The Bull Thread

Mega-Cap AI Mentions Still Strong
Thu, Sep 5, 2024

The following charts were included in our daily Closer report on 9/4/24. You can receive our Closer in your inbox with a two-week trial to Bespoke Institutional.

The table below is our mega-cap "AI" mentions tracker, which counts the number of times "AI" gets mentioned on quarterly earnings conference calls by the six $1+ trillion Tech companies: Apple (AAPL), Amazon.com (AMZN), Meta Platforms (META), Microsoft (MSFT), Alphabet (GOOGL), and NVIDIA (NVDA).

NVDA was the last to report Q2 earnings, and while its highly-anticipated results triggered share price declines, AI mentions ticked up for the first time since Q3 2023 when it mentioned AI a whopping 154 times on its call. As shown, NVDA mentioned "AI" 115 times on its Q2 call compared to just 93 in Q1.

The 115 AI mentions from NVDA topped its peers in this list again, followed by META, which has really come on strong these last two quarters with a consistent 93 mentions. GOOGL wasn’t far behind at 90, but MSFT took a step back to 61 after Q1’s 78. AMZN improved modestly to 43 and AAPL brought up the rear with just 12 mentions despite more buzz around its AI plans and ChatGPT integration after an unusually high 25 the previous quarter. The total mega-cap AI mentions for Q2 summed to 414, just four off the all-time high from Q3 2023.



Taking another view, the mean (average) and median AI mentions in quarterly conference calls between these six names has really skyrocketed since the release of ChatGPT. This quarter, median mentions grew to 76 to match the all-time high two quarters ago. The mean of 69 this quarter was an improvement from last quarter but not enough to meet Q3 2023’s high of 70. Over the past four quarters, the clearer trend upward in the median vs. a flatter picture in the mean suggests a broader adoption of AI and the discussion of it on earnings conference calls.



Q3 is poised to bring more highly anticipated AI updates from some of the biggest tech names. We’ll check back in then to see if AAPL can break out from its lackluster numbers compared to competitors, if NVDA can sustain 100+ mentions, and if the middle of the pack can help lift the quarterly total to a new high.

 

Let’s Not Sugar Coat It – Risks Are Rising


The August payroll report was kind of ok on the face of it. Payrolls grew by 142,000 in August, below expectations for a 165,000 increase but these things are noisy. The unemployment rate also declined from 4.3% to 4.2%, which is welcome. However, read one step beyond headlines and it’s fairly clear the labor market is softening. That does not mean we’re in a recession, or one is imminent – it just means risks are rising, and the Federal Reserve (Fed) needs to act.

As I noted above, monthly payroll gains are noisy and so it helps to take an average. With revisions to June and July, monthly payroll gains have now averaged just 116,000 over the past three months. That’s barely enough to keep up with population growth, and a deterioration from earlier this year. The 3-month average was running around 199,000 back in March (after including recent benchmark revisions by the Bureau of Labor Statistics, which took April 2023-March 2024 payroll growth from 2.9 million to 2.1 million).



The unemployment rate has been rising as well – it was just 3.7% when we started 2024 and is now at 4.2% (unrounded, the unemployment rate fell from 4.25% in July to 4.22% in August). Historically, when the unemployment rises, it continues to rise. That leads to a negative feedback loop between hiring and spending (with lower incomes leading to lower spending), which ultimately results in a recession. This dynamic is neatly captured in the Sahm Rule, which says that when the 3-month average of the unemployment rate moves 0.50 or more percentage points above the lowest point of that average over the last 12 months, the economy is likely in the early months of a recession. It’s correctly indicated every recession since 1970. My colleague, VP, Asset Allocation Strategist, Barry Gilbert, wrote about this several weeks ago. The bad news is that the Sahm Rule triggered in July and remains triggered in August. The good news is that the preponderance of economic data clearly tells us we’re not in a recession right now. Claudia Sahm herself, the author of the rule, has suggested that the rule may be broken and things may be different this time. Instead of weak demand, the unemployment rate may be rising due to an increase inn the supply of workers (who can’t find jobs easily). The Sahm rule doesn’t distinguish between these two dynamics.



