In this week’s edition of “Three on Thursday,” we explore the performance of the S&P 500 Index in the third quarter of 2024. The Index posted an impressive total return of 5.9% for the quarter, bringing its year-to-date (YTD) total return to 22.1%. This marks not only the best start to a year since 1997 but also the strongest first nine months ever recorded in a U.S. election year. 

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Implications:  After a shaky past few months the ISM Services index surprised to the upside in September, easily beating expectations, and rising to the fastest pace in nineteen months.  Within the sector, twelve of the eighteen major industries reported growth while five reported contraction.  Looking at the details, the major measures of activity moved mostly higher, led by big jumps from the indexes for business activity and new orders.  Akin to the overall index, the index for new orders has been on a choppy downward path in 2024, but that reversed in September, as the index rose to nineteen-month high at 59.4.  Survey comments note that although the recent half-point cut from the Federal Reserve is encouraging, it may take another 150 basis points to move the needle in sales.  Despite increased activity in September, companies remained defensive in their hiring efforts.  The index for employment fell back into contraction territory at 48.1, now the seventh month in the last ten below 50.  Meanwhile, inflation remains a problem in the services sector.  The prices paid index rose to 59.4 in September – the fastest pace since January – with twelve out of eighteen major industries paying higher prices for the month.  Developments in this category are important as the services sector has been a main driver for stubbornly high inflation over the last two years.  Our expectation is that inflation and growth in the sector decelerate as the lagged impacts from a drop in the M2 measure of the money supply from early 2022 through late 2023 take effect.  In employment news this morning, initial jobless claims rose 6,000 last week to 225,000.  Meanwhile, continuing claims declined 1,000 to 1.826 million.  Also on the labor front, ADP’s measure of private payrolls increased 143,000 in September versus a consensus expected 125,000.  We’re estimating tomorrow’s government report will show a nonfarm payroll gain of 157,000 with the unemployment rate staying steady at 4.2%.  In other recent news, cars and light trucks were sold at a 15.8 million annual rate in September, up 3.3% from August but up only 0.5% versus a year ago.

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Implications:  The ISM Manufacturing index missed consensus expectations once again in September, remaining at a soft reading of 47.2. In the last two years, activity in the manufacturing sector has contracted for all but two months.  Overall, only five of the eighteen major manufacturing industries reported growth in September, while thirteen reported contraction.  Looking at the details, demand remained weak.  The new orders index came in at 46.1 and has been in contraction in all but two months over the last two years.  Respondent comments are noting a general slowdown in the economy and are adjusting production accordingly.  That can be seen in movement from the production index, which stabilized at 49.8 after falling to the lowest level since the COVID lockdowns in August.  Manufacturing companies have been able to scrape by despite weak demand by focusing on their order backlogs, which were artificially boosted with pent-up activity from the COVID years.  That index, which remained deep in contraction territory at 44.1, has been below 50 for every month in the last two years.  At some point, this reprieve for weaker demand has to give.  Manufacturing companies have adjusted their hiring efforts with this revelation, as the employment index fell to a very weak 43.9 and hovers close to the lowest level since the COVID lockdown months.  We think the continued weakness seen in the manufacturing sector is a result of the reductions in the M2 measure of the money supply from early 2022 through late 2023.  And while M2 is up at a moderate pace in the last few months, it is still lower than it was two years ago.  It appears as if these lagged impacts are also finally making their way into the inflation data, as the prices index fell into contraction territory for the first time this year.  We expect inflationary pressures in the manufacturing sector to decline in the latter part of 2024 – along with continued manufacturing weakness – as tighter monetary policy from the last two years takes hold.  In other news this morning, construction spending declined 0.1% in August, as a large drop in homebuilding was only partially offset by an increase for highway and street projects.

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Like it does once every year, last week the Commerce Department went back and revised its GDP figures for the past several years.  And while the top line revisions to Real GDP were pretty small, there was a larger revision to corporate profits.

Real GDP was revised up 1.3% for the second quarter of 2024, which means the annualized growth rate since the start of 2020 was about 0.3 percentage points faster than previously estimated: 2.3% per year rather than 2.0%.

And the statisticians also said profits were underestimated.  The government now thinks its comprehensive national measure of pre-tax corporate profits is 11.5% higher than previously thought, mostly due to profits at domestic non-financial companies (such as manufacturers, retailers, transportation & warehousing, etc.).  Meanwhile, after-tax profits were revised up 13.3%.

As our readers know, we judge the value of the overall stock market by using a Capitalized Profits Model.  Using these revised economy-wide profits from the GDP accounts and a 10-year yield of 3.75% (Friday’s close) suggests the S&P 500 would be fairly valued at about 4,725, 18% below Friday’s S&P 500 close.

Our readers know that this measure is a view from 30,000 feet.  The Capitalized Profits Model is not a trading model and there are many other tools to judge the value of stocks.  In addition, in an election year, another factor is in play as well and that is the tax rate on corporate profits.

