Stock Market Rally: Real Strength or Merely Mirage? — ft. Kevin Gordon | Prof G Markets

Thanks for having me. Good to be here.

Yeah, it's been uh remarkable and actually I was thinking back to you I was speaking at a conference in June uh with Lizanne and um I had made this comment when we were giving the keynote but I had a friend uh text me that morning. It was right around when we got to you know unchanged year-to-date for the S&P 500. I had a friend text me and he said, "Hey, I just checked the market uh this year and it looks like it's been it's been pretty quiet." And I said, "Man, what a lovely rock uh this person gets to live under where, you know, they don't have to check it every day and see the turmoil that we went through in April." Um but it sort of speaks to the fact that yeah, there was a ton of turmoil and it manifested in a in a really different way um this year than it did last year. And I think the the 2024 to 25 switch um or comparison is really remarkable because last year, you know, there was barely any scarring at the index level. All of the turmoil was underneath the the market surface. So you only got to sort of a traditional correction for the S&P at the index level, but you know, the average member uh average members maximum draw down was more than 20%. Our view coming into 2025 when we wrote our our outlook for this year was that you were probably going to see that dynamic flipped. um much of it almost all of it uh our our thinking at the time was driven you know going to be driven by policy both on the tariff front but also on the immigration front which gets you know shockingly still to me gets you know less attention um than than tariffs I think it's a much you know bigger part of the longer-term growth story for the economy which we can get into later but uh you know admittedly we didn't think it would manifest or or happen as fast as it did uh when you got to early April but that's really our outlook for the the remainder of the year as we look even to the back half and and frankly for you know a good chunk of the next uh couple of years if you think about the world that we live in now which is one that's driven a lot more by policy that's coming out of the White House in particular um and you know normally Washington is this kind of sleepier slower moving beast um don't really have to pay a lot of attention to it but uh when you're talking about two huge components of the economy which is trade and then also labor um you know they become much stronger drivers of day-to-day activity so I think that you know as we turn to the back half of the year. Um it's not necessarily that we're, you know, outright skeptical of the rally or skeptical of what the economy has shown so far this year. Um it's just that when you actually listen to what companies are saying, and we have, you know, a ton of clients that are are, you know, small business owners up to a really large, you know, executives, um we represent a pretty good chunk of the, you know, the average retail investor out there. Um, and when you talk to them and and see how they're thinking about this, everything tariff related and how this is playing out, a lot of the adjustments to pricing or a lot of the expected hits to growth are not really expected to come for for a while. So even though you were in that really strong turmoil phase from, you know, April into a little bit into May, um, it was never our thinking that you were going to see everything unfold all at once in terms of the overall impact to the economy. So I still think we have a lot to work through. Um, I do think that hopefully, you know, the worst is behind us in terms of the depth and the breadth of what was announced in April. Uh, I think that's been one of the reasons that the market's been able to rally. But, um, in terms of this index like volatility both to the upside and the downside, I'm not sure that I'm not sure we're past that.

Well, I think it's a, you know, I like that you put the market in quotes because there is a difference when you talk about, you know, the market at the index level versus at the sector or even at the industry level. And I think, you know, we we we have recommendations that we put out um at the sector level across all 11. We don't go as granular as the 25 industries because it's just a little bit too it's a little bit too granular. However, um I have found myself peeling back the onion a little bit more to that layer lately because if you actually look at performance, whether it's year-to-date, whether it's since the April 8th lows, what has lagged the most um are those industries that are sort of at the epicenter of the tariff drama there, you know, it's it's food uh food companies and retailers and consumer staples. You broaden that out to consumer discretionary, it's the auto companies. even this earning season. I mean, look at the two opposite ends of the spectrum where you've got the banks that were out of the gate first, which did quite exceptionally well. Um, and then you have a lot of auto companies that have struggled and and mentioned uh, you know, a lot of the profit that they've taken from a tariff standpoint. The difference though between a lot of those industries, if you look at something like banks or semiconductors, I mean, their weighted average profit margins are are upwards of 20 to 30, sometimes 40%. um and they're a much larger share of the overall market in market cap terms. If you look at kind of what is traditional old economy stuff like autos or manufacturing, it's a smaller portion of the market. So I actually think a big reason that we've seen such a strong and and uh you know miraculous rebound in the market is you know yes those those kind of heavier weight sectors or industries or companies in some instances have really driven you you know back to those new all-time highs.