In any case, hiring has stalled. The hiring rate, which is hires as a percent of employment, has fallen to 3.4%. Other than during the heights of the pandemic, the last time hiring was at this level was in 2014. It’s unclear why employers have stopped hiring as much as they have. It could be uncertainty around future demand, policy expectations or uncertainty (from the Fed or Washington), or simply that employers hired too many people in 2021-2022 and have no need to increase payrolls immediately.



Risks Rising Doesn’t Mean Recession Is Here or Near
The only solace in the deteriorating trends I cited above is that that it’s very gradual. Plus, other labor market data suggest that the labor market is in a reasonable place right now. It’s just that the trend is in the wrong direction. But it’s worth highlighting the positive data points.

I’ve mentioned in previous blogs how I prefer looking at the “prime-age” (25-54 years) employment-population ratio, since it gets around definitional issues that crop up with the unemployment rate (someone is counted as being “unemployed” only if they’re “actively looking for a job”) or demographics (an aging population with more people retiring and leaving the labor force every day). The prime-age employment population ratio was unchanged at 80.9% in August. That’s higher than anything we saw between 2001 and 2019 (when it peaked at 80.4%). In fact, for women, this ratio is at 75.6%, only a tick below the highest we’ve seen (75.7% back in May). This by itself should tell you the labor market still quite healthy, with more people participating in it. This supports Claudia Sahm’s view that the Sahm Rule has triggered because of more workers coming into the labor force, rather than weak demand.



Layoffs are also low, which should also tell you we’re not in the middle of a recession or very close to one. The layoff rate, which is layoffs as a percent of employment, is running at 1.1%. That’s historically low. For perspective, it was running around 1.2-1.3% from 2017-2019, and around 1.3-1.6% from 2005-2007. Also, initial claims for unemployment benefits, which is one of the better leading economic indicators out there (if you had to pick one) still shows layoffs remain low, in line with what we saw in 2023 amid a strong labor market and even 2018-20019. The “insured unemployment rate,” which measures the number of unemployed people continuing to receive unemployment benefits as a percent of covered employment, is at 1.2% – above where it was pre-pandemic. All of this tells you that people aren’t at great risk of losing jobs, but finding a job has gotten harder (which is why continuing claims for benefits are higher).



So, as you can see, the labor market is still in a reasonably healthy place if the downtrend stops. The good news is that the downtrends can likely be arrested, or even reversed, if the Fed acts to cut off the risks that have clearly risen. As I wrote in a blog earlier this week, the Fed can act on Chair Powell’s recent comments that they do not “seek or welcome further cooling in labor market conditions” with a bigger-than-expected interest rate cut of 0.5%-points at their September meeting. Instead of opting for a more gradual approach that will clearly indicate institutional inertia in the face of rising risks. As Powell himself said, with the policy rate target currently at 5.25-5.50%, the Fed has ample room to respond to risks.

We know the labor market is trending down. The big question going forward is how quickly the Fed responds to get in front of that trend to potentially reverse it.

 

No Need to be Superstitious, S&P 500 Up 8 of 13 Friday 13th Days in September



Since 1930, the S&P 500 has traded a grand total of 158 Friday 13th across all twelve months. The overall track record is 87 up days and 71 down days with a modestly bullish average gain of 0.04% on all Friday 13ths. The worst Friday 13th loss was 6.12% in October 1989. This day is often referred to as “Black Friday.” The best Friday 13th gain was 9.29% in March 2020. Digging deeper into the data reveals that September Friday 13th has been up 8 times, down 5 times with an average gain of 0.06%. Although a modest gain, there is no reason to fear Friday 13th in September.

 

The Inflation Fight Is Over but Fed Policy Remains Uncertain


We’ve consistently said for several months now that inflation was last year’s problem. The latest consumer price index (CPI) data confirms this. Headline CPI is up 2.5% year over year (y/y) through August, which is the slowest pace in three and half years. Here’s some perspective on how far we’ve come:

• A year ago (August 2023), headline CPI was 3.7% y/y
• Two years ago (August 2022), it was 8.3%
• At the end of 2019, it was 2.3%

The inflation fight is done. This is welcome news for American households and even the Federal Reserve (Fed) as it seals the deal for the Fed to embark on a series of interest rate cuts over the next few months.

