Unraveling the Economic Factors Behind the Stock Market Surge

September 5, 2023 Season 5 | Episode 28

Want to understand the unexpected surge in the stock market amidst rising inflation? Join us (and our special guest Keith Lante), as we take a deep dive into the economic shifts over the past two decades that have seen households and companies cut their debt and reduce their dependency on short-term borrowing. We also unravel how companies with solid fundamentals have harnessed the power of the inverted yield curve, making sense of why the net interest expense as a percentage of net profits is currently lower than it was 20 years ago. Stay tuned as we dissect the sectors that have been significantly impacted by inflation.

Fasten your seatbelt as we transition into discussing the cooling labor market and the predictions for September. The August jobs report revealed a higher than expected gain - what does that mean for the financial market? We break down the role of the consumer price index and why September tends to be a challenging month for financial markets. Also, get a close look at On Holdings, a growth company that has seen its stock skyrocket 70% since the year's start. As we traverse these intricate economic landscapes, our goal is to equip you with valuable insights to empower your decision-making. Let's get the ball rolling!

** For informational and educational purposes only, not intended as investment advice. Views and opinions are subject to change without notice.

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Transcript

Alan Eppers: 0:00

And now introducing Mr Keith Lante.

Keith Lanton: 0:04

Hi, good morning. First opportunity to get together in September Morning for the day of September 5th. I hope Labor Day weekend was enjoyable for all. Some really nice weather here on the east coast in New York. Got a lot to discuss this Tuesday morning Financial markets, getting back to work after the summer and Labor Day vacation, lots of kids getting back to school full time so lots to digest as we close out 2023.

Keith Lanton: 0:43

This morning what we're going to talk about is we're going to talk about rising stock market in the face of rising inflation. What was contrary to lots of expectations. With rising inflation, the expectation is that we would typically see a falling stock market. At least that's what investors often associate with rising inflation. We'll talk about why the markets may have gone up in the face of this rising inflation, as well as why there may be risks going forward now that we're starting to see inflation peak and come down. We'll talk about the Federal Reserve meeting next week Making a decision on interest rates, barron's talking about events last week, what's going on in the month of September, how the month of September has historically been for equity investors, and then Brad will speak to us about the bond market and perhaps help us understand what's taking place here in Fixed Income, where we're seeing some rising interest rates despite the fact that we had a fairly friendly to say very friendly inflation numbers as it applies to the job market. Yet here we are this morning seeing Daniels pick up. So back in ourselves, up to the talk about inflation, tying it all together Article in Barron's, which was a op-ed piece, opinion piece by Stephen Dover, and what he talked about was the Fed rate hikes were supposed to kill corporate profits and why they didn't.

Keith Lanton: 2:28

So, as I started discussing, conventional thinking is that inflation is a negative for the stock market. After all, it causes interest rates to rise, causing consumers to pause, raises the cost of service debt and causes price earnings multiple contraction as future earnings are discounted back at a higher rate, thus making future earnings less valuable. Now, this did occur in a segment of the market, but not in the entire market. This occurred in the most aggressive speculative stocks that are participants in the overall market. We saw the IPO market dry up and these stocks that are reliant upon future earnings as well as debt, as well as valuations from private equity and hedge fund investors. Those situations did fall back to earth and that sector of the market certainly was out of favor. Ipos became virtually nonexistent, private equity slowed meaningfully, real estate investment trust re-evaluations declined and we saw a big slowdown in funds getting plowed into some of the re-investment funds. However, companies with strong fundamentals bucked the trend. Now, why did that happen?

Keith Lanton: 3:47

Well, if you think back, the economy has changed in important ways in the last 15 to 20 years, especially post financial crisis. So if you go back to 2007 and 2009 that time period, since then, household debt as a share of gross domestic product has fallen by nearly a third. Credit standards have tightened, with fewer households at risk as a result of the increase in interest rates, and fewer households are borrowing as much as they did going into 2007 to 2009. Partly because the banks won't lend to them and partly because a lot of investors learn their lessons of overextending themselves during the financial crisis. In addition, mortgage borrowing has reverted to conventional 30 year fixed rate mortgages, away from floating rate or adjustable rate mortgages. As a result, the lags between the Fed short rate hikes and debt servicing costs in the household sector have lengthened, so perhaps the effects have been delayed as a result of the fact that households have insulated themselves to a greater extent than they previously have been in past financial cycles. Also, there has been another interesting debt development underway. Rising interest rates have not had any meaningful impact yet on corporate profitability, just as for the household sector.

