Markets Notch Record Rally: Is it Sustainable?

MIKE TOWNSEND: Last Friday, both the S&P 500^® and the Dow Jones Industrial Average hit all-time highs, a clear sign that Wall Street is feeling confident. Much of the headline data about the economy is similarly encouraging. Inflation is continuing to ease, unemployment remains low, consumer sentiment is surging.

Yet there continues to be a big gap between some of the economic data and how ordinary people feel about the economy. In the most recent Gallup economic confidence poll taken in December, 78% of respondents said the economy was fair or poor, and 68% said the economy is getting worse, not better. And beneath the records for larger stocks, smaller stocks are struggling.

The Russell 2000, a bellwether for small-cap stocks, began this week down more than 3% for the year. So how can all of these things be true at the same time? And what does it mean for the year ahead? Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

Coming up, Schwab Senior Investment Strategist Kevin Gordon returns to the podcast to discuss the state of the economy and the markets right now as we sort through what's beneath the surface of the latest data and what it all means for investors. But first, here are three things to know about what's going on here in Washington, D.C.

Number one, Congress last week averted a government shutdown by doing what it does best, kicking the can down the road for a few weeks. If this feels like deja vu all over again, well, it's because it is. This is the third time since the end of September that Congress has come within a few hours of a government shutdown and passed a last-minute bill to buy themselves a little more time. On this occasion, funding for a handful of federal agencies was slated to run out on January 19, while the rest of the government was funded through February 2. The bill passed last week and signed into law by the president resets those two deadlines to March 1and March 8.

But here's the thing. There is absolutely no chance that much will change between now and the end of February. In agreeing to the delay, congressional leaders argued that this would give them additional time to negotiate the details of the 12 appropriations bills that fund every federal agency and every federal program. Now the leaders did agree earlier this month to the total amount of spending for the fiscal year that started back on October 1, about $1.6 trillion, though a side agreement takes that total up closer to $1.7 trillion.

But now Congress has to divvy that money up among the various agencies and programs. And that is always complicated, even more so this year, with the House Republicans who are internally divided about whether to push for a shutdown in hopes of forcing Democrats to accept tougher border restrictions.

Congress may get a couple of the least controversial appropriations bills finished over the next few weeks, but there is no chance they'll finish all 12. And that means we're likely to have another dance in early March over whether to pass another temporary extension of funding or shut down the government. Of course, February and March is typically the timing when the budget for the next fiscal year begins working its way through the legislative process. So it's likely Congress will be working on next year's funding before this year's funding has been sorted out.

And there's one more deadline to watch. As part of the debt ceiling agreement last year, Congress put in a trigger mechanism that says if it has not passed all the spending bills by April 30, then there will be an automatic, across-the-board, one percent cut in spending.

That means a cut to defense spending, a cut to domestic spending, a cut to everything. Neither party really wants to see that. So maybe that will act as an incentive to get to a resolution. Call me skeptical, given the deep divisions on Capitol Hill.

But that brings me to my second development to watch in Washington, and this is one where bipartisanship is the real surprise. Last week, the Republican chair of the House Ways and Means Committee and the Democratic chair of the Senate Finance Committee teamed up to announce a modest tax bill. The bill would enhance the child tax credit, a top priority for Democrats, while expanding some business tax breaks, a priority for Republicans. The bill was considered last Friday by the full Ways and Means Committee where it was approved on a vote of 40 to three, a pretty amazing show of bipartisanship in the current atmosphere. That said, the bill has a tricky future.

House Speaker Mike Johnson has not made a commitment yet on when, or even if, he'll bring the bill to the full House for a vote. And the path forward in the Senate is even dicier, since tax bills are open to unlimited amendments in that chamber. Any tax bill moving forward is likely to attract a lot of lawmakers who have their own tax priorities that they'd like to attach to the bill.

One example is a large bipartisan group that has been pushing for an increase in the $10,000 cap on the state and local tax deduction. Trying to attach that to the child tax credit expansion would be very controversial.

I have no idea whether this bill will pass in the coming weeks or not, but I made note of it because of the strange bedfellows who produced it and because no matter what happens in the election this November, the biggest priority in the next Congress will be a tax bill.

