Markets Stumble to Start August, All Eyes on the Economy

·???????? The S&P 500 and Nasdaq remain up double digits in 2024 despite the latest bout of selling

·???????? Amid a softer labor market and weak manufacturing activity, interest rate cuts are imminent

·???????? Small caps surged in July, then retreated amid rising volatility and strength in the bond market

Something normal happened in markets last week and this morning. Volatility. They say it’s like the price of admission to markets, and the typical year sees a 14% drop that often coincides with a spike in fear on Wall Street. It’s a bad time if you’re a short-term trader or a professional mutual fund manager who must meet near-term goals. For long-term investors like us, it’s an opportunity. A pullback within a broader uptrend serves up the chance to buy on the cheap.

S&P 500 Annual Returns and Intra-Year Declines: Average Decline is 14% Since 1980

Of course, the overall goal is not to try and be so cute as to time near-term troughs but rather to buy on a set schedule – the boring buy-and-hold stuff. Investors who did that through 2008, 2011, 2016, 2020, 2022, and even in Q3 of last year, are surely happy they just kept buying. “Just keep buying” - that sounds like Polyana guidance, but it’s far better than turning pessimistic and fearing markets.

In case you missed it last Thursday and Friday, the S&P 500 suffered its worst two-day loss going back to the Silicon Valley Bank mini-crisis of March 2023. The drop was nothing catastrophic, just 3.2% to begin August. It’s a reminder that there’s no reward with the acceptance of risk in markets – no pain, no gain.

The Nasdaq has fallen about 10% from its all-time high notched in July. Shares of the Magnificent Seven stocks have taken it on the chin after a stellar first half. Apple (AAPL) has performed the best, down only 6% from its peak, while NVIDIA (NVDA) has reached so-called “bear market territory,” down 21% from its recent high.

Magnificent Seven Pullbacks: AAPL –6%, NVDA –21%

So what’s caused this current bout of weakness? Not inflation. Not turmoil in the banking sector. Not geopolitical jitters overseas. This time, it’s concerns about a recession. Last week, there were a handful of weak economic reports that sent interest rates lower and once high-flying stocks into descent. A key gauge of the health of the US manufacturing sector came in particularly soft, including a dreadful employment reading for that slice of the economy. Then on Friday, the monthly jobs report was weaker than economists expected.

The US created just 114,000 new positions, below the 175,000-consensus estimate. More eyebrow-raising was the unemployment rate which climbed from 4.1% in May to 4.25% in July, triggering the “Sahm Rule.” A few months ago, only grizzly old economists had heard of the Sahm Rule, but now it’s bantered about nonstop on financial TV. It suggests that a recession is likely underway if the three-month average of the unemployment rate rises by at least 0.5 percentage points relative to its low during the previous 12 months.

A bit quantitative, yes, but the upshot is that with the jobless rate now at 4.25%, up from a low of 3.4% in April last year, it’s clear that the economy is weaker today than it has been for the last few years.

US Unemployment Rate Rises for a Fourth Straight Month, Fewer Jobs Created in July

The good news is that inflation is yesterday’s news, something we have written about for quite some time. Real-time measures of inflation point to about a 2% annualized rise in consumer prices, very close to the Federal Reserve’s target. There is outright deflation in many categories of goods while services inflation is higher. Prices remain significantly above what they were pre-pandemic, though, and voters may express frustration about that at the ballot box in November.

Inflation Running Under 2% Using Real-Time Pricing Analysis

Volatility Often Increases Heading into Elections

Sticking with markets and the economy, the other big news last week was the Fed meeting. Led by Chair Powell, the Federal Open Market Committee (FOMC) decided to leave interest rates unchanged. It was no surprise, as the Fed had telegraphed as much in the days leading up to the July 31 announcement.

Still, some experts were concerned that the economy had turned weaker in June and July, warranting the start of an interest rate-easing cycle. Alas, Powell signaled that a rate cut would perhaps be on the way at the FOMC’s September meeting.

