We hope you had a good, productive, and peaceful week. It appears that the markets are trying to digest the latest data, economic inputs, and newsworthy items. We want to take a look at a few of these and determine what, if any, effect they may have on the markets in the near future.

Please note that we have officially started the summer malaise. This is the time of the year that markets experience less volume, more volatility, and potentially subpar performance from the indices. But first, let’s examine the big data points from this week.

1. Fitch US Credit Downgrade

By now, most of you know that one of the big three ratings agencies, Fitch, cut the credit rating for the United States from AAA to AA+. This was a notch down in the US credit rating by Fitch.

This action was immediately met with higher interest rates across the curve. The two most-watched, longer-term US Treasury bonds, the 10-year and the 30-year, sold off on the news (rates went higher). Both instruments broke through their long-held resistance (for the 10-year this was the pivotal 4.0% barrier). The 30-year climbed 9 basis points to 4.10 in Asia on Tuesday afternoon.

Fitch said that tax cuts and new spending initiatives, along with several economic shocks, have pushed up budget deficits. The rating agency voiced concern about the sustainability of the interest payments on our current debt, which are approaching $1 trillion and climbing.

The move follows a decision by S&P Global Ratings to downgrade the US from its top tier in 2011, and leaves Moody’s Investors Service as the only one of the main ratings agencies to keep the nation at its highest level.

In their statement, Fitch offered the following:

“The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades.”

That erosion in governance “has manifested in repeated debt limit standoffs and last-minute resolutions,” the ratings company said. My initial thought was, “what took them so long?”

Prominent economists Larry Summers and Mohamed El-Erian joined a cohort of their peers in criticizing Fitch Ratings’ decision to downgrade the US given signs of resilience in the world’s largest economy.

Bloomberg strategists said: “There shouldn’t be much lasting impact on Treasuries as Fitch put the US onto a stable outlook from negative. That means another move is very unlikely — it's a one-and-done operation and marking to market with S&P’s AA+ rating.”

As you can see from the chart below, the last credit downgrade in 2011 by Standard & Poor’s had little lasting effect on higher Treasury rates afterwards.

At the end of the day, most economists’ prognosis of the Fitch cut is that it may have little effect on US Treasuries. The US sovereign rating may have slipped, but Treasuries remain a buy.

2. Debt is Beginning to Alarm More Than the Ratings Agencies

Part of the issue that Fitch has, along with the other rating agencies, is not only the growth of interest payments on that debt, as stated above, but also the ever growing deficit. Outside of COVID-19 and the 2020-2021 pandemic, 2023 will prove to be the largest deficit in history.

While the economy is on better footing since the pandemic, the government, with its many social spending issues, has continued to spend money well above the budget at an alarming rate. Revenue receipts this year by the government are expected to fall a minimum of 10%, exacerbating revenue shortfall projections. Take a look at the revenue projection chart below.

3. 10-Year Treasuries Cross the 4.0% Barrier

Perhaps even more impactful this week than the actual ratings cut was the spike in rates of the US Treasuries. Thursday, the 10-year hit 4.18%, marking an eight-month high.

Crossing the 4.0% barrier on the 10-year may put a short-term buffer on the stock market. You might notice the last highs in interest rates came in October 2022 and were in line with new lows on the S&P 500 index.

We have shared with you in recent outlooks that during 2022/23, when the 10-year Treasuries wandered above 4%, it halted stock advancements. This week was no exception. The S&P 500 index was down 2.2% for the week while the Dow fared a bit better, only down -1.1%. However, the tech heavy Nasdaq 100 (QQQ) was down about 3%

A move higher (and a breakout) in US Treasury rates would put pressure on stocks as some investors (and institutional funds) move assets to higher-yielding Treasuries and corporate paper, which attracts capital at these higher rates.

Also, Wall Street analysts, who are the architects of sophisticated earnings models, have to adjust their earnings models to include higher interest rates. That usually means that they will use lower P/E multiples for a fair value calculation. They then get the message out that they are adjusting their price targets down a bit to incorporate the cost of debt.

