the growth of company earnings is a risk to today’s lofty stock prices. Even without such weakness, valuations suggest that large cap US stocks are priced well above historical levels relative to expected earnings and also well above segments of the market, like mid and small cap stocks, that haven’t seen as strong returns this year.
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