Last week the stock of Dollar General declined over 25 percent in one day. The reason was reported to be earnings that were reported below consensus and a subdued outlook. Other dollar chains such as Dollar Tree declined in unison. The prior investment case for Dollar General centered on its low prices and lower-income clientele. The idea was that they would keep buying even if the overall economy declined. The fact that their target market is under stress should be a source of concern.
In general terms, the economy is on the verge of not doing well. Consumers make up 70 percent of the country’s GDP. While incomes have gone up, so have the cost of several things, some of which are hard to avoid like insurance, housing cost, and groceries. There is no realistic plan to increase the minimum wage, which would support workers. Critics of increasing the minimum wage argue such would make things even more expensive. Supporters say such an increase will be spent almost immediately by the lower wage earners which will buoy the economy. As this argument has been going on since the last increase in the minimum wage in 2009, it is not expected to be resolved anytime soon.
There is a general debate as to whether the Federal Reserve (The Fed) will be able to engineer a soft landing as opposed to a hard one. In the former there is more of a gradual decline to some steady state level. The latter is more of an abrupt change. Either way, a landing is a landing. The implications are that the economy under either scenario shifts down to some lower level of activity. Such a shift would have negative implications for employment and corporate profits. It is the latter that moves stock prices. Take away the growth in corporate profits and their future improvement and stock prices have been known to decline.
So where does the current market leave us? The latest estimate of earnings of the Standard & Poor’s 500 is $261. At the current level of 5400 for the S&P it results in a projected Price/Earnings ratio of 20.7. The yield on the index is 1.27%. Historically, the P/E ratio for the S&P is 16. Even if earnings were to come through, the projected level of the S&P with a 16 P/E ratio would be 4176.This implies a 23 percent decline. Should both earnings be reduced, and the P/E ratio revert to its mean, the decline will be greater.
It was written about previously how the S&P Index depends on seven technology stocks to maintain its value. Since early July that leadership has faltered. While the rotation out of the “Magnificent 7 “is happening, so far, the rotation has been subtle enough for the other 497 stocks in the index to keep the overall index number up. There is no assurance such will continue.
Possible sources of valuation disruption would include the decline in commercial real estate values and the impact on financial firms who lent money for the same. China seems to be adrift and no longer a material source of growth for the world economy. Finally, next year seems to be one of looking at a tax increase of some magnitude. While such an increase should help keep interest rates lower than otherwise, there is a great deal of debate of what “otherwise” will be. It is a foregone conclusion that rates will not go back to the levels of 2011-19. The government deficits have been too large over this time period. Such debt must be serviced. Even if investors are found to buy new debt to replace the old, the incremental increase in interest payments make this category the fastest growing part of the Federal budget, exceeding the percentage growth of Medicare and Social Security.
The obvious question becomes where does one invest given this scenario? That would depend on income needs and time frame. The ability to see across the valley to the next up market is very prized here. Just remember that there is less than a one in five chance of the previous leadership being at the forefront of the next up market. Indeed, given their rich valuation, index funds could underperform for years.
There is a sense that the market is leading to some period of being range-bound given the greater than historical returns of the past decade. In investing, the past is seldom prologue. A keen eye for trends dividends and an ability to value an investment for its substance will hopefully help cushion a downside and will serve investors going forward.
The Economy
The economy continues to decelerate as the effects of Covid spending wear off and middle and lower economic classes are pinched by the rising cost of necessities. After declining during Covid, consumer debt defaults are beginning to increase, even for real estate.
Housing is a particular source of consternation. Homes appreciated as sellers held properties off the market on the assumption prices would surge higher. High interest rates precluded a number of people from looking for a home. Now, listings are growing as supply is increasing and prices are moderating. Lower interest rates may help stabilize prices at some level.
Inflation
Inflation is continuing to moderate as buyers resist the efforts to make them pay ever higher prices. For some, the cost of necessities leaves little room for splurging on things like restaurants or travel.
Restaurants are under pressure on several fronts. Rising ingredient cost makes dining a challenge, especially when customers will disappear over the smallest price increase. Restaurant wages have gone up in several localities with local minimum wage increases. Finally, restaurant traffic is falling as the universe of those who can afford to eat our shrinks.
Interest Rates
Interest rates are due to decline after a long process of telegraphing the same by the Fed. There is some debate about whether the increase will be for 25 or 50 basis points. It would seem, that cutting interest rates by half a percent, would telegraph to the public that the Fed believes the economy is more imperiled than people believe. Longer term, the rising debt of the US requires whatever interest rate necessary to attract bond buyers.
The Stock Market
Stocks are entering a time of being tested. Historically the fall months see stocks under pressure as estimates made earlier in the year are taken down a notch. If the market is overvalued, it gets taken down with them.
There are several programs being floated which promise to immunize portfolios against decline. The original concept was “portfolio insurance” which caused the market to decline 20 percent in a day in September of 1987.
Almost all such strategies assume there is someone on the other side of the trade ready to buy or sell at close to the previous price. In unruly markets this is not the case. Recently some very large stocks have gone up or down 20-25 percent in a day. This is symptomatic of illiquid markets. A liquid market allows for orderly execution of trades. An illiquid market does not.
Warren M. Barnett, CFA
September 11, 2024
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