Examining the Health of the Stock Market with Dr. Ed Yardeni

U.S. stocks found their footing last week, finishing up a July to remember. The Dow popped nearly 3% while the S&P added 4.3% last week and the Nasdaq Composite rose 4.7% for the month. For the month, the S&P 500 rallied 9.1% while the Nasdaq popped in a 12.3% gain, recording one of the strongest months in the index’s history. If that was a bear trap, it wasn’t very convincing, as nine out of the 11 sectors in the S&P 500 all posted gains. If you want to get technical about it, the major indexes all found support for the time being, and we’re starting to see some true breadth thrusts playing out across the stock market. A breadth thrust, my friends, is not a fencing move. It’s a technical indicator that flashes when a large percentage of stocks make new short-term highs, driving their moving averages higher, with more of those stocks advancing rather than declining.

If we look back into the history of the S&P 500, every time we’ve seen a breath thrust this strong, according to our friends at All Star Charts, the market was higher 12 months later 27 out of 28 times. Does that mean it will play out this way again this time? No. But the odds are pretty compelling. And the bad news in the economy is starting to be taken as good news in the stock market. It’s one of those weird inflection points when we see markets get stretched to extremes. The preliminary estimates for second quarter GDP showed a 1.1% slowdown, not as bad as forecast, but still a drop, and the second consecutive quarterly decline in a row. That is one of the indicators of a recession which has become a hot potato issue in politics and media and everywhere else. The Fed, for its part, doesn’t think we’re in a recession.

Let’s get set up for the week ahead. It’ll be another busy one, with the U.S. labor market in full focus and second quarter earnings season in full bloom. In total, 148 companies of the S&P 500 will report second quarter results this week, including Activision blizzard, PayPal, Square, Caterpillar, BP, Uber, JetBlue, and Starbucks, just to name a few. According to FactSet, of the 56% of companies in the S&P 500 that have already reported results, 73% had beaten estimates. The big oil giants have been awash in profits given the surge in oil prices earlier this year. We’re going to be keeping a close eye on Caterpillar’s results this week. It’s a good proxy for the health of the global economy, given that it is subject to long lead times for its customers’ orders. If demand looks strong for the rest of this year and 2023, that’s a pretty good indicator that recession fears may be easing.

We’re going to be watching oil prices very closely this week as well. The OPEC+ group is meeting to decide whether to hold oil production targets at current levels or hike output to ease supplies. It couldn’t come at a more crucial time as Russia’s President Vladimir Putin will be meeting with Turkey’s President Erdogan later this week as Russia is cutting off gas supplies to Europe in response to Western sanctions. Europe gets 60% of its energy supplies from Russia. Back in the USA, we’re going to be locked into Friday’s jobs report for the month of July. Economists are forecasting gains of around 250,000 jobs added last month, and for the unemployment rate to hold steady at 3.6%. Remember what Chair Jerome Powell said. The strong labor market is telling the Fed that this is no recession.

Meet Ed Yardeni

Dr. Ed Yardeni is the founder and President of Yardeni Research, Inc., a provider of global investment strategies and asset allocation analyses and recommendations. Prior to founding Yardeni Research, Ed served as the Chief Investment Strategist of Oak Associates, Prudential Equity Group, and Deutsche Bank’s U.S. equities division in New York City. He was also the Chief Economist of CJ Lawrence, Prudential-Bache Securities, and EF Hutton. He taught at Columbia University’s Graduate School of Business and was an economist with the Federal Reserve Bank of New York. He has also held positions at the Federal Reserve Board of Governors and the U.S. Treasury Department in Washington, D.C.

What’s in This Episode?

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The summer winds of late July have been blowing a nice rally across U.S. equity markets, and the walls of worry that felt insurmountable in late May and June? They feel a little bit lower all of a sudden. Is the worst behind us or is this just a spell of smooth sailing until the next set of fear factor scare investors back out of the stock market? You’re going to hear a lot of market watchers and shock callers make predictions, call bottoms, or false alarms over the next few weeks. That’s just part of the game. But there are only a few people who I listen to very closely when they share their outlooks. And one of them is Dr. Ed Yardeni. He’s the founder, president and chief investment officer of Yardeni Research, a sell-side consulting firm that provides a wide range of investment strategies and asset allocation analysis and recommendations. He’s the author of the must-read Predicting the Markets: A Professional Autobiography. That’s a must read for anyone serious about investing. And he’s a widely cited and followed investing expert, whom I’ve been learning from for over 20 years. When Ed Yardeni talks, people listen. And we have the pleasure of welcoming Ed on board The Express this week. Thanks so much for being with us.

