To rotate or not to rotate

Both are on sale (i.e., undervalued). However, I spent entirely too much money on these four-inch-heeled Christian Louboutins that I rocked at a women's event in Kansas City this week. I have to wear them despite my feet's protestations (post Covid!), as I figure the price per wear reduces each time. Complete with a gourmet chef's class and appetizers in a historic venue (now a B&B), the ladies wanted to know if the unbelievable DC events will harm their portfolios. And, "Why (reacting to my presentation data) do women, job for equivalent job, continue to earn 20% less than men?" I responded with my diplomatic best. Advisors here are cautious. One in Kansas City, MO, believes diversification is called for, while in Lawrence, KS, another is positioning portfolios for trouble. With the S&P 500 up 75 points on midday Friday, one might ask, "What trouble?" Sentiment, a contrarian indicator, is a headwind, with BCA's composite sentiment reading at its third-highest point in 34 years. The 2.3% drop in the S&P on Wednesday marked the close of the tenth-longest period without a 2% drop in the last 97 years of market history. Historically in an election year, seasonality augurs well for August, which is otherwise often a weak month. Three-fourths of stocks remain above their 200-day moving average, which could be supportive. Also, bonds shrugged at Wednesday's equity selloff and credit spreads are muted. Fundstrat sees confirmation of a breakout in small caps and a clearer signal that this is being funded by rotation out of large caps. The current market may not be limber enough to further rotate, though. Its P/E ratio is unprecedentedly high for a start to Fed easing. Furthermore, its free cash flow yield is fully 70 basis points below that of 10-year Treasuries, the most since 2002. Pre-election corrections, where they have occurred, have often been rather modest. Meantime, regarding a key issue on which the election will be fought: inflation expectations in the US have come down though remain high relative to developed market peers, suggesting that the Fed may move at a measured pace once it begins to cut. Trump mentioned "inflation" 14 times in his acceptance speech at the Republican convention. But by Election Day, who knows? The Fed's preferred PCE measure satisfied. And a previous sore spot, carmakers and dealers are now lowering prices due to damp demand.

Earnings results, especially from the biggest companies, will be the driver of stock prices in the coming weeks. One potential sign of a change to the AI story: rising costs of AI emerged as a key theme in results from Alphabet and Tesla. And small caps? Their earnings estimates are up YTD, but too many Russell 2000 companies are unprofitable. For this small-cap rally to have legs, smaller companies will need to guide toward improving fundamentals in their earnings calls. Protecting profit margins is key, as revenue surprises have been decelerating throughout the market over the past two quarters. Are companies losing pricing power? That would be good for inflation but bad for profits. So far this season, earnings are still intact-witness the early-reporting Financials sector. A series of earnings disappointments from mega-cap tech might prompt a significant rotation. With one third of the S&P 500 having reported thus far in Q2, earnings are coming in well above the 7.6% growth expected, with an average 10.2% on a dollar-weighted basis and 79% of companies surprising to the upside. Growth estimates for this year and next stand at 11% and 14%, respectively, well above long-term average growth of 6-7%. No trouble yet.

It's been a tough run for macro forecasters. Since 2020, prominent missed themes include: the V-shaped recovery of 2020, the steep inflation of 2021, the 425bps rise in the Fed funds rate that began in 2022 and the recession-that-wasn't of 2023. That brings us to the present day, where in just the past week we've seen a massive tech outage (earning me a new badge as war-torn road warrior) and a new leader of the Democratic party. Yet complacency is strong, with equity risk underpriced. Options markets in mega cap tech appear unconcerned about earnings, even though their valuations make them fragile in case of disappointment. Deficit-financed stimulus is finally rolling off right about the time the "long and variable lags" of rate hikes start to bite. Past-due credit cards are at their highest level in a dozen years, while Discover says that 80% of Americans are anxious about their finances. A recent survey showed companies pessimistic about Q3 wages and pricing power. If things were to sour into a US recession (not our base case), that would likely turn global, as neither Europe nor China appear positioned to take up the slack. Leuthold sees valuations stretched to mania levels (1999-2000). Speaking of the tech bubble: defensive sectors went up 35-45% in the last nine months of 2000, after the bubble burst. Hmm. Since July 11, the S&P is down but most sectors are higher, with Utilities and Health Care (defense) leading the way, while the Russell 2000 is up 7% (offense). Hmm. A US recession is not yet in view, and unemployment remains low. Variable-rate debt is half the share of consumer debt that it was in 2007. Corporations, too, locked in low rates years ago, and interest rates increasingly appear to be headed down. To rotate or not to rotate, that is the question. Plus, into offense or defense? There's two questions?!