There’s actually good reason to believe that CPI data is overstating things. As you can see in the chart below, the big contributor to inflation is shelter, which is severely lagging more real-time private market data on rental inflation.



If you exclude shelter, inflation is running well below what we saw just before the pandemic hit, whether you look at short-term trends or the long-term trend. CPI excluding shelter is running at an annualized pace of 0.5% over the past three months, and it’s been in negative territory for the third month in a row. On a year-over-year basis, CPI ex shelter is up only 1.2%.



The problem created by lagging shelter inflation is magnified when you look at core inflation, which excludes food and energy. It’s the number the Fed typically likes to focus on. Core CPI is running at 3.2% year on year, with shelter contributing 2.2%-points of that. For perspective, at the end of 2019, core CPI was running at 2.3% year on year with shelter contributing 1.4%-points of that. In other words, the “excess” core inflation of about 0.9%-points we’re seeing now is coming almost entirely from the shelter component.

We’ve tackled the issue with official shelter inflation data a lot over the last couple of years. Shelter makes up 43% of core CPI, and the data runs with significant lags to what we see in actual rental markets. Rents of primary residence account for 10%-points of that, while “owners’ equivalent rent” (OER) accounts for the other 33%-points. OER is the “implied rent” homeowners pay, and it’s based on market rents as opposed to home prices. Private market data, like those from Apartment List, have been telling us that rents have actually been declining for over a year now. The good news is that official data is turning toward what the private data is telling us, but it’s happening ever so slowly. We’re not going to see the official data show outright deflation eventually, but it’s likely to stabilize around where it was pre-pandemic—it’s just going to take a while.



All Eyes on the Fed, but the Onus Is on Chair Powell
It looks like Fed members have gotten comfortable with the notion that the inflation fight is more or less over. The problem is that labor market trends are going in the wrong direction. I wrote about this last week. Note that the Fed has two mandates: low and stable inflation, along with maximum employment. At this point, they’ve mostly achieved the former, but the latter is clearly at risk.

What is worrying is that several Fed members have talked about cutting rates in a “gradual,” or “careful,” or “prudent” manner, indicating they don’t see any urgency to get ahead of declining labor market trends. Meaning they are inclined to start with a 0.25%-point cut at their September meeting next week and proceed at that pace over the remainder of the year. The slightly hotter core CPI data from August, albeit on the back of lagging shelter inflation, further reduces the odds of them starting the rate cut cycle with a big 0.50%-point cut. But this also makes it even more likely that they find themselves further behind the curve in a few months and will have to play catch-up by going big later on, a rerun of when they waited too long to raise rates as inflation was picking up in late 2021/early 2022—but from the opposite side.

A notable exception to the gradualist approach appears to be Fed Chair Jerome Powell himself. At his Jackson Hole speech about three weeks ago he made no mention of following a “careful” or “gradual” approach. Instead, he said they would not tolerate further cooling in the labor market. Since then, we got a slew of labor market data, including August payrolls, showing things are slowing down further. There’s a reasonable chance that Powell may buck the opinion of other Fed members and decide to “go big” with a 0.50%-point cut at their September meeting. That will also show intentionality that they do intend to support the labor market—and hence the economy, since incomes drive consumption.

While the economy is in a reasonably healthy place today, that may not be the case 6-12 months from now if the Fed starts to fall further behind the curve. Safe to say we’re not in a recession now, nor is one imminent over the next few months, but the odds of one by mid-2025 is starting to increase. This raises the stakes for the Fed’s September meeting and all eyes will be on Chair Powell.

 

Three Things To Know About Last Week


“There are decades where nothing happens; and there are weeks where decades happen.” Vladimir Lenin



Last week was Carson’s Excell conference down in Orlando and it was a ton of fun, but a little exhausting as well. I’m glad it is over, but looking back it was such a fun and productive week for our Investment Research team.

From interviewing Tom Lee, Fundstrat’s Founder and CEO, in front of nearly 1,000 people on Facts vs Feelings 100th episode, to various breakouts from members of our team, to doing random Spaces with some of the big names guests in attendance, to just hanging out with our Carson Partners to learn more about what we can do to help them build their businesses and help their clients, it was a great week in the Sunshine State.

