Rallying Market Ignores Warning Signs: Our Monthly Survey of the Economy, Interest Rates, and Stocks

In this edition, we say viva Veeva; the China housing market is building up to something positive; computer software has a great future; and Sensata, Sunny Optical, and Onsemi.

The major stock indices recently completed four straight weeks of impressive gains and many believe it's clear sailing until the end of the year. When seasonals work, we hear about it constantly. When they don't, bad news will be blamed on 'something.' While the recent gains have been welcome, short- and intermediate-term momentum gauges are stretched -- so a pause/pullback would be a technical positive. There is an old saying: 'There is only one free lunch on Wall Street.' That references a pullback in the middle of December.

This pick list highlights constituents of the Morningstar US Large Cap Index that we believe offer investors the best risk-adjusted return prospects. Stocks of large-cap companies where neither growth nor value characteristics predominate. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap.

Our bond/stock asset allocation model is indicating that bonds are the asset class offering the most value at this market juncture, as interest rates have risen over the past few weeks. But stocks are not yet seriously overvalued. Our model takes into account current levels and forecasts of short-term and long-term government and corporate fixed-income yields, inflation, stock prices, GDP, and corporate earnings, among other factors. The model output is expressed in terms of standard deviations to the mean, or sigma. The mean reading from the model, going back to 1960, is a modest premium for stocks, of 0.15 sigma, with a standard deviation of 1.0. The current valuation level is a 0.90 sigma premium for stocks, which is inside the normal range but up from the 0.50% sigma premium at the beginning of the year. Other measures also show reasonable valuations for stocks. The current forward P/E ratio for the S&P 500 is 18, which is within the normal range of 10-21 and down from 22 a year ago. The current S&P 500 dividend yield of 1.6%, while below the historical average of 2.9%, is up from an ultralow 1.2% as recently as 2021. Based on the current valuation levels, as well as our interest-rate and earnings forecasts, we have called for a recovery in stock prices in 2023 from bear-market lows and are maintaining our year-end S&P 500 target of 4,600. Our current recommended asset allocation model for moderate accounts is 68% growth assets, including 64% equities and 4% alternatives; and 32% fixed income, with a focus on opportunistic segments of the bond market.

Monday Tee Up: Inflation and Jobs

This pick list highlights constituents of the Morningstar US Large Cap Index that we believe offer investors the best risk-adjusted return prospects. Stocks of large-cap companies where neither growth nor value characteristics predominate. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap.

This pick list highlights constituents of the Morningstar US Large Cap Index that we believe offer investors the best risk-adjusted return prospects. Stocks of large-cap companies where neither growth nor value characteristics predominate. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap.

This pick list highlights constituents of the Morningstar US Large Cap Index that we believe offer investors the best risk-adjusted return prospects. Stocks of large-cap companies where neither growth nor value characteristics predominate. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap.

Weekly Tee Up: Jobs Friday

This pick list highlights constituents of the Morningstar US Large Cap Index that we believe offer investors the best risk-adjusted return prospects. Stocks of large-cap companies where neither growth nor value characteristics predominate. Stocks in the top 70% of the capitalization of the U.S. equity market are defined as large cap.

We recently raised our rating on the Technology sector to Over-Weight from Market-Weight. As interest rates start to fall, IT demand in enterprise and data center markets is holding up. And mounting interest in ChatGPT could herald the age of AI, which could be a huge industry driver. Over the long term, we expect the Technology sector to benefit from pervasive digitization across the economy, greater acceptance of transformative technologies, and the development of the Internet of Things (IoT). Healthy company and sector fundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad international business exposure. The sector is outperforming the market thus far in 2023, with a gain of 12.4%. Tech underperformed the market in 2022, with a loss of 28.9%, and outperformed in 2021, with a gain of 33.4%. The P/E ratio on projected 2023 earnings is 23, above the market multiple. Earnings are expected to grow 14.5% in 2023 after having fallen 3.3% in 2022. Earnings rose 37.9% in 2021 and 7.7% in 2020. The sector's debt ratios are below the market average, as is the average dividend yield of 0.5%. Here is how we use our analysts' Technology sector ideas in our Focus List and Model Portfolios.

