Coming off the second quarter and now halfway through the third quarter, the stock market has become volatile and considerably more defensive. Clearly, the sharp downward revisions in the year-over-year and previous monthly employment statistics reveal a job market that is not as healthy as reported. The three-month average for total nonfarm payrolls decreased to 116,000 from 141,000. July nonfarm payrolls revised to 89,000 from 114,000. June nonfarm payrolls revised to 118,000 from 179,000. It is disturbing that the numbers are so off the mark of reality and that the greatest number of people being hired are illegal aliens.
A review of the second quarter runs counter to the current bearish narrative that has emerged of late. Consider the following takeaways from Q2: the S&P 500 reported growth in earnings of 11.3% — the highest year-over-year growth since Q4 2021. Only 67 companies issued negative earnings-per-share (EPS) guidance for Q2 — the lowest number since Q4 2022. 80% of S&P 500 companies reported actual EPS above estimated EPS — above the five-year average of 77%. Nine sectors reported higher earnings due to upward revisions to EPS estimates and positive EPS surprises.
Pretty impressive one would think. But the rub on the market now brought about the worst week of performance for the major averages since March 2023, in what is called multiple compression, when price over earnings (P/E) ratios shrink due to a lower outlook for GDP growth. The S&P dropped about 4% and the Nasdaq 100 fell nearly 6% fueled by the weak August jobs report, which raised concerns about a potential recession instead of the soft landing that had embraced investor sentiment through mid-July. The forward 12-month P/E ratio for the S&P 500 is 20.6 and is above the five-year average (19.4) and above the 10-year average (18.0).
Concerns about a slowing economy have rapidly emerged that now have analysts trimming S&P earnings estimates for the third quarter. According to FactSet, the Q3 bottom-up EPS estimate (which is an aggregation of the median EPS estimates for Q3 for all the companies in the index) decreased by 2.8% (to $61.44 from $63.20) from June 30 to Aug. 31. This is only a 2.8% reduction for the Q3 forecast and falls in line with historical downward revisions for the first two months of the third quarter.
Conversely, in the same report, the analyst community increased EPS estimates for calendar year 2025 by 0.3% to $279.52 from $278.79 over this same June-August period. The rising level of market anxiety is whether that 2.8% reduction will increase, and the Fed will be slow to react more aggressively to prevent the labor market from exhibiting negative growth. It is thought the Fed’s telegraphing of a rate cut at the Sept. 18 Federal Open Market Committee (FOMC) meeting would provide some real-time action to address investor handwringing, but the new narrative is calling for the Fed to take bolder action.
There are increasing odds the Fed will consider a 50-basis-point cut instead of a quarter-point hike if they are truly as data dependent as they claim. Between now and the FOMC meeting, the market will digest both the Consumer Price Index (CPI) and Producer Price Index (PPI) inflation reports, the University of Michigan Consumer Sentiment report, Industrial Production, August Retail Sales and both Housing Starts and Housing Permits. This set of reports could well pave the way for a half-point cut, something the bond market has already voted in favor of.
While the Fed has maintained the fed funds rate at 5.25-5.50%, the yield on the 2-year Treasury has declined from 5.04% back in early May to 3.65% as of last Friday, Sept. 6. This 150-basis-point move in yield to the downside is nothing short of dramatic as the Fed has stood pat and watched energy prices fall, commodity prices fall and consumer credit spike to all-time highs. In my opinion, the Fed should have cut rates following the July Nonfarm Payroll report released the first week of August, and even more so following the 181,000 year-over-year downward revision.
To see equity P/E multiples contract within most of the market sectors leveraged to a robust economy is not really much of a surprise as it is frustrating if the Fed doesn’t meet the bond market where it is trading. If the Fed only cuts a quarter-point this month and then waits to cut another quarter point on Nov. 7, one could argue they will miss a window of opportunity to provide some insurance for a soft landing. The suddenly weaker job market data should send a strong signal to Fed officials to get in front of this reality check in the labor market before risking a negative monthly Nom-Farm Payroll print that would surely rattle the market further.
Taking into account the historically tough months of August-October it makes sense that investors are hunkering down somewhat in defensive areas of the market. Sector rotation has been swift, with technology, consumer discretion, energy, industrials, transportation, travel/leisure and materials all experiencing selling pressure as consumer staples, utilities, health care and real estate are seeing strong fund flows. Amid the volatility and multiple-hundred-point swings in the Dow and 2-3% daily moves in the S&P 500 and Nasdaq, there are some very bullish charts at work — namely, the four sectors noted that are on the receiving end of positive inflows.
At this juncture, the bond futures market is forecasting a full point of cuts by year from the three scheduled FOMC meetings (Sept. 18, Nov. 7, Dec. 18). Oddly enough, the CME Fed Watch Tool shows the half-point cut coming at the December meeting. Why not pull the half-point cut forward to next week and shore employer confidence? The Fed has a dual mandate — low inflation and full employment. The Fed already botched inflation and had to spend 18 months getting back control over soaring prices. Now is not the time to lose control of the other mandate.
