Last week many investors were bracing for the “long-awaited” rise in the consumer price index and a subsequent market selloff. Instead, the CPI report matched consensus expectations, igniting a rally in the market.
The CPI rose 0.2% in July. The inflation index is now up 2.7% year-over-year. The all-important core CPI, which excludes food and energy, also matched consensus, coming in at 0.3% in July and up 3.1% year-over-year.
However, after digging into the numbers, what we at Cornerstone find most interesting is the trajectory over the past six months. That period encompasses higher U.S. tariffs. And yet, overall inflation has risen at an annualized rate of just 1.9%:
Significantly, there was an immediate 94% jump in the CME FedWatch’s odds of a September interest rate cut by the Federal Reserve:
To us, that’s evidence the markets interpreted last week’s CPI report as doveish, creating foundational support for the market rally we experienced.
Recession?
The CPI data caused us to investigate commentary by S&P 500* companies in their most recent earnings calls. We wondered how often companies commented on recessions during their Q2 earnings calls, especially given the overall concerns this year about tariffs and a potential economic slowdown.
Thanks to FactSet we know the answer, and it’s not much. From June 15 to Aug. 7, the term “recession” was cited on 16 earnings calls. That’s well below the five-year average of 74 and the 10-year average of 61:
Furthermore, this figure is an 87% decline compared to the first quarter, when the term “recession” was cited 124 times. This quarter, the word has been said on only 4% of the 442 earnings calls through Aug. 7.
Maybe most surprisingly is that six of the 11 sectors saw no companies cite recession:
To us, that further reflects continued corporate strength through earnings and profits.
Don’t Look at Valuation in a Vacuum
Sitting here today, we’ve received most of this quarter’s critical market and economic data. So, it’s important to discuss and debunk the “bear-ista” concern over “elevated” valuations coming out of this earnings season.
In fact, plenty of areas are not currently trading at extremes. So, objective data doesn’t support the idea that stocks are widely overvalued.
Don’t look at valuation in a vacuum. Per-share earnings growth must be considered. That’s because if EPS growth is occurring, elevated valuations have never been a reason to sell.
Stocks currently trading at a premium have the earnings growth to justify it. Remember that the market is a forward-looking pricing mechanism. Growth stocks and cyclical sectors like technology, communications, industrials, and financials are the winning sectors compared to the rest of the S&P 500:
The recent growth of these sectors has increased their weighting in the S&P 500 to 60% overall. That is what has contributed to perceived inflated large-cap valuations.
But if you dig into it, these growth stocks are the reason that second-quarter S&P 500 EPS has grown to over 10% versus the 5% originally expected. For example, “Magnificent 7” profits alone grew 15.5% versus just 4.5% for the remaining 493 companies in the S&P 500.
Net profit margins came in at about 12.3% this past quarter. It's clear there is plenty of growth and profit supporting the forward-looking valuations.
It's also important to recognize that in areas that aren’t seeing this level of growth, we’re also not seeing stretched valuations:
- The equal-weight S&P 500 is priced at 17.7 times future earnings,
- The S&P MidCap 400 is at 16.7 times future earnings, and
- The S&P Small Cap 600 is at 15.6 times future earnings.
The good news is there are a handful of macro reasons to believe that this profit momentum will continue to broaden:
- The labor market isn't as weak as many believe – the four-week moving average of weekly jobless claims is 221,000 versus an average 362,000 since 1967.
- Upcoming fiscal and monetary policy stimulus (e.g., tax cuts and Fed rate cuts) and continuing deregulation are already paving the way for increased merger & acquisition activity.
There’s also been a recovery in corporate capital expenditures from 2022 lows, which supports current valuations. Will it continue?
Well, history tells us that as corporate tax rates fall, businesses tend to invest more. Thus, if history repeats itself, it's fair to anticipate a continued increase in capital expenditures. Since 1962, capital expenditures have averaged a 2.5% year-over-year increase when corporate taxes fell:
How does this relate to equity valuations? Since 1985, there is a strong correlation between corporate spending and P/E multiple expansion. Why?
It’s because markets look ahead and higher capital spending is a sign of corporate confidence. That can make corporate equities currently appear rich to some investors.
But history shows how valuations often later normalize as anticipated earnings growth is validated in future quarters. We've seen this dynamic happen repeatedly. When companies are investing, equity valuations climb 81% of the time, historically:
Drilling down to the sector level further confirms the outperformance during capital expenditure increases. Typical forward relative performance, within cyclical sectors, in years after capital spending increases has beaten the S&P 500 by 0.8% versus -2.4% in defensive sector underperformance:
This reflects the strength in cyclical sectors like tech, communications, financials, industrials, and AI-related utilities.
Many pundits have continually misunderstood the correlation between valuations, capital expenses, and earnings growth over the last four months. Following historical objective data has once again turned out to be a more prudent course.
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*Past performance does not guarantee future results.
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* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
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