The 10-year Treasury yield hits a new, recent high … why Luke is paying more attention to earnings than valuations … the consumer remains strong … are we done with rate hikes?

 

As I write Thursday afternoon, the 10-year Treasury yield stands at 4.96%. Earlier today, it nearly broached 5.0%.

As we’ve been detailing here in the Digest for months, this relentless surge in treasury yields creates a fierce headwind for stocks. The higher the 10-year yield goes, the more expensive it makes today’s stock prices appear.

To make sure we’re all on the same page, when analysts estimate a stock’s value, they use what’s called a “discount rate” that is heavily influenced by the 10-year Treasury yield.

Analysts add up what they believe will be a company’s future cash flows, then use this discount rate to calculate a “net present value” of all those future cash flows. This net present value is what analysts think is a fair stock price.

Given the math involved, the higher the discount rate, the lower the net present value of future flows.

So, as yields have surged, the calculus suggests one of two outcomes for stock prices: 1) they fall, reflecting the higher discount rate, 2) they don’t fall, but appear increasingly overvalued.

So, what’s the bullish perspective on this 10-year treasury yield surge, its impact on stock valuations, and the implications for where stocks are headed?

For the answer, let’s go to our hypergrowth expert, Luke Lango.

From Luke’s Daily Notes in Innovation Investor:

Everyone likes to talk about how expensive the market is these days – and indeed, it is expensive. Even we’re bearish on the valuation outlook for stocks.

But that does not make us overall bearish on stocks because valuations are a less important driver of stocks than earnings.

And while valuations don’t look good, earnings look really good. So long as the earnings trend remains favorable, stocks can and will rally, despite a bearish valuation backdrop.

So, all eyes are on earnings. With that context, let’s turn to FactSet, which is the go-to earnings data analytics group used by the pros.

From last Friday’s Earnings Insight:

At this very early stage, the third quarter earnings season for the S&P 500 is off to a strong start…

For Q3 2023, the blended (year-over-year) earnings growth rate for the S&P 500 is 0.4%. If 0.4% is the actual growth rate for the quarter, it will mark the first quarter of year-over-year earnings growth for the index since Q3 2022….

Both the number of positive earnings surprises and the magnitude of these earnings surprises are above their 5-year and 10-year averages.

As a result, the index is reporting higher earnings for the third quarter today relative to the end of last week and relative to the end of the quarter.

This is certainly a good start. But Wall Street likes to look beyond the most immediate quarter.

Do we have reason to remain optimistic as we gaze farther out toward 2024?

Back to Luke:

…Since late 2021, earnings growth has been slowing consistently.

That slowdown bottomed last quarter, so earnings growth is expected to improve this quarter and then keep improving into late 2024, with growth accelerating from ~3% to ~15% over that same time frame.

If things play out as expected, stocks should rally very strongly in the fourth quarter of this year and throughout next year, too. 

I’ll quickly point out one illustration of earnings strength resulting in a rally despite macro headwinds. This morning, Netflix released earnings that pleased Wall Street. The stock is exploding 16% higher as I write. It’s just another reminder that there’s always a bull market somewhere.

How does this week’s strong retail sales report and its impact on the Federal Reserve affect Luke’s analysis?

On Tuesday, the retail sales report showed that consumer spending smashed expectations.

Retail sales rose 0.7% month-over-month in September. That was more than double the 0.3% gain forecasted by economists. Core retail sales surged 0.6% month-over-month. That was roughly 6X the consensus estimate of a 0.1% increase.

Some analysts fear how this consumer strength will impact Federal Reserve interest rate policy. For example, here’s Reuters:

Coming on the heels of stronger-than-expected employment growth and consumer price readings in September, the reports raise the risk of the Federal Reserve hiking interest rates in December or January.

“The economy looks like it is getting used to the new normal of interest rates being higher for longer because shoppers are not taking a break,” said Christopher Rupkey, chief economist at FWDBONDS.

“Fed officials have another rate hike this year up on their forecast board, and they will need to use it, if the economic data continues to surprise economists on the upside.”

Luke has a different take. Back to his Daily Notes:

That hot retail sales report suggests earnings are going to be very good. The consumer powers the economy. If the consumer isn’t rolling over, neither are earnings. The Q3 earnings season should be quite good.

…We are getting back to a “Goldilocks” economy that is running hotter than it was last year (when it felt like a recession was just around the corner) yet cooler than it was this past summer (when we got painful reinflation). Now we’re shifting back into a slow-growth, falling-inflation environment that should be very helpful for stocks.

…The “summer of reinflation” is ending, and the disinflation trend is returning. Plus, it seems pretty clear to us that the Fed is done hiking rates.

Comments from Federal Reserve Chairman Jerome Powell today support Luke’s conclusion

Today, Powell spoke at the Economic Club of New York. Here’s The Wall Street Journal with the takeaway:

Federal Reserve Chair Jerome Powell suggested that he is pleased with inflation’s decline this summer and that the central bank is unlikely to raise interest rates again unless it sees clear evidence that stronger economic activity jeopardizes such progress.

 “Given the uncertainties and risks, and how far we have come, the committee is proceeding carefully,” Powell said in prepared remarks for a Thursday lunchtime address in New York.

“Incoming data over recent months show ongoing progress toward both” of the Fed’s goals to maintain stable inflation and strong employment.

As usual, Powell was careful not to box himself in by saying anything too definitive. But the overall tone was encouraging, giving investors no reason to believe he’s already made the decision to hike once more.

Most traders agree with Luke’s assessment about rate hikes being over. We can see this by looking at the CME Group’s FedWatch Tool. This tool surveys traders to assign probabilities for different fed funds rate target levels at various dates in the future.

As I write, the heaviest odds that we get one more rate hike fall on January 2024. But those odds stand at just 35.1%. Meanwhile, traders assign a 60.7% probability that rates remain where they are today in January. The odds of a rate hike decrease in all other months as we look out to 2024.

Tying back to Luke’s analysis, all eyes are on earnings going forward

We need the U.S. consumer to walk a tightrope – spend enough to prop up earnings growth that supports today’s stock market, but don’t spend so much that it heats up the economy, promoting Powell to hike again. At this early point in the Q3 earnings season, we’re off to a good start.

Here’s Luke’s bottom line:

Overall, we feel really good about our stocks here at the start of the fourth quarter.

According to the technicals, the stock market is acting like it is just starting a big rebound rally. Fundamentally speaking, this upcoming earnings season should be really good.

We remain very confident in our call for a major Q4 rally in stocks. And in fact, we think that rally actually started two weeks ago.

To get Luke’s Daily Updates and all his latest analysis as an Innovation Investor subscriber, click here to learn more.

Have a good evening,

Jeff Remsburg