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Posted by Jeffrey Buchbinder, CFA, Chief Equity Strategist

Wednesday, August 30, 2023

Key takeaways

• The increase in interest rates in recent months has left equity valuations more challenged.
• Based on the Equity Risk Premium (ERP), the S&P 500 Index offers very little additional compensation for equity investors relative to fixed income, which offers some of the most attractive yields in decades.
• The ERP is one of the primary reasons that LPL Research has a slight preference for fixed income over equities in its current recommended tactical asset allocation, but consider that valuations have not historically been good short-to-intermediate term timing tools.
• LPL Research suggests sourcing a slight fixed income overweight from cash to maintain a neutral equities allocation relative to appropriate benchmarks.

What is the ERP?

Let’s start with the basics. We can measure the relationship between stock and bond valuations by comparing earnings yields to bond yields, giving us the so-called equity risk premium (ERP). The earnings yield is simply the inverse of the price-to-earnings ratio, which is currently at 22 based on trailing four quarters S&P 500 earnings per share (EPS).

The ERP compares the earnings yield on the S&P 500 (the inverse of the price-to-earnings ratio, or P/E) to the 10-year US Treasury yield. The inverse of 22 gives us an earnings yield for the S&P 500 of about 4.5%

We can then compare that 4.5% number to the 10-year Treasury yield (not risk free but referred to as a “risk-free rate” in the textbooks). The 10-year yield is trading at 4.11% currently, down from a recent closing high of 4.34% on August 21. Take 4.5% minus 4.11% and you get roughly 0.4%, the current ERP for the S&P 500 as shown in the chart below.

View enlarged chart

LPL Research believes the ERP gives investors a more complete valuation picture. Going back to those finance textbooks again, the theoretical value of a stock is the present value of future cash flows. So, a higher interest rate raises the discount rate, which then lowers the value of those future cash flows discounted back to today’s dollars. From that perspective, rates should be part of any valuation discussion for the stock market.

Also consider that investors have a choice between stocks and bonds. Of course, there are other choices like alternative investments, real estate, commodities, etc., but for this exercise we focus on the two primary investment options, stocks and bonds. As interest rates rise, bonds become relatively more attractive because of higher yields. This is another important reason why interest rates matter to stock investors. You might say fixed income investments are a competitive threat for stock investors.

Does the Low ERP Really Matter?

The S&P 500 ERP of 0.4% is low but not much below the long-term average of 0.7%. However, 0.4% is the lowest the ERP has been since before the 2008-2009 financial crisis. Essentially, the S&P 500 Index offers very little additional compensation for investors to take on equity risk relative to fixed income, which offers some of the most attractive yields in decades.

The logical next question is how much do valuations influence future stock market performance? The data is quite mixed on that. In fact, based on monthly data back to 1990, the S&P 500 has gained an average 8.7% in the year after registering an ERP between 0 and 1%. Below-average performance has typically come at the extremes, particularly at minus 2% and below which is where we were in the first quarter of 2000 at the peak of the dotcom bubble.

Bottom line, the low ERP is perhaps a reason to temper expectations a bit for stock market gains in the coming year, but that assumes rates stay this high or go higher. If rates fall, as LPL Research anticipates as the economy potentially slows and inflation comes down further, then stock valuations may garner support. So the low ERP is not a valid reason to be bearish on equities, in our view, especially given that expectations for company earnings have improved quite a bit recently as recession fears have abated.

Asset Allocation Considerations

The low ERP is one of the key reasons that LPL Research has a slight preference for fixed income over equities in its current recommended tactical asset allocation. Valuations have not historically been great timing tools over the short-to-intermediate term, but when they are high, they do raise the bar for the economy and corporate America to deliver enough good news to push stocks higher. We see this as a reason to temper enthusiasm for equities, not to be bearish. We remain neutral equities and suggest sourcing a slight fixed income overweight from cash, relative to appropriate benchmarks.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

Posted by Jeffrey J. Roach, PhD, Chief Economist

Tuesday, August 29, 2023

Key Takeaways:

• Despite a hawkish tone, Chairman Powell is in full-on risk management mode.
• Federal Reserve (Fed) officials are uncertain about the time it takes for tighter policy to flow through the economy.
• Fed funds are above inflation and unequivocally restrictive.
• Being data-dependent means the markets are right—the Fed will likely cut rates in 2024.

