Stock Outlook Brightens as Jobs Stay Strong, Commodities Prices Decline

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The economy looks resilient, and inflation is coming down. That combination could mean a solid second half of the year for stocks after a tough first six months in which the

S&P 500
index fell 20%.

The June employment report released on Friday offered some support for the upbeat scenario. Payrolls rose by a net 372,000 positions, versus the consensus estimate of 250,000, while wages grew 5.1% from the level a year earlier, against a 5.3% increase in May. The jobless rate held steady at 3.6%.

The Federal Reserve is expected to raise short-term interest rates by three-quarters of a percentage point this month, lifting its benchmark rate to a range of 2.25% to 2.5%.

The markets still anticipate another one percentage point of rate hikes by year end, based on the CME FedWatch tool, as the Fed seeks to suppress 8%-plus inflation. But the nation’s central bank might show some restraint, given widespread commodity-price declines and other signs of lower inflation.

Those hopes lately have bolstered stocks and the bond market, where the yield on the 10-year Treasury, at 3.1%, is down by more than a quarter of a percentage point from its June high. The S&P 500 is up 6% from its June low, including a gain of 2% this past week. Key indexes were little changed on Friday after the employment news.

Jim Paulsen, chief investment strategist at the Leuthold Group, says the Fed might even pause its tightening after its next meeting, on July 27-28. “If the Fed is going to take a pause and the economy is not going into recession, we could be setting up for a pretty good rally,” he tells Barron’s. The S&P 500 has a below-average valuation, and small-caps have an extremely low valuation.”

The S&P is valued at 17 times projected operating earnings for 2022 and under 16 times for 2023. Its 2022 earnings yield—profits divided by the current index level—is nearly 6%, double the 10-year Treasury yield. The

S&P SmallCap 600
is valued at just 12 times estimated 2022 operating earnings.

Many investors stick with S&P 500 index funds and don’t bother with small-caps, but smaller stocks are worth a look, given the large valuation gap. The

iShares Core S&P Small-Cap
exchange-traded fund (ticker: IJR) is down 18% this year, and up just 20% since the start of 2018, against a 45% gain in the S&P 500 in that stretch. The ETF yields nearly 2%.

Bank stocks have faltered on recession fears, with industry leaders JPMorgan Chase (JPM) and

Bank of America

(BAC) down more than 25% this year. Four of the six largest banks report earnings this coming week—

Citigroup

(C),

Morgan Stanley

(MS), JPMorgan, and

Wells Fargo

(WFC).

Goldman Sachs Group

(GS) and Bank of America follow on July 18.

The earnings aren’t expected to be great because of weak investment banking, a drop in mortgage fees, and generally tough comparisons with 2021. Stock buybacks are down, thanks to higher rates that are hitting bank bond portfolios and reducing capital. But all of these issues probably are discounted in the banks’ depressed stock prices.

The Big Six trade at just seven to 11 times projected 2022 profits. Bank of America, Wells Fargo, and Goldman change hands near book value, which often has proved to be a floor underneath their stocks. Turnaround candidate Citigroup fetches just half of book value. Most yield 3% or more after some recent dividend increases, with Citigroup above 4%. Absent an economic meltdown, those payouts look secure.

Wells Fargo analyst Michael Mayo recently cut earnings estimates and price targets for most of the big banks, but he reiterated a bullish view. He cited rising net interest income, controlled expenses, and balance-sheet strength. His favorite among the giants: Bank of America.

Write to Andrew Bary at [email protected]