The Election Distracts Investors from the Real Catalysts & Part II of Our Interview with Greg Holst of JPMorgan   

Five Things You Should Know

1. Equity Markets – remain mixed this week with U.S. stocks (S&P 500) up .85% while international stocks (EAFE) fell – .43%.  
2. Fixed Income Markets – were steady this week with no change in investment grade bonds (AGG) and high yield bonds (JNK) rising .3%.
3. ECB Rate Cuts – As expected the European Central Bank elected to cut rates for the 3rd time this year and first back-to-back monthly cuts in 13 years. Comments from ECB President Lagarde suggests high interest rates have hurt investments and economic growth but the economy remains on track for a “soft landing”. As of now market expectations are for one more cut before year-end. 
4. U.S. Housing Market – Housing starts and permits saw a pullback in September following a sharp jump in August, a sign that lower rates may not be all that’s needed for a smooth rebound in the housing market. Demand continues to far outweigh supply, which remains below the sustainable equilibrium of 1.7 million annual starts. 
5. Key Insight – [VIDEO] In Part II, Greg Holst of JPMorgan shares his philosophies on investing in fixed income markets, as well as potential opportunities in today’s market. [ARTICLE] Investors naturally believe that whatever matters to them (i.e. election results), must also matter to markets but in reality there are other things the market cares far more about.

Insights for Investors

By Tim Mitrovich

The Election Distracts Investors from the Real Catalysts

In last week’s article, (see here) we touched on the importance of not letting one’s politics drive one’s portfolio decisions and the incredible cost historically of doing so. It’s so easy to feel like something that is important to us, or may even be truly important in a broader sense, should be reflected in the markets. However, the reality is often something quite different. 

Why? 

To steal from last week’s piece and requote the team at First Trust “The reality is that the market grows over time because companies consistently innovate, create, and drive increasing profits. It’s easy to let politics cloud our judgment, but history has shown that regardless of who is President or what policies are enacted, entrepreneurs and companies find ways to adapt and thrive within or around the rules. Innovation and creativity are the true engines of market growth over time.” (Source: First Trust Economics, Three on Thursday June 6, 2024) 

Similarly, the Hartford Funds election piece we shared also concluded, “Market returns are more dependent on the outlook for the economy than on the outcome of an election.” (Source: Hartford Funds, December 2023) 

The Current Tug-of-War Over the Market’s Future 

What then is the status of the economy and corporate earnings picture? 

As it relates to the economy, the real concern that we’ve called out a number of times this year, is our belief that inflation is going to prove far stickier than consensus has wanted to believe all year. We continue to believe that inflation is likely to pick back up heading into year end, and this seems to be borne out by a bond market that has seen yields rise in recent weeks after August’s strong rally and a futures market that has greatly reduced expectations for further rates cuts from the Fed for the remainder of 2024 in the immediate days after their 50 basis point cut in September. And of course, most recently last Thursday’s report from the US Labor Department for the month of September which showed inflation is still running hotter than consensus. Most notably the closely watched metric on core inflation, which excludes the volatile costs of energy and food, increased 3.3% year-over-year compared to expectations of 3.2%. And month over month, core CPI rose +0.3%. 

As summarized by Trend Macro, “Expectations for Fed rate cuts by year-end have already come in considerably, with only an 85% probability of a November cut — based on a new consensus that there will be no recession. Beyond the noise of a single data-point, we have to ask why our monetarist model is now forecasting CPI to keep rising over the coming year from below the Fed’s target, where it is now, eventually to exceed the Fed’s target.” In a related piece the team noted further evidence for caution citing other inflation tracking indices and noting “the two unofficial ones based on real-time prices — Adobe and Truflation — are hooking upward just like our monetarist model.”  

None of this means the equity markets must fall, but it does likely mean that those expecting another super-sized rate cut from the Fed next month could be disappointed, and markets will need another catalyst to continue their advance. As analyst Michael Gayed highlighted, “The odds of a terminal Fed Funds rate of around 3%, which seems to have been the Fed’s target just a matter of weeks ago, is looking like a much longer shot today. The markets have been rallying for a while now on the belief that the Fed will keep easing into an already healthy economic environment. The markets may soon get a lesson that there are consequences to getting too dovish at the wrong time…”  

It is important to note that underlying inflation concerns, there is the positive that the economy does seem to be on solid ground with a still resilient labor market, steady retail sales and a recent ISM services reading of 54.9 indicative of expansion in the largest part of the US economy. 

With a tug of war between solid economic data and a still troublesome inflation picture (along with related Fed cut concerns) occurring in the midst of a contentious Presidential election no less, what should an investor be focusing on?  

Keep Your Eye on Earnings and Valuations 

While corporate valuations are not a market timing mechanism, nor something that can give you a good idea of the near–term direction of markets, they are very important to investors because historically they have had a very strong correlation to future returns over the coming full-market cycle (e.g. 10 years). 

As you can see below, depending on what segment of the global equity market one is looking at the potential “opportunity” or “danger” is quite different. Most global value sectors are trading near or below their long-term averages, while the tech dominated S&P 500 index, let alone Growth Index, are trading well-above their long-term averages. 

Why does this matter so much to us and what does it mean for investors? 

As we stated above, and the following graphic demonstrates, current valuation and forward-looking returns have a strong correlation.  

While of course, you don’t invest into an asset-class on valuation alone (make sure you have a quality professional partner and personal plan to evaluate the appropriateness of all investments for you and your family), you can see from the chart below that today’s growth stocks trade at almost a 28x multiple which projects to a low single digit average over the next 10 years with most historical occurrences at such valuations having negative returns. While value sectors, currently with multiples between 10-17x earnings, have traditionally posted the types of returns equity investors hope to achieve.  