A funny thing happened while we were all together though, stocks soared! You can’t make this up, as the S&P 500 was up more than 4% for the best week since last November, but all five days were higher as well on the week. I’m calling this a perfect week and the bottom line is they tend to happen in bullish trends. I found 29 other times all five days of the week where higher, all five days were above the 200-day moving average, and on Friday it was less than 3% from an all-time high. In other words, a similar situation to right now. Well, a year later stocks were higher more than 86% of the time and up a median of 17.0%, not bad, not bad.



The second thing that happened last week that I think you should know about is stocks rebounded from their worst week of the year to have their best week of the year, talk about an Excell bounce! We have no clue if these will still be the best and worst weeks of the year at the end of the year, but we do know we saw a 4% or greater weekly decline, only to turn into a 4% or more weekly bounce the next week. Would you believe the past 11 times we saw that stocks were higher a year later by the tune of up 23.7% on average? Yep, it is true and it just happened. Going out further, I found 22 times this happened since 1950 and stocks were higher a year later 18 times (81.8%) and up an average of 16.4% and a median of 18.8%.



Lastly, on Wednesday last week, S&P 500 was down 1.6% about 90 minutes into trading over worries about inflation and the Debate the night before, but by the end of the day stocks were up more than 1%. This was a huge reversal and usually days like this led to higher prices in the future, in fact, the last time we saw anything like this was the exact lows of the bear market from 2022 back in October 2022. Up a median of more than 9% six months later and more than 16% a year later says it all, as this is another feather in the cap for the bulls.



Last week was a lot of fun for Carson, but also for the bulls. It might not always be this way, especially as we are entering one of the more seasonally weak times the last two weeks of September (below) and into October of an election year, but any near-term weakness will likely be fairly contained and these three stats I’ve mentioned here continue to support this bull market is alive and well.

 

Doomsayers Have Their New Indicator: The Yield Curve Uninverts


The pandemic and post-pandemic environment has been a breeding ground of economic anomalies born out of deep disruptions and policy extremes that have echoed across the years. That doesn’t mean good economic analysis doesn’t hold true; it does mean that good analysis takes some extra work. You couldn’t just paint by numbers over the last several years. You had to think a little bit about how you’re counting things up and what the “true count” is given the unusual circumstances. My colleagues Sonu Varghese, VP, Global Macro Strategist, and Ryan Detrick, Chief Market Strategist, have had a keen eye for the numbers that mattered over the last couple of years, cutting across the onslaught of doomsaying charts that treated the environment as “business as usual.”

Writing on the eve of the Fed’s first rate cut of the cycle, I thought I would take a quick look at the latest harbinger of doom making the rounds. The yield curve has uninverted. What does that mean? The 10-year Treasury yield is normally higher than the 2-year Treasury yield. Investors expect a higher yield for a bond whose maturity is further out. Since June 1976, the 10-year has been above the 2-year 83% of the time. When the 2-year yield moves above the 10-year, called yield curve inversion, it’s usually a sign that markets expect the Fed to get more aggressive, and sometimes, to a lesser extent, that the economy may weaken.

Much was made of the yield curve inverting back in July of 2022. But the bear market bottomed three months later and the expansion continued. In fact, real GDP grew at an annualized pace of 2.8% over the two years since July 2022, above the 2010-2019 average of 2.4% and the S&P 500 rose over 40% from July 31, 2022 to August 31, 2024. Much was made of the inversion reaching more than 1% for the first time since 1981 in June of 2023. Markets pressed higher and the expansion continued. By our measure the yield curve uninverted (assuming it stays that way) on Friday, September 6, 2024. (It had uninverted a little earlier but had inverted again.) What happens next?

Like inversion, uninversion (or reversion, or yield curve normalization) is a reflection of what investors expect the Fed to do. A curve that has uninverted means investors expect the Fed to lower interest rates. It could probably be a stronger sign of economic risk than inversion, but historically, the Fed’s been behind the curve and was playing catch up – economic data was already deteriorating by the time the Fed started lowering rates (e.g. 1990, 2001, 2007, 2020). In other words, you can’t paint by numbers.

