Main Street More Optimistic After Early 2023 Gains

 

Executive Summary

• Market Sentiment – Main Street Becomes More Optimistic
• Econ Numbers – More Negative than Positive in the Latest Statistics
• Econ Outlook – Little Change in the Forecast; Corporate Profits Likely to Remain Solid
• Inflation – PPI Pulls Back; Modest Reduction in Market Projections for Peak Fed Funds Rate
• Washington – Favorable Historical Evidence & Debt Ceiling Perspective
• Wall of Worry – Plenty About Which to Fret, But Stocks Long Have Proved Resilient
• Stock News – Updates on a consumer discretionary stock and 9 stocks in the financial sector (including 7 regional banks)

 

Market Sentiment – Main Street Becomes More Optimistic

We were all set to attribute last week’s sizable setback in stocks that had been shaping up as of Thursday evening to the big improvement in investor sentiment at the American Association of Individual Investors (AAII).

After all, the gauge is widely viewed with a contrarian eye, so the tally of Bulls in the latest AAII Sentiment Survey rising to 31.0% and the number of Bears falling to 33.1% has taken the measure to a much more neutral level and out of extreme pessimism territory, with the Bull-Bear Spread now residing at minus 2.1%.

 

The good folks in the AAII Sentiment Survey are much more optimistic today than they have been in a long while, even as they are still far more pessimistic than has been normal over the last 36 years.

To be sure, this is well below the normal level of optimism usually seen, and we still think the metric is suggesting investors should be greedy when others are fearful, but subsequent returns data generally show that the more pessimistic investors are, the better returns will be going forward.

Alas, as AAII illustrates, far too many folks zig when they should have zagged. For example, per data analytics firm DALBAR, equity fund investors had awful relative returns in 2021, gaining only 18.4% on average, compared to a 28.7% return for the S&P 500, for a whopping 1030 basis point (10.3%) difference in performance. The longer-term historical numbers are even worse for bonds as Fixed Income fund investors had an annual return 500 basis points lower than the U.S. Aggregate Bond index over the past three decades.

 

Econ Numbers – More Negative than Positive in the Latest Statistics

We might also have placed the blame on the latest batch of economic data, especially as The Wall Street Journal told us on Thursday evening, “Stocks Fall as Data Signal Slump.”

Indeed, two indexes of East Coast factory activity are in contraction and well below their norms. The Empire State gauge of manufacturing activity in the New York area weakened in January to a much-worse-than-expected minus 32.9, down from minus 11.2 in December. On the other hand, the Philadelphia Fed’s measure of manufacturing activity in the mid-Atlantic region improved in January to a reading of minus 8.9, which was above forecasts even as it was down from minus 13.7 in December.

 

More importantly, with November’s reading coming in at a revised 1.0% decrease, retail sales last month slipped by a seasonally adjusted 1.1%, a tad worse than estimates. Clearly, the consumer has been tightening his or her pocketbook, but total sales for all of 2022 were up 9.2% over 2021, no doubt boosted by much higher inflation.

Retail sales were strong in 2022, though the year ended on a decidedly negative note.

Turning to new home construction, the National Association of Home Builders’ monthly confidence index for January beat forecasts, climbing to 35, up 4 points from December, though the figure was well below the long-term average on the 35-year-old gauge. High prices and the spike in mortgage rates did not help, and ground was broken on just 1.38 million homes last month, in line with what was reported in November. Building permits came in below expectations in December, dipping to 1.33 million units, down from 1.35 million the month prior.

 

And other economic numbers were not exactly robust. U.S. existing home sales fell by 1.5% in December to a seasonally adjusted annual rate of 4.02 million, a bit better than projections but the 11th straight monthly decline as higher interest rates and elevated prices weighed heavily on affordability. Meanwhile, industrial production edged lower by 0.7% in December to 78.8%, weaker than estimates of a slight advance and falling from the November tally of 79.4%. Manufacturing output dropped 1.3% and capacity utilization of 78.8% came in below expectations.

 

All that said, it isn’t as if there has been much change in the economic outlook of late. The respective 1.6% and 0.6% contractions in Q1 and Q2 2022 real (inflation-adjusted) GDP means economists could say that the U.S. economy was already in recession, but the odds of an official declaration have held steady at 65.0%, even as the latest consensus forecast for GDP growth this year is 0.5% and 1.2% for 2024.

 

Further, the jobs picture remains very healthy. While higher than readings earlier in 2022 with a 1-handle, yet still coming in near the lowest levels since 1969 when the work force was much smaller, new filings for unemployment benefits for the period ended January 14 were a seasonally adjusted 190,000, down from a revised 205,000 the week prior. Continuing claims filed through state programs inched up to 1.65 million, as businesses continue to hold onto most workers with qualified labor difficult to obtain, though the tally is expected to move up.

