Equities paused their early August momentum, becoming somewhat rangebound for about five trading days leading up to last week's July consumer price index report on Wednesday morning.
Going into the CPI report, Wall Street expected July “core” CPI (not including volatile food and gas prices) to be about 0.22% month-over-month:
We at Cornerstone expected the July “core” CPI to be in-line or softer than consensus. That’s because we believe the overall inflation trend will fall through the remainder of this year.
Wednesday morning, the actual “core” CPI data came in at 0.2% month-over-month (slightly softer than expectations), leading to the “core” CPI year-over-year increase of 2.5% – another decrease from last month's 2.6%.
Equity markets immediately responded positively to this report, with continued market strength the rest of the week.
The logical reason for this initial upside equity catalyst is that it strengthens the argument about inflation falling in the coming months. That would mean the current popular narrative of the Federal Reserve hiking rates doesn’t happen.
Leading into last week's report, the bond market was pricing in a 52% chance of a September hike. But it should trend towards zero by the end of this month because of the softer positive data.
Last week's initial positive market reaction is an early indicator in support of this thesis. If our expectation is accurate, then the bond market will begin to flip doveish, reducing the risk premium in bond market pricing.
That would create an immediate positive effect for equities because it would support rising price-earnings equity multiples. That could be the beginning of further P/E expansion, which would also be turbocharged by the extraordinarily strong foundation that’s been created by the continued historic earnings results.
With 90% of S&P 500 companies reporting earnings, 87% of them have reported positive per-share earnings surprises. This positive EPS surprise rate is well above the 10-year average of 76%.
Additionally, in aggregate those companies are reporting earnings 28.9% above estimates, which is astounding when you realize the 10-year average is almost four times less at 7.4%.
If 28.9% is the actual number for the quarter, it will be the highest figure ever recorded since FactSet began tracking this metric in 2008. With earnings season almost completed, the blended earnings growth rate for Q2 is now 50.4% year-over-year:
That’s more than double the initial earnings growth expectation rate of 23.1% when earning season began.
More importantly, last week provided us with new information in support of earnings strength to continue.
The first example is the announcement by NVIDIA of $500 billion in financing being made available for customers from a consortium of the biggest and most important banks on Wall Street.
The reason this matters is it’s the first instance of bank financing and compute infrastructure capital expenditures. Structuring this now provides new sources of capital for the AI buildout, creating additional liquidity and transparency. That should lower the overall cost of funding.
It also provides the market with confidence that the AI infrastructure spending will continue. Thus, the revenue and earnings realized by the greatest beneficiaries of the infrastructure buildout will also continue.
In simpler terms, lower cost of funding plus liquidity plus transparency equals more earnings and upside for AI related stocks.
The second fundamentally important information provided last week came directly from CoreWeave CEO Mike Intrator during and after their earnings call. Specifically, he said they’re able to contract 2020 CPU architecture all the way out to at least 2029 at full cost.
This helps debunk the “AI bubble” point about equipment having a short useful life and needing to be refreshed within a few years. If those concerns were accurate, then it would be significantly more difficult for these companies to be able to generate large enough returns to support AI financing and profitability simultaneously.
The fact that even older NVIDIA A100 units will still generate full revenue at least twice as long as initially predicted provides long-term profit margin sustainability. It also begins to support the most bullish of unit economics.
Of course, what matters most is earnings, earnings, earnings. The Q2 results combined with announcements like the two made last week show why analysts keep increasing their earnings estimates for Q3 (the bottom-up estimate as of the end of July was increased by 0.3%).
Typically, analysts reduce their earnings estimates during the first month of a quarter. Specifically, over the last 20 years, the average decline in the bottom-up EPS estimate during the first month of the quarter has been -1.9%.
This earnings momentum strength isn’t a one-quarter outlier. It’s the fourth time in the past five quarters that the bottom-up EPS estimate has increased. It’s now a trend, not an aberration.
Additionally, analysts expect it to continue. They’ve increased bottom-up EPS estimates for the full year through the end of July by an astounding 3.2%.
This means analysts are now predicting year-over-year earnings growth of 30% for the entire year. This level of earnings strength now compresses the forward 12-month P/E ratio for the S&P 500 to 20.0, which is below the 20.4 recorded prior to this earnings season.
Taken together, this is evidence that the groundwork has been laid for significant P/E expansion to support increasing equity market prices. This fundamental strength is also evidence of why institutional inflows exploded ever since the irresponsible leverage in the system was wiped out at the end of last month:
If there's one lesson we can learn from the last month, it’s how quickly the narrative can change from emotional decision making to fundamentals-based decision making. It’s a stark reminder of why removing emotion from decisions allows us to avoid foolishly trying to time the market.
Notice above how history clearly shows us that any attempt to time the market significantly increases risk and decreases returns.
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