A Wild Ride, Tamed
After a tumultuous start, major indexes finished nearly unchanged last week. The most volatile of those indexes, the Nasdaq, dropped 3.4% on Monday, yet investor demand for companies in the technology-heavy Nasdaq allowed valuations to recover almost completely, down a mere 0.18%, while the S&P 500 barely budged (down 0.04%). That relatively calm finish masked a longer slide that reflects broader concerns among investors with the Nasdaq down 10.2% and the S&P 500 5.7% from their peaks in mid-July. Even so, declines of these magnitudes occur most every single year. When we dig under the surface to the earnings power of companies across the market, we find more encouraging signs for equities, despite last week’s events.
Our Chief Investment Officer, Chuck Lieberman, wrote several times last week highlighting the role played by the unwinding of the yen “carry trade” on Monday. Put simply, the market’s vast swings reflected a very specific adjustment and did not indicate broader trouble with equities. Since then, a slew of articles and analysts have come out in agreement with his views.
So, we return to the ongoing question surrounding the potential of US equities in a world where the Federal Reserve needs still to tamp down inflationary forces even as the US economy slows. Some slowdown in growth has been the Fed’s objective for a few years now and we do seem to be approaching a soft landing. There have been some company reports of weaker consumer demand, less tolerance of price increases, and more shifting of spending toward lower-priced options (whether on a menu or from high-end retail to off-price alternatives). Job openings shrank, net new hires came in well below expectations, and the unemployment rate ticked higher. Even so, inflation-adjusted disposable personal income continues to grow on a year-over-year basis. Actual GDP growth was almost 3% in the second quarter and the Atlanta Fed’s projection for the third quarter is about the same. A recession, this is not.
Because much of the market’s rise this year was driven by the mega-cap technology, communications, and consumer stocks, their relative weakness over the last few weeks left the major indexes without strong drivers. Beyond the macro, investors are looking to earnings growth to drive stocks higher. This fits the Magnificent 7 companies, most of which are being powered by the expectation that generative artificial intelligence (AI) will bring new sources of revenue and profits for many years to come. And while those Mag 7 companies are set to deliver earnings growth of 35% from last year’s second quarter, that wasn’t quite enough to quell concerns among some that AI’s returns would fail to deliver profits sufficient to pay for the massive amounts of money being spent on new data centers and software. Doubts crept in and these stocks tumbled. Note, though, that it is far too soon to expect much of a boost to sales and profits from AI – the productivity-enhancing effects are unlikely to appear for at least several quarters, and maybe years. Afterall, companies must figure out how to deploy that AI, to build it into day-to-day operations to speed things up, to reduce errors, to deliver better products, to bring new features to customers, etc. And then workers must be reallocated either to guide those developments or deployed to other, more productive activities across the economy. Make no mistake, this is going to be a long process, and one we expect will power not only the “picks and shovels” companies of AI, but also those deploying AI capabilities.
Outside of the Magnificent 7, earnings growth is improving. If we exclude the Mag 7, the other 493 or so companies of the S&P 500 are on track to deliver earnings growth of 7.4% over last year’s 2Q, according to Bloomberg Intelligence. This would mark the first quarter of profit growth for this broad array of companies in the last six quarters. So, while some may be worrying about recession, profits outside of the mega-caps are growing and that’s a plus for equity investors even as the Fed continues to beat inflation into submission.
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