Even with that, uninversion hasn’t meant a lot for stocks. We looked at the date the yield curve uninverted around the last six recessions (all the history we had). It’s a small sample, but at the very least it tells us that uninversion hasn’t spelled doom for markets. To the contrary, the one-year numbers historically are actually pretty good, up a median of 17%.



We can’t ignore the risks. Labor market trends have turned negative increasing the possibility of an economic downturn. However, we still think a Federal Reserve that is at least moderately aggressive about lowering currently restrictive rates can avoid falling behind the curve. How restrictive are we now? In 2019 a fed funds rate of just 2.5% was considered high enough to break a pretty good economy and the Fed had to make a mid-cycle adjustment. The fed funds rate is at 5.5% now, a meaningful hurdle for economic expansion, but the economy has actually held up quite well. The Fed’s current aggressive efforts to control inflation were needed, but with inflation under control and job gains slowing, highly restrictive rates can do unnecessary damage to the economy whether or not it causes a recession.

In the table above, stock gains were strongest despite uninversion in the early 80s. While we don’t think the current situation is completely analogous to the early 80s, there are some common factors. The current hiking cycle is the most aggressive since the early 80s. The motivation was also similar—the focus was on inflation, not necessarily an economy that was overheating. The 80s had their own market drivers, but we do think market resilience in response to an aggressive Fed has some parallels.

Each uninversion in the table above was in fact associated with a market drawdown of at least 15%, but that just shows how difficult it is to time drawdowns. And if you think, “Oh, I’ll buy near the bottom,” be aware that this would be very atypical investor behavior. As Ryan often likes to say, investing is the only place where everyone runs out of the store screaming when things go on sale.

If your concern isn’t markets, uninversion has done ok as a recession warning but it’s been highly variable. In the 1980s, uninversion actually came after the recession started, unlike the other four cases. If the current situation ends up being somewhat parallel, you could point to the 2022 bear market as the primary response to Fed rate hikes, which started back in March 2022.

In the other four cases, uninversion was a pretty good signal, but we don’t think we’re on the verge of a global pandemic, or a 100-year financial crisis, or even tech bubble valuation extremes. (We have had two bear markets in the last five years after all.) Uninversion likely just reflects the fact that the Fed is going to normalize interest rates after raising them to very restrictive levels last year. The bottom line is that uninversion may signal the need for more vigilance, but if you needed the yield curve to tell you that you just haven’t been paying attention. But it should not dictate your investment decisions.

 

Best and Worst Performers Since 8/5
Thu, Sep 19, 2024

The large-cap S&P 500 and Russell 1,000 are both now up more than 10% since the summer low made on August 5th. They're also trading back to new all-time highs today.

Within the Russell 1,000, the average stock in the index is up 10% as well, meaning breadth has been strong. This is different from what we saw in the first half of the year when the mega-caps pretty much drove all of the market's gains.

We've seen some pretty massive moves higher in individual stocks since August 5th. There are 137 stocks in the Russell 1,000 up more than 20% since then (just 32 trading days), and there are 21 stocks up more than 40%. Below is a list of those 40%+ gainers.

As shown, buy-now-pay-later stock Affirm (AFRM) is up the most since 8/5 with a gain of nearly 88%. App-maker AppLovin (APP) is up the second-most at +83.8%.

Language-learning app Duolingo (DUOL), online real estate search site Zillow (ZG), and fast-casual Mediterranean menu company Cava (CAVA) round out the top five with gains of more than 56%.

Other notables on the list of big winners recently include Palantir (PLTR) with a gain of 53%, Five Below (FIVE) at +45.4%, SharkNinja (SN) at 44.9%, and RH at 41.1%.



While more than 87% of stocks in the Russell 1,000 are up since 8/5, there are 123 stocks that are in the red, including the 26 listed below that are down more than 10%.

