Personal consumption accounts for two-thirds of economic activity. Therefore, the means by which consumers can spend is essential for forecasting economic growth. The San Francisco Fed just released an article warning that a significant source of spending since the pandemic is no longer available. Per their article, Pandemic Savings Are Gone: What’s Next for U.S. Consumers?– “The latest estimates of overall pandemic excess savings remaining in the U.S. economy have turned negative, suggesting that American households fully spent their pandemic-era savings as of March 2024.“

Since 2021, GDP has grown by 2.93% on an annualized basis, about half a percent greater than during the post-financial crisis – pre-pandemic era. The $2.5 trillion of excess savings, boosted by fiscal stimulus, helped GDP grow above its natural rate. However, excess savings from the pandemic have been depleted. This does not spell imminent recession. However, it argues growth should return to pre-pandemic levels. Per the Fed article, consumers still have some savings and healthy income growth to support consumption. Higher asset prices may also help. Lastly, per the Fed: “Consumers could use debt—such as credit cards and personal loans—to further support their current spending habits, although the current elevated interest rate environment means that the cost of using credit is higher than in the decade preceding the pandemic recession.“

What To Watch Today

Earnings

Economy

• No notable economic reports today

Market Trading Update

In yesterday’s commentary, we noted the market was on the verge of breaking above resistance at the 50-DMA. Furthermore, in yesterday’s blog, we laid out 3-potential market outcomes. To wit:

“The stock rally is at a critical juncture, and what happens next will determine whether the current market correction is over. Three possible scenarios over the next month or so exist.

Path A: The market breaks above the 50-DMA and retests previous highs. While this path is indeed possible, the markets are overbought on a very short-term basis, suggesting further price appreciation will become more challenging.

Path B: Many investors were surprised by the recent market decline. As such, these “trapped longs” will likely use the current stock rally as an opportunity to reduce risk. Another retest of the 100-DMA seems probable before the next leg of the current bull rally ensues.

Path C: With earnings season mostly behind us and stock buybacks set to resume, a reversion to the 200-DMA seems the least probable. However, as is always the case, it is a risk that we should not ignore. A sharp uptick in inflation or stronger-than-expected economic data could spark concerns about a “higher for longer” Fed policy. Such an event would likely lead to a further repricing of risk assets.“

Yesterday, the market broke above the 50-DMA, putting “Path A” as the potential scenario to consider in the near future. However, if it is going to be confirmed, the market must maintain that breakout through Friday. A failure in the next day or so that takes the market back below the 50-DMA will be considered a “failed breakout,” reinforcing resistance at the 50-DMA. In such an event, expect a retest of the 100-DMA shortly thereafter.

The bullish case is improving short-term, but continue to manage risk until the break above the 50-DMA is confirmed.

Berkshire Is Sitting On A Mountain Of Cash

At Berkshire Hathaway’s annual meeting this past weekend, Warren Buffett stated: “We only swing at pitches we like.” Accordingly, given that they are sitting on $189 billion in cash, they probably don’t like many investment ideas. Indeed, the 5% interest rate on cash lessens the opportunity cost of not being more fully invested. Buffett plans to use some excess cash to buy back its shares but admits the stock “isn’t that liquid, so it’s hard to do.”

The graph below shows that Berkshire generates nearly $30 billion of free cash flow a quarter. Unless Buffett puts cash to work, the amount of cash and marketable securities will continue to grow rapidly. Given that valuations are generally high and Buffett tends to have a value orientation, it’s quite likely that Berkshire will wait for a correction. At that time, they will have significant funds to supply liquidity to the market.

Staples Following Utilities Lead

Two weeks ago, we shared a SimpleVisor sector analysis, showing that the utility sector was leading the market. While the sector continues to outperform every other sector and the broader S&P 500, consumer staples (XLP) stocks are now following their lead. The first SimpleVisor graphic below highlights that staples are now the second most overbought sector behind utilities. The graph on the right side plots the rotation of its absolute and relative SV scores for the past six weeks. As we often find, stocks and sectors rotate from oversold on an absolute and relative basis to overbought. Currently, the staples sector is overbought but only moderately so. There is plenty of room to become more overbought.

The second graph charts its relative score in the top graph. The bottom graph highlights the relative performance versus the S&P 500. As shown, its recent scores in the top graph are the highest or most overbought in a year. The relative performance of staples has been lousy this past year. However, that leaves plenty of room for it to catch up with the market.