That's because the 2017 tax cuts, including lower income tax rates, a higher standard deduction, and the increase in the amount of assets exempt from the estate tax are all set to expire at the end of 2025. So next year, Congress will have to figure out whether to let those expire, raising taxes on just about everyone, or extend them, which will have a big impact on the deficit and the national debt. That decision is still more than a year away.

But the fact that at least some members of the two parties could find some common ground on a tax issue in 2024 is perhaps the tiniest glimmer of hope that lawmakers will find a way to work together on next year's much larger looming tax fight.

Finally, this month also saw a notable development at the SEC, where after six years of rejecting every application for a Bitcoin exchange-traded fund, the agency finally relented. On January 10, the SEC voted to approve the launching of 11 Bitcoin ETFs, most of which began trading the next day.

But this was no big change of heart at the SEC. This was the direct result of a court decision last fall, where an appeals court ruled that the SEC had not provided adequate reasoning for rejecting the products. While the court did not directly order the SEC to approve a Bitcoin ETF, it was pretty clear that was the intended message. SEC chair Gary Gensler has been an outspoken opponent of cryptocurrency, and his agency has taken several crypto exchanges to court in recent months. But Gensler reluctantly agreed to join with the SEC's two Republican commissioners in a three-to-two vote earlier this month to approve the Bitcoin ETFs, which in the wake of the court decision, he called, "the most sustainable path forward."

But Gensler did not hold back in his statement about his vote, noting that while the agency may have approved Bitcoin ETFs, it, quote, "did not approve or endorse Bitcoin." "Investors should remain cautious about the myriad risks associated with Bitcoin and products whose value is tied to crypto," Gensler added. Circumstances may have pushed the SEC chair to approve these new crypto-related products, but he sure isn't happy about it.

On my Deeper Dive today, we're going to take a closer look at what's going on in the economy and in the markets. The S&P 500 hit an all-time high last Friday and consumer sentiment has been ticking upwards over the last couple of months. But does that mean we will avoid a recession? Has the recovery and the bull market already started? And why is there so much skepticism that the economy is actually doing well?

I'm pleased to welcome back to the podcast Kevin Gordon, Schwab's senior investment strategist. Kevin is fantastic at getting beyond the headline numbers and explaining what's really going on with the economy. Kevin, thanks so much for joining me today.

KEVIN GORDON: Hey, Mike. Great to be back, and thanks for having me.

MIKE: Well, Kevin, with the market on such an upward trajectory, the big question is just how sustainable that is, and I think we need to look beneath the surface a bit to understand what will keep it going or knock it back. The state of the economy seems like the right starting point, and I want to break this down into a couple of different parts. Jobs numbers earlier this month continued to be strong, but you and Liz Ann Sonders wrote recently that there may be a bit of trouble beneath the headline numbers. So what concerns you, and how concerned should investors be?

KEVIN: A major theme that we've really been emphasizing in the labor market over the past year has been one of these major divergences. Whether it's the household versus the establishment survey, or the cuts to hours worked versus the increase in the number of jobs added, or the decline in full-time workers versus the increase in part-time workers, there have been serious gaps in data sets that are increasingly unusual. And that's confirmed the fact that we continue to see these cracks under the surface of the labor market, but they haven't widened enough to push the labor market and the broader economy into a recession.

And I mentioned several things there, so I'll break each of them down, starting with the household versus the establishment surveys. So it's important to note that when we get the jobs report each month, the number of jobs reported is what comes from the establishment survey. It's a survey of companies. They're reporting payroll data. And then, conversely, there's another survey called the household survey, which is a survey of households. It just asks individuals if they're employed. Are you working or are you not working?           

So the most recent jobs report that we have for the month of December showed a gain of 216,000 jobs in the establishment survey, but actually a loss of 683,000 jobs in the household survey. So that's a massive divergence. That's really not typical in what you would see in a normal—I'm putting that in air quotes—a "normal" cycle. And the reason the spread between both of these matters is because the gap started occurring almost two years ago, so you have to go back to April of 2022 to see when they first started diverging. You had the gain in payrolls since then being nearly 6 million jobs. Conversely, the gain in household employment has been just 3 million. So if you look back at history at these major turning points in the economy, it's really the household survey that tends to lead the establishment survey. So today, that would tell us that we're in store for more softening in that payroll data.

