Bob’s Journal for July 6, 2023

Without AI, Stock Indexes are Down 2% This Year

The S&P 500 Index is up 16.79% so far in 2023, and the tech-heavy Nasdaq 100 is up 39.14%.

But those gains are because of a remarkably few stocks, and those stocks are closely connected to artificial intelligence (AI). The rest of the market isn’t doing well.

AI stocks are the investors’ favorites of 2023. Enthusiasm for them triggered a rally that started in late February.

But a strategist at Societe Generale, Manish Kabra, estimates that without the AI stocks the S&P 500 would be down 2% so far this year.

Kabra attributes most of the year’s gains to three AI-related stocks, Nvidia (NVDA), Microsoft (MSFT) and Alphabet (GOOG). (Apple (AAPL) also has had a strong year but isn’t considered an AI stock.) Remove these three stocks, and the index is down 2% for the year.

The powerful AI surge pushed prices of a few stocks to extremely high valuations. NVDA already is up 96% for the year. There’s no margin of safety or room for disappointment.

Investors need to decide if they want to ride this market trend or pursue opportunities with higher margins of safety.

Bankruptcies are Ticking Higher

Instant Pot was a hot item during the pandemic. But the after-effects of that surge and other factors caused the product’s maker, which carries the same name, to file for bankruptcy reorganization recently.

Supply chain issues during the pandemic caused the company’s costs to surge at the same time demand jumped. Instant Pot ordered more parts, and it ordered them further in advance than usual to lock in prevailing prices.

The supply chain problems finally began to ease. But the company had locked in the higher costs. Unfortunately, demand fell as consumers returned to pre-pandemic lifestyles.

Higher interest rates also battered the company. It must pay higher rates on the substantial debt it now carries.

Instant Pot is not in an unusual situation.

There have been 41 corporate debt defaults in the United States so far in 2023, according to Moody’s Investor Service, about double the number at this time last year.

The number of bankruptcy filings also has increased to the highest number since 2010. There were 324 bankruptcy filings through June 22. That compares to 374 in all of 2022.

That’s not surprising, and we should expect the trend to continue, according to a recent study from Federal Reserve economists.

The study found that companies already in distress respond strongly when the Fed reduces the money supply. Those firms reduce both investment and employment as monetary policy is tightened.

Companies not in financial distress don’t change their investment and employment policies significantly in response to changes in monetary policy.

Distressed firms have strong reactions because less credit becomes available to them, and interest rates increase on the credit they can obtain.

The economists also found that a high share of U.S. companies currently face financial distress.

A Surge in Income Taxes is Coming

Individual income tax payments are likely to surge past 10% of gross domestic product (GDP) and stay there for years, according to the Congressional Budget Office (CBO).

Individual income tax collections averaged about 8% of GDP for the 30 years ending with 2022. Tax collections in 2022 surged to 10.5% of GDP, the highest rate in 89 years.

The 2022 surge was the result of higher capital gains tax collections (primarily due to people cashing in gains from the post-pandemic stock market surge) and payments of previous years’ taxes that were allowed to be deferred during the pandemic.

The CBO estimates that individual tax collections will fall below 10% of GDP for the next few years, but then rise in response to two factors.

One factor is one I’ve emphasized, the expiration after 2025 of many of the tax reductions in the Tax Cuts and Jobs Act that was enacted in 2017. Individual income tax rates will be higher and the standard deduction will be cut in half, among other changes.

That projection assumes Congress doesn’t agree to extend some or all of the 2017 tax cuts. The CBO estimates an extension of all the expiring tax cuts would reduce tax revenue by $3.5 trillion over the following 10 years.

The other factor is what the CBO calls real tax bracket creep. Many parts of the tax code are indexed for inflation. But the indexing is done using the Consumer Price Index (CPI).

The 2017 tax law changed the calculation so that now the chain-weighted CPI is used. The chained CPI increases at a slower rate than the unchained version that was used in the past.

In addition, the CPI is based on price changes for consumer goods and services. Incomes usually rise at a faster rate than prices. The result is that over time people are pushed into higher tax brackets because income increases outpace adjustments in the tax brackets and other tax items.

That’s what the CBO calls real bracket creep. CBO estimates that in 2033, the 9% of taxpayers with the highest incomes will pay the top individual income tax rate. By 2053, the top tax bracket will capture the 11% of taxpayers with the highest incomes.

The CBO estimates real bracket creep will increase individual income tax collections by two percentage points of GDP over time.

The Data

The Fed’s preferred measure of inflation remains well above the target rate.

The Personal Consumer Expenditure (PCE) Price Index increased 0.1% in May after rising 0.4% in April. Over 12 months, the PCE Price Index is up 3.8%, an improvement from the 4.3% at the end of April.

But the more important core PCE Price Index, which excludes food and energy, increased 0.3% in May after rising 0.4% in April.

Over 12 months, the core PCE Price Index is up 4.6%, only a marginal improvement from the 4.7% rate at the end of April.

Manufacturing activity declined again in June, according to the ISM Manufacturing Index. The index was 46 in June, down from 46.9 in May.

The PMI Manufacturing Index for June was 46.3, a decline from 48.4 in May.

Factory orders increased 0.3% in May, the same percentage as in April.

But after excluding transportation, orders declined 0.5% in May. That’s the fourth consecutive month non-transportation orders declined.

Personal income increased 0.4% in May, following a 0.3% increase in April.

Personal spending increased 0.1% in May after increasing 0.6% in April. Spending for services increased in May, while spending for goods declined.

The Consumer Sentiment Index from the University of Michigan was 64.4 at the end of June. That’s the highest level in four months and compares to 59.2 at the end of May and 63.9 in mid-June.

Pending home sales fell 2.7% in May, following a 0.4% decline in April.

Pending sales are down 22.2% over the last 12 months. The 12-month change in pending sales has been negative for 24 consecutive months.

The decline in sales might be due primarily to a lack of homes for sale. The National Association of Realtors reported that each listing receives approximately three offers.

The Chicago Purchasing Managers Index improved to 41.5 in June from 40.4 in May. June is the 10th consecutive month the index was below 50, indicating economic activity is contracting.

GDP increased at an annualized rate of 2% in the first quarter, according to the third and final estimate. The previous estimate was 1.3%. The main difference was an estimated increase in consumer spending of 4.2%, the highest rate in almost two years.

Spending on durable goods and on services also had healthy increases.

But corporate profits declined 5.9% in the first quarter, according to the final estimate. That’s better than the 6.8% decline in the previous estimate, but larger than the 2.7% decline estimated for the fourth quarter of 2022 and is the most significant decline in profits since the last quarter of 2020.

New unemployment claims declined by 26,000 to 239,000 in the latest week, the biggest one-week decline since October 2021. The previous week’s claims were a 20-month high.

Continuing claims, which lag a week behind new claims, decreased to 1.742 million from 1.761 million. That result brings continuing claims to their lowest level in four months.

The Markets

The S&P 500 rose 1.75% for the week ended with Monday’s close. (Markets were closed Tuesday.) The Dow Jones Industrial Average gained 1.43%. The Russell 2000 increased 2.34%. The All-Country World Index (excluding U.S. stocks) added 1.10%. Emerging market equities advanced 0.76%.

Long-term treasuries lost 0.79% for the week. Investment-grade bonds increased 0.13%. Treasury Inflation-Protected Securities (TIPS) lost 0.14%. High-yield bonds gained 0.63%.

In the currency arena, the U.S. dollar gained 0.57%.

Energy-based commodities increased 1.20%. Broader-based commodities rose 0.43%. Gold advanced 0.44%.

Bob’s News & Updates

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