The third graph below is from the TPA weekly RRG report. TPA is a standalone service within SimpleVisor offering its subscribers a unique way to take advantage of sector and stock rotations. The third graph below from Monday’s relative rotation report shows the rotations of 27 sectors and subsectors. As we circle, utilities (XLU) and XLP are “improving” and likely headed toward the “leading” quadrant. TPA’s analysis argues that both sectors have more relative upside performance. The following link shows TPA’s RRG model and how sectors and subsectors move in and out of favor over time: https://youtu.be/jl7nGbZKWa0  

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The latest FOMC meeting caused a stock rally as Jerome Powell turned more “dovish” than expected. While Powell did note that progress on inflation has been lackluster, the announcement of the reversal of “Quantitative Tightening” (QT) excited the bulls.

Beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage‑backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities”

Of course, the reversal of QT means a buyer of Treasury bonds is returning to the market, increasing overall market liquidity. It also means the Treasury will issue $105 billion less in gross in Q3. The bond market also got the memo, as the Fed’s return to the bond market suggests lower yields in the months ahead, easing financing pressure in the economy.

We have previously discussed the following chart of “liquidity,” which subtracts the Treasury General Account and Reverse Repo from the Federal Reserve’s balance sheet. The recent market decline coincided with a sharp drop in liquidity as the TGA account surged to almost $1 trillion from April tax receipts. Over the next few months, that liquidity in the TGA will get released into the economy. At the same time, the Federal Reserve will reduce its balance sheet runoff, which will further add to overall liquidity.

Notably, the market has weathered the reduction in liquidity to date. While higher rates and the reversal of “Quantitative Easing” led to a 20% market decline in 2022, investors began to “front run” the Fed in anticipation of rate cuts and a return to balance sheet expansion.

Given that “QE” programs increase bank reserves by crediting their reserve accounts for bonds bought, the introduction of the tapering of “QT” is the first step in increasing system liquidity.

This is why there was a vicious stock rally last week. For the markets, this rang “Pavlov’s Bell.”

The Correction May Not Be Over Just Yet

While the stock rally last week certainly surprised many, given the weaker-than-expected economic data, there are some reasons to suspect the correction may not be complete just yet.

In mid-March, we suggested that due to the “buyback blackout” window, a 5-10% correction was likely. To wit:

“As noted, the market remains in a bullish trend. The 20-DMA, the bottom of the trend channel, will likely serve as an initial warning sign to reduce risk when it is violated. That level has repeatedly seen ‘buying programs’ kick in and suggests that breaking that support will cause the algos to start selling. Such a switch in market dynamics would likely lead to a 5-10% correction over a few months.“

The following month, the market violated that 20-DMA, and selling commenced, leading to a 5.5% drawdown. However, buyers initially stepped back in at the 100-DMA, which has now acted as support over the last two weeks. With the rally last week, the stock rally is now testing crucial resistance at the 50-DMA.

The stock rally is at a critical juncture, and what happens next will determine whether the current market correction is over. Three possible scenarios over the next month or so exist.

Path A: The market breaks above the 50-DMA and retests previous highs. While this path is indeed possible, the markets are overbought on a very short-term basis, suggesting further price appreciation will become more challenging.

Path B: Many investors were surprised by the recent market decline. As such, these “trapped longs” will likely use the current stock rally as an opportunity to reduce risk. Another retest of the 100-DMA seems probable before the next leg of the current bull rally ensues.

Path C: With earnings season mostly behind us and stock buybacks set to resume, a reversion to the 200-DMA seems the least probable. However, as is always the case, it is a risk that we should not ignore. A sharp uptick in inflation or stronger-than-expected economic data could spark concerns about a “higher for longer” Fed policy. Such an event would likely lead to a further repricing of risk assets.

I am less concerned about “Path C” for three reasons.

Little Evidence Of Market Stress

While a more profound decline is certainly possible, there is little evidence of market stress. For example, even during the latest correction, volatility remained very subdued. Yes, volatility increased during the decline but failed to reach the levels witnessed during the 10% correction last summer.

Secondly, a substantially deeper market decline would likely widen credit spreads between junk bonds and treasuries. That was not evident during the latest market decline, as spreads remain well below the long-term average. Watching credit spreads is the best indicator for investors to determine market risks.

Third, the window for stock buybacks reopens this week, and with Apple and Google announcing $110 and $70 billion programs, respectively, those two companies alone will account for roughly 18% of this year’s slated activity.

Combining current sentiment, buybacks, and liquidity hopes makes the stock rally over the last two weeks logical. Furthermore, given that early summer months tend to be bullish for markets during election years, it is likely too soon to be overly bearish.

However, we are also not completely oblivious to the numerous risks that lie ahead. Weaker economic data, the lag effect from higher rates, and sticker inflation pose portfolio risks worth monitoring. Furthermore, in the two months before the election, investors tend to de-risk their portfolios. This year, we could see a larger-than-normal event, given the risks associated with the current matchup.

While Powell’s “dovish” twist fueled the current stock rally, continue to manage risk accordingly. There is a reasonable chance this correction is not over just yet.