The next crack worth noting is the cuts that we've seen to the work week. So if you look at average weekly hours worked, they've come down significantly from their peak in 2021, from about 35 to 34.3 hours. So to put that in context, it's actually the same magnitude of hours lost during the global financial crisis, and the recession that was caused by that. And it's pretty rare to see that degree of work week cutting without a significant decline in overall jobs. But this is just how companies have been managing labor costs over the past few years. They've engaged in what I would call stealth layoffs by keeping hourly paid people employed, but just shortening how much they work each week.

And then that last divergence that I want to touch on is this decline that we've seen in full-time workers and the increase in part-time employment. So in December alone, within that household survey, there was a decline of more than one-and-a-half million full-time workers. And that was actually the largest drop since April of 2020, during the pandemic shutdown. Conversely, there was a notable increase of 760,000 part-time workers, but that was obviously overshadowed by the decline in full-time work.

MIKE: That's really helpful to get that perspective on some of the divergences in those numbers that go beyond just what we kind of read about in the papers.

You know, in that same report that I mentioned that you worked on with Liz Ann, you also pointed out that in 2023, there was only one month where job numbers were not later revised downwards. And I'm always curious, what does this mean, and does it make those numbers less reliable? We watch the headlines, but the numbers then a couple months later, they change, and we don't get that same kind of headline reaction to the new number.

KEVIN: Yeah, so just for context, when we get each jobs report, we also get revisions for the prior month. So as of December, it was confirmed that November's payroll gain was revised lower. So it doesn't mean that November saw a decline in payrolls; it was just that it wasn't as strong. And that means that so far, every single month of 2023, except for July, when we actually had an upward revision, and then December, just because we haven't gotten that data yet, every month has seen a downward revision. And that's pretty unusual to see outside of a recession. And it doesn't necessarily mean that you're guaranteed to be in a recession at this moment. And I actually think a key reason we've seen so many revisions lately is because the response rates to the Bureau of Labor Statistics, which we just shorten and call the BLS, to their surveys have actually plunged since the pandemic.

So the two that are most in focus on the labor market are the payroll survey and the job opening survey. So a decade ago, the response rate for the payroll survey was at 65%. Today, it's dropped to 41.8%. And then the response rate to the job opening survey is doing even worse. So it's gone from 75% a decade ago to just 32.4% today. And nobody truly knows the main driver of the plunge, and, more importantly, why we haven't seen a recovery, but the BLS has pointed out some things around the pandemic's forcing of remote work really disrupting how they collect data from companies, and all the effects from that, and it just seems that we haven't really gotten out of that funk yet.

And this is important because when only 30 to 35% of the companies polled are responding, it's hard to get a good read on what's actually happening. And the way I see it, it's not really that we should not be trusting the data; it's just that we should be aware of these hefty revisions that can occur down the road, given the fall in these response rates.

MIKE: The other big headline data earlier this months was, of course, inflation, which is also trending in the right direction. But there seems to be a big disconnect, Kevin, between the headline news that inflation is falling and the average person's experience of inflation. I mean, most people aren't seeing much change in their grocery bill, for example. And that feeds the perception, and we are definitely seeing this in polls related to the presidential election, that things aren't getting better. Why is that happening, and is there anywhere where prices are actually coming down?

KEVIN: So I think this is still the biggest pain point for Main Street and Wall Street, especially given the fact that both of these cohorts tend to look at inflation in different ways. And I wrote a report back on this in November, titled "Lose Yourself in the Inflation Data." And it just explored the many ways that we all look at inflation, along with the fact that there are many metrics to analyze when you're looking at inflation. And the gist from that report, and really when you just look at inflation in general, is you can literally paint whatever picture you want depending on which set of inflation data you choose. So if you're in the camp saying inflation is fine, and essentially back to the Fed's 2% target, you would look at an index that just excludes food, energy, and shelter costs. If you are incredibly concerned that inflation is still out of control, you would look at an index that only looks at services and excludes shelter and energy costs.