Trump Media (DJT) is the Russell 1,000 stock down the most since 8/5 with a drop of 44.7%. Wolfspeed (WOLF), elf Beauty (ELF), New Fortress (NFE), and Dollar General (DG) round out the list of the five biggest losers, and other notable names on the list include Dollar Tree (DLTR), Sirius (SIRI), Celsius (CELH), Moderna (MRNA), Walgreens Boots (WBA), Ally Financial (ALLY), and Birkenstock (BIRK).



Below is a look at the average performance of Russell 1,000 stocks since 8/5 broken out by sector. Four sectors have seen average gains in a tight range between 12.3-12.8%: Real Estate, Technology, Financials, and Consumer Discretionary. On the weaker side, the average Energy stock is up just 3.1% since 8/5.



Below is a look at the average year-over-year percentage change of Russell 1,000 stocks by sector. Over the last year (since 9/19/23), the average Russell 1,000 stock is up 23.8%, but stocks in the Financials sector have done by far the best with an average gain of 34.5%. Notably, the AI-heavy Technology sector ranks third behind Financials and Industrials. Energy stocks, on the other hand, are only up an average of 1.9% YoY.

 

Here’s Why Markets Liked What the Fed Did and Hit a New Record High


Stocks reacted in a fairly neutral way after the Federal Reserve’s historically significant decision to jumpstart the rate cutting cycle with a 0.5%-point cut. But the real follow-through came on the day after the Fed meeting, perhaps after everyone slept on it. The S&P 500 surged 1.7% to close at a new record high on Thursday, September 19 (the first since July 16). The index is now up over 20% for the year. But wait, wasn’t the equity market supposed to move lower, not higher, in response to a large cut, on the assumption that a recession was looming?

On top of that, Treasury yields for maturities over two years are now higher than they were relative to the day prior to the Fed meeting. If the Fed signaled a more dovish path for policy rates, why weren’t longer-term yields moving lower, not higher?



There’s No Puzzle: It’s About the Fed Supporting the Economy
I wrote yesterday that the key takeaway from the Fed meeting was that they are not willing to tolerate the unemployment rate moving much higher — their projections capped the unemployment rate at 4.4% (it’s currently at 4.2%). The Fed’s essentially putting a floor under the labor market.

Unlike in prior rate cutting cycles, the big rate cut wasn’t a “panic cut.” Safe to say we’re not in the middle of a recession, nor is one imminent over the next few months. Amongst other things, the August retail sales report showed that online sales grew at an annualized pace of 15% over the past three months. Layoffs are also relatively low. Notably, Fed Chair Powell said the time to support the labor market is when it’s strong, not when you begin to see layoffs. In other words, the large cut was about risk management, with the Fed looking to get ahead of deteriorating labor market data.

The good news is that the Fed has room to support the labor market because inflation has eased a lot. An underrated factor here is lower energy prices. Beyond headline inflation, higher energy prices can even feed into core inflation numbers that the Fed typically focuses on. For example, higher energy prices can raise restaurant prices and airfares. We’ve gotten a break there, with WTI oil prices pulling back by about 17% since early April.

All this is very positive for the economy. And if economic growth remains resilient, bond yields should not be moving lower. On the other hand, if investors didn’t believe the Fed and thought they were behind the curve, we’d likely have seen bond yields fall, as investors priced in a higher risk of recession. For now, investors appear to be taking the Fed’s word that they’re putting a floor under the labor market, and therefore the economy.

Equity markets have been reflecting this since last week, after a Wall Street Journal report published on September 12 suggested the Fed was considering a big cut. The massive rally on Thursday capped what was already happening. From September 11 through September 19, the S&P 500 rose 3%. But mid- and small-cap stocks, which are even more geared to economic growth, outperformed. The Russell mid cap index rose over 4% during this period, while the Russell 2000 small cap index rose over 7%. As you can see below, these still lag their large cap counterpart year to date, but we believe there’s potentially more follow-through to come, especially with the Fed backstopping the economy. Full disclosure: we’re overweight these areas of the equity market in our model portfolios. Economic growth is what you need for profit growth, and that’s what drives returns. The new record is not a “sugar high” by any means.



We also saw this story of stronger economic growth expectations playing out within large-cap sectors. Cyclical sectors, including energy, communications, industrials, consumer discretionary, materials, and financials all outperformed the broad index, whereas more defensive sectors like consumer staples underperformed.



