In the summertime parents often send their children off to camp which generally is somewhere in a forest often near a body of water. For parents it gives them a reprieve from having to keep their children occupied while not in school and for the children it is an opportunity to hang out with others their age as well as take part in outdoor activities. While certainly not a restful vacation, camp tends to be a quiet time over the summer and a break from the normal routine. The markets seem to be slowing down and taking a bit of a break, leaving us to wonder if this will continue for the remainder of the summer or if it will be short lived.
Last week the major indices finished lower with the S&P 500 breaking a five-week winning streak and the Nasdaq an eight-week streak. There was not a main driver of the slight pullback with many analysts attributing it to the possibility the stocks which have recently enjoyed abnormally large gains perhaps are overextended or at least need to take a breather. Otherwise, there were few changes to the broader themes that have been recently discussed. During an appearance on Capitol Hill, Federal Reserve Chair Jerome Powell reiterated that two additional rate hikes are “a good guess” if the economy continues to perform as expected. This is in-line with comments made the prior week and the recently released Fed “dot-plot.”
The markets have been led higher this year by a small group of stocks with outsized gains, most of which have been associated with the artificial intelligence (A.I.) craze. Reviewing valuation metrics of the stock market, the valuations of hyper growth stocks has fallen considerably from two years ago but remain elevated above long-term averages. The recent market run-up has made them more expensive, especially on a relative basis compared to other sectors and higher quality stocks. But as we’ve often seen in the past just because a stock or sector is cheaper does not necessarily guarantee it will perform better going forward. We remain cautiously optimistic on the markets for the second half but think strength will come from different sectors and names than we saw in the first half.
While at camp, once the sun goes down and it gets dark the children may gather around a campfire to sing songs and tell stories. The songs tend to be of good nature and often elicit laughs while the stories may be of the scarier variety, often of a dreaded creature emerging from the darkness of the forest in which the campers are gathered. What types of scary creatures could emerge from the darkness to derail your retirement?
There are always unanticipated threats such as war, natural disasters, pandemics, just to name a few, but we also try to think about the more common occurrences which could negatively impact the markets. With the Fed seemingly winding down, the threat of higher interest rates seems to be abating but are we being lulled into a false sense of security? Will inflation continue to abate and eventually fall to a level comfortable for the Fed as well as the general public where it does not inhibit economic growth? It seems to be slowly headed this direction, but still has a long way to go. And while no longer near the multi-decade highs in inflation we were experiencing a year ago, increases in prices continue to lead to an erosion of purchasing power. Even if inflation remains in the 4-5% range, this will erode purchasing power considerably faster than if inflation were around 1-2% so obviously should not be overlooked in your retirement planning.
We also remain focused on corporate profits, which is the largest driver of stock market returns over the long term. As of March, earnings expectations for the S&P 500 had been lowered by 12% from the prior year, leading to more positive earnings surprises from the first quarter than expected, providing a tailwind for the markets. Since then, Wall Street analysts have increased their earnings estimates 2-3% for the next twelve months. The change in sentiment, while not large but if proven accurate, does give stocks a firm foundation to climb. On the other hand, with increased expectations comes increased risk they are not met, providing a headwind for the markets. Historically, positive earnings surprises have averaged 4-5% of the companies in the S&P 500 in any quarter. The first quarter of this year, nearly 7% of companies beat expectations, much better than the less than 1% that did in the fourth quarter of last year.
This is the last week of this quarter and will end a positive first half of the year, exceeding most expectations and predictions. The threat of a recession continues to loom large, especially as the yield curve remains inverted with the negative yield spread between 2-year and 10-year Treasury bonds around a full one percent, which is significant by historical standards. In the past an inverted yield curve has been a strong recession predictor, with a lag of 12 – 18 months. For reference, the 2-year/10-year inversion began in July of last year and if history is any indication, we very well could see a recession in the second half of the year. But since a recession has been so widely anticipated for so long, it may not have much impact on the stock market since it may already be priced in.
We will continue to watch inflation and further action from the Federal Reserve. A quarter-point hike at their next meeting in July is expected. The Personal Consumption Expenditures (PCE) inflation report this week will give ore clarity but since a major move is not anticipated it seems unlikely to derail the Fed. Even though it is summer and market activity seems to be slowing, we continue to remain vigilant and watch the markets so you can spend time at camp, on vacation or at your cabin. We are here to help you feel confident in your retirement, despite what might be lurking in the darkness.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
Office phone # 952-460-3260