The Takeaway 

Outside of one’s goals as a driver of allocation, investors need to understand the real drivers of returns over time.  

Sure, a news headline, a period of momentum or even a Presidential election can drive emotions and maybe even returns for a time, but such periods are usually brief, and impossible to time and/or predict the effect of. Therefore, they are useless to a sound investment process seeking repeatable successes. 

Understanding the general direction of forward-looking indicators, correlations around monetary policy, M2 supply and rates, and of course most importantly earnings and valuations, while not a silver bullet, can help investors make sure they are better positioned for the long-term and most probable outcomes. 

Your feelings matter, elections matter … they just shouldn’t matter when it comes to your investments and related decisions. 

For more on valuations, corporate earnings and what may lie ahead for the stock market check out the great piece by Brian Wesbury of First Trust below. 

As always if you or someone your care about would like to make sure they are well positioned, we are here to help.  

Have a wonderful weekend, 

Tim and the team at TEN Capital 

Monday Morning Outlook

To view this article, Click Here. 
 
Brian S. Wesbury, Chief Economist 
Robert Stein, Deputy Chief Economist 
Date: 9/30/2024 

Like it does once every year, last week the Commerce Department went back and revised its GDP figures for the past several years.  And while the top line revisions to Real GDP were pretty small, there was a larger revision to corporate profits. 

Real GDP was revised up 1.3% for the second quarter of 2024, which means the annualized growth rate since the start of 2020 was about 0.3 percentage points faster than previously estimated: 2.3% per year rather than 2.0%. 

And the statisticians also said profits were underestimated.  The government now thinks its comprehensive national measure of pre-tax corporate profits is 11.5% higher than previously thought, mostly due to profits at domestic non-financial companies (such as manufacturers, retailers, transportation & warehousing, etc.).  Meanwhile, after-tax profits were revised up 13.3%. 

As our readers know, we judge the value of the overall stock market by using a Capitalized Profits Model.  Using these revised economy-wide profits from the GDP accounts and a 10-year yield of 3.75% (Friday’s close) suggests the S&P 500 would be fairly valued at about 4,725, 18% below Friday’s S&P 500 close. 

Our readers know that this measure is a view from 30,000 feet.  The Capitalized Profits Model is not a trading model and there are many other tools to judge the value of stocks.  In addition, in an election year, another factor is in play as well and that is the tax rate on corporate profits. 

In 2018 the top tax rate on corporate profits was cut from 35% to 21%.  This 21% tax rate is the lowest tax rate on corporate profits since the Great Depression. 

We have always used pre-tax profits to judge stock values because the corporate tax rate moves up and down with the political cycle and pre-tax profits are a true reflection of economic activity, not just tax rate changes. 

Clearly, the stock market has continued to rise in spite of the fact that our 30,000-foot view suggests it is overvalued.  This could be a repeat of what happened in the late 1990s, when stocks rose in spite of the fact that they were overvalued, or it could be explained by an expectation that tax rates will stay low, and possibly be cut again. 

Using newly revised after-tax profits in our model, instead of pre-tax profits, suggests that stocks are fairly valued today.  And if President Trump were to win the election, and cut the corporate tax rate further as he has suggested (to 15%, from 21%) then there’s a case for stocks being mildly undervalued.  (In theory, cutting the tax rate to 15%, which means companies would get to keep 85 cents on the dollar rather than 79 cents, translates into an 8% increase in after-tax profits). 

However, there is also a risk of corporate tax increases, both in the near future as well as beyond.  Vice President Harris’s campaign has mentioned lifting the rate to 28%, which would translate into a 9% reduction in after-tax profits. 

It is hard to look at the federal budget situation and think the US government won’t be raising tax rates in the future.  We’d prefer spending cuts, but we don’t live in a world where policymakers do what we want.  In a worst-case scenario, tax rates could go up on both corporate profits as well as investors’ capital gains. 

Net, net, what does this all mean?  At the very best, upward revisions to profits mean stocks aren’t as overvalued as our models showed before.  Nonetheless, with the M2 measure of the money supply down from its 2022 peak, and the risk of recession higher than it has been in a long time, we still believe stocks are overvalued. 

The Federal Reserve is reducing interest rates, but even with a 10-year yield of 3% the stock market is not cheap.  From 2008 to 2022, the market was significantly undervalued, and we were bullish for almost that entire time.  Today, this is just not the case.  There are sectors of the market that remain less expensive than the market as a whole, but caution is still warranted.     

Data, Just the Data

• U.S. Retail Sales – rose 1.7% year-over-year in September, the weakest yearly gain since January. 

• U.S. Industrial Production – contracted 0.6% year-over-year in September coupled with a downwardly revised -0.2% decline in August. A slight increase in utilities production was not enough to offset contractions in the mining and manufacturing sectors. 

• U.S. Jobless Claims – initial claims fell by 19,000 last week following a 14-month high in the previous week. The decline is largely due to a surge in claims the previous week because of Hurricanes Helene and Milton, with averages still above where they were this time last year. Continuing claims saw an uptick of 9,000 for a total of 1,867,000. 

• U.K. Retail Sales – surprised to the upside with a 0.3% monthly gain in September despite expectations for a -0.3% decline. Year-over-year sales sit 3.9% higher, the largest annual rise since February 2022. 

• China Retail Sales – also beat expectations with a 3.2% year-over-year growth rate in September compared to expectations of 2.5%. The strength was largely driven by increases in grain/oil/food, personal care, and sports and entertainment sales. 

• Eurozone Industrial Production – rose 1.8% month-over-month, the most since February 2023. Output for energy, capital goods, and durable consumer goods all rebounded off of July’s weakness.