Ed:Thank you.

Caleb:I know your research well and you are no perma-bull. You don’t wear rose colored glasses. You’re not that type of a market watcher. But you’ve been saying that June 16 may have been the bear market low. And you’re right, given the returns over the last several weeks, and the rally we’ve seen since the Fed raise rates last week confirms that. What key indicators are you looking at—besides price level—to confirm your suspicions?

Ed:Well, I think one of the key indicators has been sentiment. Sentiment got extremely bearish. As a matter of fact, right around the bottom, we saw that the Investors Intelligence’s bull/bear ratio was the lowest it’s been since March 2009, which is the very depths of the Global Financial Crisis. And surely things aren’t as awful as they were back then. And there have been lots of other sentiment indicators suggesting that the market was grossly oversold. But I’m a fundamentalist, not a technician, and I’m not a contrarian all the time. But I do think that the fundamentals that the markets started to discount was that we may be getting close—if we’re not already at a peak—in inflation, and that it should start to moderate. And that, meanwhile, for all the fears that the economy was falling into a severe recession, that it’s probably a soft landing, it’s probably a mid-cycle slowdown, if you will. And I think the market can live with that. And of course, the earnings season has gone reasonably well.

Caleb:Yeah, I want to get into some of those results and what they’re telling you. And folks, if you’re interested in reading Ed’s research, you can find it on Yardeniquicktakes.com, as well as Yardeni.com where we have terrific charts. The r-word—recession—has become a political football. You would expect that during an election year, the White House tried to redefine it last week, got a lot of backlash for that. Fed Chair Powell said we’re not in one at his FOMC press conference last Wednesday. We might not be. Or if we are, it doesn’t walk, talk, and act like past recessions. Even though we’ve had those two consecutive quarters of negative GDP, which, as you know, it’s an indicator, typically one of the indicators of a recession. You’re an economist as well, and an investor. What’s your take? And you can call it a banana if you want, just like they used to do in the White House during the seventies.

Ed:Yeah—I have been writing about calling it a banana. That was way back when, during the Jimmy Carter days, when Alfred Kahn coined the expression “let’s call it a banana instead of a recession,” because people were critical of the president back then, and Jimmy Carter didn’t want to talk about the possibility of a recession. And we got the same kind of scenario now where the administration has pushed back and said, “we’re not in a recession.” I don’t really get political about this stuff. I mean, it’s pretty clear to me that what we have here is a growth recession. There’s no growth in the economy in the first quarter or the second quarter. For all practical purposes, it’s zero growth plus or minus one percent, so it’s not much. There were some technical factors that depressed the first quarter, and the second quarter was a bit more of a fundamentally weak quarter, and we’ll see how the second half of the year plays out. But the reality is inflation has really eroded the purchasing power of consumers; their spending as well, but barely. So we’ve had some growth from the consumer and we are seeing some weakness in capital spending. What we definitely have is a housing market recession that was the biggest contributor to the second quarter decline in real GDP, and that’s likely to continue. The Fed has been increasing interest rates more aggressively in the past couple of meetings, but meanwhile the credit markets have really tightened and we’ve seen the mortgage rate absolutely soar, slamming the brakes on the housing market. And it’s not just housing, it’s housing-related retail sales. And so all in all, I think we’re just in a slowdown. It may last through the end of the year, it may not get rated as an official recession, but we’ll see how the second half of the year plays out.

Caleb:You also have to realize, and I know you do this, we’ve come out of a period unlike one we’ve ever really experienced in this country. You slam the brakes on the economy, turn it off like a light switch, and then try to turn it back on. It takes a while. And then you have the supply chain imbalance, you have the bullwhip effect that retailers are dealing with right now. You have demand where we didn’t have it. You have a lack of demand where it was before. So we’ve never been through this before and the cycles are so compressed right now. You also wrote in a recent note that consumers have nothing to fear about the future, and we know consumer sentiment is already extremely negative, getting worse every month due to inflation, rising rates, and the general uncertainty. But what is it about the future that consumers should be scared of? Or are consumers scared just because of what they’re surrounded with, and the noise around recessions that they hear every single day?

