The Market Got Cheaper While Stocks Rose

In one week in August, the market went from expecting the Federal Reserve to cut interest rates to betting it will raise them instead.

Stocks rose 2.7% anyway. And they got cheaper doing it.

That second part deserves a moment, because it sounds impossible. When we say stocks got “cheaper,” we mean the price investors are paying for each dollar of expected company earnings went down — even though share prices went up. That happens for one reason. The earnings those companies are expected to produce climbed faster than their stock prices did.

That combination is rarer than it sounds, and it usually means earnings, not enthusiasm, are driving the rally. The market is not ignoring the Fed. It has decided earnings matter more.

Kevin Warsh used his first Jackson Hole speech as Fed Chair to tell investors precisely what he thinks. He called inflation persistent rather than temporary and did not hide behind circumstance: “The responsibility for 65 months of sustained, elevated inflation sits squarely with the central bank.” He also rejected the popular idea that the Fed has already done enough — “I would be hard pressed to describe broad financial conditions as restrictive.” Translated: he does not believe current interest rates are actually slowing the economy down much.

Markets reacted quickly. Traders who had been positioned for a September rate cut flipped to betting on an increase, with those odds moving from roughly 36% to 67% in the days around the speech. The 30-year Treasury yield briefly topped 5.3%, its highest in about nineteen years. That number matters to you because it sets the tone for mortgage rates and for what companies pay to borrow.

Then Friday’s jobs report arrived and made his case for him.

This is not stagflation. It is not comfortable, either. The Fed is boxed in.

In May I told you the value-and-commodities chapter was closing and that we were putting cash back to work in growth stocks. By July 3 I had walked that back, writing that chasing the most exciting growth theme was not the right answer when valuations were high and market leadership had narrowed to a handful of names.

Eight weeks. If you are scoring at home, that is a reversal — and it is one of the better decisions we made this year. Here is the cleanest way to see it.

• The S&P 500 you hear quoted every night is weighted by company size, so the largest handful of companies drive most of the movement.
• There is a second version of the same index that treats all 500 companies equally. That equal-weighted version is up 15.6% this year against 13.1% for the one everybody owns — which means the average stock is beating the index.
• Smaller companies are doing better still; the Russell 2000 is up 20.2%. And the Magnificent Seven, the mega-cap technology names that led the market for three years, have underperformed.

In July we wrote that the market appeared to be shifting its enthusiasm away from the companies building AI hardware and toward the companies actually using it. August settled the question.

Consider what that took. Nvidia reported revenue up 106% from a year earlier and forecast even more — and the stocks around it still could not hold their gains. When a quarter that good cannot lift its own sector, the market has changed what it is willing to pay for. This is not the AI story ending. It is the AI story maturing: investors are paying for adoption now, not for capacity.

You are going to hear that S&P 500 earnings grew 52% last quarter. It is the fastest growth since 2021, and it will be quoted everywhere.

Read the footnote. Companies beat analysts’ estimates in aggregate by 26.5%, against a five-year average of 7%. Strip out two companies — Alphabet and Amazon — and that figure falls to 10.8%. The reason is that both booked large gains on investments they hold, rather than profit earned from selling their products and services. Those gains are real, but they are not the same thing, and they do not repeat reliably.

The underlying picture is strong enough that it does not need the makeup. Eighty-six percent of companies beat on earnings and 77% beat on revenue, with revenue growing 15.5%. Revenue is what customers actually paid. That is demand, not accounting.

That strength is what produced the odd arithmetic in the first paragraph. The price investors pay per dollar of expected earnings fell from 20.0 to 19.6 during August, below its own five-year average, while the index rose. Prices up. Valuations down. Earnings outran both.

So where is the risk? Not the Fed. And after Friday, not the job market either.

It is the household balance sheet. People are working. They are just not getting ahead.

And consumer spending is roughly 68% of the entire economy.

Record corporate profit margins are being funded, in part, by households that have stopped saving. That gap closes eventually. The only question is from which side.

There are four ways the early fall months could unfold.

Three of those four we are positioned for today. The fourth is the one that gets our attention — because the worst time to decide what to sell is while it is happening.

The last two are where it gets complicated. We are near fully invested and overweight energy, so let me be plain about what that means. Energy has been our best performer this year, and it doubles as our protection against the Hormuz outcome. That is an efficient thing to own. It also means we are covered for the supply shock and not for the demand shock.

I am not going to pretend we have hedged both. You cannot. A supply shock rewards energy and commodities. A demand shock does the opposite, because when spending falls, so does the price of oil. Anything that protects you in one hurts you in the other. And the usual answer — spreading money across more things — is working less well than normal right now, because stocks, bonds and commodities have been moving together more closely than at almost any point in the past decade.

So our work this fall will come down to pressure-testing. Running the portfolio against each of those four outcomes and finding out which of our holdings are quietly the same bet wearing different labels. It is unglamorous work, and it is the work that matters most in a market like this one — the kind we would rather do now, while everything is calm, than under pressure later.

One more thing on the horizon: the midterms are about two months out. We will take that up properly next month, but the short version is that divided government constrains legislation, and legislation has not been what moved this market.

The Fed is not coming to rescue this market. It does not need to. Earnings are doing the work — and making sure the earnings you own are the operating kind is our job, not something you should have to think about. We will keep watching the household balance sheet. We will keep testing what we own against what could go wrong. And we will tell you plainly when something changes, the same way we told you in May and again in July.

That is the arrangement, and it has not changed.

— Meridith L. Hutchens, Fortis