Momentum in the stock market is positive, yet overbought, as signs of lower inflation has driven technology stocks to the highest levels of valuation against the S&P 500 since the dotcom bust. This is because the valuation of tech stocks has increased without an increase in earnings expectations. Much of this exuberance is based upon the emergence of artificial intelligence as “the next big thing”, although this is still grounded in speculation.
Analysts are raising earnings estimates, expecting an economic recovery, despite leading economic indicators going in the opposite direction.
A handful of mega cap growth stocks is responsible for most of this year’s rally in the S&P 500. The forward PE ratio of the 10 largest stocks in the S&P 500 is currently 28.5 times, which compares to 16.3 times for the other 490 stocks in the index. Typically, lopsided breadth like this is not considered healthy.
The Federal Reserve has now raised rates by 5% with the intention of slowing the economy, and another 1/4% hike is all but assured next week. Signs are building that this tight monetary policy is beginning to take a bite on the economy especially when we consider that “real” (inflation adjusted) yields have resumed a sharp rise upward since April.
US consumer borrowing is rising at the slowest pace since late 2020, because of high rates and tight credit standards. Our monetary system is based on the expansion of debt, yet banks are tightening their lending standards for consumer and commercial debt, forcing credit usage to slow. As credit card debt reaches all-time highs, so do credit card interest rates and delinquency rates. which are up 45% in the past year.
There has been a sharp drop in automobile loans, because consumers face increasing difficulty getting them, which caused used automobile prices to drop by 4.2% in June, one of the largest drops in history. Used car prices have been a big driver of inflation. Inflation has outpaced wage growth now for two years, forcing households to increase credit card debt in a high interest rate environment.
Recently, San Francisco fed President Mary daily said “we are likely to need a couple more rate hikes to really bring inflation back into a pass this along a sustainable 2% path.” The Fed continues to invert the bond curve, which tightens bank lending standards even further. When short term interest rates are higher than long-term rates, banks make less money, which causes them to either stop lending or raise loan rates, which leads to slowing credit creation, and a slowing economy. The same is true with commercial and industrial loans, where more than 40% of domestic banks are tightening credit standards. The following historical chart demonstrates that unemployment (lower line) generally increases when banks tighten their lending standards:
The US producer price index (PPI) is approaching deflation with a 0.1% annual rise in May. This followed in the wake of a consumer price index (CPI) which showed that inflation is indeed slowing.
Consumer prices rose at their slowest pace in June since 2021, and CPI generally follows PPI with a lag. If, after one or two more rate hikes, inflation drops further, there is a risk that we may see inflation lower than 2%, meaning that the Fed will have “overshot” by over-tightening, leading to deflation, higher unemployment, and recession. Deflation causes producers to sell goods at a lower price than the year before, which pressures margins; To keep margins up producers cut staff. The last unemployment numbers indicated that unemployment was still strong on a seasonally adjusted basis, though on an unadjusted basis, unemployment increased.
Another clue of a potential turn in the economy comes from overseas. Chinese exports to the US fell by 24% in June, their steepest annual rate of decline. Taiwanese exports fell by 23% in June versus one year ago, Vietnam was down 11%, and South Korea was down 6%. Overall US imports of goods were down by 5.5% in the first half of 2023, and over half that number goes toward the manufacture of goods.
The exuberance of the first half has led the S&P 500 to a forward P/E of 21.5 times, which is about 1.3 standard deviations higher than its average at 16.
The index of Bullish-Bearish sentiment is close to the top of a long-term channel which tends to revert over time. If a recession is in the cards, which the bond market is predicting, bonds are likely to outperform stocks over the next six months.