Higher interest rates can negatively affect the expected price of a company’s stock in the future. We are beginning to see adjustments made during this earnings season. The 30-year Treasury chart below shows its breakout from this week.

We have also commented previously that several sectors, including technology stocks (XLK), recently posted a new all-time high. It is typical that when these things happen, they are ripe for consolidation or correction. Today, with bonds reaching new lows (and higher interest rates), it will likely apply short-term pressure on sectors that were fueled higher by a recent rally in bond prices (and lower yields).

Others, like LPL Research, believe that we are likely making a double bottom in the TLT’s and that this is typically what happens five to six months before a possible recession. Their expectation is that rates will come down and propel stock prices higher over the next 12-18 months (after a soft landing or mild recession).

4. The Jobs Report: Softening but Still Robust

Friday, the markets started out on a positive note as the Jobs report showed less jobs were created than expected. The expectation was for 200,000 plus jobs, and they came in below that at 187,000. Fixed income markets rallied with this perceived softening of the labor markets. Analysts are looking for slower employment numbers to provide the Fed further ammunition to hold off on additional rate hikes.

The Unemployment rate declined from 3.6% to 3.5%. This part of the equation suggests that we are still in a very tight job market with more job openings than people to fill them.

Two Fed officials say those slower employment gains suggest the labor market is coming into better balance, arguing the central bank may soon need to pivot from raising rates to thinking about how long to hold them at elevated levels. “I expected the economy to slow down in a fairly orderly way,” Atlanta Fed President Raphael Bostic said on Friday. “The new numbers are continuing at that pace.”

The markets rallied on these comments and the softening labor market. That is, until the following was released.

5. JP Morgan Released an Economic Note at 1:40 PM on Friday

At 1:45, the S&P 500, which was up for the day, turned and quickly lost all its momentum. Within a matter of minutes, the S&P 500 did a complete reversal and fell 50 points, erasing $400 billion of market cap. Was this a mere coincidence to JP Morgan releasing their note saying they no longer expect a recession? We think not.

How soon before the Federal Reserve comes out and tells us they successfully engineered a "soft landing?"

6. There Are Other Signs of a Slowing Economy (Finally?)

One of the most-watched indicators of the economy is the global supply chain. This incorporates how goods are being moved around the US for distribution. You may notice that the chart below indicates that railroads, at the moment, have slowed dramatically. This may be further proof of what Fed Governor Bostic referred to as “moving in the right direction.”

7. Oil Prices are Rising Again

At the start of the Ukraine-Russia war in 2022, higher oil prices put pressure on the US stock and bond markets. Oil prices came down late last year and into 2023. Then, they spiked again this past spring.

Oil prices have surged in recent months due to deep production cuts by some of the world’s largest exporters, such as OPEC countries and Saudi Arabia (much to the chagrin and requests not to by the United States). The cuts are aimed at shoring up prices amid fears of a global recession and lower demand.

The price of gasoline at US gas stations has recently risen back to prices seen a year ago (around $4.25-$4.50 per gallon for premium unleaded).

8. Earnings Update

According to FactSet, 84% of S&P 500 companies have reported their Q2 2023 results, with 79% beating their earnings estimates and 65% reporting revenues above estimates. Typically, about 80% of companies beat earnings, so these numbers are in line with that. However, remember that earnings have been lowered for the most recent earnings season.

Earnings for some of the mega-caps have been disappointing. This week, Apple and Amazon both reported earnings on Thursday. Amazon crushed the Street’s expectations, and the stock ended the day up 8.2%. Apple beat earnings projections (helped by robust sales in China), but had disappointing phone handset sales. Apple ended the day down -4.8% near the lows of the day. The Apple chart looks like it incurred some damage.

Among the 7 mega-caps (that have been fueling a good part of the 2023 bull market), several have had disappointing stock performance, while others have boasted performances well above expectations since reporting their earnings for Q2.

9. We are Entering the Weakest Period of The Year (August & September) and in The Four-Year Presidential Cycle

Last week, we shared with you the long-term presidential cycle. The pre-election year historically is the strongest. However, the period between August and October of the third year of a four-year cycle (right now) is the weakest period.

