Today's Free Feature

Briefing.com Summary:

*The market is priced for positive outcomes. That will restrain upside potential and invite material downside risk if those positive outcomes don't materialize.

*Another market thrill ride awaits in the third quarter with unfolding developments on the geopolitical, legislative, tariff, and earnings fronts.

*Total return potential for passive index investing will be restrained in the third quarter given the starting point of a high valuation for the market cap-weighted S&P 500.

In The Big Picture column published on February 21 we contended that the stock market was primed to go everywhere and nowhere, likening its future performance to that of a roller-coaster ride. That view was tied to a recognition that there were many "big issues" looming over the market that lacked closure.

As it turned out, we were right on the money with that thinking.

The S&P 500 hit an all-time high of 6,147.43 on February 19, yet the market would subsequently get broadsided by tariff announcements and economic concerns that hit a fevered pitch when President Trump announced reciprocal tariff rates on April 2. The S&P 500 hit a low of 4,835.04 on April 7. By June 11, though, the S&P 500 had climbed back to 6,059.40, having rallied off that April low after President Trump announced a 90-day pause on the reciprocal tariff rates.

It was a 21.4% decline from peak to trough and a 25.3% gain from that trough to the June 11 peak. The S&P 500 currently sits at 5,967.84, up 1.5% for the year and down 0.8% since February 21. Yes, indeed, the market has gone everywhere and nowhere.

So, what might the third quarter bring? Keep your seatbelts fastened. Another thrill ride, perhaps not as extreme as the one we just experienced but thrilling nonetheless, awaits.

Factors for a V-Shaped Recovery

First, let's briefly review why the market was able to recover like it did.

• On the heels of President Trump announcing the 90-day pause for reciprocal tariffs for most countries until July 9, the U.S. and China reached an agreement to scale back their draconian tariff rates for each other.
• First quarter earnings turned out much better than expected, and while there were instances of pulling guidance because of the tariff uncertainty, the reports and guidance in aggregate were good enough to keep the market's worst tariff fears in check.
• Hard economic data, namely spending and employment data, continued to paint a picture of a resilient economy that defied the dour-looking soft survey data for consumer sentiment.

• The Trump administration, which had a heightened focus on cost cuts and the deportation of illegal immigrants, started talking more about its efforts to cut taxes and regulations. On a related note, Congress got more active and vocal in its negotiations pertaining to the "One Big, Beautiful Bill."
• Inflation data continued on an encouraging path, showing little to no impact from the tariff announcements.

• Notwithstanding concerns about inflation and the deficit, market rates were held in check.

• The "Magnificent 7" stocks, as a cohort, rebounded sharply, as did the market's excitement for the AI trade.

The V-shaped recovery was exacerbated by short-covering activity, a race to get more equity exposure, and a fear of missing out on further gains. The price action itself, which was imbued with a persistent buy-the-dip inclination, became its own positive catalyst.

Three Is a Crowd

The start of the third quarter is just around the corner, and it is primed to start with a bang. That expectation has nothing to do with Fourth of July fireworks either. Rather, it has everything to do with the fireworks that will be ignited by the following:

• The Israel-Iran conflict
  • President Trump said on June 20 that he will decide on a final course of action with respect to Iran over the next two weeks, but on June 21 a squadron of B-2 bombers dropped several bunker-busting bombs that destroyed nuclear enrichment facilities at Fordo, Natanz, and Isfahan.
  • Iran has vowed that it will respond to the U.S. attack, leaving the oil market and capital markets on edge.
• The progression of the "One Big, Beautiful Bill"
  • President Trump set an optimistic deadline of July 4 to have the "One Big, Beautiful Bill" on his desk for signing into law. 
  • The Senate is still working through its changes, and it is unclear if they will be acceptable to House members to keep the legislation on track to be signed by July 4. Senate leaders aim to have a vote on the Senate floor by the middle of the coming week.
  • The CBO estimates that the House version of the bill will add $2.8 trillion to the deficit over the next decade.
• The pause on reciprocal tariff rates expires July 9
  • Reportedly, the pause on reciprocal tariff rates for countries negotiating new trade deals in good faith with the U.S. could be extended, yet there is no assurance that will be the case. It is shaping up to be a "game-time decision," and which countries get the benefit of an extended pause will matter greatly to the market.

Accordingly, with the second quarter coming to an end, the U.S. got involved directly in destroying Iran's nuclear enrichment capabilities; and in the first two weeks of the third quarter, the "One Big Beautiful Bill" may or may not be signed into law, creating misgivings about the trajectory of the budget deficit and national debt and/or hope that it will pave the way for stronger economic growth that pays for the bill; and the lid could come off tariff rates and spark another growth scare.

The latter half of July, meanwhile, will feature second-quarter earnings reports and guidance. That is always the case, but the guidance stakes are higher this year with the market sporting a premium valuation that rests on the continuation of good earnings news.

A Valuation Snapshot

At 21.4x forward twelve-month earnings, the S&P 500 trades at a 16% premium to its 10-year average of 18.4x, according to FactSet. On a trailing twelve-month basis, the S&P 500 trades at 23.8x earnings, which is a 15% premium to its 10-year average of 20.6x.

The point we have made in the past and will continue to make is that the market's valuation is less demanding on an equal-weighted basis. To that end, the equal-weighted S&P 500 trades at just 16.8x forward twelve-month earnings and 18.3x trailing twelve-month earnings, roughly in line with the 10-year average. The discount relative to the market cap-weighted S&P 500 speaks to the influence of the mega-cap stocks on the market cap-weighted index.

