Wentz Weekly: Stocks Fall Again As Rotation Continues

Wentz Weekly Insights
Stocks Fall Again As Rotation Continues

The rotation in US stocks that began three weeks ago continued this past week – the S&P 500 and Nasdaq struggled while small and mid cap stocks did well. Mega cap stocks and the technology sector underperformed while interest rate sensitive sectors like utilities and real estate and cyclicals like materials and industrials outperformed. There has not been one specific catalysts for the rotation, but we think markets were overdue which has intensified the outperformance in small caps.

The lower than expected inflation number that was released three weeks ago seemed to have triggered the rotation, which caused a reset in rate cut expectations with markets now looking for three rate cuts by the end of the year, versus just one expected about one month ago. We are hoping to get a better idea of timing and number of cuts on Wednesday, when the FOMC releases its policy decision followed by Powell’s press conference.

We don’t think there will be a rate cut this week, given recent comments from Fed officials that more confidence is needed that inflation is on a sustainable path lower. We also think so because the interest rate futures are only pricing in a 6% chance of a cut, meaning investors have a low expectation of a rate cut, and the Fed does not like to surprise markets.

However, some believe the Fed should start with rate cuts this week, including former New York Fed President Bill Dudley. He believes rate cuts should start sooner to reduce the risk of the US economy contracting as he sees growing signs the economy may shrink. Wealthy households are still healthy and are still consuming, but less-affluent households are depleted of cash and savings and are feeling the weight of higher rates and credit card/other debt balances, he says. His comments contributed to the worst day last week, when stocks fell over 2% for the worst day since December 2022, and the Nasdaq’s 3.64% decline seeing its worst day since October 2022.

Other factors that may be contributing to the rotation are a slowing economy/profit growth, the so called Trump trade (favoring deregulation, tax cuts, more strict trade) and the increasing concern over sustainability of the Artificial Intelligence related rally as well as more worries if the substantial investment in AI will pay off. We expect this worry to continue, and investors will either be relieved or worry more after this week.

That is because four of the “Magnificent 7” companies (Microsoft, Meta (Facebook), Apple, and Amazon) report earnings this week (as well as several chip companies like AMD, Intel, and Qualcomm). These companies are so important because they are spending billions every month on AI data centers which is expected to pay off eventually through higher productivity and profits. They are also important because six of these Mag 7 companies are expected to deliver 30%+ growth in earnings this year. The remaining 454 companies in the S&P 500 are expected to see earnings growth of just 5%. To take it further, the technology sector is expected to see 19% earnings growth this year. But if you exclude Nvidia (maker of the chips that power AI), that falls to about 6.5%. So expectations are high for these companies, and if there is any weakness this week, we see the rotation continuing.

Speaking of earnings, profit growth is still expected to be around 9%-10% for the second quarter, slightly above expectations from when the quarter began. The higher than expected growth was almost all due to better profits from financials (from higher interest rates). There is still roughly 60% of S&P 500 companies yet to report.

The earnings picture has been pretty mixed, but we have seen consumer related companies are suggesting a sharp slowdown in the consumer. For example, Nestle, the world’s largest food company, cut its sales outlook for the year, Unilever, a consumer products company, cautioned about slower growth in the second half of the year, Whirlpool, one of the largest appliances makers, lowered its profit forecasts for the year, UPS was down over lower package volumes, Visa saw lower revenue with a slowdown in payment volume and cross border transactions, particularly among lower-end consumers, and automakers like Ford and Stellantis had one of their worst days in years over profit concerns from lower sales and operational issues. But it wasn’t just related to the lower-end consumer – luxury brand LVMH (Louis Vuitton, Dom Perignon, etc) and Kering (Gucci, Bottega Veneta, and others) added to the consumer slowdown worries, and that the slowdown is spreading beyond the lower-end consumer.

For stocks to get back to highs and push through, we need to see the consumer remain healthy through a strong jobs market, which will help support earnings growth. We will see more data on that this week with several labor market reports including the job openings survey on Tuesday and the DOL’s monthly report on Friday. We think higher interest rates will continue to impact consumers and businesses even after they are cut due to the time it takes for changes in rates to work through the economy, but to what extent is the more difficult part to answer.

