Investment Comments
The S&P 500 reached an intraday high of 6,457 on July 28th, nearly triple its lowest point of 2020. The NASDAQ continued setting new highs into August and has now nearly quadrupled from its relatively recent lows. The One Big Beautiful Bill Act has been a tailwind, extending 2017’s tax cuts and providing visibility for income tax rates, state and local tax deductions, and estate taxes.
Another tailwind is earnings growth. With Q2 earnings season about complete, FactSet’s John Butters reports that 81% of companies have reported positive earnings and revenue surprises, with average earnings growing nearly 12%. Q3 estimates call for 7% earnings growth on average. Strong performance has helped justify high valuations. The S&P’s forward P/E ratio based on analyst estimates has reached 22.1, 10% above both its 5-year and 10-year average.
Continued earnings growth through the rest of the year may necessitate some improvement in the economic picture, which has suddenly turned blurry. July’s employment report calculated 73,000 jobs added, falling short of expectations by about one third. Such a big miss is notable in its own right, but the worse news was that prior months were revised downward by more than 250,000 jobs. Outside of the Pandemic era, it was the largest downward revision since the 1970s. The data was so bad that President Trump alleged a conspiracy to make him look bad and fired the head of the Bureau of Labor Statistics (BLS). No kidding.
July’s unemployment rate ticked higher to 4.2%. Unemployment has very gradually trended higher since bottoming at 3.4% in April 2023. A shrinking workforce has helped suppress unemployment, which is not necessarily a good thing. Immigration crackdowns might also be a driving force. The dim employment picture pours cold water on an emerging economic bull case centered around surprisingly strong GDP growth. Second quarter GDP showed 3.0% annual growth, up starkly from the first quarter’s 0.5% contraction. This level of economic growth is highly inconsistent with such modest hiring and likely results from a combination of statistical noise and businesses stockpiling domestic inventory as a buffer against trade wars, while also delaying imports—a negative to GDP—in expectation of paying lower prices in the future when trade deals are struck. Forward estimates generally call for GDP growth of 2.5%. In the context of the recent data, that feels like a reach. Based on companies’ generally positive Q2 reports, there may be enough momentum to achieve that figure. The risk, however, is to the downside.
Consumer spending and consumer confidence have managed to hang on, both rebounding after diving in April when the stock market corrected. A thriving stock market is generally considered a predictor of strong growth but could also be, ironically, a source of concern given the degree to which the consumer has come to trust and rely on it. Consumers spend more when they feel richer. If a softer economy did cause the stock market to decline, that decline could add fuel to the fire.
Speaking of consumers, the BLS also produces the Consumer Price Index (CPI). Trillions of dollars of inflation-linked securities and labor contracts are tied to the inflation statistic, which also heavily influences Federal Reserve interest rate policy. Elected officials generally desire to see low CPI numbers. The CPI has shown a downward trend ever since peaking in early 2022. That trend is in danger of plateauing, however, around a 3% level that would have been considered quite inflationary during most of the past 40 years. July’s CPI report showed a 2.7% increase for all items and a 3.1% “core” increase backing out volatile food and energy prices. The report was interpreted as tame, but as we say, standards have evolved. It takes some mental gymnastics to turn a 3 into a 2. Playing along, the 2.7%-3.1% inflation reading includes some upward pressure from new tariffs, and we might reasonably conclude that the unaffected, natural, rate of inflation is closer to the Fed’s longstanding 2% target.
The Federal Reserve is widely expected to begin lowering short-term interest rates, with the first cut likely coming in September. President Trump has started haranguing Fed Chair Jerome Powell over the Fed’s inaction on interest rates so far in 2025. The European Union, facing a much softer economy, started cutting rates more than a year ago. The Bank of England reduced rates for the first time in early August. Powell has so far maintained that inflationary risks and economic risks appear balanced at the current level. Cutting rates while inflation remains closer to 3% than to 2% carries risk of touching off a reinflationary period, but with economic data softening it is a risk that the Fed probably has to take.
It will be interesting to see how longer-term interest rates respond. There is no law of economics that says short- and long-term yields must move in parallel. Recent government auctions for 10-year and 30-year Treasuries saw tepid demand. Yields ticked higher but still remain within their tight 2025 range. The poor auction results came despite the Treasury trying to act with a very light touch. Debt issuance has tilted ever more heavily toward Treasury Bills, short-term obligations which the financial system treats similarly to cash. The government financing rising deficits with something akin to money printing has been a longstanding pattern which started under Janet Yellen and which complicates Fed Chair Powell’s dilemma with respect to short-term rates. The Treasury would like to pay less interest. Powell and the more hawkish governors of the Fed presumably harbor doubts about the financial system’s willingness to absorb more deposits at a lower level of return. Gold touched a new all-time high above $3,500 in early August. Bitcoin is flirting with all-time highs in the $120,000 range. People have stored their wealth in gold for millennia. It is a strange modern world in which people flock to the safety of a cryptographic protocol. As we say, standards have evolved.
The stock market’s gains continue to be driven disproportionately by the AI trade. Afraid of falling behind one another, major consumer technology platforms are spending enormous amounts of money in a sort of AI land grab. The winners are the providers of inputs such as chips and servers, and also, increasingly, the human talent who know how to work with them. Meta Platforms (nee Facebook) has reportedly offered 8-figure contracts to key experts in the AI field. NVIDIA, whose graphics processing units have become the choice engine powering AI model training, trades at around 60x trailing earnings and cash flow. Semiconductor companies have historically traded at single or low-double digit multiples during boom times like this, implying that this boom is expected to last much longer than the typical technology adoption cycle. Palantir Technologies provides AI-powered data analysis for decision making. The stock trades at 125x revenue–not profits. Investors clearly think it really is different this time.
We always counsel readers to invest in healthy businesses at reasonable prices. Those instructions are hardest to follow when markets and the economy are languishing and nothing looks healthy. The other hard time to invest our way is when the best-performing stocks reach prices that already seemingly incorporate a great deal of optimism, but investors pursue them anyway out of “fear of missing out.” Far be it from us to try to predict the long evolution of the artificial intelligence space. We can only continue to preach price discipline and diversification. There are probably still opportunities in the AI space if you can find them. If not, it’s still a big world out there.
Miles Putnam, CFA®