The Big Picture
Year-to-date the S&P 500 is up 15.9% and the Nasdaq Composite is up 30.8%. Those are huge moves, but they get even better when measured from the lows registered in October 2022. From there, the S&P 500 has surged 27.6% and the Nasdaq Composite has soared 35.9%.
Those aren't bite-sized gains. They are a veritable feast of good fortune for many equity portfolios that went on a crash diet for most of 2022. Of course, when you eat too much or too fast -- or eat too much, too fast -- you are prone to suffer some indigestion.
The stock market is no different. When it moves too much, too fast, it will experience a period of indigestion otherwise referred to as a consolidation phase to work off some of the excess. Sometimes the process happens quickly and other times it takes a while.
This process is underway right now for the stock market, only we wouldn't characterize it so much as an uncomfortable process of indigestion as we would a normal digestive process.
Where To?
The S&P 500 closed the month of July at 4,588.96. It hit a low of 4,335.31 on August 18, and today it is sitting at 4,450. Where it is today, though, isn't as important as where it is going.
And where might that be? We don't know for certain. Nobody does. We think, however, that it is unlikely to go much higher from here for a spell. For some context, it would take a move of approximately 8% to get back to its all-time high.
That won't be an easy run given the headwinds posed by elevated interest rates, stretched valuations, China's economic challenges, and the slow-moving storm that is the lag effect of prior rate hikes not only from the Fed, but also from the ECB, the Reserve Bank of Australia, and the Bank of Canada to name a few others.
To be fair, the stock market might not go much lower from here either, especially if earnings estimates hold up, the Fed is done raising rates, and incoming data continue to defy hard landing fears.
What we could be looking at, then, is a stock market that needs more time to digest its feast, which means a market that has more of a sideways disposition with some volatile moments in between.
Protection Mode
One issue hanging over the market is just how well it has done already this year. The average price return for the S&P 500 since 1930 is 7.45%, according to FactSet. This year the S&P 500 has far exceeded that average -- in a rising interest rate environment no less.
We suspect plenty of investors are in a protection mode now, not wanting to surrender those gains and knowing they can still pad returns with risk-free and relatively risk-free alternatives with yields north of 5.00%.
That is an attractive option knowing that the S&P 500 is trading at 18.8x forward twelve-month earnings, which is a 7% premium to a 10-year average of 17.5x forged on the back of lower interest rates.
If there is going to be a more concerted move to boost equity allocations, it will likely be driven by multiple compression that stems either from falling prices or rising earnings estimates.
Earnings estimates have been going up, but what is important to the market's prospects is that they keep going up. That is the antidote for a market that might encounter some weakness. Still, our contention has been -- and remains -- that there is value in the equal-weighted S&P 500. It trades at 14.9x forward twelve-month estimates, which is a 15% discount to its 10-year average of 17.6x.
Notwithstanding the discounted valuation of the equal-weighted S&P 500, the magnetic appeal of the mega-cap stocks, the allure of AI growth prospects, and worries the economy will disappoint in future quarters as the lag effect of prior rate hikes kick in, have kept many other stocks in a trailing position.
At the moment, the equal-weighted S&P 500, up 4.5% for the year, is trailing the market-cap weighted S&P 500 by 1140 basis points. What this tells us is that the investment community is still not convinced the economy is going to hit the sweet spot of a soft landing that features disinflation, falling interest rates, and a continued rise in earnings estimates. If it was, the performance gap between the market-cap weighted S&P 500 and equal-weighted S&P 500 would not be as wide as it is.
Stock Market Is Not Alone
The digestive process is not exclusive to the stock market. The Treasury market is in a delicate digestive mode, contemplating where the economy and inflation might be headed, and what that means for the Fed's next move.
Ironically, the Fed itself is in a digestive mode, resolved it seems to watch incoming data to determine if it is showing the effects of its prior rate hikes, which have been aimed at slowing the economy to get inflation back down to the Fed's 2.0% target.
The labor market has been a focal point, and while it has started to show some softening, it seems only to have gone from very tight to tight. The unemployment rate sits at 3.8%, not far from a 50-year low, and there are still 1.4 job openings for every unemployed worker.
How the Fed processes the data meals it is served will be key to the stock market's performance since the market has been convincing itself that the Fed will be cutting rates in the first half of 2024. If that expectation gets pushed out, stock prices are apt to come in.
The bigger risk, though, is if the Fed has to keep raising rates. That would not only push out the timing of the first rate cut, but it would also rekindle fears about a hard landing that likely wouldn't bode well for earnings estimates.
What It All Means
The easy money so to speak looks to have been made on the move in the first half of the year that few people thought would be so "easy."
With the market running like it did in the first half of the year thanks to the vast outperformance of the mega-cap stocks, the pull higher from here won't be easy. That's because expectations are higher now, earnings multiples for the leadership stocks are more stretched, interest rates are higher, and there is some concern that the economy will be weakening because of the prior rate hikes, which raises the level of uncertainty about earnings prospects.
This is why the stock market's digestive process could have a sense of agitation about it that creates a choppy trading environment.
The future is inherently uncertain, but there is an elevated sense of uncertainty today about all things that matter for the stock market -- interest rates, monetary and fiscal policy, earnings, inflation, the economy, and the performance of the mega-cap stocks -- and that it is apt to get in the way of conviction on the part of buyers and sellers for the time being.
That is simply part of the digestive process for a market that has feasted on big returns this year and knows it can find some comfort food in alternative investments that pose less risk of a stomach upset as the digestive process continues.
