Three Market Drivers
We focus on three market drivers that lead to notable movements in the stock market: economic fundamentals, technical environment, and investor sentiment.
Our fundamental indicator follows 19 economic datapoints that track the underlying health of the US economy. From unemployment to homebuilding, changes in these economic datapoints tend to confirm recession or recovery after the technical and sentiment indicators have already reversed.
Dynamic Asset Level Investing, or D.A.L.I., is a technical indicator that compares each of the major asset classes, sectors, and sizes and styles against each other to discover emerging trends in the market. D.A.L.I. compares daily price action of each of these elements on a point-and-figure chart to illustrate momentum. The chart at the bottom of this page shows the current leadership in D.A.L.I.
Our sentiment indicator tracks how everyday investors currently feel towards the U.S. economy and the stock market. Between our own polling and professional surveys like the American Association of Individual Investors (AAII) Investment Sentiment Survey and Citigroup’s Panic/Euphoria Model, we track the two most dangerous emotions for investors: fear and greed.
Here is a breakdown of where each market driver currently sits:
U.S. Inflation came in at 8.5%, which is the highest level since December 1981. In response, the Federal Reserve has begun to publicly float the idea of a 0.50% rate hike around. We will have to see if the Fed commits to this idea at the next Fed meeting, which takes place at the beginning of May.
The Nasdaq-100 was unable to reclaim its 200-day moving average, and now finds itself below its 50-day moving average. The S&P 500 also lost support from its 200-day moving average, but remains above its 50-day moving average. Recapturing these major averages will go a long way towards rebuilding support.
The AAII Investment Sentiment Survey found that only 15.8% of investors feel bullish about the next six months in the market, which is the lowest weekly bullish sentiment since September 1992.
Earnings Season: How it works
As we leave a tumultuous first quarter behind us and enter earnings season, it is time to review where and how the stock market and economy intersect. While it can seem crazy to see the stock market demonstrate strength since 2020 given the current economic environment of rampant inflation and mixed economic data, understanding what the stock market actually follows helps to explain this disconnect.
In the same way home values are determined by the income you could generate by renting, the valuation of the stock market is driven by corporate earnings. Every three months, companies must publicly disclose their corporate earnings for the quarter so that investors can remain informed on the health and success of the company. Conveniently, the majority of companies report this financial information around the same timeframe; this is known as “earnings season.”
During earnings season, there are two main financial measures that investors focus on: revenue growth (also known as sales growth), and earnings (net income) that are measured as earnings-per-share, or EPS. Generally speaking, earnings tend to be the most important measure, as it is a measure of the true profitability of a company. For example, a company can have positive sales growth and negative earnings if the company’s expenses are high enough. By observing earnings, investors are able to view how efficient a company is with its revenue and expenses.
While negative earnings are typically a bad thing, there are exceptions. For example, companies that are in their growth stage tend to reinvest most of their revenue back into the company to promote growth, innovation, increased market presence, etc. By reinvesting this money into the company, these growth companies may have both astronomical sales growth and negative earnings. In this situation, negative earnings would not be as strong of a deterrent as it typically is, as investors would understand that the company is currently more focused on maximizing its growth than its profitability. In short, both sales growth and earnings are invaluable for understanding a company’s financial health in their own, unique ways.
Now that we know which financial measures are important, you may be wondering why earnings season tends to see such violent and volatile swings in stock prices in either direction. In between earnings seasons, Wall Street analysts track companies and create estimates for their upcoming earnings releases, which is where the idea that a company “beats” or “misses” on earnings and revenue comes from. If a company significantly misses these estimates, this is typically when you will see steep, one-day drawdowns. Likewise, companies who blow out Wall Street estimates are typically the situations where you will see a stock’s price skyrocket overnight.