Traders Expect Close to Five Quarter-Point Rate Cuts by Year-End

That was seen as a reasonable stance by many on Fed Day (Wednesday), but after troubling manufacturing and employment data struck on Thursday and Friday, the tone shifted. Today, pundits argue that there was a foul by the Fed and that rates should have been cut in July. We now must wait seven weeks until the next interest rate decision. Of course, Powell could announce an emergency inter-meeting rate cut if macro conditions deteriorate.

But let’s take a step back. Despite a dip in markets and recession fears by some, the “soft landing” narrative remains intact. Inflation is back to normal, jobs are being created, corporate profits are massive, and consumers are hanging in there (evidenced by a healthy June Retail Sales report).

What’s more, the Fed has room to ease monetary policy if it chooses, which would positively impact a host of key economic areas like durable goods, auto sales, and the housing market. Mortgage rates have already dropped to 6.4% - the lowest in more than a year.

The Average Rate on a 30-Year Mortgage Has Dropped to 6.4%

And it’s not totally clear that the July jobs report wasn’t negatively impacted by Hurricane Beryl in Texas, where power outages affected many homes and businesses in that key industrial state. Weather plays funny tricks on certain economic indicators, and the actual employment situation might not be as dire as noisemakers on TV suggest. Wall Street will pay particular attention to upcoming data releases and words from Fed officials, and rate cuts will likely begin soon.

Texas’ Employment Situation Negatively Impacted by Hurricane Beryl

Amidst the pullback, some once-underperforming areas have actually made new highs lately. Sectors like Real Estate, Utilities, Consumer Staples, and Health Care are up nicely so far in the second half. The January through June winners, such as Tech and Communication Services, have fallen back. Overall, through August 2, the S&P 500 is up 12.1% in 2024, and the Nasdaq Composite is higher by 11.8%.

S&P 500 +12% in 2024, Nasdaq Up About the Same, Small Caps Surged in July

Year-to-Date Sector Performances: Only Discretionary Is Down, Utilities Strongest

Small-cap stocks enjoyed a major boost starting in mid-July before losing ground as the calendar flipped to August. The Russell 2000 Index had been flat on the year through Independence Day, but then a rally of historic proportions ensued. The June CPI report came in better than expected, causing a drop in interest rates and a liftoff in the Russell 2000. The small-cap index then took another leg higher as former President Trump gained in the polls. If you recall back in 2016, the Russell 2000 was the primary beneficiary of Trump’s surprising victory, surging post-election through December of that year.

Though small caps have given back much of their July gains, last month’s move is a sign that there’s healthy “rotation” going on. And there’s good news for retirees or anyone with a sizable bond allocation. The recent drop in interest rates has resulted in bond funds turning much higher. The US Aggregate Bond ETF (AGG) is up 8% year to date, dividends included. The offset is that interest rates on savings accounts and in money market mutual funds are poised to drop as soon as the Fed lowers its rate. By this time next year, that 5% cash yield could be more like 3.5%.

To close, it’s important to remember that being a stock investor means you own shares of companies that produce real cash flow and profits. With more than 75% of S&P 500 firms having reported Q2 earnings results, 78% have topped estimates. More importantly, the earnings per share outlook has never been higher for US large-cap companies. Despite all of the negativity around the economy by some, corporations are doing what they do best – turning profits for shareholders. Don’t miss that.

S&P 500 Earnings Per Share by Year: 2024 Poised to be a Record High

The Bottom Line

Stocks have tumbled in recent days, but they are still up handsomely in 2024. Declines are normal, averaging 14% each year for the S&P 500, and they usually present solid buying opportunities. Interest rate cuts are imminent, which will negatively impact savings account yields, but bonds have performed well lately, helping diversified portfolios. Even with declining economic data, US companies continue to post record profit numbers for investors.