The mega-cap companies, by and large, have earned their premium valuation. Objectively, then, the market may not be as overvalued as it looks and will likely persist in an "overvalued" state so long as its mega-cap leaders continue to deliver robust earnings growth. The risk, of course, is that they don't deliver or the outlook changes to create an impression that they won't deliver, as was clearly demonstrated in the peak-to-trough selloff between February 19 and April 7.

Many of these stocks, fortunately, continue to trade with a head of AI steam. There is a mass transformation just getting started with the advancement of AI and its various applications throughout the economy. There is no slowdown in the AI economy, only questions about how long it will take the hyperscalers to see a return on their massive investment in data centers, how long it will take other companies to integrate AI solutions in their service and production work processes, and what changes this might bring to the labor market.

Fed Speak

The labor market is in reasonably good shape. Initial jobless claims have perked up a bit but remain well below levels associated with a recession, and the unemployment rate at 4.2% is consistent with full employment. The four-week average for continuing jobless claims, though, is at its highest level since November 20, 2021, and above levels that were seen before COVID.

The summation, aptly described by Fed Chair Powell, is that businesses have been slow to lay off employees but that it has grown harder to find a job after losing a job. The Federal Reserve is keeping a close eye on the labor market, and although it says it is attentive to the risks to both sides of its mandate, it continues to be steered more by its inflation concerns.

Specifically, many Fed officials are worried that cutting rates again, before they know what effect the tariffs are having on prices, could reignite inflation. Fed Chair Powell said after the June FOMC meeting that he expects a meaningful amount of inflation to arrive in coming months because of the tariffs. What he and others want to ascertain is if any tariff-driven inflation will be a one-time price adjustment or something that is longer lasting.

The consensus among Fed officials isn't shared by all. Fed Governor Waller recently said that he thinks the Fed could cut rates at its July FOMC meeting since he isn't expecting the tariffs to drive up inflation significantly and that, if the Fed is worried about the labor market weakening, it should be ahead of that and not wait for it.

Mr. Waller is in the minority, certainly at the Fed and in the market for that matter. While others have argued that the Fed should have cut rates again already or should in July, the fed funds futures market is following the voice of the Fed Chair. The CME FedWatch Tool currently shows just a 16.5% probability of a 25-basis point rate cut at the July 29-30 FOMC meeting.

There will be another employment report and another round of CPI, PPI, and PCE Price Index data before then, so the probability of a rate cut at the July meeting is certain to change in the interim, but for now, it is looking like the Fed will be keeping the target range for the fed funds rate steady at 4.25-4.50% past the July meeting.

What To Do

The Israel-Iran conflict has entered a new realm of uncertainty; the impact of the "One Big, Beautiful Bill" is wide open for the market's interpretation; the Fed is paying a lot of lip service to inflation concerns as a basis for holding the target range for the fed funds rate steady; and earnings growth prospects have been tarnished by the tariff uncertainty, geopolitical tension, and a growing body of anecdotal evidence that consumers are growing more conscientious about their discretionary spending activity.

So, what is one to do with so many loose ends left untied?

An investor should remain invested but be cognizant that total return potential for passive index investing will be restrained in the third quarter given the starting point of a high valuation for the market cap-weighted S&P 500.

For passive investing, we would favor an equal-weighted approach when it comes to the S&P 500. The Invesco S&P 500 Equal Weight ETF (RSP) is a good option in this respect. For active investors, we would look to allocate money in the equity portion of a diversified investment portfolio into several buckets, if you will, that can benefit in good times, help mitigate losses in bad times, and provide attractive long-term return potential.

Those buckets would be tilted toward the following strategies:

• Companies with attractive price-to-earnings growth ratios
  • Briefing.com analysts like: automotive supplier Dana Inc. (DAN), jewelry retailer Signet Jewelers (SIG), rideshare and food delivery company Uber (UBER)
• Companies that are less exposed to tariff issues
  • Briefing.com analysts like: appliance maker Whirlpool (WHR), warehouse retailer Costco (COST), payment processing network Visa (V)
• Companies that are steady growers regardless of economic conditions
  • Briefing.com analysts like: electric utility company Entergy (ETR), retailer Walmart (WMT), robotic-assisted surgery company Intuitive Surgical (ISRG)
• Companies with quality attributes that include a competitive advantage, a strong balance sheet, healthy free cash flow, consistent earnings growth, and solid management
  • Briefing.com analysts like: the JPMorgan U.S. Quality Factor ETF (JQUA)
• Companies that are in good position to capitalize on secular growth trends
  • Briefing.com analysts like: the iShares Cybersecurity and Tech ETF (IHAK), the Global X Artificial Intelligence & Technology ETF (AIQ)

Briefing.com Analyst Insight

While the run by the market off the April 7 lows has made things look easy, this is not an easy investing environment. Market risk has risen with valuations. Multiple expansion will be harder to achieve, and if the guidance coming out of the second qaurter earnings reporting period doesn't surpass a realtively high bar, the third quarter could be punctuated with multiple compression.

It isn't an easy period to forecast because the range of outcomes for many key issues is fairly wide, but the market is priced for positive outcomes.

There is nothing wrong with that, but it implies a lot of good news is priced in already, which makes further upside harder to come by and invites material downside risk if those positive outcomes don't materialize.

--Patrick J. O'Hare, Briefing.com