In the near term, the S&P 500 (SPX) is heading toward several important pieces of resistance following the rally off the March 13 intraday low of 3,809. Back in the latter part of February, the SPX broke down out of a bearish wedge, backtested the lower line of the pattern, and continued lower. From the February 2 closing high to the recent closing low, the index gave up almost 8% (or 324 points). Based on the size of the wedge, a minimum target was down at 3,656 -- which the index didn't come close to hitting.

The stock market has pretty much been dancing to the bond market's tune in 2023. Bond yields decline, and stocks rise as they did in January. Bond yields rise, and stocks fall as they have done in February. Investors may be 'getting used to' higher rates, because stocks have held a portion of their January gains even with the return of interest rates to the beginning-of-year-levels.

Black Friday. Cyber Monday. The retailers are out in force, with a massive marketing push to win consumer dollars during this key holiday shopping season. One dubious gift from 2022 is much lower stock prices. Just like retail merchandise, stocks seemingly are at a big discount right now. But investors must shop with care, focusing, in our opinion, on quality companies with solid finances, proven track records, and strong management teams. This week, we used the Argus Screening Tool to find a list of companies that appear to be low risk, have strong balance sheets, and seemingly represent undervalued opportunities. Specifically, we screened the Argus Universe of Coverage for companies with a BUY rating, a market cap over $8 billion, and with a HIGH financial strength rating from Argus. Then we sorted for those furthest away from their Argus 12-month target price (suggesting a deep discount). The following list is weighted towards Technology -- which is not surprising after the beating the sector has taken so far this year.

Stocks rose on Wednesday morning as investors weighed new employment and manufacturing data, and awaited the release of the Fed's latest meeting minutes this afternoon. The Labor Department said that first-time claims for state unemployment benefits rose by 17,000 to 240,000 for the week ended November 19, above the Reuters consensus forecast of 225,000. Capital goods orders were stronger than expected. The Commerce Department said that orders for core capital goods excluding aircraft rose 0.7% in October after a 0.8% decline in September. The consensus forecast had called for flat orders last month. The Dow rose 0.1%, the S&P 0.3%, and the Nasdaq 0.7%. Crude oil fell sharply to $78 per barrel, while gold traded near $1744 per ounce.

Innovation may be hard to define. But to borrow from former U.S. Supreme Court Justice Potter Stewart, you know it when you see it. The United States economy is full of innovation. It has to be. Manufacturing industries that dominated the economy decades ago - textiles, televisions, even automobiles to a large degree - have moved overseas, where labor and materials costs are lower. Yet the U.S. economy, even during the pandemic and the current period of high inflation, has expanded to record levels. If U.S. corporations weren't innovating, creating new products (such as vaccines) and services (such as Zoom calls) and moving into new markets and applications, the domestic economy would not be growing, and capital would not be flooding into the country. The current high level of the U.S. dollar relative to currencies around the world attests to the confidence that global investors have in the innovative U.S. economy.

Monday Tee-Up: August Jobs and Powell's House of Pain

Reading Tea Leaves on the Labor Market |Jobs Friday

Innovation may be hard to define. But to borrow from former U.S. Supreme Court Justice Potter Stewart, you know it when you see it. The United States economy is full of innovation. It has to be. Manufacturing industries that dominated the economy decades ago - textiles, televisions, even automobiles to a large degree - have moved overseas, where costs are lower. Yet the U.S. economy, even during the pandemic, has expanded to record levels. If U.S. corporations weren't innovating, creating new products (such as vaccines) and services and moving into new markets and applications, the domestic economy would not be growing, and capital would not be flooding into the country. Consider that U.S. GDP was approximately $1 trillion in 1930 but was more than $24 trillion at the end of 2021. That's growth of 24-times. Meanwhile, the U.S. population has grown less than three-times during that time span, to 320 million from 120 million. The delta between GDP growth and population growth has been driven, in large part, by innovation.