Last week’s Employment Cost Index (ECI) shook the stock and bond markets as investors worried that higher wages would keep inflation sticky, thus forcing the Fed to push off rate cuts. However, Friday’s BLS report provided optimism for stock and bond investors as it aligned with other wage data that did not show a jump in wages in the first quarter. As witnessed by the initial surge in stock prices and bond yields, investors appear relieved.

Average hourly earnings in the BLS report rose 0.2%, 0.1% below expectations. Year-over-year wage growth fell to 3.9% from 4.1%. That marks the first annual reading below 4% since June of 2021. Furthermore, the average workweek declined by 0.1. We share the graph below to appreciate the totality of wages, hours worked, and the number of people employed. The orange line shows average hourly earnings have been steadily rising, but the number of hours worked has been falling for three years. The red line shows that the annual growth rate of the product of hours, earnings, and number of employed is back to pre-pandemic levels.

The economy added 175k jobs in April, below estimates of 248k and last month’s 315k. The shortfall versus expectations was the biggest miss since 2021. That says something, considering economists have grossly underestimated job growth over the previous 18 months. The unemployment rate ticked up 0.1% to 3.9%. The household survey, used to calculate the unemployment rate, shows the economy lost 25k jobs last month.

What To Watch Today

Earnings

Economy

• No notable economic reports

Market Trading Update

Last week, we discussed whether the recent rally from the lows was just a sucker rally ahead of a bigger decline. Our assessment was that was likely not the case. To wit:

“On Friday, following blowout earnings from Google and Microsoft, the market challenged the intersection of the 20- and 50-DMA. With the market not overbought yet and the MACD ‘buy signal’ approaching, the bullish case is building. However, the initial resistance of the 50-DMA could prove challenging.”

On Wednesday, Jerome Powell’s speech following the conclusion of the latest FOMC meeting provided a more “dovish” than expected message. While Powell did note that progress on inflation has been lackluster, the announcement of the reversal of “Quantitative Tightening” (QT) excited the bulls.

Beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage‑backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities”

Of course, the reversal of QT means a buyer of Treasury bonds is returning to the market, increasing overall market liquidity. It also means the Treasury will issue $105 billion less in gross in Q3. The bond market also got the memo, as the Fed’s return to the bond market suggests lower yields in the months ahead, easing financing pressure in the economy.

The market surged higher on Thursday and Friday, supported by Apple’s massive $110 billion stock buyback program. With a MACD “buy signal” triggered on Friday and the market not overbought yet, a push above resistance at the 50-DMA seems likely next week. That break of resistance should allow the bulls an opportunity to retest 5200 over the next month or so.

However, while the bullish market setup is intact in the near term, we continue to expect another decline this summer before the election. Historically, institutional players are reticent about holding long exposures heading into an election, so we often see weakness in September and October.

The Week Ahead

This week will be quiet after last week’s deluge of important economic data, corporate earnings, and the Fed meeting. Earnings for the major companies that report on the traditional quarter-ending March-June-September-December cycle are primarily done. There are few companies like Nvidia that report off-cycle. There is little economic data for the week. Stock and bond investors will likely anticipate the CPI and PPI releases next week.

Given the lack of headlines, Fed speakers coming out of their media blackout will take center stage. We suspect they will broadly align with the sentiment Powell gave last week. However, they may have some thoughts on last week’s jobs data or the upcoming inflation reports.

Another Look At Inflation

With CPI being the next major economic release to help guide the Fed, we thought it would be helpful to review a Fed inflation measure that views prices with a different lens.

Multivariate Core Trend Inflation (MCT) is a mouthful but influential gauge the Fed uses to measure how persistent or transitory price changes are. MCT assesses whether price changes are a common trend amongst many goods and services or if a few sector-specific factors drive the underlying price changes.

The New York Fed starts with PCE data to compute MCT. Last Monday we learned that this version of PCE fell to 2.6%, down from 2.7% last month. Last month was revised lower from 2.9%.  MCT excludes food and energy. In comparison, Core PCE runs at 2.8%. Like PCE, it doesn’t show a resurgence of inflation as CPI alludes to. The reason is that the MCT model helps strip out seasonal and one-off price changes that are not deemed to be statistically persistent. In other words, the model doesn’t think the recent bump in inflation will be lasting.

To help you further understand this inflation measure, we share a FAQ from the New York Fed website:

How does the MCT measure differ from the core personal consumption expenditures (PCE) inflation measure?

The core inflation measure simply removes the volatile food and energy components. The MCT model seeks to further remove the transitory variation from the core sectoral inflation rates. This has been key in understanding inflation developments in recent years because, during the pandemic, many core sectors (motor vehicles and furniture, for example) were hit by unusually large transitory shocks. An ideal measure of inflation persistence should filter those out.