 

Also, we can’t forget that even as the Omicron variant, supply-chain difficulties, the war in Ukraine and inflation impacted the economy, domestic growth in Q3 rebounded to 3.2% and the Atlanta Fed’s projection for Q4 2022 real GDP growth on an annualized basis as of January 20 stood at a strong 3.5%.

 

We believe, as does the analyst community, that the economy will remain healthy enough to provide a positive backdrop for corporate profits. That does not seem to be much of a stretch when we consider that third quarter 2022 current-dollar nominal GDP of $25.7 trillion soared by 9.2% on an annualized basis to an all-time high. Yes, economists always focus on real (inflation-adjusted) numbers, but sales, earnings and stock prices are always measured in nominal dollars.

There was a huge 9.2% jump in Q3 nominal GDP, even as real (inflation-adjusted) growth was “only” 3.2%.

Econ Outlook – Little Change in the Forecast; Corporate Profits Likely to Remain Solid

It is still very early in the current reporting season, but Q4 EPS have been decent thus far, with 69.0% of the 55 companies in the S&P 500 to have announced results beating bottom-line expectations. Of course, outlooks have been subdued and stock prices often have reacted negatively.

 

Inflation – PPI Pulls Back; Modest Reduction in Market Projections for Peak Fed Funds Rate

Concerns about inflation and the Federal Reserve have also been weighing on investor psyches, but the gain in wholesale prices continued to retreat in December. The producer price index dropped 0.5% last month, the largest decline since 2020, with the year-over-year rise falling to 6.2%, down from 7.3% in November and 11.7% last spring.

 

Although the estimate for real GDP growth in 2023 was pared to 0.5% in December, down from 1.2% in September, the Federal Reserve lifted its target for the Fed Funds rate by 50 basis points last month, following 75 basis point hikes at each of the June, July, September and November FOMC meetings. Jerome H. Powell & Co. are now projecting that the Fed Funds rate will likely end 2023 at 5.1%, but the Fed Funds futures became a bit less hawkish last week as they are now estimating a 4.42% year-end 2023 Fed Funds rate and a 4.90% peak in June 2023, with a pivot lower coming in July.

 

Washington – Favorable Historical Evidence & Debt Ceiling Perspective

And we understand that drama on Capitol Hill has created plenty of uncertainty, but we like that the calendar has rolled over to the third year of the presidency. History may not repeat, but it often rhymes, and the third year historically has been the best of the four, while a Democrat in the White House and a Split Congress has seen sensational two-year returns, on average, for stocks of all stripes.

 

Of course, we realize that Janet Yellen warned on the disastrous ramifications if Congress does not raise the nation’s debt ceiling. The Treasury Secretary said last week, “If that happened, our borrowing costs would increase and every American would see that their borrowing costs would increase as well. On top of that, a failure to make payments that are due, whether it’s the bondholders or to Social Security recipients or to our military, would undoubtedly cause a recession in the U.S. economy and could cause a global financial crisis.”

Certainly, this sounds ominous, but this is not the first time we have had the debt ceiling hanging over our heads. In fact, as the Treasury’s website (https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/debt-limit) states, “Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. Congressional leaders in both parties have recognized that this is necessary.”

No doubt, a U.S. default is not something we want to see and we understand that the Treasury is taking emergency steps to keep the proverbial engine running, likely for the next five months, but here is what we wrote on the subject back in August 2011:

The debt drama in Washington is no doubt top of mind for almost every investor. Though there were initially hopes for some sort of a ‘Grand Plan’ to be struck that might see upwards of $4 trillion cut over 10 years from the country’s massive deficit, the warring parties are now trying to simply cobble something together to stave off a default prior to the somewhat arbitrary August 2nd deadline for raising the debt ceiling. As if this weren’t enough of a concern, the ratings agencies have suggested that the nation’s AAA credit rating may be downgraded even if some sort of a decent compromise is reached. Needless to say, few are happy with our supposed ‘leaders’, no matter which side of the aisle they may reside.

Not surprisingly, the political rancor has most folks on edge with reports surfacing that investors have been pulling cash from money market funds while the equity markets have been wobbling. Certainly, we do not want to make light of the debt issue, but we continue to think it highly unlikely that Uncle Sam will default on his obligations. Yes, there is a good chance that the U.S. credit rating will be downgraded, but we doubt that we will see a big change in the yields on Treasuries. The reason for this is that there is little place else for investors to go as those seeking the safety and yield of a supposedly risk-free (assuming the security is held to maturity) asset are unlikely to bail out of their Treasury investments.