In 2018 the top tax rate on corporate profits was cut from 35% to 21%.  This 21% tax rate is the lowest tax rate on corporate profits since the Great Depression.

We have always used pre-tax profits to judge stock values because the corporate tax rate moves up and down with the political cycle and pre-tax profits are a true reflection of economic activity, not just tax rate changes.

Clearly, the stock market has continued to rise in spite of the fact that our 30,000-foot view suggests it is overvalued.  This could be a repeat of what happened in the late 1990s, when stocks rose in spite of the fact that they were overvalued, or it could be explained by an expectation that tax rates will stay low, and possibly be cut again.

Using newly revised after-tax profits in our model, instead of pre-tax profits, suggests that stocks are fairly valued today.  And if President Trump were to win the election, and cut the corporate tax rate further as he has suggested (to 15%, from 21%) then there’s a case for stocks being mildly undervalued.  (In theory, cutting the tax rate to 15%, which means companies would get to keep 85 cents on the dollar rather than 79 cents, translates into an 8% increase in after-tax profits).

However, there is also a risk of corporate tax increases, both in the near future as well as beyond.  Vice President Harris’s campaign has mentioned lifting the rate to 28%, which would translate into a 9% reduction in after-tax profits.

It is hard to look at the federal budget situation and think the US government won’t be raising tax rates in the future.  We’d prefer spending cuts, but we don’t live in a world where policymakers do what we want.  In a worst-case scenario, tax rates could go up on both corporate profits as well as investors’ capital gains.

Net, net, what does this all mean?  At the very best, upward revisions to profits mean stocks aren’t as overvalued as our models showed before.  Nonetheless, with the M2 measure of the money supply down from its 2022 peak, and the risk of recession higher than it has been in a long time, we still believe stocks are overvalued.

The Federal Reserve is reducing interest rates, but even with a 10-year yield of 3% the stock market is not cheap.  From 2008 to 2022, the market was significantly undervalued, and we were bullish for almost that entire time.  Today, this is just not the case.  There are sectors of the market that remain less expensive than the market as a whole, but caution is still warranted.    

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Before we dive into incomes and spending, today’s report includes the Fed’s preferred measure of inflation.  PCE prices rose 0.1% in August and are up 2.2% in the past year compared to a 3.4% gain in the year ending in August 2023.  “Core” prices, which exclude the ever-volatile food and energy categories, also rose 0.1% in August and are up 2.7% versus a year ago, a notable improvement from the 3.8% reading for the twelve months ending August 2023.  The slowing in the pace of inflation in the past year – prices are still going up but at a slower rate – reflects the tightening of monetary policy in 2023-24.  And given that policy is still tight, although not as tight as previously given the Fed’s 50 basis point cut in short-term rates last week, inflation should continue to decline in the year ahead.  In turn, this should give the Fed additional room for making monetary policy less tight in the months ahead.  Meanwhile, the economy continues to grow.  Personal income rose 0.2% in August and is up 5.6% in the past year.  Private-sector wages and salaries led the way, up 0.5% on the month and up 6.3% in the past year.  Unfortunately government activity continues to run hot as well, as government pay rose 0.4% in August and is up 6.6% in the past year, hovering near the largest twelve-month increase in decades. We don’t think the growth in government pay – or massive government deficit spending – is sustainable or good for the US economy.  Consumer spending rose 0.2% in August, led by outlays on services which rose 0.4% on the month and are up 6.8% in the past year.  Goods spending dipped 0.1% in August but is up 1.8% from a year ago.  When adjusting for inflation, consumption rose a modest 0.1% in August.  We are closely watching the service sector as the driver of consumer activity both now and in the near future, and we expect activity to temper as interest rates – declining but still elevated – and continued inflation pressure take a toll.  In other recent news, the Kansas City Fed Manufacturing Index, a measure of factory activity in that region, fell to -8 in September from -3 in August.  On the housing front, pending home sales, which are contracts on existing homes, rose 0.6% in August following a 5.5% decline in July. Plugging these figures into our model suggests existing home sales, which are counted at closing, will remain weak in September.

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In this week’s edition of “Three on Thursday,” we examine recent trends in the U.S. housing market. On Tuesday, new data on home prices were released: the Case-Shiller Index rose 0.2% in July, up 5.0% from the previous year and reaching an all-time high. Similarly, the FHFA Index increased by 0.1% in July, up 4.6% year-over-year, also hitting record highs. In spite of continued price increases, could we be seeing early signs of a shift towards more affordability? 