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Starbucks latest earnings report sends the message that consumers may finally be retrenching after a few years of spending above their means. Cheap luxury items are low in price by definition and include items that we do not necessarily need but are nice to have. When consumers have confidence in the economy and their jobs, they tend to reward themselves by consuming more cheap luxury items. Conversely, concerns about their job status or doubts about whether they will get a raise lead many consumers to tighten their wallets. For many consumers, cheap luxury items are the easiest items to cut back on when their confidence wanes.

Starbucks coffee is an excellent example of a cheap luxury item. It is relatively inexpensive, but the alternatives of making coffee at home or getting free coffee from the office are much cheaper. Starbucks shares fell 20% on Wednesday as their earnings were poor. The following statistics from Starbucks point to a more frugal consumer:

• Same-store sales fell 4%, and traffic fell 6% in the quarter.
• International same-store sales were down 6% versus expectations of a 1.4% gain.
• Starbucks lowered its revenue growth guidance from 7% to the low-single digits.
• Per Starbucks: “Most loyal customers are looking for discounts.”

What To Watch Today

Earnings

Economy

Market Trading Update

With the bulk of earnings season behind us, the market’s focus will return to economic data and the Federal Reserve. Today is the much-anticipated employment report and hourly earnings. While the Fed suggested they will not hike rates further, a much hotter-than-expected report suggesting “higher for longer” will negatively impact stocks and rates.

As discussed yesterday, the market continues to trade above the 100-DMA, establishing a pattern of higher lows. If the market can weather today’s employment report, it could set it up for a rally next week. Notably, we are beginning to build a pattern of price compression. A break out to the upside will likely lead to a retest of this year’s highs. A downside break will lead to a test of the 200-DMA. Unfortunately, the odds for either outcome are currently 50/50. Therefore, continue to manage risk accordingly until we can confirm the next direction for the market.

JOLTs Portends Higher Unemployment

The JOLTs report published by the BLS shows the labor market continues to normalize. The number of job openings fell to 8.488 million, well below the peak in 2022 but still above the pre-pandemic levels.

The quits rate, on the other hand, has fallen back to levels last seen in 2017. The quits rate is a good measure of employee confidence. When employees feel confident in finding a better-paying job, the quit rates tend to be higher. Conversely, the quits rate tends to be lower in a weaker labor market. The second graph below shows that the quits rate (on an inverse scale) and the unemployment rate are well correlated. As we circle, the last time the quits rate was at current levels, the unemployment rate was between 4.5% and 5%. The unemployment rate is 3.8% and has yet to increase with the quits rate.

The third graph shows the same data in scatter plot format. Again, the current instance is an outlier, arguing the unemployment rate may increase in the coming months. Further making the case for higher unemployment, the JOLTs hires rate is also below pre-pandemic levels.

But… Jobless Claims Points To A Strong Labor Market

Recent jobless claims data seem to conflict with our thoughts in the prior section on the quits rate and what it may portend for unemployment. Yesterday’s initial jobless claims were 208k. As we share below, the rate is historically low and does not show any signs of turning up. The data is weekly, so it is among the best real-time job data available, or so many think.

Based on a Bloomberg article entitled Why Jobless Claims Fail As A Recession Gauge, jobless claims may not be a good gauge of the jobs market. Per the article:

Jobless claims have been a reliable indicator in the past of loosening labor-market conditions — but not at the moment. That’s because a smaller share of today’s unemployed persons are eligible for benefits — and even among those eligible, fewer are applying for benefits that haven’t kept up with inflation.

The article estimates that 78% of unemployed workers are eligible for unemployment benefits; typically, the number is closer to 85%. Further, while people may be eligible, they may not file a claim as unemployment benefits have not kept up with inflation. The following paragraph highlights the situation in California, which accounts for 11% of the nation’s total employment.

In California, for instance, unemployment benefits have not been raised in two decades, with the state’s massive budget deficit a barrier to raising the payout. While the number of unemployed in California has increased by more than 40% since mid-2022 — the state’s unemployment rate reached 5.3% in March (from 3.8% in August 2022), highest in the US — jobless claims have been persistently flat.

The authors summarize as follows:

Bottom line: Weekly UI claims figures may overstate the labor market’s resilience. Given current low levels of the recipiency, eligibility and take-up rates, claims will likely continue to present a distorted picture even if the labor market deteriorates swiftly.

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Investor psychology is one of the most significant reasons individuals consistently fall short of their investment goals. While one of the most common truisms is that “investors buy high and sell low,” the underlying reason is the behavioral traits that plague our investment decision-making.

George Dvorsky once wrote that:

“The human brain is capable of 10¹⁶ processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.“

Behavioral traits and cognitive biases are anathemas to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process.