And I think really the big disconnect between Main Street and Wall Street is that consumers are, for the most part, more focused on price levels, while analysts and strategists on Wall Street tend to be more focused on rates of change. And it's why a lot of the frustration among consumers is usually along the lines of, "I'm paying much more relative to a few years ago." And the popular baseline these days is where things were before the pandemic.

So as an example, if you look at something like the Consumer Price Index, which we just call the CPI for short, that's the most widely followed measure. It's risen by 19% since right before the pandemic began. That is the sting that consumers feel. Yet conversely, Wall Street has cheered the fact that the year-over-year percentage change in that index has come down from a peak of 9.1% to 3.4% as of this past December. So that's an impressive decline, but it's probably not too satisfying to a lot of consumers, evidenced by what we've seen in a lot of the polling and a lot of the sentiment data.

And then, additionally, many of you're looking for actual price declines. Many consumers are looking for price declines, but that's where I always remind people to be careful what they wish for because falling prices, also known as deflation, those are usually consistent with pretty troublesome times for the economy, essentially recessions. And I hate to sound like the Grinch here, but prices naturally rise over time. You can look at an index like the CPI, and you can see that it has gone up since its inception in the 1940s. Sometimes the increases are more rapid, like we saw over the past few years. And it's an unfortunate reality, but if you consider the scenario of falling prices and what that means for businesses, the economy isn't usually in a good spot when overall prices are being cut.

And tying this in with your last question, we've seen deflation in certain areas of the economy, most notably, the goods sector. That was the sector that benefited the most from the pandemic shutdown. So when we reopened, and when we shifted a lot of our spending to services at the expense of goods, that ushered in a lot of price cuts for certain goods. And of course, that hasn't been great for companies that had to build up those inventories and then see their revenues decline, but that was the unfortunate nature of what the pandemic did to our inflation dynamics.

MIKE: Kevin, another area where we often seen disconnects is in how the stock market performs versus what's going on in the real economy. As I mentioned earlier, the S&P 500 reached a new all-time high last week. Where do we stand now, and how healthy has that climb to a new high looked to you?

KEVIN: Yeah, so we've now completed this round trip from the peak reached in January of 2022, so you can officially say that that bear market ended, if you want to use the rule that you have to take out the prior high for the index. But the climb there has been a bit choppy, not only because we got very close a couple of times this month, but because there are still large swaths of the market that haven't recovered quite as nicely. So even if you take the S&P 500, on the day that the index hit the new high, the new all-time high, nearly 60% of the stocks in that index were still trading lower than where they were in January of 2022. And not only that, but if you go down the cap spectrum, and you look at something like the Russell 2000 Index of small-cap stocks, that was still down from its all-time high by more than 20% on the day that the S&P hit its all-time high.

So that dynamic, where the S&P 500 reached its all-time high at the same time that the Russell 2000 was in a bear market, that's never happened before. The closest comparison that you have is in 1998, and while the next year or so ended up being great for the market, we know that the years following that were actually quite weak given the tech bust. So I'm not saying that we're set to repeat that, and, if anything, I think the spread between the two indexes continues to highlight just the unique nature of this cycle. There are segments of the stock market that have traded as if the economy went into a recession, but that's because there are certain areas that have gone into a recession.

And then on the other side of that, there are areas that are showing signs of recovery, but it's been choppy and it's taking longer, not to mention the fact that we've had several head fakes over the past year at attempts of these recoveries.

So as long as this slow churn continues, I think we're going to see conflicting signals from the market. And, hopefully, that clears up by the end of the year, but a lot of that depends on the degree to which services and the labor market weaken, and then how the economy responds to the shift in monetary policy, from tightening to pausing, and then eventually to easing.

MIKE: Well, speaking of monetary policy, the Fed Open Markets Committee meets next week. Expectations are that they will keep rates steady for the fourth consecutive meeting, and some Fed governors have been out there trying to tamp down expectations for rate cuts, which the market continues to expect will begin as soon as March. So what is your outlook for rate cuts in 2024?

KEVIN: Yeah, so the market's expectations of a March rate cut have been pulled back a bit, given Fed officials' speeches and some of the recent economic data have really argued against a cut so soon. And for the most part, there's still this expectation, at least on the markets' part, that the Fed will be cutting five or six times this year. And I just think that in the current economic state, that's probably still too aggressive.

