Market Commentary: Earnings in the Long Run, and Short

Earnings in the Long Run, and Short

Earnings Expectations Continue to Rise

  • The summer rally continued last week, the S&P 500 gaining 1.4% and hitting more all-time highs.
  • Stock gains ultimately depend on earnings and they continue to look good in both the short and long run.
  • Inflation data finally provided some relief, with the Consumer Price Index coming in below expectations.
  • Despite reining in expectations, the Fed is still likely to cut rates 1-2 times this year.

Just like last week, it’s another week behind us and more new highs for the S&P 500, led this week by the big technology companies. The spring rally has continued, with the S&P 500 higher seven out of the last eight weeks after pulling back in April. The index is now up 14.6% in 2024 (including dividends).

Yes, there will be more ups and downs, but there’s no debating it’s been a good year for stocks. We’re not surprised. A strong job market is helping incomes grow, incomes drive earnings, and earnings drives stock prices.

And what’s the earnings picture been? Year-ahead earnings expectations have steadily advanced this year. Ultimately, that’s what you need to support stock gains. Earnings expectations can be slow to react sometimes, but right now analysts aren’t seeing anything that would lead them to shift expectations. If the earnings momentum continues, we should see additional gains for stocks over the rest of the year.

Short-term earnings growth is important, but long-term earnings growth means even more for financial planning. Stocks are a long-term investment that can continue to provide returns above more conservative assets as long as companies can continue to grow earnings. And companies can grow earnings as long as the global economy grows, which is something it has been doing much more often than not for several millennia.

More practically, as seen below, S&P 500 Index companies have been able to grow earnings along a fairly steady trend over the last 70 years. There have been short-term fluctuations when the economy has slowed, but the overall trend has been strong. Next time you’re wondering why own stocks over the long run, ask yourself if you think companies can grow earnings over the long run. If you’re not sure of that, ask yourself if you think the U.S. economy can continue to grow, and the rest follows.

Stock gains are fundamentally about earnings growth. There is a more cyclical element related to valuations, but over time the impact of valuations tends to average out to near flat. The most well-known valuation measure is the price-to-earnings ratio (P/E), which captures the amount investors are willing to pay for a dollar of current earnings as a kind of proxy for long-term earnings. The higher the P/E, the more expensive valuations are. It’s true, right now the S&P 500’s P/E is somewhat expensive relative to history (about 20.8 versus a 20-year median of 15.5) but not without reason. The S&P 500 is now dominated by technology-oriented companies that are able to run very efficient businesses, more efficient than the make-up of the index in the past. While that doesn’t necessarily justify current valuations entirely, it does make a meaningful contribution.

There are also areas of the market that are less expensive, such as small and mid-caps stocks. But areas of the market become less expensive by underperforming, which makes many investors uncomfortable. Valuations aren’t a timing mechanism, but for patient long-term investors we believe that some diversification into other these of the market can be beneficial, and think we may even see markets broadening in the near term as inflation continues to come under control and the Fed likely begins to cut interest rates.

Big picture, we don’t think there’s a reason right now for investors to shy away from US stocks in the long run or short run. Long-term trend for earnings growth is still solidly in place and 12-month forward near-term earnings expectations continue to rise. With no meaningful sign of elevated recession risk on the horizon in our view, we continue to overweight stock and have high conviction in earnings growth in the long run.

Inflation Is Headed Lower, and That Means Rate Cuts Are Coming

The Consumer Price Index (CPI) report was a welcome “surprise” after a string of uncomfortably hot inflation reports. Headline inflation was flat in May, while core inflation (stripping out volatile energy and food components) rose 0.16%, which corresponds to an annualized pace of exactly 2%, all softer than what forecasters were expecting. At the same time, headline CPI is now up 3.3% since last year, and it looks like we’ve made no progress on inflation since last fall. But a closer look at the data below tells you that shelter (in dark green) continues to keep official inflation data elevated.

