Earnings Should Power This Bull Market Forward

It was another outstanding week for the major market averages, as stocks are now reflecting the dramatic improvement we have seen in the rate of inflation over the past year. The market started to look forward last summer when the various rates of inflation peaked, but now we are at a transition point when corporate profits need to validate current price levels if we are to see a continuation of the gains. The earning season started out strong on Friday, with our largest banks posting profits much better than expected. JPMorgan CEO Jamie Dimon said "the US economy continues to be resilient," and that "almost all of our lines of business saw continued growth in the quarter." I think this is a harbinger of things to come for second-quarter reports, and I remain optimistic.

Of course, any form of resiliency is a double-edged sword, as it rejuvenates the call for a more restrictive monetary policy. Friday's consumer confidence report was a perfect example, halting the four-day rally over concerns that the economic landscape might be too resilient. The University of Michigan reported that its index rose by the most in one month since 2006 to what is almost a two-year high. The improvement was based on consumers' view that the job market remains strong, while inflation continues to abate. That's another way of describing a soft landing, but sentiment still has plenty of room for improvement and remains well below pre-pandemic levels. Sentiment improved for all groups except low-income households, but that should change soon.

One of the tenants of my bullish outlook for the market and economy at the beginning of this year was that as consumers worked down excess savings, we would see a return to real wage growth. Restoring inflation-adjusted wage growth would help offset the loss of spending power resulting from depleted savings. We finally saw that last week on a convincing basis in the Real Earnings report from the Bureau of Labor Statistics that accompanies the Consumer Price Index report. Note that real (inflation-adjusted) average weekly earnings growth, which considers changes in the length of the workweek, has improved from -3.8% in June of last year to +0.6% this June. That is an extremely positive rate of change that should help sustain real consumer spending growth.

The latest warning from the bear camp on the inflation front is that the headline number of 3% will uptick in July, due to the extremely favorable comparison we had with June of last year. That is true, but the core rate, which is higher and more important to the Fed, should continue to decline due to lower used-vehicle prices and shelter costs. Last week's Producer Price Index report revealed that we are on the cusp of deflating with just a 0.1% increase over the past year, and this tells us the disinflationary trend is intact. As this data relates to markets, Bespoke Investment Group points out that when the spread between the PPI and CPI has been at a record high, as it is today, we typically see a period of above-average stock returns follow. That makes sense to me, given the positive rates of change that are mounting.

The most important of these rates of change is in corporate earnings expectations. While only 6% of S&P 500 companies have reported to date, earnings so far are 8.8% above estimates, which is above the 5-year and 10-year averages. Note that this is a dramatic improvement from last quarter's 6.4% and the fourth quarter of 2022's 1.3%, which was the cycle low. That was also the quarter during which the bear market ended. Rates of change are far more important than absolute numbers.

Another important change comes with respect to the meaningful improvement in investor sentiment, which is another double-edged sword. When sentiment is abysmal, as it was this spring, there were countless buying opportunities. We need it to improve so that more investors buy stocks, and we realize higher prices, but that also greatly diminishes new investment opportunities. As of late, there is clearly a more speculative fervor in the air, as retail investors are once again piling into stock call options at an increasing rate.

Lastly, as it becomes more difficult to find good values in a market that continues in a steady uptrend, it may be optimal to look outside the U.S. for value. The plunge in the dollar on the tailcoats of the extremely favorable inflation news and decline in bond yields is a boon for the emerging world, as most of their debt is priced in dollars.

The Vanguard Emerging Markets ETF (VWO) has been hugging the flatline for more than a decade, with a return of about 7% as of Friday's close. The yield is approximately 3.3%. This looks like an attractive investment option to gain stock exposure without assuming the valuation risks that come with the major market averages in the U.S.

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