By understanding the impact corporate earnings has on stock prices, you can now see how the stock market has much more to do with a company’s financial information than macroeconomic data like unemployment and jobless claims. As such, it should now be easier to understand why some companies held up relatively well during the crash in 2020; while certain industries had to shut down entirely, companies who were able to manage the lockdowns through an online presence continued to see positive financial data despite the economic shutdown. If there was ever a lesson to be gained from 2020, it is another reminder of the reality mentioned at the top: the stock market is not the economy.
Large Cap indices
S&P 500: -6.71%
Dow Jones Industrial Average: -4.88%
MID AND SMALL CAP INDICES
S&P 400 (Mid Cap): -6.97%
S&P 600: (Small Cap): -7.75%
Russell 2000: -9.81%
MSCI EAFE Developed Index: -9.51%
MSCI Emerging Markets: -9.15%
MSCI ACWI ex-US: -8.52%
ECONOMIC SECTOR INDICES
Basic Materials: -1.49%
Communication Services: -14.77%
Consumer Discretionary: -11.30%
Consumer Staples: 2.52%
Real Estate: -5.51%
Are Rising Mortgage Rates a Concern?
To put it mildly, the real estate market has been on fire as of late. In spite of this, we believe it is worth keeping diligent eye on the housing market, as we are seeing some historic movement in mortgage rates. As of this writing, the average rate on a 30-year fixed-rate mortgage is roughly 5%; this is the first time since February 2011 that the average rate has reached 5%. For perspective, the average rate a year ago was just over 3%. However, it’s not just the average rate that has been a notable increase, but also the speed at which these rates have increased.
The average 30-year fixed-rate mortgage at the end of 2021 came in around 3.11%, whereas the first quarter of 2022 ended with an average rate of 4.67%, or a difference of 1.56%. That quarter-over-quarter (QoQ) increase is the third-largest increase since at least 1970, with only Q1 1980 and Q3 1981 having a larger QoQ change. With an increase of this size, we believe it is worth looking into what could be the possible consequences of a rapid ascent in mortgage rates.
Even prior to COVID and the inflation we are seeing today, homeownership had become less achievable for the average American. A recent study by the National Association of Realtors found that the median age of home buyers in 2021 was 45 compared to the median age of 31 in 1981. While there are multiple variables involved, a notable one is economic constraints such as student loan debt that have been felt by younger generations, particularly millennials as they enter into middle age. Add in higher mortgage rates and inflated home prices, and the prospects of homeownership may become even more difficult.
However, even with an average mortgage rate of 5%, there is still one silver lining for the unique economic environment we find ourselves in: negative real mortgage rates. Real mortgage rates are simply mortgage rates minus the current inflation rate. With inflation coming in at -8.5% and the average 30-year fixed-rate mortgage around 5%, this means that real mortgage rates are currently around -3.5%. As strange as it sounds, a negative real mortgage rate means that homeowners are essentially getting paid to borrow money. This phenomenon has been rare in U.S. history, as the most recent occurrence was for a few months between 1979 and 1980.
One other factor to consider is home construction. U.S. housing starts have historically needed to maintain an annualized pace of 1.5 million per year to keep pace with population growth, immigration, and net scrappage. For the past decade, however, the U.S. has been notably underbuilt in housing. While rising interest rates will impact the costs of construction and developers taking on loans to finance these projects, home construction may be necessary to make up for housing starts lagging the pace of population growth. In short, regardless of higher interest rates, the U.S. needs new homes.
While negative real mortgage rates and the U.S. being underbuilt may provide tailwinds in the short term, it is still worth being mindful of potential headwinds. The pace of rising mortgage rates has been the highest in at least 40 years, and it doesn’t seem to be slowing down anytime soon. Also, if a combination of further rate hikes and decreased consumer spending occurs, inflation may fall low enough to make real mortgage rates positive again, removing a notable incentive for home buyers. Likewise, saving for a home has already been a notable struggle for current generations, and higher mortgage rates and home prices may continue to price out these prospective home buyers. While we can’t know for certain which scenario will play out, we do believe it is prudent to keep an eye on mortgage rates and their movement moving forward.
Chairvolotti Financial, Inc. dba 401karat is a Registered Investment Advisor.