As we’ve written and talked about a lot, official shelter inflation runs with significant lags to what we see in actual rental markets. Shelter inflation matters a lot for CPI, as it makes up 35% of the basket. Rents of primary residence account for 8% of that 35%, while “owners’ equivalent rent” (OER) accounts for the other 27%. OER is the “implied rent” homeowners pay, and it’s based on market rents as opposed to home prices. If you set aside housing inflation, recent inflation trends look very encouraging. Headline inflation is running at a 2.8% annualized pace over the past three months, but if you exclude shelter it drops to 1.7%. That is not a typo.

Here’s Why We Think Inflation Is Headed Lower

CPI inflation data is backward looking (last week’s number were for May), but the guts of the report, and the trends within, can tell us what we may be looking at on a go-forward basis. There’s good news on that front.

First up, shelter. We continue to see disinflation on this front, as the official data follows what we see in private real-time data, albeit slowly. In Q4 2023, rent and OER averaged an annualized pace of 5.4%. That eased ever so slightly to 5.2% in Q1 2024, and in April-May the pace was 4.7%. For reference, the corresponding pace in 2019 was 3.6% (which is consistent with the Federal Reserve’s target of 2% inflation).

Next up is one of my favorite inflation bellwethers: inflation at seated restaurants. Interestingly, it’s not included in core CPI, but correlates well with it. That’s because seated restaurant prices combine several underlying drivers of inflation – restaurant worker wages, commodity prices (food obviously, but also energy prices involved with transportation), and restaurant premise rents. Inflation for this category peaked at 9% year over year in 2022 but it has pulled all the way back to 3.5% – which is where it was in late 2019. It tells me that underlying inflation is not running too hot. In fact, over the last four months food price inflation (groceries) has been flat or negative, and that will likely pull restaurant price inflation even lower. We’re also not seeing a surge in wage growth, in sharp contrast to what we saw in 2022.

Third, new vehicle prices. The story up until now has been used car prices and we’ve seen a lot of disinflation there. But now we’re seeing prices for new vehicles pull lower as well – prices have fallen for five straight months. There’s more to come as supply chain issues fade further into the background and vehicle assemblies pick up, leading to higher inventories. Meanwhile, private data for used cars suggests used car prices will continue to fall. All of which will exert a downward force on inflation for the rest of this year.

The Fed Is Going to Follow the Data

The Federal Reserve just wrapped up their June meeting and they chose not to move away from the current target policy rate of 5.25-5.5%. That was expected but this was an important meeting because they updated their projections for the economy, inflation, and appropriate policy under those scenarios. These policy projections are what’s known as the “Dot Plot,” which was last updated in March.

Despite having early access to the May inflation data, we believe they were clearly spooked by the hotter-than-expected inflation data in Q1. They raised their 2024 projection for core inflation from 2.6% to 2.8%. (They use the Personal Consumption Expenditure Index, or PCE, which runs a little softer than CPI.) It doesn’t seem like a big shift, except they now project just 1 rate cut (worth 0.25%-points) in 2024, versus the 3 projected in March. The Fed was on the wrong side of the whole “transitory inflation” call a couple of years ago, and they clearly don’t want to be caught offside again. Once bitten, twice shy.

They do have “catch-up” cuts in 2025 and 2026, eventually landing at the same interest rate for 2026 that they indicated in March. They project a total of 9 cuts by 2026, translating to 2.25%-points of cuts (taking the policy rate to the 3-3.25% range).

All that said, I recommend treating the dot plot with some caution. As Fed Chair Powell pointed out, the dots are based on what Fed officials think could happen. The dots are NOT a forecast of what will happen. Just as the dots shifted between March and June, we could see opinions shift between now and September, especially if inflation continues to ease. In fact, a 2.8% projection for core PCE in 2024 indicates that inflation will run around 2.4-2.5% over the second half of the year. That may be a little too high given underlying trends that I laid out earlier.

In any case, the Fed continues to project at least one cut in 2024. But there’s good reason to think we may actually get two, with the first one coming in September followed by another in December.


This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.

A diversified portfolio does not assure a profit or protect against loss in a declining market.

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