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Implications:  The unchanged reading on new orders for durable goods in August beat even the most optimistic forecast from any economics group on Bloomberg, as a concentrated decline in aircraft orders was offset by broad-based growth elsewhere.  Transportation orders can swing wildly from month to month as aircraft orders tend to come in chunks rather than steadily over time.  That was the case again in August, as commercial aircraft orders fell 7.5% after soaring in July.  Excluding the transportation sector, orders for durable goods rose 0.5% versus a consensus expected +0.1%.  Electrical equipment led non-transportation orders higher, rising 1.9% in August, while fabricated metal products (+0.6%) and machinery (+0.5%) also increased.  Although orders activity came in solid for the month, other data in the report point to dark clouds on the horizon.  The most important number in the release, core shipments – a key input for business investment in the calculation of GDP – inched up only 0.1% in August following a 0.4% decline in July. If unchanged in September, this measure would decline at a 1.8% annualized rate in Q3 versus the Q2 average.  That would be the third quarter in the last four where core shipments have declined, a clear sign that all is not well on the economic front. Meanwhile, overall orders for durable goods are failing to keep pace with inflation, up 1.5% in the last twelve months and, excluding transportation, up just 1.0%.  While GDP readings continue to run positive, we expect a rocky path forward as the economy feels the lagged effects of the Federal Reserve’s tightening of monetary policy.  In employment news this morning, initial jobless claims inched 1,000 lower last week to 218,000.  Meanwhile, continuing claims rose 13,000 to 1.834 million.  These figures are consistent with continued job growth in September.

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Implications:   The final reading for real GDP growth in the second quarter remained unchanged from last month’s estimate, holding at a 3.0% annual rate. However, the underlying components showed a slightly weaker mix. Downward revisions in consumer spending (primarily non-durables), business investment (equipment & software), and net exports were balanced by upward revisions in inventories and government spending.  For a more accurate measure of sustainable growth, we focus on "core" GDP, which includes consumer spending, business fixed investment, and home building, but excludes the more volatile categories like government purchases, inventories, and international trade. "Core" GDP grew at a 2.7% annual rate in Q2,  below the prior estimate of 2.9%. The Bureau of Economic Analysis (BEA) also released its comprehensive annual update, revising data from the past five years. It now shows that average real GDP growth from Q2 2020 through 2023 was 5.5%, compared to the previously reported 5.1%. Additionally, the second look at economy-wide corporate profits for Q2 revealed a significant upward revision, with profits rising 3.6% from Q1 (compared to the 1.7% initially reported) and up 10.8% year-over-year. Since Federal Reserve profits are included in this data – and the Fed has been posting losses – we focus on corporate profits excluding the Fed, which are up 9.0% year-over-year. Using pre-tax profits, our Capitalized Profits Model suggests stocks remain overvalued. However, using after-tax profits suggests stocks are near fair value.  We also received a second look at Q2 Real Gross Domestic Income (GDI), an alternative measure of economic activity, which was revised higher to a 3.4% annual growth rate and is now up 3.5% from a year ago. As for inflation, it remains stubborn. GDP inflation was unchanged at 2.5% annually in Q2, and GDP prices have risen 2.6% over the past year. Meanwhile, nominal GDP (real growth plus inflation) increased at a 5.6% annual rate in Q2 and is up 5.7% year-over-year.

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Implications:  New home sales took a breather in August, pulling back modestly following the largest monthly gain in nearly two years. The big question for the housing market is whether the Federal Reserve cutting rates will be enough to start a new upward trend in sales, or if buyers will continue to delay purchases in anticipation of even lower rates in the future.  Thirty-year fixed mortgage rates have fallen roughly 100bps over the past couple months, but new home sales are still roughly where they were in 2019 before COVID.  Given that new home sales are a timelier barometer of the housing market because they are calculated when contracts are signed while existing homes are only counted after the sale is closed, it doesn’t look like lower rates have had a huge impact yet. That said, affordability has been improving across the board for potential buyers, with the median sales price of new homes down 8.6% from the peak in 2022. It does look like a small part of this decline reflects a lower price per square foot as developers cut prices.  The Census Bureau reports that from 2022 to 2023 (the most recent data available) the median price per square foot for single family homes sold fell 1.1%. While that decline is modest, it represents a stark reversal from the 45% gain from 2019 to 2022.  That said, most of the drop in median prices is likely due to the mix of homes on the market including more lower priced options as developers complete smaller properties. Supply has also put more downward pressure on median prices for new homes than existing homes.  The supply of completed single-family homes is up over 200% versus the bottom in 2022. This contrasts with the market for existing homes which continues to struggle with an inventory problem, often due to the difficulty of convincing current homeowners to give up the low fixed-rate mortgages they locked-in during the pandemic.  The combination of more affordable financing, lower prices, and the abundance of inventories giving potential buyers a wider array of options will help fuel a rebound in new home sales.  In other recent housing news, home prices continued to rise in July. The Case-Shiller index rose 0.2% and is up 5.0% from a year ago. The FHFA index increased 0.1% and is up 4.6% from a year ago.  In the manufacturing sector, the Richmond Fed index fell to -21 in September from -19 in August, highlighting weakness in that sector.   Finally, the Federal Reserve released monthly figures on M2, showing it up 0.6% in August (the largest monthly gain since 2021) but still up only 2.0% in the past year.  The faster gain in August signals that the Fed needs to be cautious with rate cuts if it wants to prevent a resurgence of inflation in 2025-26.

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