Bold bull

Bottom line 

The S&P 500 has soared nearly 14% from its August 5 intra-day low to today’s new record of 5,822. That’s its 45th new high this year, and it is trading at an elevated price/earnings (P/E) ratio of 21.2 times next year’s estimated earnings of $275. But bond investors seem to have received a cautious memo. Over the past month, benchmark 10-year Treasury yields have risen from 3.60% to 4.10%, which translates into a more muted target P/E of about 17.9 times in the so-called Fed model. That suggests that stock valuations may be overly optimistic by about 18%. 

What accounts for this equity market euphoria? It appears to us that stock investors may be looking through sticky inflation and a deteriorating labor market to a Federal Reserve that it believes is hellbent on lowering interest rates over the next two years. As a result, financial markets are scaling an impressive wall of worry. Low-end consumers are retrenching, corporate profit growth is slowing, geopolitical risk—and its impact on the oil market—is rising. Hurricanes Helene and Milton have devastated the Southeast, the federal debt and deficit are unchecked at record levels and there is tremendous election uncertainty. If equity investors begin to focus on these deteriorating fundamentals, we could experience a temporary 5-10% air pocket.

Inflation remains sticky and persistent Although the Fed has made strong progress lowering inflation over the past two years, we have seen a reacceleration in several key metrics in recent months:

• Core PPI wholesale inflation has risen from 1.8% y/y in December 2023 to 2.8% in September 2024. 
• Although core CPI retail inflation has declined from 3.9% y/y in December 2023 and January 2024 to 3.2% in both July and August 2024, it ticked up to 3.3% in September 2024. 
• Although average hourly earnings declined from 4.4% y/y in January 2024 to 3.6% in July, it has risen to 4.0% in September. The Fed is targeting 3%.
• Core PCE inflation (the Fed’s preferred measure) stalled at 2.6% y/y in May, June and July 2024—down from 5.6% in February 2022—but increased to 2.7% in August. The Fed is targeting 2%.

Labor market softening The unemployment rate (U-3) has risen from a 53-year low of 3.4% in April 2023 to 4.1% in September 2024, triggering the Sahm Rule in each of the last three months. It states that, if U-3 rises a half percentage point or more on a rolling 3-month basis within a year, the economy typically slows into a recession. In addition, temporary hires (an important leading employment indicator) have lost jobs in 19 of the past 20 months. 

Fed navigates dual mandate Balancing the Phillips Curve tradeoff between moderate inflation and full employment, we believe that the Fed is more concerned about the deterioration in the labor market over the past few months, rather than inflation. After their supersized 50 basis-point rate cut last month, we expect policymakers to cut rates by an additional quarter point in each of the upcoming November 7 and December 18 meetings, followed by 25 basis-point cuts each quarter over the course of 2025 and the first half of 2026, which would reduce the terminal fed funds rate to 3.0% two years from now. But if inflation accelerates further, we could be overly optimistic on the pace of interest rate cuts. 

Weak Back-to-School (BTS) spending During the first three months of this important retail sales season through August, BTS spending rose by a tepid 2% y/y, their weakest results in 15 years. Consumers at the lower end of the income and wealth spectrum have been tightening their belts for the past two years—saving more and spending less—due to a deteriorating labor market, persistent inflationary pressures, and declining consumer confidence. 

Earnings growth slowing The third-quarter earnings season got off to a good start this morning with JP Morgan’s beat and raise. But overall, FactSet’s estimates for the S&P 500 for revenues and earnings are expecting slower growth. Earnings per share are now expected to increase by 3.7% y/y, half as strong as estimates for a 7.8% y/y gain at the start of the third quarter. By comparison, earnings grew by a robust 11.6% y/y in the second quarter, which marked the strongest earnings growth since the fourth quarter of 2021. Earnings growth for the Magnificent Seven peaked at 60% y/y in the fourth quarter of 2023, slowing to 50% in the first quarter, 33% in the second quarter, and an estimated 17.5% in the third quarter.

Growing geopolitical risk The Russia/Ukraine war continues to rage in its third year with no end in sight. Over the past year, Israel is now fighting a two-front war against Hamas in the south and Hezbollah in the north, while the Houthis are attacking shipping traffic, all of which is being funded by Iran. As a result of this incremental risk, crude oil prices (West Texas Intermediate, or WTI) over the past month have leapt by about 20% to $75 per barrel, perhaps on their way to re-test last year’s peak of $95. 

Weather devastation Over the past fortnight, Hurricanes Helene and Milton have devastated the southeast, particularly North Carolina and Florida. Aside from the tragic loss of life, the damage could at least temporarily worsen the economic, inflation and labor-market picture. 

Federal debt & deficit growing unsustainably The Congressional Budget Office announced this week that with a record $35.7 trillion in Federal debt, the budget deficit was $1.83 trillion for the fiscal year that ended on September 30. The Fed began raising interest rates in March 2022, and interest payments on the debt at $950 billion in 2024 were higher than either our defense ($826 billion) or Medicare ($869 billion) budgets. Total tax revenues soared to a record $4.92 trillion in 2024, but total spending surged 11% to $6.75 trillion, amid a non-crisis environment.

Rollercoaster election Vice President Harris’ post-convention bounce appears to be fading, in part due to her unwillingness to conduct interviews with independent journalists and provide greater policy detail. It appears Trump has regained the upper hand in the race for the White House, given his modest lead in several of the seven key swing states. We believe the Senate will flip to Republican control, and the House of Representatives will likely reflect the down-ballot impact from whichever candidate wins the presidency.

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