So right now, we're mostly in line with what Fed officials are thinking, in that three cuts seem plausible. But I will say that it could be a little risky to look out over a one-year time horizon because none of us can really have extremely high conviction in where the economy will be, how resilient the labor market will stay, or even how inflation will trend. But if you were sitting here and extrapolating the current set of economic data just to March, then I think a cut is off the table. It's not likely to me, at least, that the Fed would be pivoting to cuts this soon with an unemployment rate at 3.7%, inflation not quite back to their target, and then estimates for GDP growth actually moving up a bit.

But I do agree with the assessment that with the way inflation is trending, the background conditions are increasingly favorable for the Fed to start cutting this year, assuming that remains the case where inflation is trending lower. Moving beyond that, though, weakness in the labor market is what I think will ultimately push them to cut. And the degree of that weakness is going to determine the size of the cuts and how many there are. So if you continue to see minor cracks in the labor market, like I mentioned earlier, that probably argues for just a few cuts. But if there is a larger decline in overall payrolls, and the unemployment rates starts rising markedly and goes up at a pretty quick pace, that probably ushers in a more aggressive cutting cycle.

MIKE: Whenever the Fed is discussed, Kevin, we're always hearing about whether we've avoided a recession or still might go into a recession. But you have been talking about rolling recessions for the last 18 months or so. So are we going to see, or are we already seeing, rolling recoveries as well? What are the implications for the markets if sectors are at different stages of recovery over the next year ahead? Does that mean, maybe, there are opportunities for investors in some sectors?

KEVIN: Well, we are starting to see some hints of rolling recoveries, but only in select sectors at the moment. And just as a refresher for listeners, some of the more cyclically oriented parts of the economy, like manufacturing, and housing, and goods, those started showing recession-like weakness almost two years ago. And so as they continued to weaken, there was this offsetting strength in services in the labor market. And given services is a much larger chunk of the economy, it's a much larger employer, that strength has helped keep us out of this broad-based recession. And a major part of our outlook for 2024 hinges on a lot of these rolling recessions turning into rolling recoveries, as you mentioned, as services and labor start to take their own hits. So, so far, something like Home Builders Sentiment, which is a key leading economic indicator that we watch, that's actually started to turn higher. And although manufacturing sentiment looks to be following and bottoming out, it's not yet fully entering recovery mode.

So just to visualize how this plays out, maybe we start to see manufacturing and housing improve this year, back into their own expansions, even as services metrics in the labor market deteriorate more from here. So in an ideal world, that continued roll-through of the recession would still keep us out of that broad-based recession. And in a less-ideal world, if that hit to services and labor is much stronger than expected, it would probably be hard to avoid that broad-based recession.

And if we stay in the ideal world, though, I do think that the stock market will start to normalize, meaning you won't have these huge divergences like we did last year, whether it's the Magnificent Seven versus the rest of the market, or large caps completely dominating small caps. I think an environment in which we can see the labor market normalize, the Fed cut a few times, and then manufacturing and housing start to recover, is one in which you could find solid returns—not necessarily amazing as in the case of 2023, but just solid, especially for portfolios and individuals who are well diversified.

MIKE: Well, Kevin, one other topic that I want to get your views on, and this is one that's close to my world, of course, and that's that this is a presidential election year. Generally, the market performs pretty well in an election year, not spectacularly. The S&P 500 has averaged about a 7.5% return in presidential election years going back nearly a century. But in the year before a presidential election year, the return has been nearly 14%. Another interesting thing about elections is that it feels to a lot of investors like market volatility increases around an election, but the data really doesn't show that. So what do you think? Does the market do anything different in an election year?

KEVIN: Well, as you know, Mike, I am not a big fan of basing my market analysis on seasonality or politics. I think the market is concerned a lot more with things other than politics. But to answer your question in a more pointed way, if we look at presidential elections going back to 1900, and we use the Dow Jones Industrial Average as our stock benchmark, given it has a longer history, the pattern in an election year, on average, has been a weaker first half of the year, followed by a sizable move up in the back half. And of course, I'm just citing an average. And it's worth keeping in mind a phrase that actually Liz Ann and I included in our 2024 Outlook quite a bit, which is "Analysis of an average leads to average analysis." So you as the investor cannot just look at what the market has typically done in a presidential year and use that to build some investing thesis.

