9-10-24: A “Compression Cycle” Hits the Market on Weaker Labor Data

by Bryan Perry

September 10, 2024

Pretty impressive one would think. But the rub on the market now, that brought about the worst week of

Please edit this line to read “when lower earnings growth prospects cause price-earnings ratios to shrink.”

Coming off great second quarter earnings, the stock market has suddenly become more volatile and considerably more defensive. Clearly, the sharp downward revisions in year-over-year and monthly job totals reveal a job market that is not as healthy as first reported.  July non-farm payrolls fell by 25,000, while June non-farm payrolls were revised down by 61,000 jobs, from an initial 179,000 jobs to 118,000.

A review of the second quarter data runs counter to the latest sentiment. Consider these 2Q earnings data:

The S&P 500 reported earnings growth of 11.3%, the highest year-over-year rate since Q4’21.
Only 67 companies issued negative EPS guidance for Q2 – the lowest number since Q4’22.
80% of S&P 500 companies reported EPS above estimates – above the five-year average of 77%.
Nine of 11 sectors reported higher earnings due to upward EPS revisions and positive EPS surprises.

–Data from FactSet

That’s a pretty impressive list, but last week delivered the worst market week for the major averages since March of 2023, causing a “multiple compression,” when lower earnings growth prospects cause price-earnings ratios to shrink. As a result, the S&P dropped 4.25% and the NASDAQ composite fell 5.77% fueled by that weak August jobs report, which raised concerns about a potential recession instead of a soft landing. The forward 12-month P/E ratio for the S&P 500 is now 20.6, vs. the five-year average of 19.4.

Concerns about a slowing economy have rapidly emerged. This has caused analysts to trim their 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 August 31. This falls in line with many past downward revisions.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Conversely, in the same report, the analyst community increased its 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 all about whether that 2.8% reduction will increase, and whether the Fed will be slow to react more aggressively to prevent the labor market from exhibiting negative growth. It is thought that the Fed’s telegraphing of a rate cut at the September 18 FOMC meeting would provide some real-time action to address investor hand-wringing, but the new narrative is calling for the Fed to take even bolder action.

There are increasing odds now that the Fed will consider a 50-basis point cut instead of a quarter-point cut if they are truly as data dependent as they claim to be. Between now and the FOMC meeting next week, the market will digest both the CPI and PPI inflation news, University of Michigan Consumer Sentiment, Industrial Production, August Retail Sales, 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 a range of 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 September 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.

The 2-Year Treasury Note Rate Has Declined Sharply

– From 5.04% to 3.65% in the Last Four Months

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In my opinion, the Fed should have cut rates following the July Non-Farm Payroll report released the first week of August, and even more so following the 181,000 year-over-year downward jobs revision.

It becomes frustrating if the Fed doesn’t meet the bond market where it is trading. If the Fed only cuts by a quarter-point next week and then waits until after the election to cut another quarter point on November 7, one could argue that they will miss a window of opportunity to provide insurance for a soft landing.

The suddenly weak job market data should send a strong signal to Fed officials to get in front of this weak labor market before risking another negative monthly payroll report that would rattle the market further.

Taking into account the historically tough market months of August through 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, healthcare, and real estate enjoy 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 above:

Recent Buying in Consumer Staples… Utilities …. Health Care … and Real Estate (below)

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

At this juncture, the bond futures market is forecasting a full point of cuts by year-end from the three scheduled FOMC meetings (September 18, November 7, and December 18). Oddly enough, the CME Fed Watch Tool shows the half-point cut coming at the final (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 their other mandate – seeking full employment.