CAPITAL IDEAS: What recent jobs and inflation reports will mean for the US economy

Photo courtesy of Flickr.

The U.S. economy added 528,000 jobs in July 2022. The Jobs Situation report found that average hourly wages rose 5.2% year-over-year. Although robust, this rate of 5.2% was lower than the recent year-over-year inflation rate of 8.5%. I’m glad to see revenue moving in the right direction, but it still represents a 3.1% drop in wages over the past year, accounting for inflation.

Household income relative to inflation looks more promising over a longer period. Over the past five years, wage growth has been roughly equal to inflation plus productivity growth. Still, the Federal Reserve Bank of San Francisco argues that workers who haven’t received recent increases 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 can ask their employees the same question. Employment and wages are up, but output (measured by gross domestic product) has fallen for two consecutive quarters. Overall, new hires are not as productive as older employees.

Rising labor costs and falling productivity will be a headwind for corporate profit margins. Has the stock market reached its valuation peak?

Lower profit margins mean corporate valuations should cap stock market targets on the upside. The S&P 500 forward price/earnings ratio is close to 19. This is roughly where it was before the stock market stalled in 2018 and early 2020. I suspect the market is close to a temporary high and will have to adjust a bit before it can reach new heights.

Some smart people have convinced me that there is a good chance that the market will return to its old highs by the end of the year or perhaps the beginning of 2023. It is ambitious to expect that the S&P 500 hits 4,800 again within six months, which is not necessarily unrealistic. , but ambitious. As long as my baseline forecast unfolds as I suspect (no deep recession, inflation has peaked, corporate earnings are down but not significantly, and the Federal Reserve mostly follows my scenario), the S&P 500 should hold. trading at around 4,450 points towards the end of the year or possibly the beginning of 2023.

A price target of 4,450 points represents a 4-5% return over six months. This level of return would be consistent with previous periods when the CPI was down, according to Bespoke’s chart below.

Graphic courtesy of Bespoke.

To get that kind of return, I have to be right that inflation has peaked. Whether I’m right or not will depend on housing costs. The costs of some goods and services offered modest relief. However, house prices remain sticky.

Housing accounts for 32.77% of the CPI. Rent, a component of housing, accounts for 7.8% of the CPI. Mortgage rates have risen sharply, which should slow house prices. Rent, however, shows fewer signs of falling prices in the coming months. The silver lining is that publicly traded companies in the apartment rental industry are reporting 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 used to live.

SentimenTrader’s Smart Money Confidence and Dumb Money Confidence indices are used to see what “good” market timers are doing with their money versus what “bad” market timers are doing and are presented on a scale of 0% to 100 %. When the Smart Money Confidence Index is 100%, it means those who are most correct about the direction of the market are 100% confident of a rising market. When it is at 0%. this means the market timers have 0% confidence in a rally. The Dumb Monev Trust Index works in the opposite way. Chart courtesy of Charles Schwab, SentimenTrader, as of 02/08/2022.

My list of basic “if” predictions is grimly optimistic. My comfort level makes me uncomfortable. As I noted in previous columns, investors had become so bearish that it made me bullish. I fear that two months after the peak crowd decline, a specific subset of traders has become overly bullish too quickly. This subset includes day traders, meme-stock enthusiasts, and other “dumb money.” The froth in so-called dumb money sentiment leaves the stock market vulnerable to bad news or even missed economic estimates.

A decline in the market from here would be consistent with the seasonal tendency to see market lows around September during midterm election years.

The economy is improving, but remains fragile

Many people disagree with my assessment that the US economy is in a recession. Admittedly, the robust jobs report threw a wrench in my argument, especially since the creation of 528,000 new jobs pushed payrolls above its pre-COVID peak in February 2020.

The National Bureau of Economic Research is the off-the-record arbiter of whether or not recession periods are defined. I don’t want to die on Call the Recession Hill. The only reason I watch the economy is because 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 doing badly but improving, which I believe has happened recently. Consider Bespoke’s Economic Indicator Diffusion Index. The Diffusion Index measures whether economic data is above or below consensus estimates.

Graphic courtesy of Bespoke.

In June 2022, the index reached a low that rivaled the Great Financial Crisis. The index has since improved, jumping 22 points. Part of this increase is due to strong job creation. However, rising payrolls and recessions are not mutually exclusive. In the early 1970s, job growth continued long after a recession had begun. I will likely remain concerned about a recession, even if the stock market returns to previous highs. Not because I’m 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 it a recession” to “yes, I think we’re in a recession now.”

An economic concern is the inverted yield curve. A yield curve is considered inverted when short-term rates rise above longer-term rates. The spread between two-year and ten-year Treasury bills is around minus 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 scenario is that everything works out, it’s understandable that I’m still concerned about the stock market if the economic stars don’t align properly.

Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing over $700 million in investments. Unless specifically identified as original research or data collection, some or all of the data cited is attributable to third-party sources. Unless otherwise stated, any mention of specific securities or investments is for illustrative purposes only. The adviser’s clients may or may not hold the securities in question in their portfolios. The Advisor makes no representation that any of the securities mentioned have been or will be profitable. Full disclosures: Direct inquiries to Allen at [email protected]

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