Keith Lanton: 5:19

The financial crisis unleashed significant changes in the way companies borrow. Companies have reduced their overall debt in the same way households have. Specifically, companies now rely less on short term borrowing, such as commercial paper or bank loans. Instead, they are turning to public and private credit instruments with longer maturities and fixed terms. The commercial paper market is shrunk from $2.2 trillion in 2007 to $1.2 trillion as of early August 2023. In the same span, us investment grade and high yield debt markets have grown from $2.1 trillion to $7.8 trillion and from $700 billion to $1.2 trillion respectively, and these borrowings are typically, as I mentioned, at fixed rates and at average maturities that range from 4 to 10 years. So these effects have lengthened the time it takes for corporate debt servicing costs to rise when the Fed raises rate.

Keith Lanton: 6:16

And that's not all. The most recent data for the second quarter of 2023 earning season shows companies across many sectors are reporting falling net interest costs, despite higher rates at all maturities. How is that possible? Well, mr Dover suggests that part of the answer here may be in the inverted yield curve, with short-term rates above long-term rates. So companies with strong fundamentals are enjoying high cash balances based on resilient earnings as well as prudent capital spending. Therefore, they are enjoying higher interest revenues by parking their money in short dated notes, while their longer-term borrowing has locked in low interest costs. The corporate sector, in some, has been playing an inviored yield curve to its benefit. That is a contributing factor to explain why for virtually every sector in the S&P 500, except consumer staples and healthcare, net interest expense as a percentage of net profits is lower today. That's, net interest expense as a percentage of net profits lower today than it was 20 years ago. Indeed, for the S&P 500 as a whole, net interest expense as a percentage of net profits is only about 40% of the 2003 level.

Keith Lanton: 7:31

So some reasons why, at least for the time being, perhaps there is a lagged effect and why the rise in inflation has been beneficial to corporate America with strong fundamentals we talked about. There are certainly sectors out there that have been dramatically impacted and this is causing a big have and have not effect in the financial markets. In addition, wall Street Journal today talking about how slowing inflation can hit corporate profits, in other words, why rising inflation in the past may have helped corporate profits. Some additional thoughts, additional reasons to put into your thought process. So one of the reasons why these rising inflation has been beneficial to corporate profits, the journal suggests, is that the cost that companies are able to charge for their goods and services has risen faster than their labor costs. Now this is something that is starting to reverse. In the second quarter of last year, employment costs were up 4.5%. Consumer prices were up 4.1%, but if you go back a quarter or two, you were seeing inflation running at 9% and you were seeing labor costs only up about 4.5% as well Obviously a big tailwind to corporate profitability.

Keith Lanton: 8:51

Another factor helping companies is that companies were booking their profits against inventory that had a lower cost. What do we mean by that? Companies are enjoying better profit margins because they had already produced goods and services six to twelve months ago. Those products are sitting in their warehouses. Most companies use by full accounting Excuse me, they use life or account by full, yes, by full accounting. Most companies use by full accounting first in, first out. So what that means is goods and services that were produced six to twelve months ago that are going out the door now Are being booked against prices that have been marked up recently as a result of the fact that the companies have been raising prices. So the companies have been raising their prices, but the goods and services that they're selling are reflective of their cost six to twelve months ago in some cases, and therefore they are experiencing Higher profit margins. Unfortunately, as a result of this, by full accounting what's happening now, things are starting to reverse. The goods and services that they have now in inventory are at the higher cost to them and they are not able to increase the prices as much as they were in the past. So you're going to see margins start to compress from these elevated levels.