In other words:

“The most dangerous element to our success as investors…is ourselves.”

Here are the top five most insidious behavioral traits keeping us from achieving our long-term investment goals.

Confirmation Bias

Probably one of the most insidious behavioral traits is “confirmation bias.” Confirmation bias is a term from cognitive psychology that describes how people naturally favor information that confirms their previously existing beliefs.

“Experts in behavioral finance find that this fundamental principle applies to investors in notable ways. Because investors seek out information that confirms their opinions and ignore facts or data that refutes them, they may skew the value of their decisions based on their cognitive biases. This psychological phenomenon occurs when investors filter out potentially useful facts and opinions contradicting their preconceived notions.” – Investopedia

In other words, investors tend to seek information that confirms their beliefs. If they believe the stock market will rise, they tend only to read news and information that supports that view. This confirmation bias is a primary driver of individuals’ psychological investing cycles. As shown below, there are always “headlines” from the media to “confirm” an investor’s opinion, whether it’s bullish or bearish.

As investors, we want “affirmation” that our current thought process is correct. That is why we tend to join groups on social media that confirm our thoughts and ideals. Therefore, since we hate being wrong, we subconsciously avoid contradicting sources of information.

For investors, it is crucial to weigh both sides of each debate equally and analyze the data accordingly.

Being right and making money are not mutually exclusive.

Gambler’s Fallacy

The “Gambler’s Fallacy” is another of the more common behavioral traits. As emotionally driven human beings, we tend to put tremendous weight on previous events, believing that future outcomes will be the same.

At the bottom of every piece of financial literature, Wall Street addresses that behavioral trait.

“Past performance is no guarantee of future results.”

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns, expecting similar results in the future.

This particular behavioral trait is a critical issue affecting investors’ long-term returns. Performance chasing has a high propensity to fail, pushing individuals to jump from one late-cycle strategy to the next. The periodic table of returns below shows this. Historically, “hot hands” last 2-3 years before going “cold.”

I highlighted the annual returns of both Emerging and Large-Cap markets for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom in subsequent years. 

“Performance chasing” is a significant detraction from investors’ long-term investment returns.

Probability Neglect

Third, when it comes to “risk-taking,” there are two ways to assess the potential outcome.

There are “possibilities” and “probabilities.” 

When it comes to humans, we tend to lean toward what is possible, such as playing the “lottery.” The statistical probabilities of winning the lottery are astronomical. You are more likely to die on the way to purchasing the ticket than winning it. However, it is the “possibility” of being fabulously wealthy that makes the lottery so successful as a “tax on poor people.”

As investors, we neglect the “probabilities” of any given action. Such is specifically the statistical measure of “risk” undertaken with any given investment. As individuals, our behavioral trait is to “chase” stocks that have already shown the largest increase in price as it is “possible” they could move even higher. However, the “probability” is that the price reflects investor exuberance, and most gains have already occurred.

Probability neglect is another contributory factor as to why investors consistently “buy high and sell low.”

Herd Bias

Though we are often unconscious of this particular behavioral trait, humans tend to “go with the crowd.” Much of this behavior relates to “confirmation” of our decisions and the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, I must do it also if I want to be accepted.

In life, “conforming” to the norm is socially accepted and, in many ways, expected. However, the “herding” behavior drives market excesses during advances and declines in the financial markets.

As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

Investors generate the most profits in the long term by moving against the “herd.” Unfortunately, most individuals have difficulty knowing when to “bet” against the stampede.

Anchoring Effect

Lastly, “Anchoring,” also known as the “relativity trap,” is the tendency to compare our current situation within the scope of our limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for. However, can you tell me exactly what you paid for your first soap bar, hamburger, or pair of shoes? Probably not.

The reason is that the home purchase was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event, and therefore, we assume that the next home purchase will have a similar result. We are mentally “anchored” to that event and base our future decisions around very limited data.

When it comes to investing, we do very much the same thing. If we buy a stock that goes up, we remember that event. Therefore, we become anchored to that stock instead of one that lost value. Individuals tend to “shun” stocks that lost value even if they were bought and sold at the wrong times due to investor error. 

After all, it is not “our” fault that the investment lost money; it was just a bad stock. Right?

Make Better Bad Choices

My nutrition coach had a great saying about dieting; “make better bad choices.”

We are all going to make bad choices from time to time. The goal is to try and make bad choices that don’t have an outsized effect on our plan. When it comes to dieting, if you eat a burger, order it without cheese and mayonnaise.

If you make speculative bets in your portfolio, do it in smaller amounts. Or, if you are leaning towards “panic selling” everything, start by selling some but not all of your holdings.

Importantly, focus on the rules and your investment discipline.