Introduction

Chairman Powell closed out his speech at last week’s Jackson Hole Symposium with a whimsical, yet fitting analogy for setting monetary policy. He said the Fed is “navigating by the stars under cloudy skies.”  The markets are getting comfortable with a Fed fully aware of a toolbox full of limitations. Monetary policy is oft considered a blunt tool since the fed funds target rate is one rate for 50 states, thousands of industries, and all ages. Therefore, policy must not be entered into lightly, and the fact that the Fed is talking about risk management provides some salve for investors increasingly confident the Fed won’t break something in their efforts to quell inflation.

Risk Management is Paramount

When it comes to hiking the fed funds rate, the Fed is currently very close to the place where the risks of doing too much are roughly in line with the risks of doing too little. One main reason for risk management is the lagged effects of monetary policy. Tightening credit conditions take time to filter through the economy, so that’s why policymakers are concerned about the unknown effects yet to emerge on the economy. The Fed is focusing on risk management now and carefully dissecting the data for any emerging economic cracks. One risk is the rising debt burden among consumers who hold balances on their credit cards.

The Fed is highly data dependent and will be ready to hold rates unchanged if the data clearly supports the notion that inflation is trending close to the 2% target. Our view is that the Fed is becoming even more data dependent, so this week of economic data will be especially important for asset allocators. As inflation pressures ease and the job market cools, investors could see more improvement in equities as markets look to 2024. Job growth in August might be the lowest monthly gain since 2020, but wages seem to remain hot.

Policy Gets More Restrictive When Inflation Falls

The Fed raised the fed funds rate by 525 basis points since early 2022, and as shown in the chart below, monetary policy is clearly restrictive and will continue to dampen economic activity and inflation.

View enlarged chart

As inflation falls, policy will get more restrictive as the gap widens between the fed funds rate (upper bound) and the core deflator, the Fed’s preferred inflation metric.

Summary

Investors should get better news later this week as the job market is expected to slow and inflation rates will likely cool. As the data supports a pause in Fed policy, markets should get a little more comfortable about heading into 2024. A recession could still emerge as consumers buckle under debt burdens and excess savings dry up, but a Fed sensitive to risk management might provide the salve necessary for more risk appetite.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

Posted by George Smith, CFA, CAIA, CIPM, Portfolio Strategist

Thursday, August 24, 2023

Additional content provided by Kent Cullinane, Analyst

• Much was riding on NVIDIA’s earnings report last night and the company didn’t disappoint with better-than-expected top and bottom line results and a big guidance raise.

After having its price targets ratcheted up seemingly on a daily basis, much was riding on the NVIDIA’s (NVDA) earnings report following yesterday’s close. The company didn’t disappoint and reported sales and earnings results that blew past expectations, fueled in large part by artificial intelligence (AI) driven sales.

NVDA’s blowout first quarter earnings season guidance propelled this AI star to even greater stardom to the point where there’s been an ongoing debate on whether NVDA is even more important to the broad trajectory of markets than Federal Reserve (Fed) Chair Jerome Powell’s comments at Jackson Hole this Friday.

NVDA is the largest producer of graphics processing units (GPU) that power AI applications, like ChatGPT, in the world, making them one of the few “pure-play” large-cap AI stocks out there and a bellwether for the rapidly expanding AI industry.

As shown in the chart below, NVDA has outperformed the broader technology sector and stock market by a significant margin this year, rising 222% (as of yesterdays close) compared to the technology sector’s still impressive 38% increase and the S&P 500’s 17% recovery. NVDA is the top performing stock in the S&P 500 year to date and has contributed meaningfully to the S&P’s rally this year. The semiconductor industry as a whole has benefitted tremendously from the hype surrounding AI, along with easing inflation and a constructive technical backdrop.

View enlarged chart

Year-to-date performance of the largest stocks by market cap in the semiconductor industry has been driven more by price multiple expansion than actual earnings growth. For example, NVDA, the largest stock in the Philly SOXX Semiconductor Index, at more than a 9% weighting, currently trades at a forward price-to-earnings (PE) ratio of over 56, much higher than the broader technology sector’s PE of 29 and the S&P’s PE of 23 (based on 2023 estimates). As shown in the chart below, when breaking the technology sector into quintiles by PE, the stocks in the top quintile (highest PE) trade at significantly higher valuations than the remaining four quintiles, hence having an outsized contribution to the elevated sector PE.

