The U.S. economy added 528,000 jobs in July 2022. The employment situation report revealed that average hourly earnings were up 5.2% year over year. While robust, that 5.2% rate was below the recent year-over-year inflation rate of 8.5%. I am happy to see earnings move in the right direction, but that is still a 3.1% decline in wages over the last year, accounting for inflation.
Household income relative to inflation has looked more promising over an extended period. For the last five years, wage growth has roughly equaled inflation plus productivity growth. Nonetheless, the Federal Reserve Bank of San Francisco argues that workers who have not received recent raises will demand a cost of living adjustment.
People tend to have a recency bias, which supports the SF Fed’s expectation that workers will ask their employers, “what have you done for me lately?” Of course, employers may ask the same question of their employees. Employment and wages are up, but the output (as measured by gross domestic product) has declined for two straight quarters. Aggregately, the new hires are not as productive as previous employees.
Higher labor costs and declining productivity will be a headwind for corporate profit margins. Has the stock market reached peak valuation?
Lower profit margins mean that company valuations should cap upside stock market targets. The forward-looking price-to-earnings ratio for the S&P 500 is nearly 19. That’s about the level reached before the stock market stalled out in 2018 and early 2020. I suspect the market is close to a temporary ceiling and will need to adjust down a bit before it can break to new highs.
Some intelligent people have convinced me that there is a strong possibility that the market will reclaim its old highs by the end of the year or maybe early 2023. It is ambitious to expect the S&P 500 to hit 4,800 again within six months—not necessarily unrealistic, but ambitious. So long as my baseline forecast unfolds as I suspect (no deep recession, inflation has peaked, corporate earnings decline but not meaningfully, and the Federal Reserve mostly follows my script), the S&P 500 should trade at about 4,450 points by about year-end or maybe early 2023.
A price target of 4,450 points represents a 4-5% return over six months. That level of return would be consistent with previous periods when the CPI was declining, per Bespoke’s graphic below.
To get that type of return, I will have to be right that inflation has peaked. Whether or not I am correct will be dependent on housing costs. The costs of some goods and services have offered modest relief. However, housing prices remain sticky.
Shelter is 32.77% of CPI. Rent, a component of shelter, is 7.8% of CPI. Mortgage rates have risen sharply, which should slow home prices. Rent, however, shows less evidence of seeing lower prices in the months ahead. The silver lining is that publicly traded companies in the business of renting apartments report that the income-to-rent ratio has barely budged. Working from home has made workers more portable. People can take their higher incomes and move to cities and towns that charge less rent than where they had lived previously.
My list of baseline forecast “ifs” is ominously optimistic. My level of comfort makes me uncomfortable. As I’ve noted in previous columns, investors had become so bearish that it made me bullish. I fear that two months since peak bearishness by the crowd, a specific subset of traders have become too optimistic too quickly. That subset includes day traders, meme-stock enthusiasts, and other “dumb money.” The froth in the sentiment of the so-called dumb money leaves the stock market vulnerable to bad news or even just missed economic estimates.
A market dip from here would be consistent with the seasonal tendency to see market lows around September during mid-term election years.
The Economy is Improving, but Still Fragile
Many people disagree with my assessment that the U.S. economy is in a recession. Admittedly, the robust jobs report threw a wrench into my argument, especially since the creation of 528,000 new jobs boosted total payrolls above their pre-COVID peak in February 2020.
The National Bureau of Economic Research is the unofficial-official arbiter of defining periods as recessionary or not. I’m not willing to die on Call the Recession Hill. The only reason I track economics is that it’s a predictor of the direction of the markets. I care more about direction than definitions. The stock market tends to perform well when the economy is bad but getting better, which I believe has been occurring recently. Consider Bespoke’s Economic Indicator Diffusion Index. The Diffusion Index measures whether economic data is coming in ahead of or below consensus estimates.
In June 2022, the index hit a low that rivaled the Great Financial Crisis. The index has improved since then, jumping 22 points. Part of that increase was because of solid job creation. However, growing payrolls and recessions are not mutually exclusive. In the early 1970s, job growth continued well after the start of a recession. I will likely remain concerned about a recession, even if the stock market reclaims its prior highs. Not because I am a nervous person (although I am), but because the economy is fragile. It wouldn’t take much for the narrative to shift from “the job market is too strong to call this a recession” to “yeah, I think we’re in a recession now.”
One economic concern is the inverted yield curve. A yield curve is considered inverted when short-term rates exceed longer-term ones. The spread between the two-year and ten-year Treasury is about negative 40 basis points (or 0.4 percentage points). There have only been a few times since the early 1980s when the yield curve has been so inverted. While my base case is for everything to work out, it is understandable that I remain concerned about the stock market if the economic stars don’t properly align.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures: https://berkshiremm.com/capital-ideas-disclosures/ Direct inquiries to Allen at AHarris@BerkshireMM.com.