Keith Lanton: 10:05

Also, companies have gotten the benefit of the benefits of the fact that their capital expenditures are based on the cost of the goods and services and equipment that they've purchased in the past and they depreciate that going forward. So you bought a new machine a year or two ago and you depreciate that over its lifetime, let's say, five years. The fact that that machine now is going to cost a lot more to replace in a few years from now is not being factored into the current metrics. So the fact that you bought that machine At a good price relative to prices today is helping earnings today, but it is not taking into account the fact that in a few years you're going to have to replace that machine and, of course, hold you're going to have to replace that machine at a higher price. Therefore, you're getting the betting for your buck or the benefit of the fact that this capital expenditure is reflective of old prices. So all these things at the at the moment Contributing to higher profitability for some of the best and strongest companies in the US as a result of inflation, counterintuitive to what we may think, but also to be mindful that these trends may reverse as as we start to see inflation slow down in the future. So some of the reasons why inflation has actually been helping corporate America.

Keith Lanton: 11:30

Let's move on to what's going on this morning in financial markets. Right now we are seeing S&P futures down modestly this morning. Dow futures now down about 50 points. S&p futures down 12.5. Nasdaq futures down about 68 points this morning. Equity futures are seeing some of this pressure from some of the large cap stocks which have been driving the markets higher, sporting pre-open losses. Also, we are seeing rising interest rates this morning and that weighing on some of the equity prices as well. The two-year yield is up five basis points to a 492. The 10 years up five basis points to a 422. And the 30-year also a five basis points to about a 433. So everything from two years out is up about five basis points in yield.

Keith Lanton: 12:24

On Friday we got the employment report. The report looked to show a Goldilocks type scenario. Initially the bond market rallied. Later in the day it sold off. Volume was light and now we are getting some follow-through this morning. This morning Goldman Sachs lowered its US recession probability to 15% from 20%, perhaps attributing to some of the strength in the bond market. As the market expects more expansion and less probability of recession, the Reserve Bank of Australia left its cash rate unchanged at 4.1%.

Keith Lanton: 12:57

Overseas, china's services PMI decelerated again in August, coming in at its lowest level of the year. In Australia their services PMI remained in contraction for the second consecutive month and in the Eurozone, services PMI readings for August confirmed a renewed contraction in activity. Taking a look at markets in Asia, they began Tuesday on a mostly lower note Markets down anywhere from 0.1% to about 2% for the Hang Seng. Eight major European indices are trading near their flat lines.

Keith Lanton: 13:35

Some news this morning New York Times reporting that North Korean leader Kim Jong-un will discuss possibility of supplying weapons to Russia with Vladimir Putin. Wall Street Journal reporting that President Biden and Donald Trump are tied at 46% in 2024 election polling. As 48% of voters believe the economy had gotten worse over the last two years, including large majorities of independence. Wall Street Journal. Chinese developer Country Garden Holdings, one of the big property developers that's been weighing on pressures in China, has narrowly avoided default. Foreigners reporting that China is going to launch a new $40 billion fund to boost their chip industry. Journal reporting that Russia will not rejoin the Ukraine grain deal until its demands are met. This following discussions between Vladimir Putin and President Erdogan of Turkey. And also the Times talking about the UAW United Auto Workers looking more likely that they will strike against the big three automakers. There are two weeks left to negotiate a contract before they say they will go out on strike.

Keith Lanton: 14:48

In company news, oracle or RCL upgraded to overweight from equal weight at Barclays. American Express, up about half of a percent, was upgraded to outperform from sector perform at RBC. Blackstone is going to be joining the S&P 500, replacing Lincoln National, effective prior to the opening of trading on Monday, september 18. Also, airbnb, abnb is going to be joining the S&P 500. It's up about 5.5%, replacing Newell brand symbol NWL Separately. Airbnb in the news today. Today is the day in New York City that if you want to utilize Airbnb, if you're building allows you to that, you need to register it with the city and there are reports that there is a big backlog of license requests amid the new regulations, leading to lots of confusion and frustration. That's according to Bloomberg. Next Gen Health Care symbol, nxgn, is in advance talks with Thomas Bravo for a buyout. So some private equity still taking place. Disney symbol, dis, relatively unchanged this morning as they are urging spectrum CHTR stock symbol customers to watch Hulu, as they have an ongoing dispute between Disney and the spectrum users Disney pulling their cable channels from Spectrum's network amid a dispute over payments for a renegotiation of contracts about how much Disney will get paid by spectrum for spectrum to Enjoy carrying Disney channels.