I think the way that you could sort of make the distinction here and it what I what we are increasingly seeing with these tariffs is that we have made this very arbitrary line that doesn't really make any sense in today's modern economy of physical goods versus digital services. And for whatever reason, we've decided that we're only going to tariff physical goods. And it's kind of a logistical thing. it's it's easier to sort of track a physical good that is shipped to America and we're going to tariff those things. But as you describe the differences we've seen in the market, it feels as though those are kinds of the two buckets that we can categorize the market into. If you're in the business of services, as most of the most valuable companies in America are, you're fine because for whatever reason we've said services are okay. But if you're in the business of making and shipping physical items, things that we can touch and feel, then you're not as fine. And I'm just wondering if you would agree that that is sort of the right distinction to make. Um, and if you think we could characterize what we've seen this year like that.

Yeah, I think generally um not only in in this environment is that has that been the dynamic but actually post-pandemic um that has kind of been you know in this past 5-year cycle that's sort of been the dynamic where everything manufacturing related has really struggled. Um, you know, we we were sort of calling it we weren't the only ones to call it or the first ones to call it, but we were we were thinking about it in terms of rolling recessions hitting the economy starting around 2022 into 23 where if you were just looking at manufacturing or just looking at survey-based data, all of that was telling you that we were going definitively into a recession. The offset of that was a much stronger services economy and is really what insulated us from having to go into, you know, a much broader NBER defined recession. But I think, you know, even today, um, you're right to point this out and it's amazing to me still how many, you know, when I hear people talk about trade and especially criticize the trade deficit, um, it's it's incredible that the service surplus we have gets really little attention, if any at all. And I do think that if there was one particular pain point that I would sort of point to and emphasize in this entire, you know, trade uncertainty cloud that we've been in, um I do worry a little bit more about the potential hit to our, you know, services demand because if you start to look actually and dissect some of the inflation data, um yes, broadly at the headline level, tariffs have not shown up in a meaningful way. However, if you break it down into core goods and core services, take out the impacts of energy, um you are starting to see a little bit more heat on the good side, but that's being um sort of the counterforce to that is is disinflation on the services side. However, some of the declines we've seen recently in services like in the lodging and the hotel and the leisure space um have been pretty strong. So, if that doesn't turn, um, that'll sort of give me a little bit of a more negative signal of what's actually happening in the economy, which is goods prices rising for the wrong reason and then services prices falling, uh, also for the wrong reason. So, I think that dynamic um, is incredibly important to watch because for the, you know, many years that we've been expanding and running a goods trade deficit, we've been expanding and running a services surplus in addition to a capital account surplus. That to me is not a bad thing. um you know our economy has been able to grow you know quite well. Um I know this is sort of a it can be now a politically hot button you know issue but I think if you just look at the data how much household net worth has climbed how much you know our asset markets have done well not to say that there haven't been issues uh but I think that those those two things are not are not bad uh when you look at the goods deficit versus a capital account surplus or and/or a service of surplus.