The good news (from the chart shown above) is that the fourth quarter of these third years is generally bullish. Here is a chart of the average yearly returns by month. You may notice that August & September are typically the weakest. This is taken from the average of all years.

10. New Bull Markets Don’t Go Up in a Straight Line

For the past few months, we have provided historical charts illustrating the typical, new “bull” market. We thought we would provide a graph to illustrate what bull markets look like. They don’t go up in a straight line.

Some Additional Thoughts About the Markets

While some of the above appears negative, the facts are that consumers have been resilient during 2023. They continue to spend. How long this continues is anyone’s guess.

Inflation has cooled, but we don’t believe we are out of this inflationary cycle, as of yet. Oil is a major component of the CPI and figures heavily into the inflation rate calculation. Oil per barrel is sitting at $82 and trending up. Its recent rise will put pressure on upcoming monthly inflation numbers.

Therefore, we expect those numbers will likely tick up, not down, in the next few months. That very well could motivate the Federal Reserve to take further tightening action.

Economic growth is slowing. If inflation stays elevated, then we will most likely enter a period of stagflation. This is a period that could send stock prices sideways for an extended period.

Looking out over the next 12 to 18 months, we can see lower Treasury yields (hopefully), a stock picker’s market, and returns that are more in line with long-term averages. It is our belief that the “easy money” coming out of 2022 has already been made.

We are confident that our investment strategies, whether utilized through subscriptions or through our assistance, are uniquely positioned to help you navigate through uncertain economic conditions and volatile markets. We will now turn it over to this week’s market summary.

Risk-On

• Despite the nasty market environment this week, our risk gauges still remain in risk-on territory.
• The new high/new low ratio remains positive for the S&P 500, although the slopes of the key moving averages of the ratio are turning down.

Risk-Off

• All 4 key US Indices closed negative on the week, with the S&P 500 (SPY) and Nasdaq both down more than -2% over the past five trading days, while the lagging indices were only down about -1% each for the Russell 2000 (IWM) and the Dow Jones Industrial (DIA).
• The S&P 500 and the Nasdaq appear to be primed for a test of their respective 50-day moving averages.
• Volume patterns weakened across the key indices with the exception of the Dow, which still maintains neutral volume readings. However, all 4 key US indices ended the week with a distribution day on Friday.
• The only positive sector of the markets this week was energy (XLE). In contrast, more speculative sectors such as technology and semiconductors (SMH) were the worst performers, indicating risk-on sectors were hit especially hard by the most recent Fed rate hike.
• Market internals, according to the McClellan Oscillator, continue to weaken, with the McClellan now in negative territory for both the S&P 500 and Nasdaq.
• The new high/new low ratio for the Nasdaq Composite flipped negative. The Hindenburg Omen indicator on the S&P 500 reached new long-term highs, which is a weary signal for equities.
• The short-term vs. mid-term volatility ratio convincingly flipped negative for the first time since March.
• Cash volatility broke out above its 50-day moving average, and it is now in a recovery phase.
• The number of stocks within the S&P 500 that are above their 10-, 50-, and 200-day moving averages is now stacked negatively and continues to decline.
• Although both value (VTV) and growth (VUG) broke down on a short-term basis, value stocks appear to be slightly outperforming growth stocks on a relative basis over the short-term.
• Foreign equities are still underperforming US equities. However, more established foreign markets (EFA) closed in a warning phase beneath the 50-day moving average.

Neutral

• The S&P 500 has improved strength relative to utilities (XLU), which broke down hard and are in a bear phase thanks to the rise in rates by the Fed.
• Fossil fuels caught a bid this week, with US oil (USO) and oil exploration (XOP) both up on the week, while more new age energy sources such as solar (TAN) and natural gas (UNG) got hit hard.
• The 20-year US treasury bond broke down below key support levels, but it looks to have gotten oversold and may be subject to mean reversion.
• Despite the fact that gold (GLD) closed the week in a warning phase, it is now outperforming the S&P 500 for the first time since May.

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