Stepping On Ice This Summer

Tariff Tango: President Trump has rolled out bad news when the market is strong, and backs off as it falls. We believe the administration is planning on tariffs that end up at the high end, close to 20%, but the market has sold off at that prospect previously. Therefore, Trump may wait for the first rate cut to boost the stock market before settling on the final tariff format. If this unfolds, brace for less hiring, depressed capex outside of AI spend, and more investor uncertainty until the mid-September or late-October Fed meeting. 

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One Big Beautiful Bloat

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Soundbite: NVDA stock valuation has ballooned to 4% of global GDP, and the Magnificent Seven is a hefty 35% of the S&P 500. So, we decided it was time to account for these stocks using Pave’s factor models. Our data shows that increases across price-earnings ratios, price-to-sales ratios, market cap, and analyst price targets generate even more demand for these marquee names. Rising valuations at these levels are historically a red flag, but any notion of value is clearly not front-of-mind. This sets conditions for a sharp reversal once this speculative outlook reverses.

Given the fact that the Magnificent Seven stocks dominate the price action of the S&P 500, we expected our risk scores would track closely between the two. Therefore, when divergences arise between them, it can shed light on current investment dynamics.

Investors are hyper-focused on expansion in the top line of these firms. While earnings are important, revenues are critical. The fact that the group exhibits strong cash flow growth is, of course, one of their main attractions. However, this is where any notion of value comes to an end.

There is a long-standing tendency for one-month moves in stocks to reverse the following month; however, momentum is such a massive force that the direction in any given month for stocks tends to persist into the next month. This could illustrate the importance of a new breed of retail investors, who showed up en masse to buy the dip in April and are momentum, not value, oriented.

We noticed a large retail investor footprint that caused a negative Unemployment beta for the Mag Seven, but not for the S&P. Normally, as unemployment rises, the chances of a Fed rate cut improve, which generally increases stock buying. However, among these individual speculators, as job insecurity rises, they save more, resulting in a cutback of spontaneous purchases of large cap tech stocks. This view is reinforced by our CPI factor, which is much more negative for large cap tech than for stocks overall. As inflation rises, reduced discretionary income seems to translate into less money to chase mega cap techs by retail investors.

Furthermore, there is an extremely positive relationship between the Mag Seven and M2 money supply. The relative strength of large cap tech to the S&P 500 accelerated when the annual growth rate of money supply stopped contracting in the second half of 2023. It is no coincidence that on an absolute basis, the recent new highs in M2 has fueled Mag Seven outperformance.

As investors continue to chase these stocks higher, they become increasingly vulnerable to higher inflation, weaker payrolls, and tightening liquidity conditions. As momentum builds, complacency about these stocks is at a peak, which can make for volatile conditions ahead.

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Buybacks Could Be the Tell

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Soundbite: Corporate buybacks are by far the greatest source of equity demand, but are currently paused during earnings announcement season. As companies are allowed to begin buying their stock two days after they report, the hope is that more all-time equity highs are in store this summer. Because valuations are stretched, we will see if market participants use this added liquidity as an opportunity to sell.

According to Morgan Stanley, companies that make up 80% of the S&P 500 market cap are currently restricted from stock buybacks. Bullishly, that percentage should fall to 20% by the first week of August. This is a typical quarterly cycle that brings in strong demand. While retail buyers rushed to buy at the April lows, corporates quickly joined, taking authorized buybacks to a year-to-date record in 2025. While the headlines focused on the army of small buyers, the true driver was corporate buying starting when peak buyback restrictions fell sharply into early May. We had written about that underlying dynamic:

Companies are not spending their profits on hiring more staff (or increasing capex) due to tariff uncertainty. What has helped buoy the stock market recently is that those companies have decided instead to plow those profits into stock buybacks.

There is a tendency for stocks to peak during the summer of the first year of the Presidential Cycle. As we mentioned in our first Point above, the current unbalanced market condition could lead to a large distribution top, followed by a selloff. Despite estimates of $1 trillion in buybacks this year, if flows are neutralized later this month by increased supply from long-term investors, expect to see a rotation out of the current leaders and an increase in risk premiums.

