The S&P 500 jumped over 7% in the last 2 weeks. Why? Because economic data tanked, leading analysts to believe the Fed will come to the rescue and keep the bull market going.
But is that a solid thesis? We explore that in today’s newsletter. We also highlight a worrisome development in delinquencies, alongside updates on Tech stocks and Treasury bonds.
What the Market is Pricing In
Stocks are surging, driven by a pullback in interest rates from multi-year highs. The economic data reported recently has come in weaker than expected, increasing the odds of a Fed pause.
Fed pauses are generally good for stocks, but not all the time:
- The Fed pause of 1995 led to a melt-up in the following years
- But the one in 2000 signaled the burst of the Dot-Com bubble
What should we expect this time around? While a year-end rally is possible, we don’t think it’ll extend much beyond that.
One the big headwinds facing stocks we mentioned back in June was that valuations were expensive.
- The S&P 500 had already seen the best returns going into a Fed pause in decades
- The bar was set so high that stocks missing Q3 EPS estimates got penalized the most in years
It’s difficult for stocks to gain traction if decent earnings are already priced in. Companies would have to deliver much better than expected growth rates to move higher.
The rebound in stocks has been driven by valuations (i.e., falling interest rates), not improving fundamentals. That doesn’t spark a lot of confidence that stocks will be melting up:
- The rally between April and July was driven by an improving earnings outlook
- But analysts aren’t upgrading their EPS estimates today (there’s not much to get excited about)
- In fact, revenue growth is decelerating (where is the growth going to come from?)
That said, stocks can sometimes behave very irrationally. We saw that with Tech stocks during the internet bubble of the 1990s.
As rational investors we’re not looking to participate in stocks today. But keep in mind the following:
- Today’s Tech companies are very profitable with big earnings growth rates (captivating stories)
- While those advantages are reflected in high valuations, investors may not care
- AI-driven euphoria could return, leading to another surge in Tech stocks
What the Market Should Be Pricing In
Stocks are generally driven by earnings growth. That said, you should care about revenue growth too, and here’s why:
- Companies can still grow earnings in the short-term if they lay off workers (like Tech)
- But without revenue growth companies will find it increasingly difficult to generate profits
- Companies then lay off more workers to protect earnings, leading to rising unemployment and eventually a recession
The S&P 500 is tracking decelerating revenue growth. We expect this downtrend to continue, dragging stocks with it in a recession.
With consumer savings running out, we don’t anticipate revenue growth to accelerate anytime soon:
- The savings built up during Covid shot up quickly, unlike in prior recessions
- But they also got spent fast, leading to a boom in consumer spending
- With little to support spending in coming months, the post-Covid recovery will prove unstable
With no savings to fall back on, credit card delinquencies have been on the rise:
- They’re now at higher rates than pre-pandemic
- They’re worse for those with auto and student debt
The recent end of the moratorium on student loans could see delinquencies rise even quicker in coming months.
Conclusion: Among Rate Plays, We Prefer Treasury Bonds Over Tech Stocks
Putting it all together:
- Weakening economic data may give stocks a short-term boost
- But eventually a recession will ensue (by the first-half of 2024)
- The longer-term impact is negative for the bull market continuing
We believe Treasury bonds (TLT) offer a good risk-reward into the coming economic contraction:
- Recent economic deterioration led TLT to break out of a downtrend last week
- TLT looks far away from its 200-daily moving average, pointing to significant upside
A long-term risk to TLT lies with the potential for rates to continue moving higher:
- With a consumer so fragile, fiscal stimulus could become a recurring necessity to drive growth
- That means more economic volatility, with inflation a potential side effect
- Bond investors may demand higher yields to compensate for the additional risk
- Higher interest rates would equate to losses for bond holders
Tech stocks (XLK) could benefit too from falling interest rates given their sensitivity to them:
- They’re breaking out of downtrend resistance, signaling the consolidation may be over
- Solid bounce off key moving averages, indicating investors are buying on weakness
Tech stocks are breaking away from the S&P 500 following a multi-month consolidation:
- Falling interest rates disproportionately boost Tech valuations relative to other sectors
- Investors are expecting real rates to fall without a recession materializing
- Excitement around AI-driven growth could return, leading to a renewed melt-up
Investors that are bullish Tech may even find it opportune to play out this breakout through a small call option position.
For us, however, we don’t see Tech stocks as a great bet here. Despite Tech behaving like bonds, we believe bonds offer a better risk-reward:
- Tech looks overvalued relative to where real rates are trading
- We expect real rates to move lower due to a recession developing in coming months
- But we expect that to be negative for Tech, as recessions typically see expensive mega-cap stocks underperform