View enlarged chart

So where does the technology sector go from here?

Technology stocks have underperformed the market in July and August thus far, but remain well-ahead on a year-to-date basis. Earnings continue to exceed expectations with the technology sector reporting a 1.1% increase in year-over-year earnings for Q2 compared to consensus estimates of a 3.5% decrease as of June 30. Additionally, more than 90% of stocks in the technology sector have reported earnings that have exceeded results, beating the 5-year average of 77% of stocks in the S&P.

While AI-fueled optimism continues to drive the sector higher, there is also technical support within the sector. Nearly 80% of stocks in the technology sector are trading above their 200-day moving averages, well above the S&P’s 59%. In addition, the relative trend of the technology sector compared to the S&P 500 remains positive, with the sector hovering above support levels from December 2021 highs. However, the MACD indicator is trending lower, with the indicator now below neutral, signifying potential for short-term weakness ahead.

Our Strategic and Tactical Asset Allocation Committee (STAAC) remains neutral on the technology sector, as lofty valuations and risk of additional upside to interest rates keep us from a more positive view despite insatiable demand for AI chips and an ongoing uptrend in the sector’s relative performance despite the latest pullback. We continue to monitor the evolving landscape for AI while watching for potentially lower interest rates or another leg up in earnings, which could help keep valuations in check.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

Posted by Jeffrey Buchbinder, CFA, Chief Equity Strategist

Tuesday, August 22, 2023

Additional content is provided by John Lohse, CFA

Key Takeaways

• The Hang Seng Index (HSI), Hong Kong’s benchmark stock index, finished last Friday’s trading session in bear market territory.
• As of the end of last week, the HSI has shed 20.9% since its January 27, 2023, high of 22,688.9, meeting the technical definition of a bear market.
• Economic woes in China have left the index on shaky ground.

Investors are growing increasingly cautious over China’s problematic economy. Those fears have been wreaking havoc on the HSI where many large Chinese-incorporated companies list their shares for foreign investors. As of August 21, the HSI has declined 10.9% year-to-date, 12.2% for the month, and 22.3% from its January 27 peak. The index hasn’t traded at levels this low since November 28, 2022. The chart below highlights 1-year price action of the HSI.

View enlarged chart

China is facing a deluge of negative economic data. Both consumer and producer prices (measured by the CPI and PPI) declined into a deflationary state last month for the first time since 2020. Consumer prices declined 0.3% year over year (YOY), while producer prices sunk for the tenth consecutive month, coming in at 4.4% YOY. Both exports and imports have declined YOY as well. Perhaps most noteworthy, has been the crisis engulfing property developers Evergrande, which filed for Chapter 15 bankruptcy protection in New York last week, and Country Garden Holdings, which recently missed bond coupon payments. Country Garden is set to be removed from the HSI in September.

LPL Research maintains its underweight to emerging markets equities. China makes up roughly 30% of the MSCI Emerging Markets (EM) Index and has many visible headwinds. The MSCI China Index has declined over 51% since its February 2021 highs. While we’re less favorable on broad-based passive investing in EM, we do recognize that active management in EM can provide attractive opportunities. Faltering China sentiment and global supply chain de-risking have contributed to a resurgence for Latin American and other Asian countries, including India, which have seen increasing economic investment. As the Hang Seng Index bears the brunt of an ailing Chinese market, investors have been waiting to see if the central government of the world’s second- largest economy will enact large-scale economic reforms. While those investors wait, however, many of them are choosing to do so outside of the Hong Kong stock market.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

Posted by Adam Turnquist, CMT, VP Chief Technical Strategist

Friday, August 18, 2023

Key Takeaways:

• Yields have moved a little too much too fast for equity markets, pushing the correlation between stocks and 10-year Treasury yields into negative territory for the first time since March.
• From a technical perspective, 10-year Treasury yields remain uncomfortably high as they approach resistance from the October highs. Considering stocks bottomed nearly at the same time longer duration yields topped out last fall, a breakout to new highs on the 10-year would be a warning sign for a potentially deeper pullback in stocks.
• Energy could outperform if yields continue higher. The sector is the only one positively correlated to 10-year Treasury yields.

