Charts of the Month - July

The charts and themes that tell the current story in markets and investing.

All-Time Highs Within Reach

One of the funny aspects of investing: when it’s the best time to buy, you rarely want to.

Markets found a bottom last October. At that time, the Fed was in the middle of one of its most aggressive rate hiking cycles ever, inflation was at a 40-year high, and sentiment readings looked like they stepped into a ring with Mike Tyson.

The S&P 500 and the NASDAQ were in painful bear markets, down 24% and 35%, respectively.

Fast forward to present and those indexes are within whispering distance of all-time highs.

The S&P 500 is only 2% from a new all-time high—the NASDAQ only 4%.

How is this possible?

For one, the outlook for earnings has been improving. And we know earnings are one of the most important drivers of stock prices.

Take one example: Meta, formerly Facebook.

Meta’s net income declined in three consecutive quarters last year, hitting its trough in the third quarter, coinciding with the previously mentioned October bottom. Since, earnings have grown in every quarter.

Meta’s stock price has followed the path of its earnings. Since its lowest point late last year, the stock is up more than 250%.

Meta is only a single example, but the market broadly reflects a similar trend regarding earnings.

Earnings Season

Corporate earnings have been extremely weak over the past year. Earnings peaked in the second quarter of 2022 and have declined in three consecutive quarters; with the expectation they will decline for a fourth consecutive time in the current quarter.

The weak earnings outlook is why numerous market forecasters warned of a pullback in the first half of this year—one that never came to fruition.

A likely reason the market didn’t fall further? Stocks are discounting mechanisms, which is a fancy way of saying they attempt to price in future expectations in today’s prices.

The market likely looked beyond the period of declining earnings we’re experiencing now and began to price in earnings growth that is expected to start next quarter.

One example? In the last week of July—a significant week for corporate earnings—analysts raised their next 12-month earnings per share (EPS) estimates every day of the week. The "E" in the P/E ratio is finally starting to move higher after trending sideways for months.

While oversimplifying, it’s probably not a stretch to argue that last year’s stock market troubles came in anticipation of the downturn in earnings. And it’s likely fair to argue the bull market we’re currently experiencing has been in anticipation of re-accelerating earnings growth.

One of the main reasons for optimism around earnings growth? A strong and resilient consumer.

Don’t Underestimate the American Consumer

Consumption is a key factor in U.S. economic growth. Nearly 70% of the U.S. economy, as measured by GDP, is based on personal consumption.

So, in theory, “as the consumer goes, so goes the economy.” And right now, the consumer is holding up better than many expected.

Consumer confidence is at its highest levels in more than two years, using data from The Conference Board, which is a monthly report summarizing consumer attitudes, buying intentions, vacation plans, and expectations for inflation, stock prices, and interest rates.

If there is a recession around the corner, the remedy might be to put Taylor Swift back on tour.

Swift’s current Eras Tour will likely go down as the highest-grossing concert tour of all time, earning more than $1 billion in total sales.

Market research firm QuestionPro estimated last month that her tour could help add $5 billion to the worldwide economy, which is larger than the gross domestic product of 50 countries.

The impact has been so significant the Federal Reserve Bank of Philadelphia recently called attention to it:

“May was the strongest month for hotel revenue in Philadelphia since the onset of the pandemic, in large part due to an influx of guests for the Taylor Swift concerts in the city," the reserve wrote in the Beige Book, which is published by the regional banks to share information about the state of the economy.

Sampling data from earnings reports, we see many other encouraging trends related to the consumer.

American Express, Bank of America, JPMorgan, and Visa all reported total payment spend across debit and credit cardholders up mid-to-high single digits versus last year.

Bank of America gave a brief state of the union on the consumer on their earnings call:

“The consumer is still in a healthy place and remains resilient. We believe that remains the case, and we're benefiting it.”

The airlines also had positive things to say.

American Airlines reported their highest revenue quarter in company history. And United Airlines flew a daily average of more than 2,400 flights, the most mainline flights during a single quarter in company history.

In short, despite much anxiety, the U.S. consumer remains healthy. And a major factor pushing consumer confidence has been the continued trend of falling inflation.

Inflation

Only a year ago—June 2022—we had the highest inflation reading in more than forty years at 9.1%.

Since then, the rate of growth in inflation has declined in 12 consecutive months.

Overall U.S. CPI is now at 3.0%, its lowest level since March 2021.

The Misery Index—which combines inflation and the unemployment rate—has also drifted down to its lowest levels since 2020.

When inflation peaked a year ago it seemed obvious the only way to tame inflation would require a significant uptick in unemployment. In effect, the labor market had to be sacrificed to stop inflation.

But to our good fortune, that outcome has not manifested.

Valuation Concerns?

An argument that is becoming more common has been the bulk of stock price gains this year have come from multiple expansion, or investors simply paying higher prices, rather than earnings growth.

U.S. large caps now trade at 19.5 times forward earnings, up from under 17 at the end of last year.

On one hand, you could diversify away from U.S. large caps—international and emerging markets are much cheaper on a valuation basis.

On the other hand, U.S. large caps have remained above their longer-term averages for many years. There is no iron law that says valuations must return to some defined long-term average.

For example, using the Shiller PE, you can see valuations have been adjusting higher since the 1980s.

You can point to a few reasons for this.

It’s never been easier to invest. With the rise of cheap equity exposure and the ability to easily diversify, investors today are willing to accept lower future returns (i.e., higher valuations) than investors of the past. There’s an argument to be made this has fundamentally changed valuation metrics and made historical comparisons less useful than they once were.

The cost of trading has been coming down for decades. If it costs less to trade, then the returns required by investors should probably be lower.

Interest rates are much lower today. Many investing legends—from Warren Buffett to Howard Marks—have argued lower rates can justify higher valuations.

While there is much historical evidence that valuations inform long-term returns, that same data also shows valuations tell you almost nothing about where stocks will go over the next year.

While future returns for U.S. stocks will likely be lower from today’s starting valuations, when we will experience them is nothing more than a guess.  

The bottom line is that you should use valuation metrics like the P/E ratio with caution. Just because valuations are high at a given moment does not necessarily mean the next 12 months’ return will be weak.