Ed:Well, I think you made a very good point about how this seems to be a business cycle on steroids and speed. So it’s been a very compressed business cycle and that’s made everybody nervous because we’re not used to things changing as frequently and as potentially cataclysmically as people fear. So there’s clearly a lot of issues to fear. Obviously, the situation in Ukraine is horrible. The potential for Europe to fall into very severe recession this winter because of the shutoff of Russian gas is a very big deal. China’s going through, I think in some ways what we went through in 2008 with the property bubble and market calamity. And then, of course, there’s inflation, which you don’t have to go abroad to talk about. It’s here and now, and it’s been a real problem for us all. And we’ve seen that it’s squeezing consumers’ purchasing power. So I think right now, the consumer is, to a large extent, depressed by inflation. They’re depressed that, on the one hand, they’ve gotten some pretty nice wage increases, but when they go and spend them in the stores, they’re concluding they’re no better off—in terms of real purchasing power—than they were before the wage increase. So that’s an issue. And I think we could talk ourselves into a severe recession, I suppose. But, you know, if we have a recession, a conventional recession, that would probably be the most anticipated recession of all time, which is one of the reasons why it probably isn’t going to be all that terrible, because everybody’s mostly prepared for things slowing down. And so nobody’s going to suddenly get surprised and find that they have to slash their business activity. So I think a slowdown is what consumers are likely to experience, but meanwhile, they’re fearful of things getting worse.

Caleb:Meanwhile, we keep spending—we’re really good at that—spending. Consumer spending, which accounts for 70% of U.S. GDP, hasn’t cracked yet. We have seen some increases in credit card debt levels and we’ve seen some pullback in discretionary areas, particularly among lower income folks. You would expect that in any economy, but especially one that’s slowing down. Let’s look at some of the key fundamental indicators that you and your team track and chart every day for some economic health indicators—and folks—you can access these for free on your strategist handbook at Yardeni.com. Let’s go through a couple of them that are key to you. What are you seeing? What’s standing out to you the most in terms of of where we are in terms of P/E ratios, earnings per share (EPS), and some of these other metrics?

Ed:In terms of the macroeconomic fundamentals, before we turn to the stock market fundamentals. Clearly, the consumer, as you said, is extremely important. And so I am watching inflation-adjusted personal income. I’m watching inflation-adjusted consumption. I’m watching the distribution of consumption. What are they spending on? Well, they’ve cut back on spending on durable goods. As you said, we’ve had an extraordinary period here with the pandemic and they’re coming out of the lockdown recession. People had cabin fever and they they had to get over it by going shopping. And the services were largely closed. So they bought a lot of durable goods and now they’ve sort of satisfied all their demand for those kinds of items. And now you’re seeing that people want to go travel, they want to use services and have fun. And we are seeing that in the data, as a matter of fact, that there is sort of a pivot by the consumer from goods to services, so that’s fine and makes make sense. And it’s not exactly a reason to be particularly worried about. And as I said, I am watching the housing indicators. There’s some forward indicators—pending home sales, for example, which look very weak. I’m a big fan of using the regional business surveys. There’s five of them that the Federal Reserve banks put together, and they’re leading indicators of the Purchasing Managers Index (PMI), which comes out at the beginning of the month. So those are all the things I watch, and they’re all confirming that things are slowing down, but not in a freefall situation.

With regards to the market, I’ve always said that it’s not that hard to be an investment strategist. All you have to do is forecast two variables: earnings and the P/E ratio, or the valuation of those earnings. Getting those two variables right is the challenge and I’m always challenged by it. But as an economist, I think I have some insights when I focus on earnings. I wish I had a psychology degree, because that would probably help me a lot with the valuation multiples. But with regards to earnings, again in a soft landing slowdown scenario, I think earnings growth is going to slow, but I don’t think it’s necessarily going to turn negative and I think it may kind of go sideways for a while, which might mean a sideways stock market for a while. But I think by next year we will be back seeing the economy growing, earnings growing and the market does look ahead. The market did a really brilliant job of anticipating the slowdown in the middle of this year. At the beginning of the year, the market has been down during the first half of the year anticipating trouble. But now I think it’s looking into 2023 already and recognizing that we’re probably going to get through these problems without any major calamity. And all of a sudden, this rally that we’ve had since June 16 has really been led by a kind of reversal of valuation multiples. At the beginning of the year, I was arguing that investors are on Mars and analysts are on Venus. They are different planets, and the analysts kept singing a happy tune and raising their earnings estimates for this year. And meanwhile, the analysts just couldn’t buy it, and they were smashing valuation multiples from about 20 to 15. And that’s really where the decline in the market came from. And now we’re seeing that investors are saying, well, maybe the investors, the analysts were too optimistic, but maybe we were too pessimistic about the outlook, and now we’re seeing some rebound here in the valuation multiple.