I mean I think that it's uh I mean not as a cop-out answer because I'll expand on it. I think it is a mix of everything because if you do if you look at you know pre-April 2nd it's not that we were in a zero-tariff world. I mean we knew that higher tariffs were coming. there were already announcements you know it started with Canada Mexico um there were already announcements and implementations not just at the country level but also at the sector level so the market was starting to digest this and price it in and even absent the DeepSeek inspired sell-off that started in February for big tech there were dislocations in the market where you started to see some of that you know some of that breakdown um so it's really just the April 2nd uh sort of moment when all of it became again to the breadth and the depth point I made earlier all of that became a lot more real. And I think at the time too when you look at the policy of the administration and what they were using as justification for those tariffs, uh, which by the way is still under question in terms of the legality of them, uh, which I'll get to in a second, but that, um, I think was the, oh my gosh moment from the markets saying this is really an effort to sort of turn this ocean liner around, um, with the attempt of doing it like we would with a speedboat. So I think some of it is maybe the the market being a little bit more sanguine about what the goal of the administration is. Not necessarily being as serious about closing these trade deficits and making sure that we source things here and becoming this export powerhouse which economically um you could argue is just you know it's just not feasible. Uh not not least because we just don't have the labor force for it. But I think the other thing too I mean there are other aspects of this that are still unresolved. Number one, and I know you guys, you know, have mentioned this a lot in the past week, all of these deals and frameworks that have been sort of put together, you know, they're not binding in in any ways. Now, you know, no ink has really been put on paper yet. Um, I think even with some of these investments that are being proposed either from Japan or from the EU, there's a lot of questions around how that's enforced. There's a lot of questions, especially for the EU, I think what struck me the most reading it on on Sunday when I got the notification, um, was the commitment from an energy perspective. uh because even the the way that energy policy is being approached right now, there's this goal of becoming an export powerhouse, you know, again, for for energy in particular, but I'm not really sure how you do that when there's also the goal of making sure oil prices stay low and that doesn't really inspire, you know, energy production in this country. So, I'm not sure how you ramp up, you know, close to 800 billion worth a billion dollars worth of energy exports to the EU. So those are a couple of examples where I think the market's probably being a little bit more optimistic that either those won't be enforced as strongly or that there will be a question around the legality of the tariffs. I mean we're start we're going to start hearing you know oral arguments this week uh later this week as to whether the AIPA tariffs um which is what everything so far has sort of been under minus the sectoral stuff you know whether that is legal or not. But I think that you know to answer your question and maybe not the most you know direct way I do think it's a combination of many things. at the end of the day for you know large-cap US companies um I'll borrow a quote you know from one of my he's he's become a you know good friend of mine Tom Keen at Bloomberg but he always says you know companies adjust so what our argument has been most of this time throughout the tariff uh turmoil has been if you you know set the rate don't change the rate and we hear this a ton I hear this a ton from clients I'm on the road all the time you know talking to clients uh many of whom are trying to figure out how to deal with this for their businesses, but they've, you know, many of them have told me in particular, um, that they're just wanting the rate to stay where it's at. Stop moving it around, you know, based on the country. Stop moving it around based on the sector because ultimately companies will be able to adjust. I think it'll be harder for smaller companies because they just don't have the the balance sheets or the cash positions or, you know, the flexibility to be able to diversify their sourcing. So, if you're going to think about it in market terms, that's why I think the S&P 500 has continued to do so well relative to the Russell 2000, just as an example.

You know, I think for for interest rates, kind of the the path of that path that we've been on, uh, which I've been calling the path to nowhere in terms, if you look at the 10-year yield, I mean, it's largely been trendless for the past year or year and a half. I mean, it really hasn't moved. It's stayed in a pretty wide range. I think that speaks to the upward and downward pressure that we're facing from a policy, you know, standpoint. Um, in terms of the risks of some inflation from immigration policy or tariffs, but also the back end of that, which I think is more important, which is potentially the growth negative that you have, um, not necessarily as much with tariffs. Um I actually worry a little bit longer term that from the labor policy side if we continue to go down the route of trying to constrict or you know sort of restrict growth um particularly with foreign-born labor not just via deportations but um sort of at the border you know at the physical border or or non-physical border of people coming into the to the country to sort of fuel our labor force growth. that all you know over time um is a hit to growth because you know at the most basic level um the the product of economic growth is really just whatever you get from productivity growth and your labor force growth. So if we're not assuming some massive boom in productivity which it's been it's been generally okay over the past several years but if you're going to hold that sort of where it's been um but you're going to see your labor force growth continue to stall or fall then you probably have lower potential GDP growth. I I think that from a labor policy standpoint, I don't necessarily view it as um inflationary right now because yes, even though you could go into a world where we have more labor shortages, um you can raise, you know, wages all you want for a job that you're trying to fill, but if someone doesn't want to do that job or you can't find the labor, you can't recruit the laborer, then you're not going to fill the job. Um, and I think companies will maybe start to resort to what has become a little bit of a trend lately, which is just, you know, beefing up their existing workforce, whether it's paying them a little bit more or expanding their work week. You know, the Dallas Fed just released a survey on this uh for the current month and they, you know, they had a special question in their surveying companies and what they were doing in response to, you know, tighter labor policy and that's, you know, one of the things or two of the things that they they had mentioned doing. So I think ultimately that probably slows growth and therefore is maybe a little bit more of a depressant on inflation. So you know the optimistic take of that would be that you don't go necessarily into a stagflationary scenario where inflation is is running really hot uh but you also have relatively high unemployment.