Recent Economic Data

• Q2 GDP: GDP increased at an annualized rate of 2.8% in the second quarter this year, according to the first estimate which is expected to see revisions over the next couple months, much better than the 2.0% expected. However this is not as strong as the headline suggests: Inventory adjustments, which declined significantly in the prior two quarters, bounced back and contributed 0.8% to GDP. Government spending, which has been very strong since the pandemic, increased another 3.1% and contributed 0.5% to GDP. Excluding these two, GDP would have increased 1.5%. Other main components include the most important – consumer spending rose 2.3% which was arguably stronger than expected after seeing a slight slowdown in Q1. For the first time in several quarters there was a bigger increase in speding on goods versus services. Goods spending rose 2.5% while spending on services increased 2.2%. Overall, consumer spending contributed 1.6%. Residential investment fell 1.4% as the housing market cooled, contributing a -0.1% to GDP. Business fixed investments rose a solid 5.2% and has increased for 11 consecutive quarters, which has largely been driven by intellectual property. Business investment contributed 0.7% to GDP. Finally, exports rose 2.0% while imports increased 6.9%, with the combination of the two contributing a -0.7% to GDP.

• Personal Income & Spending: In June, Income growth was lower than expected, consumer spending was in line with expectations, while PCE inflation was in line with expectations but core prices slightly higher. Personal income increased 0.2% in June, half the increase that was expected. More importantly, wages and salaries grew 0.3%. Wages and salaries are up 4.5% from a year ago, decelerating from the 4.8% rate in May. That will be another piece of welcoming data for the Fed/markets when it comes to being closer to rate cuts. Consumer spending increased 0.3% in June, as expected, but May’s increase was upgraded to 0.4% from 0.2%. Spending was driven by services which has been the case for some time, with a 0.4% increase, and to a lesser degree spending on goods which increased 0.1%. Over the past year spending is up 5.2%, slowing from 5.3% in May. The result is a decline in the savings rate to 3.4%. The savings rate has been historically low since the economic reopening following the pandemic. The 10-year period prior to the pandemic the savings rate averaged 7.5%. The PCE price index, which is the inflation reading the Fed puts the most weighting on, rose 0.1% in June after no change in May. This has helped the annual rate come down to 2.5%, down from 2.6% in May. The core PCE index rose 0.2%, slightly higher than the 0.1% expected. Compared to a year ago the core index is up 2.6%, slightly more than expected and matching May’s increase.

• Existing Home Sales: The number of existing home sales in June fell 5.4% compared to May to a seasonally adjusted annualized pace of 3.890 million, a weaker number than expected. This is also 5.4% below the level from a year ago and back to the weakest level since the pandemic period after a brief bump the beginning of this year. Sales are measured by closings so these represent homes that went under contract in May. Inventories of existing homes on the market was up another 3.1% in the month and 23.4% from a year go to 1.32 million units. As the report notes, the housing market is steadily transitioning from a sellers market to a buyers market – homes are sitting on the market longer and sellers are receiving fewer offers. Yet the median existing home price continues to rise, up 4.1% from a year ago to a new record high of $426,900. Housing market has been on a steady slowing trend due to affordability and possibly potential buyers anticipating rate cuts, delaying purchases.

• New Home Sales: New home sales were at an annualize pace of 617,000 in June, a new low for the year and about 30k lower than expected, falling 0.6% from May and down 7.4% from the sales pace a year ago. The number of new homes for sale on the market increased again, now at 467,000 for the most new homes on the market since the housing crisis in the mid 2000’s. Despite the sharp increase in supply, the median sales price increased again in June to $417,300, 2.5% above May and relatively unchanged from a year ago. It is very apparent the housing market is slowing dramatically the past several months – the number of homes for sale where construction has not started is at a new cycle high. Realtors are saying it also appears homebuilders, instead of bringing prices down to help demand, are offering more points for a lower interest rate.

• Durable Goods Orders: Durable goods orders for June were very weak, seeing a 6.6% decline. However that was all transportation related (think aircraft orders, which are very large orders in dollar terms and sway the index). Durable goods orders excluding transportation, which is a good proxy for capital investment, rose a better 0.5% with core capital goods orders rising 1.9%, both much better than expected. However this is a bounce from a period over the end of spring. Shipments of nondefense core capital goods excluding aircraft, which is an input to GDP, rose 0.1% coming after a 0.7% decline from May.