Treasury yields are beginning to resemble the popular Cliff Hanger game on the “Price is Right” television show—how high can they go before the game is over for equity markets? Considering stocks bottomed at nearly the same time longer duration yields topped out last fall (not a coincidence), a breakout to new highs on the 10-year would serve as a warning sign for a potentially deeper pullback in stocks. Furthermore, the correlation between stocks and 10-year yields turned negative last month, suggesting the recent advance in yields may be a little too much too fast for stocks to digest. The diverging paths have been especially apparent in the heavyweight and longer-duration technology sector, which may face additional valuation pressure if rates continue to rise.

How High Will They Go?

As shown below, 10-year Treasury yields have surpassed resistance at 4.09% and are now contending with the highs set last October. Technically, a move above 4.34% would qualify for a breakout.

While momentum remains bullish and further validated by the 50-day moving average (dma) crossing above the 200-dma, near-term upside pressure appears to be losing a little steam. The Relative Strength Index (RSI)—a momentum oscillator used to measure the speed and magnitude of price action—has registered a series of lower highs over the last few weeks. This negative divergence raises the question about the sustainability of upside momentum in yields.

In the event of a breakout, the next significant areas of resistance for yields set up near 4.50% (2006 lows) and 4.70% (prior mid-2000s highs).

View enlarged chart

Sector Impact

If 10-year Treasury yields breakout to new highs, communication services, consumer staples, and technology could see outsized headwinds as they have been the most inversely correlated sectors to yields over the past year. Energy, which continues to gain technical traction and relative strength, could see further outperformance if yields advance.

View enlarged chart

SUMMARY

Benchmark 10-year Treasury yields have rallied back toward their October highs. This area is not only a significant resistance level for yields but also an important level for stocks, as the equity bear market low closely overlapped with the highs set on the 10-year last fall. On a near-term basis, a negative divergence between yields and momentum has formed, raising the question of the sustainability of the recent upside in 10-year yields. If yields continue higher, energy could see further relative outperformance as it is the only sector positively correlated to 10-year Treasury yields. LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its slight preference for fixed income over equities, mainly due to valuations, and would look for future stock market weakness for potential buying opportunities.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

Posted by George Smith, CFA, CAIA, CIPM, Portfolio Strategist

Thursday, August 17, 2023

The latest weekly data from the American Association of Individual Investors (AAII) showed that individual investor sentiment plummeted over the last week from fairly bullish to pretty neutral as the market and economic environment so far in August caused bulls to disappear and bears to come out of hibernation. This is perhaps not surprising as individual investors, who have been bullish overall since the start of June—the longest period since the summer of 2021—are worried about a stock market correction (the S&P 500 is down 4% in August), rising interest rates, the Fitch downgrade of U.S. debt, China weakness, and a potential reacceleration in inflation.

The percentage of individual investors who are bullish about short-term market expectations is 36%, down from 45% last week but still just above the long-term (10-year rolling) average of 34%, while the percentage of investors who are bearish rose to 5% to 30%, compared to the long-term average of 32%. This puts the statistic that we normally pay attention to, the spread between the bulls and the bears, at 6%, so still slightly bullish versus a long-term average of 2%, but a steep decline from 19% last week, and 28% the week prior.

As shown in chart the below, investor sentiment, as measured by the spread between bulls and bears in the AAII data, moved decisively closer to its long-term average, having been elevated more than one standard deviation above that, and into very bullish territory, for the last month. The weekly decline in the bull-bear spread of over 13% represents the second largest weekly decline this year.

View enlarged chart

We generally look at investor sentiment from a contrarian perspective, so the fact that this indicator is still marginally bullish is not supportive of stock prices (although it is getting more supportive as the bullishness fades). Historically, when the bull-bear spread has been around average the forward S&P 500 returns have also been right around average. We wouldn’t expect this measure of sentiment to be supportive of stocks unless it reaches a bearish extreme of greater than one standard deviation below the long-term average (below -14%, where it was until May of this year before we saw the run up in the S&P 500 in June and July).

View enlarged chart

Another gauge of investor sentiment we follow is also showing waning (but still slightly bullish) investor confidence. Bulls in the Investors Intelligence survey fell to 47% for the week ending August 15, down 10% from two weeks ago. Bears have been rather steady in that survey at around 19%. The bull-bear spread in this survey is now at +27%, down from +38% two weeks ago (which was a two-year high). The CNN Fear & Greed Index (which is a composite of seven market-based indicators) is in the neutral zone at 52 (out of 100), compared to a “Greed” score of 62 a week ago and “Extreme Greed” (80) a month ago.