Oh rates I think that ultimately helps put downward pressure on rates over time. Uh but I also think that when you look at you know just the term premium and how investors have treated fixed income over the past few years um and and just sort of the the built-in now geopolitical risk premium especially for the US um I think it is probably safe to say that we're in a higher for longer sort of interest rate world and you know for all that's happened this year um and when you sort of think about how the Fed fits into this um if if they're sort of seeing that their inflation target is still they're still further away from their inflation target than they are their labor target which is still the case today and the economy continues to hang in there even if it's not expanding at you know um at a except you know exceptional pace um then that's probably all the more reason for them to stay on hold or adjust policy just a little bit lower. So as long as they keep rates pinned relatively higher compared to where we were several years ago, certainly compared to post-financial crisis, then yeah, I think that still keeps a higher floor for for interest rates.

Yeah, I think I would generally agree with that. But I think still it's a small share of overall earnings and when you look at you know the aggregate S&P 500 and what earnings growth has done um you know the blended growth rate we call it so taking what's been reported in addition to and combining it with um the expected growth rate for the rest of the quarter you know that's continued to move up throughout reporting season following a similar trend um which you normally see during reporting season but in particular the past couple where we started very low because analysts lowered the bar so much because they really didn't know you know how to bake in a lot of these uh a lot of the tariff impacts, but then we ended up at pretty exceptional levels. And just as a as an example, for Q1, we started at low to mid-single digits for expected growth for just that quarter. And by the time we got to the end of the reporting season and the end of the quarter, uh you were at almost 14% for earnings growth. So there was just this massive jump higher because the bar was set so low. And that's a similar case of what we're seeing so far early days for the second quarter. And I would mention too, it's similar for the third and the fourth quarter. None of the earnings optimism in the first quarter was extrapolated to the rest of the year. So the bar has been set super low and it's easy, you know, in a relative sense for companies to jump over that bar, which is why the beat rate has been, you know, close to 80%. Which is pretty exceptional. Um, so you're starting, you're seeing it, you know, happen in certain companies like you mentioned, but so far it's a bit more, you know, idiosyncratic and company specific where it's not filtering through to the rest of the economy. Um, you know, ultimately this comes down to uh what we've been talking about a lot in terms of services, whether the demand for services really starts to get hit. Um, and if if the weakness in some of these more consumer-facing or cyclically oriented parts of the economy, if that starts to translate into broader consumer weakness and then you get a hit to the labor market, that's where sort of the economy becomes one uh where you start to see everything kind of roll back into a recession. Uh but I think that you know we need more we need more time with this because to the earlier point you know I made about companies just haven't having not adjusted prices uh yet and really not having to probably do it until closer to the end of the year. You know there's a lot of pricing agreements and contracts that you can't adjust uh even if you're starting to face higher tariffs. We've also got an inventory build that we're still working through. You know as as corporate America that we're still working through. Um so there's still enough of a cushion I think. Um and and this, you know, doesn't really start getting real, I think, for the broader economy until the end of the year. But again, you know, if this you would need to see a much more material hit for those sectors and industries that have really really strong profit margins because a lot of those have been the ones that have been carrying, you know, most of most of the markets gains recently. And it's not just a couple. I mean, there's there's quite a few. But if if it starts to translate into weakness for those sectors, that's where I feel that you probably see a broader hit to the economy.

Yeah. your your thoughts on Sydney Sweeney, Kevin? That's not a meme stock. That's just common sense. I'll buy whatever she's selling.