With the market focus shifting from inflation to the Russian invasion of Ukraine, stocks finished last week with a surprise two-day rally that included the best stock day of 2022. On Friday, the Dow Jones Industrial Average soared by 835 points, or 2.51%. The S&P 500 rose 2.24%, and the Nasdaq Composite gained 1.64%. For the week, the DJIA was down 20 points, or 0.1%, while the S&P 500 rose 0.82%, and the Nasdaq Composite gained 1.09%. For the year to date, the Dow is down 6.2%; the S&P 500 is off 8.01%; and the Nasdaq Composite remains in correction territory though off its lows, down 12.47%.

Stocks slumped in late November due to the onset of the Omicron variant. But heading into the homestretch for 2021, stocks maintain a sizable performance lead over bonds. Our Stock-Bond Barometer is close to equally balanced between stocks and bonds for long-term investors. In other words, these asset classes should be near their normal weights in diversified portfolios. We have looked for large-cap companies with strong balance sheets and experienced managements to lead during the eventual recovery from COVID-19. This has played well, and now, with vaccines being distributed, small-cap risks are reduced and values are attractive. Our recommended exposure to small- and mid-caps is now 15% of equity allocation, in line with the benchmark weighting. U.S. stocks have outperformed global stocks over the trailing one- and five-year periods. We expect this to continue over the long term, given volatile global economic and currency conditions. That said, international stocks offer favorable near-term valuations, and we target 15%-18% of equity exposure to the group. Value took an early lead in 2021, but recently growth has outperformed. We anticipate that growth, led by Tech and Healthcare, will once again outperform value, led by Energy and Materials, as long as interest rates remain low.

Stocks fell on Tuesday morning amid continued uncertainty about the impact of the new Omicron variant, including its ability to evade vaccines and force a new round of lockdowns. Moderna CEO Bancel noted that she expects the current vaccine would be less effective against the Omicron variant. Fed Chair Powell, in remarks made before the Senate Banking Committee said that due to rising inflation, the central bank may speed up the pace of tapering. The Dow fell 1.3%, the S&P 1.2%, and the Nasdaq 1.3%. Crude oil fell 4% to $67 per barrel, while gold traded near $1781 per ounce.

The United States economy is full of innovation. It has to be. Manufacturing industries that dominated the economy decades ago - textiles, televisions, even automobiles to a large degree - have moved overseas, where costs are lower. Yet the U.S. economy, even during the pandemic, has expanded to record levels. If U.S. corporations weren't innovating, the domestic economy would not be growing and capital would not be flooding into the country. Consider that U.S. GDP was approximately $1 trillion in 1930 but nearly $23 trillion at the end of 1H21. That's growth of 23-times. Meanwhile, the U.S. population has grown less than three-times during that time span, to 320 million from 120 million. The delta between GDP growth and population growth has been driven, in large part, by innovation. In addition, the value of listed corporations on U.S. stock exchanges at the end of 2020 was approximately $41 trillion, according to SIFMA, representing 38% of global equity market capitalization, while U.S. GDP represented only 26% of global GDP. The current low level of interest rates and the relatively high level of the dollar both attest to the confidence that global investors have in the innovative U.S. economy.

The Technology sector started slowly in 2021 as investors focused on value stocks. But the sector has come on strong in recent months (up 22% year-to-date) and now is outperforming the market (up 20.7%) as well as value sectors such as Consumer Staples (+8%), Utilities (+10%), Materials (+17%), and Industrials (+18%). The sector is the largest in the U.S. market and now accounts for more than 28% of the S&P 500. Over the long term, we expect the sector to benefit from pervasive digitization across the economy, greater acceptance of transformative technologies, and the development of the Internet of Things (IoT). Healthy company and sector fundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad international business exposure. We have an Over-Weight ranking on the Tech sector and think investors should look to allocate up to 30% of their diversified portfolios to the group. Here is how we use our analysts' Tech sector ideas in our Focus List and Model Portfolios.