• Do more of what is working and less of what isn’t. 
• Remember that the “Trend Is My Friend.”
• Be either bullish or bearish, but not “hoggish.” (Hogs get slaughtered)
• Remember, it is “Okay” to pay taxes.
• Maximize profits by staging buys, working orders, and getting the best price.
• Look to buy damaged opportunities, not damaged investments.
• Diversify to control risk.
• Control risk by always having pre-determined sell levels and stop-losses.
• Do your homework.
• Not allow panic to influence buy/sell decisions.
• Remember that “cash” is for winners.
• Expect, but do not fear, corrections.
• Expect to be wrong, and will correct errors quickly. 
• Check “hope” at the door.
• Be flexible.
• Have the patience to allow your discipline and strategy to work.
• Turn off the television, put down the newspaper, and focus on your analysis.

Importantly, keep your market perspectives and behavioral traits in check. Our goal is to ensure that our decisions are influenced by reliable data and psychological emotions.

Most importantly, if you don’t have an investment strategy and discipline you are stringently following, that is an ideal place to begin.

As was widely expected, the Fed left interest rates unchanged. Jerome Powell alluded that it’s much more likely the next Fed move will be rate cuts, not an increase in interest rates. Given the November elections and the internal pressure on the Fed to remain independent, it now seems likely that barring a sharp upturn in unemployment or a renewed decline in prices, rate cuts are not likely this year. The FOMC statement was largely unchanged, but there are two important changes from the prior meeting. First, as highlighted in the first paragraph below, the Fed acknowledges that inflation has become sticky. However, in the second paragraph, they note that supply and demand are in better balance, which should allow for more disinflation.

Second, and more importantly, for the markets, the Fed will start reducing the amount of QT in June. While this was expected based on their FOMC minutes released three weeks ago, the reduction was larger than expected. Further, the entire reduction will be in U.S. Treasury securities, not mortgage-backed securities. This action will help ease market concerns of heavy Treasury debt issuance. During the press conference, Jerome Powell sent mixed messages. While he firmly believes the Fed will meet its 2% inflation goal, they do not want to cut rates too soon. He doesn’t expect to, but they would raise rates if needed. The highlight of the press conference occurred when Powell was asked about stagflation. His reply: “I don’t see the stag or the ‘flation.”

What To Watch Today

Earnings

Economy

Market Trading Update

Following yesterday’s discussion, the market failed at the 50-DMA and is continuing its correction to retest the 100-DMA. The FOMC meeting concluded its 2-day meeting, and even though rate cuts may not occur this year, the larger-than-expected reversal of Quantitative Tightening (QT) surprised the market. Given that the Federal Reserve is now positioned to start monetizing more debt from the Treasury, it suggests more liquidity for the financial markets and lower yields. As such, stocks and bonds rallied sharply yesterday following the announcement, but day-end sellers emerged, taking away the gain.

There is still likely some near-term downward pressure on stocks, and Apple reports after the bell today, wrapping up the bulk of the earnings season for the S&P 500. Continue to monitor risk accordingly, but with the Fed on hold, stocks will likely find a bottom soon.

Nvidia And The Fabulous Three

The S&P 500’s market cap was up 6.27% through April 26, as shown by the black line in the graph below, courtesy of Bianco Research. Last year, the Magnificent Seven accounted for almost all of the market gains. This year, the Magnificent Seven is being widdled down to the Fabulous Three and Nvidia. Four stocks account for 62% of the year’s gains. AMZN, MSFT, and META contributed about 19% of the increase in market cap. Nvidia doubles the Fabulous Three, accounting for 38% of the increase. In fact, as shown below, Nvidia single-handedly contributed more to the S&P 500 than the remaining 496 stocks. Nvidia reports its earnings on May 22, a month after most other companies. Accordingly, it has avoided the volatility that has impacted many of the Magnificent Seven stocks this earnings season.

The Dallas Fed Services Sector Bemoans Higher Rates

Over the past two years, the service sectors have generally prospered while manufacturing has been in a recession. Recently, manufacturing has shown signs of life, but the service sector is starting to exhibit problems. The service sectors represent almost 90% of the economy. Consequently, the recession in manufacturing did not put the economy into a recession. However, avoiding a recession would be difficult if the service sector struggles. The graphic below shows the March ISM Services survey is still above 50%, an indication of economic expansion. However, the trend is heading toward 50, and a few of its components are below 50.

The most recent Dallas Fed services survey for April indicates that Friday’s ISM services could be weaker than expected. More importantly, it appears that high interest rates are starting to impact the economy negatively. The quotes below, with the respondent’s industry, are from the survey.

Publishing– The impact of the higher rate environment seems to be catching up, with general purchase intent among customers flattening out.