Positives

• The Goldilocks narrative gets a boostGDP rose at a 2.8% rate in Q2, well above the 1.9% expected and double the 1.4% Q1 rate, with inventory investment the main factor. Core PCE fell from Q1's 3.7% to 2.9%, only somewhat above the 2.7% forecast. On a monthly basis, core PCE rose 0.2% m/m and 2.6% y/y. Inflation is declining apace. Also, US composite PMI rose to 55.0 in July, the highest since April 2022, with services expanding but manufacturing contracting.
• Aside from planes, capex rebounds Durable goods orders ex-transport rose 0.5% in June, versus 0.2% expected. The headline number fell, however, due to a steep drop in commercial aircraft orders. Core capital goods orders rose 1.0% versus 0.2% expected, while core capital goods shipments increased 0.1%, slightly less than the 0.2% expected. Core orders and shipments have both moved sideways since last year.
• Consumers stay steady The University of Michigan's July consumer sentiment reading came in as expected at 66.4, although this is down from last month's 68.2. Of note: year-ahead inflation expectations dropped to 2.9% from 3.0% last month while long-term inflation expectations remained unchanged at 3.0%.

Negatives

• An F in home economics Existing home sales in June fell 5.4% y/y to an annual rate of 3.9 million units, the lowest since December. The median price rose 4.1% y/y to a new high of $426.9K even as housing inventory rose 3.1% last month. For their part, new home sales declined 0.6% to an annual rate of 617K, while inventory is the most since 2008. Home prices have risen nearly 50% since 2019 whereas wages have risen 25%, meaning a retreat in rates would still leave affordability poor unless prices also fell.
• More regional Feds slip The Richmond Fed's manufacturing index fell to -17 in July from -10 in June. Shipments, new orders and employment were all weak. The Philadelphia Fed's non-manufacturing index sank to -19.1 in July from 2.9 in June as new orders dropped and full-time employment gave its first negative reading in a year.
• International roundup The eurozone's composite PMI fell in July to 50.1, below ECB expectations, with manufacturing contracting sharply even as services picked up. Eurozone consumer confidence continued to rise, though it remains below pre-Covid levels. In China, the Third Plenum left some unsatisfied but did result in stimulus to subsidize renewal of equipment and trade-in of consumer goods.

What Else

Go big or stay home? A recent study looked at year-to-date S&P 500 performance outside of the Financial and Real Estate sectors and found that the best performance was in companies that either increased headcount substantially (more than 20%) or decreased it modestly (flat to -20%). Companies that cut headcount more than 20% and those who grew it 0-20% have performed worse.

Legal tender The dollar has stayed strong - rising 3% year-to-date and up 16.5% since May 2021. It's notat an all-time high but has been broadly strong since the Global Financial Crisis. One reason for the latest signs of strength? Overseas investors have been buying dollars to buy US tech stocks. If tech stocks were to fall, that could be bad for the dollar.

Pay phones The first Olympic Games took place in 776 BC. Gold was harder to come by then. Nowadays, an Olympic gold medal contains at least as much gold as can be found in 177 smartphones. Consequently, for the 2020 Olympics, 6.2 million used mobile phones were melted down and recycled to make the Olympic medals.

Public link

Please use the above public link if you want to share this noodl on another website.