Stocks rose on Friday morning after Fed Chair Jerome Powell said that the central bank would move cautiously as it prepared to taper its bond buying program, and steered clear of announcing a specific timeline. Mr. Powell also reiterated his view that current high inflation would prove temporary. Meanwhile, new data showed slower growth in consumer spending. The Commerce Department said that U.S. consumer spending rose 0.3% last month, in line with the Reuters consensus forecast but down from 1.1% growth in June. The Dow rose 0.6%, the S&P 0.8%, and the Nasdaq 1.1%. Crude oil traded near $68.50 per barrel, while gold rose $14 to $1809 per ounce.

Stocks were mostly lower on Thursday morning, with the sharpest declines in Technology and Communication Services. On the employment front, the Labor Department said that first-time claims for state unemployment benefits fell to 385,000 for the week ended May 29, down from 405,000 a week earlier and slightly below the Bloomberg consensus of 387,000. The Dow rose 0.2%, the S&P fell 0.2%, and the Nasdaq fell 0.8%. Crude oil fell slightly to $68 per barrel, while gold traded near $1871 per ounce.

The economic data that has emerged in recent weeks illustrates that conditions are improving, though serious risks remain. The primary driver of GDP over the next few quarters is likely to be public health, as the nation battles COVID-19. Currently, the country is moving beyond the so-called "third wave" of cases, and more states are opening up. The employment environment is in better shape than it was a year ago, though still far from a position of strength, as it had been prior to the pandemic. Consumer confidence also is improving. We expect that rising confidence levels will lead to continued growth in consumer spending. Auto sales have recovered, and the housing market remains strong, even as interest rates tick higher. Businesses are again expanding. Rolling all the data up, our GDP model now calls for a 2.1% increase in absolute GDP in 2Q21 from 1Q21, which translates to an annualized gain of 8.8%. We expect further improvement into 2H21. On an annual basis, we look for overall GDP growth of approximately 5.7% in 2021 and 3.7% in 2022. Our estimates are consistent with consensus forecasts and the outlook from the Federal Reserve, which call for growth of 4%-6% in 2021.

The United States economy is full of innovation. It has to be. Manufacturing industries that dominated the economy decades ago - textiles, televisions, even automobiles, to a large degree - have moved overseas, where costs are lower. Yet the U.S. economy, prior to the pandemic, had expanded to record levels. And now, the U.S. Healthcare industry is mobilizing to improve COVID-19 testing, treatments and vaccines. Consider that U.S. GDP was approximately $1 trillion in 1930 but nearly $22 trillion at the end of 2019. That's growth of 22-times. Meanwhile, the U.S. population has grown less than 3-times during that time span, to 320 million from 120 million. The delta between GDP growth and population growth has been driven in large part by innovation. In addition, the value of listed corporations on U.S. stock exchanges at the end of 2020 was approximately $32 trillion, representing 41% of global equity market capitalization, while U.S. GDP represented only 25% of global GDP. The current low level of interest rates (the benchmark 10-year Treasury bond yield is 1.1%) and the relatively high level of the dollar both attest to the confidence that global investors have in the innovative U.S. economy.

Stocks were mixed on Thursday morning as investors weighed new employment data and awaited comments from Fed Chair Jerome Powell at a Wall Street Journal conference. Mr. Powell is expected to address inflation concerns and rising bond yields, which have rattled equity markets over the last two weeks. The Labor Department said that first-time claims for state unemployment benefits rose to 745,000 for the week ended February 27, up from 736,000 a week earlier but slightly below the Bloomberg consensus forecast of 750,000. The Dow rose 0.3%, the S&P rose 0.3%, and the Nasdaq fell 0.1%. Crude oil rose $3 to $64 per barrel, while gold traded near $1716 per ounce.

