Highlights for This Week Include:

• Stock market pullbacks are a normal occurrence with the average year seeing an intra-year decline of 14% while producing an average full-year return of positive 10%. Corrections typically present buying opportunities with the forward path of returns dependent upon whether the economy enters recession, or economic growth remains positive.
• Most current economic signals remain consistent with further economic growth and lower inflation. Lower inflation gives the Federal Reserve flexibility to lower interest rates, if needed, to react to weaker labor markets and other economic readings.
• The healthy economic backdrop continues to support better-than-expected profit growth, with second-quarter earnings following the positive trends of the first quarter and last year.
• Given the still positive economic and profit backdrop, this suggests the current correction is a normal pullback within an ongoing bull market. See below for details and stay tuned.

Market Pullbacks Are a Normal Occurrence with Further Economic Growth the Key

While the recent stock market drawdown has been sharp, it has not reached the magnitude of the market decline in a typical year, and the market is still 9% higher than at the start of the year. Since 1980, the average intra-year drop has been 14%, while the S&P 500 produced positive annual returns in 33 of the last 43 years with average total returns over that period of 10%.

Since 1980, an investor buying the S&P 500 index 5% below its recent high would have generated a median return of 6% over the subsequent three months, enjoying a positive return in 84% of episodes. Corrections of 10% (which would correspond with an S&P 500 level of 5100, while it stood at 5200 as of Wednesday’s close) have also typically been attractive buying opportunities, but with a weaker success rate of 70% than following 5% drawdowns.

The forward path of the S&P 500 following 10% corrections has been markedly different depending on whether the economy enters recession or growth remains positive. Regarding the economy, we continue to see signs of positive economic growth. Despite the disappointing July employment report, most economic indicators remain consistent with further economic growth, as discussed below.

The just released ISM Services PMI (a timely business survey of the private sector service economy) rebounded in July with most ISM individual activity indexes reflecting an improvement in services growth. Business activity, new orders, and employment all swung back into expansion territory. It should be noted that the service sector makes up the vast majority of economic activity.

In a further sign of lower inflation, the ISM Prices Index is now basically in line with pre-pandemic, as cost pressures have dissipated. This is another lower inflation indicator that suggests the Fed has flexibility to lower interest rates.

A separate important business survey, the S&P Global U.S. Services PMI, saw its July reading match its three-month average, which was the highest since May 2022. It remains consistent with solid service sector growth.

The global backdrop is also consistent with further economic growth. The J.P. Morgan Global Composite PMI (a timely global business survey that combines both manufacturing and services) showed decelerating economic growth but is still firmly in expansion territory and well above its recession level.

In addition, the OECD U.S. Composite Leading Indicator, designed to signal major economic turning points, was above 100 in June for the third consecutive month, indicating above-trend growth. Its six-month annualized growth rate of 1.5% was near the fastest pace since October 2021 and suggests that economic momentum will remain positive in the third quarter.

The economy grew at a 2.8% annualized rate in the second quarter, well above the consensus estimate of 2.0%, with sales to private domestic purchasers suggesting healthy underlying demand. While it is still early for the incoming third quarter economic readings, the Atlanta Fed GDPNow model is currently showing growth coming in at a healthy 2.9%, while the Blue-Chip consensus stands at close to 2%.

The July employment report was undeniably weak, showing slowing payroll growth, more industries cutting than adding jobs, and rising unemployment. While this report is a concern and signals that at least a slowdown is in the offering, some of the weakness was overstated by weather and other seasonal factors. Given the positive growth signals noted above, this suggests it is too early to draw a definitive conclusion from this one economic reading.

We also emphasize that recent lower inflation readings give the Fed flexibility to react aggressively, if needed, with lower interest rates to support the economy, if future employment and other economic readings show weakness.

Thoughts on Stock Market Dynamics and Earnings Season

Stocks experienced a 5% correction back in March and April, and the market often experiences seasonal headwinds, with the August-September period typically the weakest two-month timeframe of the year. Given the still positive economic backdrop noted above, this suggests the current correction is a normal pullback within an ongoing bull market.

Meanwhile, corporate profits continue to come in better-than-expected, supported by the healthy second quarter economic backdrop. We are in the heart of second quarter earnings reporting season with about 86% of S&P 500 companies having reported. Second quarter expectations are now for earnings to grow by 11% y/y. Similar to recent quarterly results, earnings continue to come in better-than-expected. Earnings are beating estimates by 3.7%, with 74% of companies topping projections. For companies that have reported, earnings growth is 11.7%.

Information Technology and Communication Services are expected delivering the fastest earnings growth at the sector level, led by the mega-cap tech stocks. Analysts expect earnings to decline in the Materials, Industrials, and Energy sectors.