Keith Lanton: 16:37

Moving on to barons barons in the trader column Talks about the August jobs report showing that the labor markets are cooling and that may persuade the Fed to pause. The jobs report for August was about as good as you can get, they said. It's very Indicative of a Goldilocks report. Yet on Friday the S&P barely budged but it did finish the week up two and a half percent. The Dow finished the week up 1.4 percent. The NASDAQ was up three and a quarter percent last week. Barron saying those gains make sense given the numbers.

Keith Lanton: 17:12

Us government data on Friday showed a larger than expected gain of 187,000 non-farm payrolls in August, but significant downward revisions for the previous two months. Totally, 110,000 fewer jobs than initially reported, pulled a three-month average job growth near 150,000. That is below February of 2020, so below the pre-covid levels. Unemployment rate jumped to 3.8 percent from 3.5. Labor force participation rose point two percent for its first increase since March and even the monthly gain. An average hourly Earning slowed while average hours worked rose. Put it all together in the picture is decidedly encouraging. Labor market continues to rebalance in a healthy direction. The US economy is still adding jobs. The unemployment uptick was due to an increase in labor supply, not mass layoffs. And for employers there are now work, more workers available per open position and wage pressures are abating. Barron saying even the Federal Reserve should be happy. For stocks, the data and set up suggests more gains in the near term, at least through the September Fed meeting.

Keith Lanton: 18:19

Bond yields could drift lower, as we're seeing this morning as the market prices out, fed hikes, reversing More of August, move higher, which weighed on stocks. That process did begin last week. The two-year note that did close Friday at the 487 is now up to 491, but it began last week at a 505. So perhaps some of the weakness in the bond market is undoing a little bit of the rally that that took place, especially on the short end. Investors now have more reason to think that August surge in Treasury yields was an echo of 2022 and the last gas of something old instead of the something new, said David Russell, the global head of market strategy at trade station. It went on to say continued easing in yields could help feed the Goldilocks narrative and comparisons to the 1994 1995 soft landing. Next potential market moving data will be the August consumer price index to be released on September 13th. You, just before the Fed meeting, investors and policymakers will be watching for confirmation that an easing labor market is showing up in the form of less pricing pressure on inflation. It could be a messy report because commodities did rally over the summer, which could push up headline CPI figures.

Keith Lanton: 19:34

So let's talk about September. We've made it, as we said here this morning post Labor Day, we've made it to September, but September is typically a challenging month for financial markets. Stocks have typically been negative in September and they've been negative for three years in a row. In fact, if you look back, september is by far and away historically since 1945, the worst month for equity markets. On average since 1945, post World War II, the S&P has dropped an average of 1.1%, the only month to average a loss greater than 0.13%. But Barron's goes on to say September doesn't have to be awful and history suggests this year might be one of the better ones. The last time, the S&P had a three September losing streak, which is what we're in the midst of now. Going back the last three years, the S&P has been down each of the last three September. The last time that happened was 2014 to 2016. And when that has happened, it followed with a winning streak. So perhaps the three consecutive week September's we've had will now show that we are going to have a better September this year. Also even better perhaps is when the S&P is posted a gain of between 10 and 20% through August, like it has this year. It has averaged a gain of 7.6% for the rest of the year. According to Bank of America, that suggests the S&P could close the year at 4850, which would be a new high for the index. Finally, I will mention one stock and then turn things over to Brad to give us some more insights.

Keith Lanton: 21:23

So one growth company that Barron did speak favorably on is On Sneakers, also known as On Holdings. The symbol of On Holdings is Oscar November, oscar November, so On. On On Holdings makes sneakers that are easy to spot. Nearly all of On Holdings models sport, perforated soles, uncluttered designs and a stacked letter logo that sets them apart from Nike, adidas and other sneaker maker offerings. The company's patented cloud tech cushioning quickly attracted celebrities like Roger Federer. On stock became red hot as well, jumping 70% since the start of the year to around $29 per share.

Keith Lanton: 22:12

Fleetfooted investors, though, barron says, can still get on on the trend thanks to recent pullback in the shares, concerns about inventories, high marketing expenses and lack cluster guidance over shadow and an earnings beat and a guidance raise. Shares fell 14% on August 15th. On closer review, barron says it's unclear what the shares are being punished for. There was nothing particularly concerning, they said, about earnings, certainly not inventory, they said, which reflects attempts to meet demand, nor marketing expenses, which they say were put in place to ensure that demand stays strong. In fact, this is all typical for On, which fell nearly 10% after reporting first quarter earnings. That proved to be a buying opportunity and Barron feels that this drop will also be a buying opportunity On reported sales of $507 million US dollars during the second quarter, up 52% from the previous year and ahead of analysts expectations of $475 million.