Caleb:But it’s always kind of like that. We take it too far in one direction. We’re animals. We have animal spirits that sort of rule over us. So we get a little too pessimistic on the downside, a little too optimistic or way too optimistic on the upside. Nothing surprising about any of that, right?

Ed:No, it’s the old fear and greed. And we saw a tremendous amount of fear in the first half of the year, and the sentiment indicators did an awfully good job of measuring that. It turned out to be, so far, a good contrarian indicator once again. look, just because it seems like we made an important low on June 16, this doesn’t come with a money back guarantee. We live in a very dynamic, fluid world and things can change pretty rapidly here. But we did discount a lot of potentially really, really bad news and it turned out to be—so far—not as awful as feared.

Caleb:Yeah, we’re right in the middle of earnings season. You mentioned it already. The results have been mixed, but maybe better than expected for some companies and sectors. But let’s focus on that revenue per share, profits per share and operating profits. These are three of the major organs inside companies’ balance sheets. What’s the prognosis, Dr. Yardeni?

Ed:Revenues per share have been growing very rapidly, and that that’s because of inflation, I mean, nominal GDP and revenues are basically the same concept. And so as inflation has picked up, so have revenues. The remarkable thing is that companies have been able to pretty easily pass through this inflation to their consumers. As a result, earnings have continued to grow and profit margins have actually held up surprisingly well. Now, as you said, it’s a mixed picture. Retailers got stuck with inventories that they didn’t expect. They didn’t anticipate that consumers might have satisfied a lot of pent-up demand over the past couple of years. And now, all of a sudden, some may have to discount, which, by the way, is a healthy development in terms of getting inflation down. On the other hand, some of the technology names are displaying that they continue to do a pretty good job of generating earnings. So I think we’re looking in the second quarter, once the results are all in, at something like a 5-7% year-over-year increase in earnings per share, and I think that it’ll continue to be single digit comparisons in the second half of the year. And then I think we’ll probably see low double digits, something like 10% to 15%, next year. And so that’s, I think, fundamentally consistent with continuation of the move higher that we’ve seen since June 16.

Caleb: So what is nobody talking about as it relates to the health and direction of the U.S. stock market that you think deserves more attention? What is the overlooked key indicator that you think you need to pay attention to?

Ed: I’m glad you asked that, because we do tend to be too U.S.-focused, too U.S.-centric. I think you really want to have a global perspective when you think about the stock market, and when you look around the world, you see that it’s a pretty messy situation. China’s got some terrible problems, Europe’s got some awful problems. And now we’re seeing that emerging markets are having unsettled political situations because of the high cost of food and energy. And so when global investors look for where to put their money, it certainly looks like the U.S. is a safe haven. And that explains why the dollar’s been so strong. And that explains to an extent, I think, why the 10-year Treasury yield got up to three and a half percent. And suddenly, I think, foreigners were important buyers of bonds in the U.S., helping to bring the bond yield down. They haven’t really been buying equities, but by bringing bond yields back down, that’s helped on the valuation multiples side. But I think increasingly you’re going to find that global investors, and that includes American investors who diversify on a global basis, are going to conclude that there is no alternative country to overweight other than the U.S., and so TINAC stands for “there is no alternative country.” Not to be confused with TINA, which is kind of a close cousin to “there is no alternative to stocks.” But I think on a global basis, the U.S. looks like the place to overweight.

Caleb:You’re a movie buff, Dr. Yardeni, and a pretty avid movie reviewer. You have a great list of movie reviews going back many years on your site. Let’s talk about business and finance movies. We love those here at Investopedia. I have to know your top five. Can you give us your top finance-related movie picks of your lifetime?

