June 2023 Market Update

At the June FOMC meeting the Federal Reserve's updated Summary of Economic Projections showed the 2023 year end median fed funds rate forecast was moved from 5.1% up to 5.6%, the FOMC also signaled a pause to interest rate hikes at the 5.00%-5.25% level. This is a hawkish pause message which informs the market that should inflation reaccelerate or remain sticky, then the Fed could raise interest rates further.

The main message we believe the Fed sent to the market in June is to not expect interest rate cuts in 2023. We have been consistent in saying that rate cuts for 2023 should get priced out. Now that the Fed has delivered their message to the market, expected interest rate cuts for 2023 are likely to be priced out, company guidance should begin to decline, which likely leads to analysts revising forward earnings estimates downward. For tracking purposes, the current S&P500 2023, 2024 and 2025 earnings estimates are $214, $250 and $270.

The purpose of incorporating business cycle analysis into investment outlook is to forecast the direction of profit or earnings. We are not interested in paying more for assets that are becoming less profitable. It is our belief that the current S&P500 earnings estimate projections are creating a false sense of optimism and belief about the future of profitability. We believe as time marches forward that these earnings forecasts will prove incorrect and end up being revised downward during an economic downturn.

The ISM manufacturing index for the month of May recorded at 46.9, in continued contractionary territory below 50 and suggesting the onset of a recession. This has been the case leading up to the previous four recessions in the United States since 1990. Meanwhile, the ISM service index recorded at 50.3, missing estimates and holding barely above the 50-level threshold that signals recession. The Chicago PMI recorded at 40.4 for the month of May, the lowest level since November 2022, suggesting a continued deterioration to S&P500 earnings estimates ahead. This is occurring while real gross domestic income has turned negative on a year over year basis, permanent job losses continue to a new high since July 2022, continuing unemployment claims keep inching higher and real retail sales continue to decline. Real retail sales have now been negative, for four consecutive months. The longest streak since 2009. The economy appears to be slipping into contraction.

However, even with all this negative leading economic data the market continues to shrug it off. The S&P500 at 4444, is now up 14.85% year to date. Surging in the face of the Feds restrictive monetary policy and ignoring every economic risk it sees. If we look under the hood, we can see that the internals of the market are not very healthy. Market breadth, which is a reading of how well all stocks are trending, is demonstrating something ominous. There are 503 stocks in S&P500. We wanted to view the S&P500 ytd returns of the top 8 stocks against the other 495 stocks in the index. On an equal weighted basis, the SPY 8 ytd returns are +69.5% while the SPY 495 ytd returns are -.04%.

This performance is unhealthy and demonstrates many stocks struggling to provide a return. We believe this is occurring because there is little to no growth forecast for many companies while the eight big tech names currently represent most of the earnings growth forecast S&P500 index buyers are searching for. The market sees this and is allocating most of its capital to the few stocks it perceives as safe and impervious to the Feds restrictive monetary policy stance. Because these eight stocks are such a large weighting to the index, in the short term, it has caused the price to surge.

We believe that the Feds willingness to hold interest rates in restrictive territory reduces demand, evidenced by the real retail sales and gross domestic income data, and ultimately disrupts the current earnings growth forecast and profitability of the eight big tech names, while continuing to weigh on the rest. In 2021 the S&P500 earned $208 and in 2022, $197, a -5.4% decline in earnings has already occurred as interest rates moved from .25% to 4.1% by December 2022. Now that interest rates are being held at 5.25% with the option to move toward 5.6%, the most probable result in our view is further reductions to 2023, 2024 and 2025 S&P500 earnings estimates. The market’s performance follows the direction of profitability, we are not interested in paying up for a market with deteriorating earnings expectations and profitability.

For these reasons we do not recommend chasing the S&P500 index here at 4444.

There will be an event or a catalyst that will shock the system. It could be any number of things. But when it happens, the valuation readjustment will be fast. Manage your risk and prepare your portfolio to endure a recession.

With the S&P 500 trading around 4444, at approximately 20.6x earnings, we continue to believe investors will be rewarded by being positioned defensive, risk off and in cash, short term interest rates, 0–5-year U.S. Treasury bills and notes, money market funds, 10-year minus 2-year yield curve re steepening and select low duration equities.