The economic data that has emerged in recent weeks illustrates that conditions are improving, though serious risks remain. The primary driver of GDP over the next few quarters is likely to be the country's physical health, as the nation battles the COVID-19 pandemic. Right now, the country is slowly moving beyond the so-called "third wave" of cases, and more vaccines are on the way. The employment environment is in better shape than it was nine months ago, though still far from strong, as it had been prior to the pandemic. Consumer confidence is improving, and we expect that rising confidence levels will lead to continued growth in consumer spending. Auto sales have recovered, and the housing market remains strong. Businesses are again expanding. Rolling all the data up, our GDP model calls for a 1.2% increase in absolute GDP in 1Q21 from 4Q20, which translates to an annualized gain of 5.0%. We expect further absolute improvement into 2021. On an annual basis, we look for overall GDP growth of approximately 3.2% in 2021 and 2.6% in 2022.

After about a month of puzzling sentiment signals from corporate insiders, we finally see some insider-trading data that aligns itself with broader trends in the stock market. By way of a quick review, insiders were more bearish than we expected during the 2020 holiday season. But with the dizzying array of economic, political and global health headlines in play at the time, it was hard to figure what inputs were driving the weak sentiment.

The Technology sector has led the market recovery from the COVID-19 depths of March 2020. Through November 20, the sector was up 31% for the year, compared to a 10% gain for the S&P 500. The Tech sector is the largest in the U.S. market and now accounts for more than 27% of the S&P 500. Over the long term, we expect the Tech sector to benefit from pervasive digitization across the economy, greater acceptance of transformative technologies, and the development of the Internet of Things (IoT): Healthy company and sector fundamentals are also positive. For individual companies, these include high cash levels, low debt, and broad international business exposure. We have an Over-Weight ranking on the Tech sector and think investors should look to allocate up to 30% of their diversified portfolios to the group. Here is how we use our Tech sector ideas from our analysts in our Focus List and Model Portfolios.

Stocks were mixed on Wednesday morning after reaching record levels on Tuesday. On the employment front, first-time claims for state unemployment benefits rose to 778,000 for the week ended November 21, up from 748,000 a week earlier and above the Bloomberg consensus forecast of 730,000. Core capital goods orders excluding aircraft rose 0.7% in October, down from 1.9% in September but above the consensus forecast of 0.5% growth. The Dow fell 0.6%, the S&P fell 0.3%, and the Nasdaq rose 0.1%. Crude oil traded near $45 per barrel, while gold rose $5 to $1809 per ounce.

We continue to think that 2Q20 marked the trough of the recession, and that GDP results are going to improve through year-end and into 2021. How rapidly things improve, as we have said, depends on the status of public health and the number of COVID-19 cases in the U.S. Given all the uncertainty, economists' forecasts are all over the map. Members of the Federal Reserve call for a 6.5% GDP decline in 2020, a 5.0% rebound in 2021 and another year of above-trend growth (at 3.5%) in 2022. The Atlanta Fed GDPNow forecast calls for a 3Q rebound of 26%. Our quarterly forecasts call for a 6% increase in absolute GDP in 3Q from 2Q, which in our model translates to an annualized gain of 24.0%. Our annual forecasts now call for overall GDP to decline about 1% in 2020 and rebound 3.2% in 2021. The economic data that has emerged in recent weeks (ranging from consumer confidence and spending, to housing statistics and auto sales, and to manufacturing surveys and even financial market performance) illustrates that conditions are improving, yet serious risks remain.

We continue to think that 2Q20 marked the trough of the recession, and that GDP results are going to improve through year-end and into 2021. How rapidly things improve, as we have said, depends on the status of public health and the number of COVID-19 cases in the U.S. Given all the uncertainty, economists' forecasts are all over the map. Members of the Federal Reserve call for a 6.5% GDP decline in 2020, a 5.0% rebound in 2021 and another year of above-trend growth (at 3.5%) in 2022. The Atlanta Fed GDPNow forecast calls for a 3Q rebound of 26%. Our quarterly forecasts call for a 6% increase in absolute GDP in 3Q from 2Q, which in our model translates to an annualized gain of 24.0%. Our annual forecasts now call for overall GDP to decline about 1% in 2020 and rebound 3.2% in 2021. The economic data that has emerged in recent weeks (ranging from consumer confidence and spending, to housing statistics and auto sales, and to manufacturing surveys and even financial market performance) illustrates that conditions are improving, yet serious risks remain.