So if I put some meat on the bones here in a historical perspective, look at the election years 2000, 2008, 2016, and then 2020. In the cases of 2000 and 2008, returns were quite poor for the entire year. There was certainly no rebound in the back half, and, in fact, you had the opposite. In 2016, there was a stumble in the first couple months, but then the market did quite well for the rest of the year. And then in 2020, we all know that the market plunged sharply in February and March, but then was lifted by the Big Five, which were the five largest companies at the time, to actually finish the year in positive territory.

So there's a lot of other examples to comb through, but just those four instances alone should just serve as reminders that there are always other factors to consider when it comes to the market's trend and its overall strength.

MIKE: Yeah, that's great, Kevin, and I'll add to that by pointing to the presidency of George W. Bush as a great illustration of what you're saying. If you just look at how the market has performed over each of the presidencies of the last 10 or 15 presidents, George W. Bush stands out because the market lost about 40% over the course of his eight years in office. Of course, you have to remember that his presidency was bookended by 9/11 in his first year in office and the financial crisis of 2008 in his last year in office, two of the biggest market-moving events of the last 30 years. So I think it's just a great reminder that the market doesn't really care at all who is in the White House—it's what happens in the world that matters.

That said, the number one question I've been getting at my events with investors over the last few months: Should investors do anything different in an election year? And I think it's especially a question that comes up this year because a lot of investors are worried not just about who wins and loses the election, but about bigger questions that are raised by this election, and some even have said the stability of the country itself. So what is your perspective on that?

KEVIN: Well, anytime I get a question like that, I always say that politics should never play a role in anyone's investing decisions. It almost works always against the investor. And here's what we know using historical returns data. So if you go back to 1900, again using the Dow Jones Industrial Average because of the longer history, as of just a few days ago, the average annualized gain under Republican presidents has been 3.5%. The average annualized gain under Democrat presidents has been 7.7%. So someone with a bias towards Democrats might say to themselves, "Well, I'll just wait until a Democrat wins, and then I'll invest." But that means that you're not staying invested. So that's a huge risk. Plus, there are times when parties control the White House for two consecutive terms. So that means someone would be sitting out for a maximum of eight years potentially. And just as an example, if you as an investor didn't want to invest during the Obama administration from 2009 to 2017, you would have missed a gain of 182% for the S&P 500. Same line of thinking for the Trump administration. You would have missed a gain of nearly 70% for the S&P 500.

And the last example I'll use, because I get a lot of questions around this one, is with a sector. So if you go back to when Trump was elected, it's pretty well known and documented that there was a lot of buzz around how friendly he was going to be to the energy industry, specifically oil and gas. And if you look at sector performance in the stock market during Trump's term, the only sector that declined from when he took office to when he left office was energy. It was dead last, and it was down by almost 40% in that period. Conversely, when Biden was elected, there was almost the exact opposite sentiment about his attitude on energy. And I'm generalizing, but this is, you know, what the broad picture looked like for both individuals. And if you look at sector performance since Biden took office, guess what sector is doing the best? It's energy. It has had a gain of just more than 80%. So in both cases, there were many factors other than political that actually drove the performance of the energy sector itself.

So anybody who invested based solely on assumptions about how a particular president would act towards a certain industry would have been wrong twice.

MIKE: Well, that's a great place to end this conversation, Kevin. I think there will certainly be a lot of emotion around this election, and it's really important to keep those emotions out of your investing decisions. Kevin, thanks so much for making the time to talk today.

KEVIN: Thanks, Mike. It's always great to be with you.

MIKE: That's Kevin Gordon, senior investment strategist here at Charles Schwab. You can catch his latest research and commentary at Schwab.com/learn.

Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks when Schwab's Chief Global Investment Strategist Jeffrey Kleintop will join me to talk about the recent election in Taiwan, the growing challenges to global shipping because of tensions in the Middle East, the war in Ukraine, and much more. Take a moment now to follow the show on your listening app so you don't miss an episode. And if you like what you've heard, leave us a rating or a review—those really help new listeners discover the show. For important disclosures, see the show notes or Schwab.com/WashingtonWise, where you can also find a transcript. I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.