Credit Intermediation– We recently renegotiated our $600 million debt facility. Our cost of funds went from 9 percent to 14 percent—that’s a pretty big hit to our bottom line and resulted in us increasing prices to our customers. Our business focus has been on forecasted easing; however, the reality of rates staying higher longer is creating uncertainty. The Federal Reserve signaling it will hold the rate at the current level for longer has affected our outlook negatively.

Securities– Recent movement in long-term rates, combined with the Fed holding rates longer, have delayed the expected value of investment recovery until 2025 or later.

Real Estate– Cost of capital is weighing on our customers and decreasing volume. The increase in treasury yields since last fall has negatively impacted deal-making activity in the income property industry.

Professional, Scientific and Technical– Persistent inflation and the Fed potentially delaying rate cuts are causing uncertainty for the second half of 2024. This real estate market is hard to figure out. With the 10-year rate still moving in the wrong direction, and the likelihood of a rate cut not coming this year due to inflation and the strength of the economy, we just can’t see the market improving until next year.

Administrative and Support– Continued high interest rates, inflation and general economic malaise has caused employers to be very reluctant to hire professional level talent. High interest rates have drastically hindered our ability to grow our business, and it looks like a rate cut is not likely happening in 2024.

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Eli Lilly (LLY) shares have risen significantly as the company is proving to be a leader in a new class of drugs that help with weight loss and diabetes. For the quarter, its total revenue was $8.77 billion, which is 26% higher than the first quarter of 2023. Revenues for their four drugs that help with weight loss and diabetes are as follows: Trulicity ($1.46bn), Mounjaro ($1.81bn), Zepbound ($515mm), and Humalog ($538mm). These drugs single-handedly account for almost half of Lilly’s revenue.

Bloomberg estimates that by the year 2030, annual sales of weight-loss medications will reach $80bn, making them among the largest class of drugs in history, as measured by sales. Further, they expect Eli Lilly and Novo Nordisk to garner more than 90% of the market. The revenue from these weight loss and diabetes drugs is snowballing, and plenty of potential remains. First, consider that 83% of Mounjaro’s sales are domestic, and Novo Nordisk reports that 90% of Ozempic sales are domestic. Rapid revenue growth can continue as sales in the U.S. and worldwide increase. Further driving growth, Medicare’s decision to subsidize Wegovy for heart disease patients and similar actions by the insurance companies provide another impetus for growth.

The graph below shows the tremendous growth in Eli Lilly (LLY) and Novo Nordisk (NVO) shares as compared to the broader healthcare sector (XLV).

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the market failed at the test initial resistance at the 50-DMA. While that failure is unsurprising, given the recent rally from the lows, it is now paramount the market holds crucial support at the 100-DMA. This correction continues to be a low volatility event, which suggests it is unlikely to devolve into a deeper decline. However, it is always important to never discount a possibility entirely. The outcome of the FOMC meeting today is expected to be a non-event, with Fed Chair Powell continuing to hold the line on economic data and rate cuts later this year. Of course, going into the meeting, it is unsurprising traders took some of the recent gains just in case the Fed comes out more “hawkish” than expected.

Earnings continue to be okay, with Apple (AAPL) reporting tomorrow and the employment report on Friday. However, there is plenty of room for additional volatility until next week.

Higher Wages Spook Markets

The employment cost index (ECI) rose more than expected, prompting concern that the Fed may further delay rate cuts. The ECI for the quarter was up 1.1%, above estimates of 0.9% and last quarter’s 0.9% reading. The graph below shows that the private and civilian sectors are closely aligned.

For the last few years, the Fed has been worried that higher wages will feed more inflation. Such a feedback loop is known as a price-wage spiral. Per Nick Timiraos of the Wall Street Journal, “The ECI is seen inside the Fed as the highest-quality measure of compensation growth.” While ECI adds to concerns that inflation could stay sticky, Nick caveats the increase, saying that the higher-than-expected increase in wages may be a function of cost-of-living increases and minimum wage adjustments given at the start of the year. Again, this is a quarterly number, so the data encompasses January, February, and March.

Thus far, the monthly BLS labor report has not confirmed the latest ECI data. The second graph shows average hourly earnings continue to decline. The monthly changes in hourly earnings also do not show a recent upward bias, as we see in ECI. This Friday’s BLS will provide an update on wages.

Chicago PMI And Consumer Confidence

Manufacturing in the midwest, as evidenced by the well-followed Chicago PMI index, may not be recovering. While only one month of data, if the national ISM survey follows the Chicago PMI, the recent optimism that the manufacturing sector may exit an 18-month recession may fade quickly. Other than 2020, when Chicago PMI plunged for just two months during Covid and spiked back, the Chicago PMI hasn’t been this low since 2009.