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Waller Has Good News for Trump but Not Investors

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Soundbite: President Trump should be careful what he wishes for. Fed Governor Christopher Waller said unemployment, consumption, and growth are all weak. Hence, we need a rate cut—not to “turbo charge the economy” as cited by Trump—to insure against a recession. 

The crux of Waller’s argument for a July cut is that the Fed has a stated goal of cutting twice this year. With only four meetings left in 2025 to cut, it is reasonable to act now, and if inflation or employment data strengthen, they can hold policy steady. Given that he sees:

· Real GDP was 1% in the first half of 2025 and is forecast to be the same in the second half,

· Consumption is running at 1% in the first half, and real disposable income growth will be hit somewhat by tariffs so consumption should remain near 1% in the second half of the year,

· While the tax bill has stimulative elements, most elements will only show up in 2026, and

· Inflation is on track to hit the 2% target and tariffs will only postpone that inevitability with a one-time price increase,

The policy rate should be around its neutral (long-term) target of 3%, which is 1.25-1.50% above its current level.

The market is cheered by these arguments, but the underlying message is decidedly bearish. With hiring already low and monetary policy far too tight, Waller warns:

“Declining demand would overcome any instinct to hold on to workers, and if that attitude does shift, it implies that a larger and more sudden reduction in payrolls and an increase in the unemployment rate are a risk.”

He referenced the Quarterly Census of Employment and Wages (QCEW) used to benchmark the payroll data. That series shows a distinct pattern of data revisions to correct fat payroll overstatements of 60,000 since March 2024. That means that although last month’s 140,000 nonfarm payrolls looks solid, over half was from government hiring. With a good chance of subtracting 60,000 from the private payroll increase when the 2026 benchmark revisions are out, the actual private-sector employment gain could be zero. He concluded by saying:

"This is why I say private-sector payroll gains are near stall speed and flashing red."

He did address two of our concerns. First is that companies may stretch out tariff increases and already elevated long-term inflation expectations could accelerate. He believes that insignificant incremental price rises still end up at the same point and not affect expectations.

Secondly, he admits the key risk is if long-term inflation expectations become unanchored, but market-based measures reflect no evidence of that happening. He admits we could see a more serious discrete jump, but he believes that could only happen if waves of sequential tariffs are rolled out by the White House. 

Futures markets are 96% certain Fed voters will not be swayed by Waller’s arguments and will leave rates unchanged at the July 29-30 meeting. We believe stock market bulls may want to listen more carefully to the Governor’s warning about economic weakness and not be as complacent.

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What to Look for This Week

(All times E.S.T.)

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1. Wednesday, July 23, at 7:00 a.m. MBA Mortgage Applications for July 18 have continued to increase. June Existing Home Sales is also released at 10:00 a.m. and this series also rose last month. New Home Sales is the following day and May hit lows at the bottom of a two-year range.

2. Thursday, July 24, at 8:30 Initial Claims for July 12, which has seen its 4-week moving average fall for three consecutive weeks. Continuing Claims for July 5, which last notched another high. Later at 11:00 am is the Kansas City Fed Manufacturing Index for July which has our attention because it hit near a three year high last month.

3. Friday, July 25 at 8:30 a.m. June Durable Goods Orders. The critical Non-Defense Capital Goods Orders ex-Aircraft for May jumped to 1.7% after April hit a two-year low of -1.4%. It is a solid indicator of overall business capex activity. That series has not been above 1.8% for three years.

FOMC Voters Speaking: Tuesday, July 22 at 8:30 a.m. Fed Chair Powell speaks. Fed Governor Michelle Bowman speaks later at 1:00 p.m. Tuesday. Because the two-week blackout period is in place, do not expect any comments on monetary policy. Thursday, July 24 at 8:15 a.m. is the time of the ECB rate decision followed by Christiane Lagarde’s press conference at 8:45 p.m. No rate change expected.

Earnings: Wednesday, July 23, after market close of Google, Tesla, and IBM. GM and D.R. Horton Tuesday, July 22 before market open, Texas Instruments and SAP after market close. Thursday, July 24 before market open: Blackstone and Union Pacific. Intel after market close.