Keith Lanton: 23:14

Profit margins expanded to 59.5% from 55.1% held by easing freight costs. Earnings did take a rare dip, but are expected to resume growth, they say, in the quarters ahead. Investors were particularly focused on On's inventory, which more than doubled from the same quarter in 2022. Raising concerns. The shoppers may be tired of the sneakers. Thoughts of Nike, which have been marking down and choose to work off surplus, were probably at the forefront of investors' minds, but at the moment, barron says On is no. Nike Inventory, which includes highly anticipated new sneakers and gear, fell 6% quarter over quarter, while On's direct to consumer business surged nearly 55% in the quarter. Even wholesale partners like Nordstroms have noted that shoppers have been clamoring for On products Discounts even for previous year.

Keith Lanton: 24:08

Models remain slim. Barron's field growth should continue, and not just because of ads featuring Federer and top-ranked tennis player EGAS SwyTech. Onshoos, which account for some 90% of its business, are growing in popularity with serious athletes as well as weekend warriors. Along with its new apparel and accessory lines, and while North America accounts for 60% of its business, on has been expanding its presence in markets like Asia, where sales have nearly doubled On's valuation. It trades at 40, one times forward earnings and that's certainly not cheap. Yet the reason Selloff puts us near its record low valuation of 39 times earnings and well below the nearly 250 times earnings it has averaged since going public in 2021. I'm going to turn it over to Brad to give us some more thoughts and insights. Good morning, brad.

Brad Harris: 24:58

Good morning everyone. There's no rest for the weary in these markets, especially bonds. The volatility in the bond market as equities look actually sane. However, we have to watch out because of rates keep going up. Now, even on the longer end of the curve, the equity market may have a real wake up call. So we have to keep an eye on this 10 year. I think that it might be a little bit overdone here, but let's definitely watch what's going on.

Brad Harris: 25:26

Everything I've been reading, speaking to professionals in the industry, friends and recent economic numbers, including Fridays, are all pointing to stabilization in bonds. But Friday's action, with the 10 year yield down, with the 10 year price down over one point and the yield about 10 base points higher, was shocking. I was hoping to blame that on an illiquid summer Friday, but this morning the bleeding continues a little bit. My bet is that the shorts are building up their positions and the algos are piling on to this short position. So hopefully we will see some stability as the week goes on if we get the continued economic reports that we've been seeing.

Brad Harris: 26:15

As for investing, I've been suggesting for taxable accounts for a while a barbell approach of buying short-term treasuries with better than 5% rate of return barbelled with 20 year-ish 4% municipals. On the munis, I'd like to see at minimum 8 year call protection, even though I don't think the Fed is anywhere near lowering rates. If and when they do, you don't want to get caught having to worry about reinvestment on those short treasuries or money markets or bank CDs or whatever you may be in. So for those and let's also understand the reality here that 4% tax-free is much better than 7% taxable equivalent yield in high tax dates. So you don't want to be too greedy and that's a pretty nice rate of return to lock-in. As always for this week, I expect the unexpected in the markets. The roadmap has been and will continue for the foreseeable future to be blurry, but let's all work together to try and figure this all out. I hope everyone has a great week and I'll send it back to Keith. Thanks.

Alan Eppers: 27:23

(Keith Lanton) Thank you, Brad. That's everything I've got. (Alan Eppers) Thank you for listening to Mr. Keith Lanton. This podcast is available on most platforms, including Apple Podcasts, Spotify and Pandora. For more information, please visit our website at www. heraldlantern. com.

Sophie Cohen: 27:43

Opinions expressed herein are subject to change and not necessarily the opinion of the firm. Past performance is no guarantee of future results. The information presented herein is for informational purposes only and is not intended to provide personal investment advice. It is important that you consider your tolerance for risk and investment goals when making investment decisions. Investing in securities does involve risk and the potential of losing money. The material does not constitute research, investment advice or trade recommendations.