Pulse of the Markets Report 8/11/23: A Period of Stock Market Consolidation

Following a largely uninterrupted ascent since the close of March, the stock market encountered some hitches in early August. These bumps arose mainly due to its nearly uninterrupted climb, prompting suggestions that it could be overbought in the short term and overvalued compared to its historical average in the long term.

To put it differently, the prevailing sentiment is that the stock market might be poised for a step back, or to use more technical jargon, a consolidation phase. This process seems to be unfolding in the initial days of August. The key indices have each experienced a moderate retreat, several sectors within the S&P 500 have also pulled back, and both the Russell 3000 Value Index and the Russell 3000 Growth Index have undergone similar retracements.

This withdrawal has been systematic and all-encompassing, which aligns with typical patterns observed during a consolidation period. Another typical occurrence during or at the conclusion of such a phase is a readiness to buy during instances of market weakness.

This predisposition to buy should manifest once more in this consolidation interval, as there have been no significant developments in the fundamental news flow that would derail the underlying reasons for the stock market's near-linear ascent since late March.

Laying the Foundation

To commence, the minor banking crisis in the early part of March was contained through a coordinated announcement by the Department of the Treasury, the Federal Reserve, and the FDIC. This proclamation aimed to reinforce public trust in the banking system and included an implicit assurance of bank deposits along with supplementary funding to ensure the fulfillment of depositors' needs.

Some interpreted these actions as a restoration of the so-called "Fed put." Regardless of how these actions were interpreted, it's undeniable that the stock market responded positively to the announcement and subsequent weeks, signifying that the consequences of the banking crisis were less severe than feared.

Beyond this, a string of economic indicators indicated that the economy was performing better than anticipated, despite the interest rate hikes that preceded the banking crisis.

Furthermore, since the March banking crisis, the Fed has executed three more rate hikes, and the aggregate economic data have consistently surpassed expectations. Notably, employment figures and inflation metrics have been particularly encouraging for the stock market. The employment data continues to underscore a tight labor market, exemplified by an unemployment rate of 3.5%, which is close to a 50-year low. Simultaneously, inflation data indicate a trend of disinflation.

While core inflation remains above the Fed's target, incoming data revealing disinflation have fortified the market's belief that the Fed has concluded or is nearing the conclusion of its rate-raising cycle.

Positive Shifts in Earnings Outlook

The second-quarter earnings reporting phase is nearing its conclusion. While it outperformed projections, it did not translate into overall earnings growth. According to FactSet, the blended second-quarter earnings growth estimate stands at -5.0%, an improvement from the -7.4% estimate at the start of July.

Nonetheless, what occurred with second-quarter earnings is less impactful for investor sentiment than the expected trajectory of earnings in subsequent quarters. This is where the positive news emerges.

Throughout the second-quarter earnings reporting period, consensus estimates for earnings in the next 12 months, for both calendar 2023 and calendar 2024, have all been revised upwards. This has instilled some confidence in the idea that earnings have bottomed out. While this notion will likely be debated in the upcoming months, it is currently reasonable to assert that earnings estimates are on the rise.

As of June 30, the forecast for the next 12 months stood at $231.52, the projection for calendar 2023 was $218.63, and for calendar 2024, it was $244.63. Presently, these estimates have increased to $234.87, $219.39, and $244.96, respectively.

Although the upward adjustments to consensus earnings estimates may appear modest, in a market actively seeking signs of an earnings trough, even marginal improvements hold significance. This is particularly true for a market that entered the earnings reporting season at a premium compared to its 10-year historical average.

On June 30, the forward 12-month P/E ratio for the market-cap weighted S&P 500 was 19.3x, in contrast to the 10-year average of 17.3x, as reported by FactSet. Thus, the S&P 500 was trading at an approximately 12% premium relative to the long-term average. Presently, this ratio stands at 19.1x, influenced by the early August stock price fluctuations and the concurrent rise in earnings estimates.

This observed consolidation in stock prices, accompanied by the upward adjustment of earnings estimates, represents a favorable trade-off. Notably, the elevated P/E multiple is substantially attributable to the remarkable returns of the "Magnificent Seven" mega-cap stocks.

A More Nuanced View

From a valuation perspective, the equal-weighted S&P 500 appears more appealing, trading at a forward 12-month P/E of 15.7x. This is in comparison to the 10-year historical average of 17.6x. Essentially, there is more underlying value in the stock market than may be readily apparent when focusing solely on the market-cap weighted S&P 500.

Implications and Future Outlook

The retracement witnessed thus far in August should not come as a surprise. If anything, it is a welcome development for a bull market that had been exhibiting signs of complacency, concentration in select stocks, and a maturing rally that had persisted nearly uninterrupted since late March.

This momentum was propelled by a shift in narrative from anticipating a severe economic downturn to a more moderate one, from expecting multiple interest rate hikes to the possibility of none, and from projecting declining earnings revisions to upward revisions.

This fundamental shift prompted portfolio realignments that were initially designed for a more challenging environment. Moreover, it spurred performance-driven actions among underperforming fund managers, buybacks by short sellers, and the reentry of cash into equities.

So, what lies ahead? It is reasonable to expect ongoing selling interest as this pullback is still in its early stages. However, in the absence of a fundamental driver capable of undermining the foundation of this year's recovery, there should persist a willingness to purchase during periods of market weakness.

Yet, this does not necessarily entail a swift ascent to new market highs. The stock market will continue to grapple with concerns related to valuation and the potential delayed effects of the Fed's interest rate increases. Nonetheless, this current pullback is likely to align with the characteristics of a typical consolidation phase, as long as the underlying fundamental shift remains intact.

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