Inflation fears on a weaker stock market

We are in the period September-October, early autumn and a season when the stock market has more often than other parts of the year gone through major price falls. The prolonged rally in the S&P 500 index of plus 18.7 percent year-to-date combined with historically high valuations of corporate earnings is contributing to this.

What usually triggers stock market crashes are external events such as wars, but also changes in the economic outlook for the US, the rest of the western world and nowadays also the large economy in the east, China. Ahead of the Black Monday in October 1987 for example, beside an economic soft landing for the US economy 1985-1986, there had been some corporate tax legislation changes combined with high US trade deficit figures. The outbreak of the Kuwait war in August 1990, as well as 9/11, the 20th anniversary of which was commemorated over the weekend in the US, also shook the stock markets.

We do not see any such events now, other than that the US debt ceiling will probably have to be raised another notch soon plus some inflationary fears, to which we will return. So far, the price movements on the stock market look more like a correction after several months of uninterrupted rise.

The graph below shows how the valuation of S&P 500 companies' earnings (p/e ratios) has expanded since the Covid crisis began in March 2020. A short but sharp downward price decline was followed by an almost as sharp upward price rebound. By comparison, the recovery in corporate profits came with a lag, creating a valuation gap that we have now had for almost a year and a half. It is therefore justified to speak of a liquidity-driven market, in which financial support has played a greater role in the rise of share prices than corporate earnings recovery.

Source: Earnings Insight

Then there is the lifeline for the stock market – that the central banks are expected to continue their economic support and keep interest rates low. Here, US employment statistics play a role as a leading indicator. The weak job figures in August changed the perceived probability that the Fed will keep interest rates low for a while longer.

Growth expected compared to a weak quarter

We are still a few weeks away from the start of the Q3 2021 corporate result season. Expectations are high, with S&P 500 companies' profits anticipated to increase by 28 percent compared to Q3 2020. The highest expectations of an earnings improvement in Q3 2021 are found for the Energy, Materials, Industrial and Information Technology sectors.

As in the last Q2 reporting period, the comparison period is easy to beat. Optimists point to the economy returning to normal after a long period of Covid restrictions. This is illustrated by that the Wall Street analysts have revised up earnings expectations for S&P 500 companies by just over 3 percent since 30 June 2021.

Q3 2020 were marked by Covid restrictions in the US, as well as in much of the rest of the world. Events were cancelled or arranged without an audience. Restaurants had limited opening hours, maximum number of guests, etc. Office employees were to a high degree working from home. Flying anywhere was very rare. Here global flights are still only about half of the pre-Covid levels despite the societies now opening. The S&P 500 index contains a relatively large number of such service companies that were severely affected by these restrictions.  

The balance between positive and negative earnings guidance ahead of Q3 2021 from S&P500 companies is quite even, 54 positives to 47 negatives so far, according to Earnings Insight. There is a clear preponderance of information technology companies with positive earnings guidance ahead of Q3. For other sectors, the picture is more mixed.

Inflation is ticking up

One issue is whether rising inflation could lower corporate profitability, where the manufacturing companies are especially vulnerable. Last Friday, September 10, came a PPI figure for August in the US that showed a 0.6 percent month-on-month increase, after rising by 1.0 percent in July. This week a CPI figure for August in the US is due on Tuesday 14 September, which could be the most important weekly macro figure for the stock market.

The US CPI Index from August 2019 to July 2021

Source: Refinitiv Eikon.

The US 10-year US Treasury yield rose to 1.34 percent on Friday 10 September. The long-term chart shows a clear break in the upward trend since August, although the upward movement since then has not been very strong and especially not in relation to the inflation figures that have been reported. The next Fed meeting where guidance on future central bank-directed interest rates can be obtained is 21-22 September.

The US 10-year government bond yield from December 18^th, 2020, to September 10^th, 2021

Is it too early to catch the falling knife?

Last week (6-10 September), the S&P 500 index fell by 1.7 per cent. More remarkably, the index finished down every day of the week. On Friday, the index was down 0.8 per cent and closed well below MA20. The next level is the floor of the narrow rising trend channel followed by MA50. As we have mentioned earlier, MA50 has been the level to buy-in previously. Will this be the case once again?

S&P 500 index, February 4^th to September 10^th, 2021

In the weekly five-year graph below, EMA9 at 4 438 still serves as support.

S&P 500, weekly five-year graph

Note: Past performance is not a reliable indicator of future results.

The technology-heavy Nasdaq had a similar performance as S&P500 during last week. Worth noticing is that MA20 is still intact for Nasdaq. This imply that the potential downside is greater than for the broader S&P 500 index – especially if interest rates will continue to increase. 

Nasdaq 100, February 4^th to September 10^th, 2021

Nasdaq 100, weekly five-year graph

Note: Past performance is not a reliable indicator of future results.

However, news of a court ruling between Apple and Epic on Friday 10 September contributed to some of Nasdaq's decline. Apple shares fell 3.3 percent on the news. From a technical point of view, there is still downside in the Apple share. MA50 just below 148 USD is the first support. If approached, the floor of the rising trend is likely to be tested. Also note the negative divergence between the share and MACD. In case of a break of the trend channel, MA100 may be next. The trying to catch the falling knife in the case of the Apple shares can be seen as a risky trade.

Apple share price graph, February 4^th to September 10^th, 2021

Apple, weekly five-year share price graph