Summary

The number of risks facing markets and the economy have started to dent investor confidence. As the stock market became more stretched in June and July, investor confidence approached extremely bullish levels. The recent cooling has left sentiment neutral for stocks, but should the “wall of worry” scare off more bulls, sentiment may become a catalyst for stocks once more from a contrarian perspective.

We maintain a neutral allocation to equities and are overweight fixed income (as valuations have become increasingly attractive relative to equities amid higher yields), funded from an underweight to cash which faces heightened reinvestment risk.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC).

Insurance products are offered through LPL or its licensed affiliates.  To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

• Not Insured by FDIC/NCUA or Any Other Government Agency
• Not Bank/Credit Union Guaranteed
• Not Bank/Credit Union Deposits or Obligations
• May Lose Value

Posted by Lawrence Gillum, CFA, Chief Fixed Income Strategist

Wednesday, August 16, 2023

Last week’s release of the Consumer Price Index (CPI) was the second month in a row that showed inflationary pressures were falling at a faster pace than economists’ estimates, which is undoubtedly good news. Additionally, the fall in inflationary pressures likely means the Federal Reserve (Fed) is close to the end of its aggressive rate hiking campaign, which we outlined in our recent Midyear Outlook, has historically been good news for core fixed income investors. So why haven’t Treasury yields fallen (prices increase) alongside the fall in inflationary pressures? The main reasons, in our view, are listed below:

• Supply/Demand Imbalance: Because of larger than expected budget deficits, the Treasury department announced recently that it seeks to borrow an additional $1 trillion in the third quarter alone (and nearly $2 trillion over the rest of the year). This is on top of the $1 trillion of new debt that has been issued since the debt ceiling was removed in June. The increase in supply is coming at a time when the largest owner of Treasury securities (the Fed) is reducing its footprint in the market.
• Non-U.S. Central Banks: While inflationary pressures are indeed falling in the U.S., the Eurozone and the United Kingdom are dealing with still elevated inflationary pressures. As such, those respective central banks are likely not done raising interest rates. Moreover, the Bank of Japan (BOJ) recently announced it would “conduct yield curve control with greater flexibility”. Essentially, this means the BOJ will allow the yield on the 10-year government bond to increase by another 0.50%. Higher yields on non-U.S. domestic government bonds impact U.S. Treasury yields, to certain degrees, as well.
• Better U.S. Economic Data: As evidenced by the inverted yield curve (chart below), the U.S. Treasury market has been pricing in an economic slowdown for several quarters now. However, economic data continues to surprise to the upside. The continued strength of the U.S. economy, in spite of one of the most aggressive Fed rate hiking campaigns in decades, has caused the bond market to start to price out the immediate risk of recession. Moreover, it is pricing out the immediacy of interest rate cuts as well. The higher-for-longer narrative by the Fed has put upward pressure on intermediate and long-term yields. Historically, these “bear steepener” trades don’t tend to last very long, but as long as the U.S. economy outperforms expectations we could continue to see upward pressure on intermediate and longer-term yields.

View enlarged chart

Our base case remains that the U.S. economy will slow down/contract due to the elevated interest rates caused by the Fed rate hiking campaign. So, while we still think the 10-year yield ends the year lower, as long as economic data continues to surprise to the upside, Treasury yields may remain above our 3.25%–3.75% target range in the interim. However, it’s important to remember that, over time, starting yields are the best expectation of future returns and that the coupon income, and not price appreciation, is the largest determinant of total returns regardless of what happens to interest rates in the near term. And with starting yields for most fixed income markets well above longer-term averages, we think the prospects for fixed income are as attractive as they have been in quite some time.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

For a list of descriptions of the indexes and economic terms referenced in this publication, please visit our website at lplresearch.com/definitions.