All that said, keep in mind that we could yet see some volatility over the next several weeks. As my colleague, Ryan Detrick, Chief Market Strategist, recently wrote, late September and October of an election year are a seasonally weak period for equities. But going forward, we have some strong tailwinds for markets (and the economy). If nothing else, momentum begets momentum. And we have a lot of that now.

 

Six Things to Know About Rate Cuts


“Be yourself. No one can say you’re doing it wrong.” -Charlie Brown

The big story last week was the Federal Reserve Bank (Fed) cutting interest rates for the first time since March 2020. Sonu Varghese, VP Global Macro Strategist, discussed some of the reasons stocks soared after the Fed cut rates, but today I’ll look more at how stocks and various asset classes do after cuts.

Here are six things to know about rate cuts.

Why Are They Cutting?
First things first, why are they cutting? If they were cutting due to a panic (think March 2020) or due to a recession (like in 2001 or 2007), potential trouble could indeed be lurking. But as we’ve been discussing all year, we do not see a recession coming and with inflation back to manageable levels, there was simply no reason to have interest rates up over 5%. This is what we call a normalization cut, which historically has led to continued higher prices.

Here’s a table we put together earlier this year that shows a year after the first cut in a cycle, stocks were higher a year later eight out of 10 times and up a solid 8.0% on average. Yes, 2001 and 2007 are in there, which you’ve probably heard about many times the past week if you’ve watched financial media at all. But we think now is more like the normalization cuts we saw in 1984, 1989, 1995, and even 2019, all of which saw continued gains a year later.



Historically, What Do Sectors Do After the First Cut?
Using data from BofA’s US Equity and Quant Strategy team we see that healthcare has tended to lag a year after the first cut, while areas like tech, materials, and real estate have led.



What About Various Asset Classes?
Nice chart from Bloomberg here that shows what various other asset classes do historically after the first cut.



Yes, Cuts Near All-Time Highs Are Common
Are rate cuts near all-time highs (ATH) normal? It turns out they are and the last time we saw this was in 2019. We found 20 times the Fed cut interest rates within 2% of new all-time highs and wouldn’t you know it, a year later stocks were higher all 20 times. There’s an old saying not to fight the Fed and this is what they mean.



The S&P 500 jumped 1.7% on Thursday after the rate cut, so this might be early, but it is most definitely off to a nice start. Matching the 13.9% gain on average a year later would be something we think most investors would be quite happy with right now.

Here’s a nice chart showing all the data.



Big Gains Going Into a Cut Is Quite Bullish
The S&P 500 gained more than 25% the 12 months prior to last week’s cut. One might think that big gains like that could mean some mean reversion, but that isn’t the case. Our friends at Bespoke Investment Group did this great study that showed that if the S&P 500 added more than 25% the 12 months before a first cut, it historically added nearly another 20% the next 12 months and has been higher 10 out of 10 times.



Small Caps Tend to Outperform Once the Cutting Starts
Here’s another great one the team at BofA, this time showing that small caps tend to do quite well relative to large caps that first year after the first rate cut. We’ve been overweight small and midcaps most of this year and one reason we’ve been in that camp was we expected rate cuts to be a tailwind for these areas. Similar to Lucy pulling away the football on Charlie Brown, we’ve seen small cap outperformance for stretches many times, only to have the football pulled away. Well, with cuts now here and more on the way, we think ol’ Charlie Brown is about to kick the longest field goal of his life.

 

The New Record High for Markets Is Not a “Sugar High”


Last week was all about the Federal Reserve (Fed) jump-starting the rate cut cycle with a 0.5%-point cut. But amidst all the commentary around that, it’s easy to forget about what ultimately drives equities: profits.

Note that what the Fed did was important even from this perspective. A Fed that is looking to cap the unemployment rate at around 4.4% is also trying to put a floor on the economy. And the economy is where profits come from. After all, one person’s spending is another person’s income or business’s revenue and profits. And spending is driven by incomes, which is why the labor market is the ballgame.

The good news is that profit expectations continue to rise. Expected earnings per share for the S&P 500 over the next 12 months is now at $266, about 10% higher than it was at the end of last year.