• Jobless Claims: The number of jobless claims for the week ended July 20 was 235,000, a decline of 10,000 from the week prior with the four-week average at 235,500. The number of continuing claims was 1.851 million, down slightly from the prior week and the four-week average at 1.854 million.

• US Money Supply: The US money supply (includes cash, deposits at banks, and money market balances) increased for 7 of the past 8 months, seeing a $73 billion increase in June after declining 14 of the 15 months prior to that. Since the beginning of the pandemic, money supply rose at a record pace due to the money printing and was up 41%, of $6.3 trillion, over the two year period ending April 2022, leading to the decades high inflation we saw the following 2 years. Then money supply fell 4.8% which doesn’t sound like much but is a big decline and many think will continue leading to economic weakness as it works its way through the economy.

Company News

• Nvidia’s New Chip: Nvidia shares gained nearly 5% to start the week after Bloomberg reported it is developing a new version of its next gen AI chip that will be available for the Chinese market, needing to do so because of the US export restrictions of advanced AI chips to China. In its reveal of the Blackwell chip series in March, it said it will process 30x quicker than its current advanced AI chips.

• Redditt Sports Agreement: Redditt said it has secured a partnership with several major sports leagues, including the NFL, MLB, NBA, PGA Tour, and NASCAR, to bring more content to its platform in effort to help boost advertising revenue. “More content” includes video highlights from games/tournaments, behind the scene videos, Q&A with athletes, and special content on big event games.

• Apple’s Foldable Phone Plans: The Information reported Apple continues to work on a foldable iPhone and the project has moved beyond the concept phase and is now potentially in the development phase with its suppliers. It says the company is still working to flatten the crease made when the phone is unfolded and making the device thinner. The report says Apple could reveal the foldable phone as soon as 2026 and it would fold horizontally, similar to the foldable Samsung Galaxy Z Flip.

• Automaker Issues: Automakers were hit hard last week after several earnings reports. Ford had its worst day since May 2009 after dropping over a disappointing quarter although raising cash flow forecast by $1 billion. However, profitability was a concern due to higher costs. Its warranty costs were a lot higher than expected, along with continued losses in its EV segment, equaling $1.1 billion in the quarter alone. It also said in attempt to help this issue, it is delaying the launch of the refreshed Bronco, Explorer, and Maverick to conduct additional quality control inspections. Stellantis, maker of Jeep, Dodge, Chrysler, and others, shares were down almost 8% after it reported a 48% decline in profits over lower volume, a slimmer market share, and “arrogant mistakes” in its US operations like inventory levels and manufacturing problems.

• Overcapacity Among Airlines: Airlines were another industry that saw disappointing results. American Airlines was down over 10% before recovering after significantly cutting its profit guidance, citing company specific and industry challenges including excess industry capacity which led to higher discounting of fares. Southwest Airlines beat expectations but saw unit revenue decline, citing industry wide capacity growth outpacing demand. Also announced a significant change to its seating policy.

• Southwest Assigned Seating: Expanding on that, Southwest announced it will begin offering assigned seats in a strategy shift in effort to improve customer experience and financial performance. The company said it decided to make the move from open seating and to assigned seating and premium seating options after extensive customer research that showed 80% of its customers preferred an assigned seat. Southwest will have to redesign each of its planes, and in addition to this change will implement new technologies and procedures, which it said will produce incremental revenue and cost savings.

• OpenAI New Search Feature: OpenAI, developer of ChatGPT and Microsoft’s major AI partner, said it has started testing a prototype of a new search feature which includes its AI models with information from the internet. The service can be made via signing up on a waitlist and is available to a select group of users and publishers for feedback and improvement. Alphabet, parent company of Google, stock was down as a result of worries of increased competition in the Search space.

Other News:

• Bank of Canada: The Bank of Canada cut rates 0.25% for the second straight meeting, which was widely expected. It cited broad price pressures continuing to ease and said it expects economic growth to be about 1.5% the first half of the year, but with “robust population growth of about 3%, the economy’s potential output is still growing faster than GDP, which means excess supply has increased.” The central bank is also being more aware of downside risks, another reason for additional cuts.