The term “bottoms up” is most often associated with a toast or telling people to finish their drinks, implying the bottom of the drink glass is being raised as the drink is consumed. In business, “bottom up” refers to taking action based upon feedback from lower levels of a hierarchy, generally front-line employees. And in investing, “bottom-up” refers to making investment decisions based upon individual security selection or sector analysis, as compared to top-down analysis which takes a larger view and begins with analysis of the macroeconomic environment. (Author’s note: In our updates we tend to discuss much more of the macroeconomic environment and market conditions, compared to looking at individual stocks and sectors, so this would be considered top-down analysis.) But now might be a good time to contemplate whether this is a “bottom up” situation, one different than any described above – has the stock market bottomed and are we on our way back up?
We will not definitively know the answer to that question for several months, but there are several indications the markets may have bottomed about a month ago. Thus far the markets have had a strong showing in July with the S&P 500 being higher by about 5%, led by the stocks most beat up this year – technology. Interest rates saw a spike in mid-June and have since retreated, providing a reprieve to growth stocks whose values are vulnerable to interest rates since stock prices reflect estimates of the present value of future earnings. We have also experienced a pullback in commodity prices, including energy, giving hope that inflation may be moderating. Despite this bounce, the S&P 500 remains about 15% off its all-time highs reached earlier this year.
Fears of an impending recession have been exacerbated by the inversion of the bond yield curve with 2-year U.S. Treasuries now yielding more than 10-year U.S. Treasuries. Ironically, even though the bond market is signaling a slowdown the stock market is viewing this as a positive since a recession could help quell inflation and eventually lead to lower interest rates. A slowdown in economic activity during a recession is likely to lead to lower demand, alleviating upward pressure on prices. Recessions can even be deflationary, depending upon the severity and length.
Grab Your Drinks
Much attention is paid to monthly economic releases, but over time corporate earnings drive stock market returns more than any other factor. Earnings season is gearing up in earnest with some of the largest tech companies reporting this week. The earnings already reported show that demand remains solid but inflation is providing headwinds. Tight labor markets continue to cause issues, contributing to higher costs and hindering growth prospects. Many companies expect inflation to moderate during the second half of the year. Earnings expectations have already been lowered and the earnings reported so far have not been spectacular with only a handful of names beating expectations. The fact that earnings have not been worse than the lowered expectations does provide optimism and is providing a boost to the stock market. And there is still much more to come, so grab a drink and watch what happens with earnings reports over the next few weeks; they will drive the markets and provide a clearer picture on whether we are indeed moving off the bottom and on the path to recovery.
We also cannot forget other highly anticipated events of the week, especially the Federal Reserve meeting. It is widely expected they will raise interest rates by three-quarters of one percent or 75 basis points (a basis point is equal to 0.01%). After the hotter than expected CPI report a couple of weeks ago there was speculation they would raise rates by a full point but that has now been mostly suppressed after recent comments from Fed officials. At this time, it seems likely the Fed will raise rates by at least a half point, or 50 basis points, at their September meetings. Inflation may be abating and with the potential for a recession on the horizon there is some thought the Fed will have to reverse course and begin to lower rates sometime in 2023.
It is going to be a very busy week with earnings and the Fed, as well as the Personal Consumption Expenditures (PCE) and Gross Domestic Product (GDP) reports. The PCE Deflator is the Fed’s preferred gauge of inflation and, similar to CPI, is expected to remain elevated and well above the Fed’s comfort level of 2-3% annual inflation. With all the events of the week, it is the GDP report which will likely garner the most attention. The technical definition of a recession is two consecutive quarters of negative GDP growth, a.k.a. economic contraction. GDP was negative in the first quarter of this year so if this report is also negative, we could “technically” already be in a recession. Where it gets interesting is that the headline GDP is reported on a real basis, meaning that growth is measured and then adjusted for inflation. So even though there could be positive economic growth, factoring in inflation will make it appear to be negative. On a nominal basis, GDP growth is very likely to remain positive so if the report comes in showing contraction, it may be disputed as to whether or not we really are in a recession.
We remain hopeful the recent stock market strength is the beginning of the bounce from the bottom and this is not merely a short-term bear market rally. This year has been a real wake-up call for some people, especially for those who became complacent over several years of bull markets. We remain very optimistic for long-term market prospects but continue to acknowledge there will be volatility over shorter time periods. Be sure your portfolio is aligned with your level of risk. Both your risk tolerance, what you can handle emotionally, as well as your risk capacity, what amount of money you are able to lose and maintain your lifestyle. Please give us a call if you would like to discuss your situation. If you are interested in hearing more of our thoughts on the markets, including our outlook for the second half of the year be sure to join us for our monthly Lunch & Learn on July 25th, either in-person or via livestream online.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
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