I’ve pointed out in past blogs that we can break apart the price return of a stock (or index) into two components: earnings growth and valuation multiple growth (forward P/E). Note: I use forward expectations here because markets look ahead.

As of September 23, the S&P 500 price index was up 19.9% year to date, of which

• Earnings growth contributed +10.3%-points
• Multiple growth contributed +9.6%-points

As you can see in the chart below, the volatility in the S&P 500 has come from multiples swinging wildly back and forth. Meanwhile, earnings expectations have moved steadily higher. Right now, profit growth makes up just over half the S&P 500’s year-to-date return. Contrast to two months ago, when valuations contributed the majority of the return.



A More Important Story: Margin Expansion
“Operating leverage” allows firms to expand margins as sales grow (even modestly). And corporate America now has a lot more operating leverage thanks to a lot of cost cutting in 2022, especially variable costs. 2022 was a year of low productivity, as firms felt the blowback of over-hiring and over-spending in 2020-2021. Sales grew but margins fell. So corporate America pulled back. However, getting more conservative bore fruit in 2023. Sales grew amid strong nominal GDP growth, and margins expanded. That’s a result of more operating leverage. This also showed up in rising economy-wide productivity, which has continued into 2024 and is positive for earnings/margins going forward as the economy continues to grow. S&P 500 margins are now at a new high of 13.4%.



Diving back into attribution of S&P 500 returns, we can separate earnings growth into sales growth and margin expansion. I’m going to include dividends as well, to get to “total return.” Looking back at the prior record high for the S&P 500 on July 16, it was up 19.7% year to date back then, of which the contributions broke down as

• Sales growth: +3.8 %-points (pp)
• Margin expansion: +4.2 pp
• Multiple growth: +10.8 pp
• Dividends: +0.9 pp

Fast forward to this week, and the S&P 500 was up 21.1% year to date as of September 23. Here’s how the components added to that total return:

• Sales growth: + 4.8 pp
• Margin expansion: +5.5 pp
• Multiple growth: +9.6 pp
• Dividends: +1.2 pp

My colleague, Carson’s Chief Market Strategist Ryan Detrick, was on CNBC last week talking about how the Fed going with a big cut was actually positive for markets (so far that’s borne out). However, the anchor wondered if these were “sugar highs.” I’m not sure you can call these new record highs sugar highs, especially since they’ve come on the back of sales growth and even more so, margin expansion. In other words, strong fundamentals in the corporate sector are driving returns more than just positive sentiment. (They’re obviously correlated, but sentiment can swing wildly as we saw last month.)

Even the Last 5 Years Haven’t Been a “Bubble”
New record highs for equity indices always raises concerns, and we typically see questions or comments in the form “Is this it?”, or “Should we reduce exposure?”, or “Things look stretched!”. Ryan’s done some great work showing that new highs lead to more new highs, as momentum begets momentum.

But let’s broaden out the horizon. From the end of 2019 through September 23, 2024 (a quarter shy of 5 years), the S&P 500 is up 90%. Here’s how the various components contributed to that massive total return:

• Sales growth: +41 pp
• Margin expansion: +16 pp
• Multiple growth: +19 pp
• Dividends: +14 pp

The big takeaway is that 71%-points of the total return came from “fundamentals,” i.e. profit growth (sales + margin expansion) and dividends. Another lesson is that you shouldn’t ignore dividends — its contribution is almost as strong as multiple growth.

Now, as you can see in the chart below, in individual years we can see wild swings, especially if valuations pull far ahead (like 2020) or revert back (2022). But ultimately over the long run, it’s usually earnings growth that drives returns (and dividends). As our friend Sam Ro (who writes the Tker substack), says, earnings are the most important driver of stock prices. And earnings for US companies have been going up for a very long time, which explains why stocks have gone up. The main pullbacks in profits have occurred during recessions.



(Source: Deutsche Bank)

The good news is that we’re not in the middle of a recession now, nor is one imminent. And it looks like the Fed has cut the risk of one occurring over the next 6-12 months as well by signaling its intention to backstop the labor market. That’s a tailwind for profit growth, and markets.