Ladies and gentlemen, the weekend! In this space each week, Greg and I share some of our favorite articles, notes, and graphics from the past week along with our commentary. Please feel free to provide feedback and forward along to others if you enjoy. We appreciate you taking the time to read. 

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The Bullish Case

“It seems like everyone is bearish due to a combination of inflation, rising rates, the fed trying to slow demand, falling stocks, and housing rolling over. But a lot of the economic data doesn’t seem to be cooperating with the bearish narrative. Yesterday, for example, U.S. jobless claims fell for a fourth consecutive week to a 3-month low.

As earnings season wraps up, we’re still not seeing much deterioration in corporate America. S&P 500 earnings grew 6.3% for the second quarter, with 75% of companies beating bottom-line expectations. This looks nothing like a recession, where the average decline in earnings is 21.3%...

Is everything great? Hardly. But maybe things aren’t as bad as people fear either.”

The graph of the week (below) shows just how pervasive bearish sentiment has grown over the last few weeks and compared to historical norms. Inflation, interest rates, and Federal Reserve policy/rhetoric has resulted in bearish investors outnumbering bullish investors by an almost 3 to 1 margin. That negative spread falls into their “unusually low” category, which has been historically a positive sign for forward-looking returns (it’s a fairly reliable contrarian indicator).

We know the case for bears – the Fed continues to raise interest rates even in the face of softening inflation and economic data and sends the economy into a recession and stocks down further.

So, what’s the case for bulls? We’re deep into this rate hike regime and fundamental data still looks fine. Corporate earnings continue to grow (although at a moderate pace compared to the last year) due to resilient consumer spending, and the labor market continues to grow. 

Your guide to 'good news is bad news' and 'bad news is good news' 🙃

“The Fed is actively trying to slow the economy — even if it means “some pain” for businesses and consumers — because it believes that is the prescription for getting inflation under control.

In this world, good news about the economy is potentially bad news if it’s exacerbating the dislocation between supply and demand.

Just last week, Minneapolis Fed President Neel Kashkari said he was “happy” to see stock prices fall after Powell’s hawkish speech from Jackson Hole. It’s a conundrum for investors, as the stock market is effectively being held hostage by the Fed.”

It’s been frustrating recently to see a good jobs report or consumption data release then the stock market seems to have a negative reaction. Or, vice versa.

Sam goes point-by-point to examine what data the Federal Reserve may be interpreting for policy decisions, and how we ended up with an upside-down market.

What will all those new IRS agents be doing?

“The Inflation Reduction Act will dedicate $45 billion for tens of thousands of new IRS agents focused on tax enforcement, which the CBO estimates will raise $203 billion in additional revenues over a ten year period for a ~4x return. Sounds easy, doesn’t it?

Not so fast; a May 2022 report from the General Accounting Office suggests this could be difficult to do, particularly if the IRS directs new agents to only audit taxpayers with more than $400k in income as requested by Treasury Secretary Yellen and as reiterated by IRS Commissioner Rettig.

• From 2010 to 2019, incremental taxes raised were highest for audits of those earning less than $200k; the average percent change in the amount owed was highest for this category as well.
• In contrast, higher incomes had the highest rate of “no change to taxes owed” after audit.
• Let’s assume that the audit rate for those earning more than $400k reverts back to 2010 levels (i.e., it increases by a factor of 7x). We estimate that this would raise $8-$10 billion per year in 2031 based on data in the GAO report, far short of the $35 billion estimated by the CBO…

New IRS agents are likely to focus on partnerships, sole proprietorships and owners of commercial and residential rental properties. The Treasury believes that income underreporting could be 50%-60% for these entities given less withholding and information reporting…

Last point: if you hold a lot of crypto, they may be coming for you as well if you exchange crypto for goods and services without recognizing appreciation as capital gains.”

This was an interesting analysis from JPMorgan with help from Brookings. The funding expansion of the IRS might not be able to realize quite as much through the audits of high-income taxpayers as projected through the Congressional Budget Office. They also poke holes in the Treasury Department’s estimated tax gap due to their statistical approach and newer reporting requirements. 

“The bull-bear spread (bullish minus bearish sentiment) is –35.2% and is unusually low for the 27^th time in 33 weeks. The breakpoint between typical and unusually low readings is –10.9%. The bull-bear spread has also broken its second-longest streak of negative readings, as sentiment has remained in favor of bears for the 23^rd week in a row.

Historically, the S&P 500 index has gone on to realize above-average and above-median returns during the six- and 12-month periods following unusually low readings for bullish sentiment and the bull-bear spread. The S&P 500 has also realized above-average and above-median returns following unusually high levels of pessimism.”

Thanks for reading. Have a great weekend!