Government notes, bonds, and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Tracking # 1-05377556

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

Posted by Adam Turnquist, CMT, VP Chief Technical Strategist

Friday, August 11, 2023

Key Takeaways:

• While there is strong support for stocks being in a bull market, overbought conditions, weak seasonality, rising interest rate volatility, and ongoing uncertainty over monetary policy suggest a shorter-term pullback in this rally could be underway.
• In terms of downside, support for the S&P 500 sets up at 4,450 (June highs), 4,432 (50-day moving average), and near the 4,200-4,300 range (uptrend/prior highs). We believe the latter support range is the most likely spot for a bounce given the confluence of support in this area, the degree of record-high cash sitting in money market assets, and the fact many investors missed the first half rally.
• Don’t panic—pullbacks are normal, even during years with above-average returns. History suggests a 5-10% drawdown between now and year-end is not uncommon, even during years with strong rallies into August. However, even with a drawdown, the S&P 500 has still historically generated positive average returns into year-end.

Stocks have pulled back modestly this month as overbought conditions met overhead resistance. Interest rate volatility spurred by Fitch’s downgrade of the U.S. credit rating, monetary policy uncertainty, stretched valuations, and underwhelming economic data in China have also weighed on risk appetite. The S&P 500 is down 2.6% month to date (as of August 10) after struggling to surpass the 4,600 area. While this is hardly a drawdown by most standards, it is enough to raise the question of where potential support sets up if the selling pressure continues.

As shown below, the S&P 500 began its pullback at 4,600 with a bearish engulfing candlestick on Thursday, July 27. (For reference, bearish engulfing candlesticks are often found after upward price moves and suggest a shift to supply overwhelming demand.) At that time, the index was trading at around a 12% premium to its 200-day moving average (dma), marking over two standard deviations above average, while nearly 20% of index constituents were also overbought based on their Relative Strength Index (RSI). While overbought does not mean over, we suspect this could be a logical spot for a pause or a pullback in this rally, especially as the market enters a weak seasonal period.

View enlarged chart

In terms of downside, support for the S&P 500 sets up at 4,450 (June highs), 4,432 (50-dma), and near the 4,200-4,300 range (uptrend/prior highs). We suspect the latter support range to be the most likely spot for a bounce given the confluence of support in this area, the degree of record-high cash sitting in money market assets, and the fact many investors missed the first half rally. We view the 200-dma as a worst-case scenario for a drawdown.

Bull Markets are not Linear

While there is overwhelming technical evidence supporting the case for a sustainable bull market, expect some pullbacks along the way. The table below compares annual price performance and maximum drawdowns for the S&P 500. At a high level, the chart shows that even years with double-digit gains often experience double-digit drawdowns.

To break down the data, we decile ranked annual price returns of the S&P 500 going back to 1950. The top or first decile represents the top 10% of all years based on price gains, while the bottom or tenth decile reflects the bottom 10% of all years for the index. The percentage thresholds for each decile group are also labeled for reference. After ranking each year by performance, we calculated each decile group’s peak-to-trough average maximum drawdown. We found that the average maximum drawdown for all years going back to 1950 is -13.8%. Furthermore, even years with well above-average price gains are not immune to sizable pullbacks, as the top decile groups reported drawdowns of around 10% on average.

View enlarged chart 

With the S&P 500 up 16.4% year to date (as of August 10), this year stands out as a top quintile year for performance thus far. Despite the strong momentum, we found other years with above-average gains during this stretch still experience sizable drawdowns into year-end.

The table below breaks down the S&P 500 based on decile-ranked performance from December 31 to August 11. The subsequent average returns and maximum drawdowns for each decile group are also highlighted for the August 11 to December 31 timeframe. In short, history suggests a 5-10% drawdown between now and year-end is not uncommon, even during solid rallies into August. However, even after a drawdown, the S&P 500 has still historically generated positive average returns into year-end.

View enlarged chart

SUMMARY

Stocks have pulled back modestly this month as overbought conditions met overhead resistance. Interest rate volatility, monetary policy uncertainty, stretched valuations, and underwhelming economic data in China have also weighed on risk appetite. While there is still strong support for stocks being in a sustainable bull market, we suspect odds for a pullback in this rally are increasing. However, don’t panic, pullbacks are normal, even during years with above-average returns. History suggests a 5-10% drawdown between now and year-end is not uncommon. And even with a drawdown, the S&P 500 has still historically generated positive average returns into year-end.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

Posted by Jeffrey J. Roach, PhD, Chief Economist

Thursday, August 10, 2023

Additional content provided by Colby Hesson

Highlights:

• Consumer prices rose 0.2% in July, pulling the annual rate of inflation up to 3.2% from 3.0% last month.
• Not surprising, the largest contributor to the monthly increase in prices was shelter costs.
• Monthly core inflation, which excludes food and energy, rose 0.2% for the second consecutive time, as core inflation has downshifted in recent months.
• Inflation is still considerably above the 2% level where the Federal Reserve (Fed) would like to see it but the trajectory is encouraging.
• So far, the data suggest the Fed will likely pause at the next meeting but no guarantees about the meeting after that.

