myICLUB Blog

 

Cautiously Celebrating the Market's All-Time Highs

8/16/2024

Now, what's happening with interest rates?

After spending much of the year lagging behind the Magnificent 7, a broader array of stocks joined the party and pushed the market to all-time highs. The reason appears to be investors’ growing belief that the Fed will start cutting interest rates in September in response to falling inflation and a softer employment market.

Interest rate cuts would improve the prospects of non-technology stocks by spurring economic activity and increasing the appeal of those paying dividends.

Investors take cues from the Fed’s data dependency when setting interest rates to fulfill its dual mandate: full employment and stable prices. The Fed started the year expecting three rate cuts in 2024, but inflation’s rise and a solid employment market in the first quarter led the Fed in early June to revise its expectations to just a single quarter-point cut.

Recent economic data is moving the Fed to put multiple rate cuts back on the table. The Labor Department reported that June saw employment gains of 206,000, slightly beating expectations, but also an uptick in the unemployment rate to 4.1% from 4.0% in May. Other employment metrics slowed, including average hourly earnings growth of 3.9%, the smallest gain since 2021, along with a downward revision of 111,000 jobs added in April and May. The rise in the unemployment rate is particularly concerning as labor markets tend to be a lagging indicator of overall economic activity. While the 4.1% unemployment rate is still historically low, it has steadily risen from 3.4% early last year.

Economist Claudia Sahm has popularized an observation backed up by data, known as the Sahm Rule, that if the average of the unemployment rate over three months rises a half-percentage point or more above the lowest of the three-month average recorded over the previous year, the economy is in recession. Over the past three months, the unemployment rate has averaged 4.0%, which is 0.4% percentage points above the three-month average low of 3.6%. Whether or not this rule is effective today when most economists believe we are at full employment is unknown.

Inflation fell 0.1% from the previous month in June, better than expected, dropping the year-over-year inflation rate to 3%, the lowest since June 2023. Core prices that exclude the volatile food and energy categories rose 0.1% in May, the slowest increase since January 2021. Inflation moderated for a wide range of products and services, and prices declined for housing, airfares, lodging and new cars, anecdotally confirmed by companies’ second quarter results.

Retail sales were flat in June month-over-month, and the second quarter came in at 2.5% growth, reinforcing the picture that consumers are becoming more discerning in their purchasing as wage growth slows.

Recent comments from Fed Chair Jerome Powell and other officials indicate the Fed might not need that much more data to decide to cut interest rates. Economists acknowledge that changes in interest rates act with a lag but there isn’t much agreement on how long they take to affect the economy.

The Fed’s last interest rate increase was July 2023. The last few Fed increases may just now be hitting the economy. However, rate cuts generally take longer than increases to impact the economy, an argument to begin cutting interest rates earlier rather than waiting until reaching the Fed’s 2% inflation goal. Since it is likely that the labor market and prices will continue to moderate in the short term, investors have concluded that the Fed will begin cutting rates a modest one-quarter percent in September to be followed up by two additional quarter-point increases by year end.

Analysts are bullish on corporate earnings and continued stock market gains. According to FactSet Earnings Insight, the forward P/E ratio of the S&P 500 is 21.4, above the 5-year average of 19.3 and 10-year average of 17.9.

However, this higher P/E ratio is being driven by the Magnificent 7—Apple, Amazon, Microsoft, Nvidia, Alphabet (Google), Meta (Facebook), and Tesla—which now make up about a third of the index and carry a weighted average forward P/E of 36.4. The other 493 companies in the S&P 500 are priced at a much more reasonable forward P/E of 14.1 and are expected to grow earnings by about 10% versus the 21% for the Magnificent 7. The Magnificent 7 stocks have been fueled by the growth of Artificial Intelligence far more than interest rate cuts. If AI fails to deliver expected growth the S&P 500 might not make gains as forward P/Es for the Magnificent 7 could contract even as broader market S&P 500 companies enjoy gains from stronger economic growth brought about by interest rate cuts.

The year began with the 10-year Treasury yield below 4%, but as inflation increased and delayed expected Fed interest rate cuts, the yield increased to 4.7% in April. Since then, the 10-year yield has gradually fallen to around 4.15%.

Since mortgages are roughly priced based on a 2.5% spread over 10-year Treasuries, mortgage rates should begin to decline to the mid-6% level or lower in the new few weeks. This should help the housing market by easing affordability for buyers and increasing the supply of would-be sellers that have been reluctant to give up low-rate mortgages.

Savers that have been enjoying 5%+ returns on money market funds aren’t looking forward to the Fed beginning a rate-cutting cycle. No one knows where the Federal Funds rate will ultimately land once the Fed begins to cut. The answer matters greatly to both bond and stock investors, particularly those focused on dividends.

Some investors believe that short-term rates will return to zero, like they did for much of the past decade, but with the public having experienced elevated inflation and the Fed’s desire to leave room to cut rates to stave off future recessions the odds of this seem low.

From the 1990s up to 2008, just before the financial crisis that ushered in a period of zero interest rates, the Federal Funds rate averaged 4.04% varying from 1.13% in 2003 to 6.24% in 2000. A steady state Fed Funds rate between 3%-4% seems like a reasonable expectation.

Assuming another month of supportive economic data, the Fed will likely begin cutting interest rates in September, providing a boost to economic growth and the fortunes of non-Magnificent 7 stocks that are priced reasonably for their growth potential.

Investors who missed out on the outsized returns of the Magnificent 7 shouldn’t fret, as a well-balanced portfolio of growth stocks purchased at reasonable valuations should perform well in the long run. For instance, the growing companies profiled in this month's Investor Advisory Service both offer reasonable entry valuations at their current prices. Our first pick in the issue is a healthcare business that is expected to grow faster than the overall economy. Our second selection is a midsized Internet business that is generating impressive cash flow.

Unlock these picks and get updates on roughly 67 other companies by subscribing to the IAS newsletter today.


The commentary is excerpted from the issue of the Investor Advisory Service newsletter published at the end of July. To receive commentary like this in a more timely matter and receive actionable stock ideas each and every month, subscribe today. The Investor Advisory Service stock newsletter was named to the Hulbert Investment Newsletter Honor Roll for the 14th consecutive year for outperforming every up and down market cycle since 2007

For more information about the Investor Advisory Service, to download a sample issue, or to subscribe to the best investing newsletter in the U.S. for long-term consistent returns, visit Investor Advisory Service.