Market Breakdown for the week.
Hope you are all doing well. This past week, markets remained on edge. After posting fractional gains the previous two weeks, the S&P 500 fell more than 2% for its fifth negative result out of the past seven weeks. The NASDAQ and the Dow also posted weekly declines as investors focused on earnings results and bond market volatility. Suzanne Somers passed away this week. I have broken down this week’s update using quotes from her iconic character, Chrissy in Three’s Company.
Eat your salad before it gets cold.
Earnings reports are starting to cool expectations. As of Friday, third-quarter net income was expected to decline 0.4% compared with the same period a year earlier, based on S&P 500 companies that have already reported combined with projections for those still scheduled to report. That represents a good size shift from what analysts had forecast last week, growth of 0.4%, after the first batch of earnings reports. Tesla’s lackluster earnings report was a big contributing factor to the shift in expectations.
See, the world is made up of two kinds of people, twos and ones. Sometimes two ones become a two, and other times one of the ones of the two gets tired of being a two and wants to become a one again.
Sometimes the stock market moves independently from the bond market, and sometimes the bond market dictates the movement in the stock market and they move in the same direction. This is one of those times. Treasury bond yields continued their march higher. The 10-year Treasury yield is nearing 5%, a level last seen in 2007. The two-year yield, which tends to follow the path of the fed funds rate over time, also reached a high of the cycle at close to 5.15%. That came after Fed Chair Powell spoke and alluded to the potential that the Federal Reserve could consider another interest rate hike. The rapid move higher in government bond yields is important because it increases volatility not just in bonds but in stocks as well.
Here’s why, higher yields can increase the cost of borrowing which means businesses are paying more to service debt, hence, limiting profits. Stock valuations are a function of corporate profits. The second negative about higher interest rates for stocks is opportunity cost. Right now investors can lock in a 5% return for the next ten years without risk. I have found in my career that 6% is the magic number where people are willing to shun stock investing and go into fixed products. We are creeping closer to that rate, but I don’t think we will get there. As I have said throughout the year I think the Fed is not done and will raise a quarter of percent more. Then I would expect government bond yields to normalize as the Fed and global central banks ultimately pause with the rate hikes. I think by late next year or early 2025 they will start to pivot lower and reduce rates.
With the 10-year yield hovering near 5.00% now it could go a bit higher. Maybe it caps out at 5.2% percent before eventually dropping back down to the 3.5% to 4.5% range. More downside pressure on bond prices in the near term is likely. However, I think stocks will start to move in a different direction and rally as the economy continues to absorb high interest rates without showing signs of slowing.
Oh, I love surprises. It’s funny that you never suspect them!
The surprising strength of the latest monthly report on U.S. retail sales provided further evidence of consumer spending resilience. Retail sales rose 0.7% in September relative to the previous month. That blew away the expectations of most economists. The data for August was also revised higher to show sales advancing 0.8%. The fact that Americans are still spending means the economy is likely to stay out of recession. The U.S. economy has defied all the doomsday television pundits who for the last year and a half have been calling for a recession this year. The economy continues to maintain above-trend growth rate for the first three quarters of the year. Third-quarter real GDP growth is expected to be around 3% annualized. A strong consumer and a resilient labor market has been and will continue to be the main drivers.
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