Don’t believe me? Take a look at where things stand on the benchmark 10-Year U.S. Treasury as of July 29. Clearly, if investors thought that there was a risk of the government not making good on its interest and principal payments, yields would have spiked significantly higher, rather than touching their low for the year at 2.80%.

And, believe it or not, we’ve been down this road before. Consider the following commentary:

Republicans in Congress have vowed not to raise the debt ceiling until the President agrees to their plans to trim federal spending. The President has said he will not be blackmailed into agreeing to the GOP program.

The Treasury Secretary has said it is irresponsible for Republicans to hold the debt ceiling hostage in the budget debate because even the risk of a government default on its debt could cause turmoil in financial markets

“For all their loose talk,” Mr. Clinton said, “the Congressional leaders know that if they were to allow us to go into default, this would have a severe impact on our economy, on financial markets, and on the interest rates paid by government, business and homeowners.”

Hopefully, the quote from President Clinton gave away that the time period was November 1995 when the U.S. government had to put non-essential government workers on furlough and suspend non-essential services. While not quite the same situation we are facing today, the debt ceiling was the big sticking point back then and Washington was actually able to reopen for business five days after the initial ‘non-essential’ measures were taken. Of course, a deal still could not be reached and the government actually shut down completely four weeks later in an event that lasted from December 16, 1995 to January 6, 1996. Treasuries performed very well (yields actually moved lower!) during that turbulent time.

But stocks must have taken it on the chin, right? Well, there were definitely some rocky periods, but equities moved nicely higher with the large-cap S&P 500 advancing more than 15% from August 1995 through February 1996!

At the end of the day, we do expect some sort of deal on the debt ceiling to be reached, but we should point out that the S&P 500 has had a 285% total return, or 12.45% per annum, since the July 2011 debt-ceiling scare, and a 1079% total return, or 9.42% per annum, since the one in 1995.

No doubt, there is plenty about which to worry today, including the war in Ukraine, supply-chain disruptions, inventory management woes, corporate-profit question marks, higher inflation readings, the slowing economy and increased risk of recession, not to mention comments and actions from the Federal Reserve, and the debt-ceiling, but history is filled with plenty of frightening events, yet equities have provided handsome rewards…for those who have stuck with them.

 

Wall of Worry – Plenty About Which to Fret, But Stocks Long Have Proved Resilient

Obviously, one day does not validate or disprove anything, but Friday’s trading illustrated that stocks often climb a Wall of Worry, as the week ended with a big rebound that recouped a significant chunk of the losses for the full four days of trading. This was the case even as The Wall Street Journal’s front page on Saturday included these headlines:

Google’s Parent to Cut 12,000 Jobs
Fed Probes Goldman Over Its Safeguards for Consumer Unit
China’s Global Mega-Projects Are Falling Apart
Covid-19 Enters Fourth Year
Home Sales Slip to Cap Worst Year Since 2014

Despite all the negativity, 2023 is still off to a great start, though the 12-month return tallies offer vivid reminder that stock prices move in both directions. While Growth stocks had the upper hand in the latest week, Value has been winning the performance derby for a while now.

 

Needless to say, we think time in the market trumps market timing, as even those compensated to pontificate on the short-term gyrations in stocks often end up making little sense.

For example, here are comments published on CNBC.com from one professional market watcher endeavoring to explain Friday’s rally:

“We’re having a more emotional reaction that expected. A lot of people got so pessimistic and we saw parabolic moves to kick off the year. Now, as expected, the markets aren’t going in a straight line.”

“We are finding a way to continue to move and have higher lows. The higher lows put a little bit of confidence in the bulls. However, the technicals are still favoring the bears and selling rallies. You’re seeing more weight go into some of the beat-up technology and because people are becoming a little bit more thoughtful of opportunity in the absolute tech wreck we saw in 2022.”

Clear as mud from where we sit!

Anything can happen as we move forward, so we’ll leave the short-term predictions to the soothsayers and fortune tellers. Selloffs, downturns, pullbacks, corrections and even Bear Markets are events that equity investors always have had to endure on their way to the best long-term performance of any of the financial asset classes.

 

We are always braced for downside volatility, but we see no reason to alter our long-term enthusiasm for our broadly diversified portfolios of what we believe to be undervalued stocks.

Stock News – Updates on one consumer discretionary stock and nine stocks in the financial sector (including 7 regional banks)

Jason Clark, Chris Quigley and Zack Tart take a look at earnings reports and other market-moving news of note out last week for several of our recommendations.