Bottom Line: Core inflation is getting less sticky, but for the Fed to declare victory on inflation, it is imperative it unwinds at a faster and more decisive pace. The Fed’s dove versus hawk tug-of-war appears now to be predicated on an ‘insurance’ rate hike later this year, which according to the hawks will help keep inflation expectations anchored. Although the CPI is moving in the right direction, it doesn’t mean another rate hike this year is out of the question, especially with gasoline prices rising. The probability of a rate hike in September is merely 10%, over 8 percentage points lower than this time last week according to the futures market.

The July Consumer Price Index (CPI) data provides an updated view of the inflation situation in the United States. While certain components of the report indicate inflation is slowing, there are underlying variables that continue to influence the total rate. According to the July CPI report, consumer prices rose by 3.2% year over year, a minor increase from the 3.0% annual rate recorded in June. Although this is a reduction from the high levels seen in 2022, it is crucial to remember that inflation remains considerably above the Fed’s 2% target.

View enlarged chart

The core CPI, which includes volatile food and energy costs, also slowed slightly, with a 12-month rate of 4.7%, down from 4.8% the previous month. This decrease in core inflation shows some stabilization, but it is critical to understand the variables that are contributing.

Shelter expenses rose by 0.4% in July, accounting for a large share of the overall increase in consumer prices. Notably, shelter expenses increased by 7.7% year over year, underscoring the housing sector’s continuous pressure. This factor is critical in the inflation equation because housing costs influence the consumer price index and thus the total inflation rate. Rent prices continue to rise but at a decreasing rate.

Despite a spike in crude oil prices and increased gas prices during the month, energy prices rose by only 0.1% in July. Used vehicle prices decreased by 1.3%, while medical care services decreased by 0.4%. Airline fares, which had fluctuated significantly owing to the pandemic, declined by 8.1% in July, continuing the trend begun in June.

The CPI report illustrates the continuous dynamics of consumer demand, with a shift away from goods and toward services. Restaurant prices have continued to climb at a rapid pace, showing robust consumer demand in that industry. This is consistent with a broader trend seen in recent months, in which customers have indicated a preference for experiential spending, which has influenced price dynamics in a variety of service industries.

The report also sheds light on the possible influence of housing on inflation. While housing costs have been a key contributor to the growth in consumer prices, there are signs the housing sector may cool. Increased multi-family development activity, driven by an increase in condo and apartment building projects, may result in an increase in the supply of multi-family apartments. This increase in supply may help lower rents, thereby slowing housing-related inflation.

Market reactions to the July CPI figure were overall favorable, with Dow Jones Industrial Average futures up more than 200 points and Treasury yields mostly lower. These replies indicate market participants perceive the report as showing inflation is on the rise, which may give the Fed the leeway to maintain current interest rates in the short term.

The rising level of inflation, particularly in housing expenses, presents a challenging problem as the Fed contemplates its next measures. While the overall trend in inflation appears to be positive, the Fed is likely to stay cautious. The dual mandate of the central bank of price stability and maximum employment requires careful analysis of the changing economic landscape.

When the August CPI report is released, it will be closely analyzed to see if the patterns seen in the July report continue. It will give useful information about whether the current decrease in inflation rates is sustainable or if there are new events that could influence the Fed’s policy decisions.

Conclusion

While the July CPI report indicates a good trend in inflation, it is important to note inflation remains above the Fed’s objective and the central bank faces a delicate balancing act. Continuous monitoring of inflation is required, and the Fed’s choices in the next few months will be critical in navigating the complicated economic situation. Although the CPI is moving in the right direction, it doesn’t mean another rate hike this year is out of the question, especially with gasoline prices rising. However, we think the Fed will pause during its September meeting but keep everything on the table for the November meeting. Investors should find plenty of opportunities in this market despite the disproportionate easing in inflation pressures. Cyclical sectors performed well today as inflation is easing and so far, without creating any obvious cracks in the economy.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value