Ed:Yeah, but they’re not the movie picks per se. They’re a series on cable, which I think have been very, very well done recently. So one of my favorites is The Titans that Built America about people like Henry Ford and Rockefeller. And I know that some people have a negative view of these sort of robber barons, but the series makes you appreciate the extent to which these entrepreneurs improved the standard of living of all their customers by providing their customers with better goods and services at lower prices. Inventing Anna is about Anna Sorkin, who is a pretty good scam artist, she went to jail for her scams. But you can get an idea of how con artists work in attracting funds. Speaking of that, another con artist movie, The Dropout, is a series about Elizabeth Holmes and Theranos. And, you know, she claims she had this amazing technology that with one drop of blood she could tell everything about you. And it turned out to be just a big scam. And that’s extremely well done. I really like Super Pumped: The Battle for Uber. And I actually worked with Bill Gurley, who was the venture capitalist who really made that company, financed the company, and the trials and tribulations that he had to go through to bring it to to the market are fascinating. And then again, in the same line, you can almost see this is a quintuple feature is WeCrashed, about Wework. So those will keep you busy for a long time because most of them are several one hour shows. I like these because it kind of mixes capitalism with the corruption and you get this, you get to see human nature really, really well.

Caleb:Well, I know somewhere in the recesses of your mind, you’re probably working on a script or a pilot or a movie because I know you’re such a big fan of the screen, so thank you for those picks, we’re going to link to those in the show notes and we’re big fans of all of those as well. And you know, we’re a site built on our financial terms and our definitions. You are a student and teacher of the game. What’s your favorite investing term or indicator that you love to use in your research or teach people about what’s the one that’s really close to your heart?

Ed:Well it’s the one that I invented back in the early 80s: bond vigilante. The idea being that the Federal Reserve certainly has a tremendous influence on the economy, but we shouldn’t underestimate the extent to which the financial markets, particularly the bond markets, can also have an influence. And sure enough, when the Fed pivoted from being extremely dovish for many years to being hawkish at the beginning of the year, even before the Fed really started to aggressively raise interest rates, the bond vigilantes figured it out and kind of jumped ahead of the line and pushed interest rates up dramatically again, particularly in the mortgage market, which has slowed the economy down and is having an impact. You know, we’ve seen the bond vigilantes active in Europe in the past. When those Greek bond yields went up to 40%, they were clearly screaming that something was just dead wrong with the way that country was being run, and things changed and those bond yields came down. Their previous heyday was really in the 80s and early 90s. In the early nineties, the Clinton administration basically recognized that there were limits to what they could do with fiscal policy because the bond vigilantes were watching what they were up to. So that’s a phrase I like to raise, especially when it’s becoming relevant like today.

Caleb:And it is yours and yours alone. And we’ll make sure that if we don’t have it on Investopedia, it will be there very soon, with links to you, Dr. Yardeni. Dr. Ed Yardeni, the founder, president and chief investment officer at Yardeni Research. Thanks so much for joining the Express. It’s a real honor to have you.

Ed: Thank you, Cal. My pleasure.

Term of the Week: Deflation

It’s terminology time. Time for us to get smart with the investing term we need to know this week, and this week’s term comes to us from the good people over at Wingstop. That’s right, Wingstop. That American multinational chain of aviation-themed restaurants specializing in chicken wings. The company founded in 1994 in Garland, Texas, and began offering franchises in 1997. And Wingstop CEO said in an earnings call last week that the company is benefiting from a meaningful deflation in bone wings. That’s right. Prices are falling for chicken wings. What is deflation? Well, according to my favorite website, deflation is the general decline of the price level of goods and services that is usually associated with a contraction in the supply of money and credit, but prices can also fall due to increased productivity and technological improvements. But in the case of chicken wings, there may be something foul going on in the coop.

Last week, the U.S. Department of Agriculture actually raised its wholesale poultry price estimate to a gain of between 26 and 29%, up from a prior forecast of between 20 and 23%. The increased forecast suggest chicken prices may be poised to continue to rise in the back half of the year. But then, Pilgrim’s Pride, the nation’s largest poultry producer, said prices of chicken breast, tenders, and leg quarters are trending higher than other recent years, but wing prices have slumped. That may be due to some of the cost-cutting measures restaurant companies like Wingstop took earlier this year. As wing prices soared, the companies took wings off the menu and swapped in boneless wings, which are actually made from chicken breast meat. Prices got so high for chicken wings that Wingstop actually opened a new chain of restaurants called Thigh Stop this year. Bottom line, deflation means falling prices, but chicken wings may not be the canary in the coal mine that we’ve been looking for.