Moods are not only dour in the manufacturing sector. As the second graph shows, Tuesday’s consumer confidence survey is heading lower. Like the Chicago PMI report, consumer confidence was worse than expected. The index fell to 97.0 from a downwardly revised 103.1. The estimate was 104. Both the present situation and expectations indexes were lower. Changes in consumer sentiment often precede changes in consumer spending. Again, one month does not make a trend, but given that consumers account for two-thirds of the economy, this reading, like the Chicago PMI, cautions that the economy may slow in the coming months.

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In an op-ed for the Washington Post on November 5, 2010, Ben Bernanke did a victory lap, praising the Fed’s efforts in stemming the financial crisis. In the article, he discusses how QE and other Fed policies eased financial conditions, bolstering investor confidence.

And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. 

If Bernanke wants credit for his Fed policies that boosted stock prices, he should also take responsibility for the costs. Those same monetary policies, which have been repeated many times since 2008, have played an important role in exacerbating the wealth gap in America. Accordingly, we should question his use of the term “virtuous circle” to describe how modern monetary policy works.

Graphing The Wealth Gap

Inspiration for this article comes from our recent article, Wealth Gap and the Road to Serfdom.

Before discussing the Fed’s role in widening the wealth gap, we put context to the problem. The graphs and quote below are from the article.

For 80% of Americans, the end game of too much debt, an aging demographic, and the push for “socialistic policies” is the continued extraction of wealth from the “middle class” to the “rich.”

Trickledown Economics and Monetary Policy

“Trickledown economics” was coined by John Kenneth Galbreth in 1982 and made famous by President Ronald Reagan. The expression is another name for supply-side economic policy. The policy theorizes that the populace benefits when government interference in the economy is minimal. For example, lower taxes and reduced regulations should promote economic activity and prosperity for the entire populace.

The theory is logical, but politicians have done a poor job enacting it.

In 2008, the Fed took a page from the supply-side economic playbook to stem the financial crisis. From that point forward, the Fed’s modus operandi has been trickle-down monetary policies.

Does QE Trickle Down?

Ben Bernanke wasn’t the first Fed Chair or central banker to use QE. But he did make it a household name and seemingly a permanent tool in the Fed’s toolbox.

QE has two significant impacts on the financial markets and the banking system.

First, removing assets from financial markets alters the supply-demand balance in favor of higher prices. Additionally, when investors believe QE is positive for asset prices, as is the case, demand increases, which provides even more impetus for higher asset prices.

Second, the Fed buys bonds from the banks with reserves. Reserves are a form of money that is only viable in transactions between banks or with the Fed. Reserves support bank loans and asset purchases. Therefore, when more reserves are available, banks can more easily make loans and buy assets. Further, some bank loans, specifically margin or repo loans, generate additional demand for assets.

The scatter plot below shows the positive correlation between the one-year percentage change in margin debt and the Fed’s balance sheet.

Higher stock and asset prices coupled with more leverage is a winning combination for investors.

The Graph of All Graphs

With that explanation of how trickledown monetary policy bolsters asset prices to accomplish the Fed’s goals, we share a graph explaining why the Fed’s policies widen the wealth gap.

Since 1990, the dollar’s purchasing power has declined by over 50%. At the same time, the S&P 500 has risen by over 1,300%. Those with a sufficient portfolio of stocks could more than offset the decline in the dollar’s purchasing power. Those without stocks are left behind.

Further, it doesn’t help that real household income for the lowest 20% has been unchanged since 1990. Over the same period, they have risen by about 50% for those in the upper 20% of incomes.

Share Of Wealth

The wealthier have seen their wages and the value of their financial assets rise much more than inflation. At the same time, the lower wealth and income classes have seen marginal real income gains at best and little in the way of benefits from rising stock prices. 

The two graphs below show how the percentage of the wealth owned by the top 1% and the change in the S&P 500 are well correlated.

On the contrary, the aggregate wealth of much of the bottom half of the nation, as a percentage of total wealth, has a negative relationship with the S&P 500.  

There is a straightforward explanation as to why the correlation between the share of the wealth of the rich versus that of the rest of the population has opposing correlations to the S&P 500. 10% of the population holds nearly 90% of the stocks.

Trickledown Monetary Policy Handicaps Capitalism

QE and other Fed policies may help the economy on the margin and save some jobs. However, there is little evidence that, over the longer term, the economic benefits increase the prosperity of most of the populace. Further, as we share, there is compelling evidence it further exacerbates the wealth gap.

Capitalism has proven to be the best economic system for growing the wealth of the entire population. A key tenant of capitalism promises financial incentives for those who work hard and have unique skill sets. That incentive results in productivity gains, which benefit economic growth and allow for higher wages and a broad distribution of wealth.

Unfortunately, when financial incentives are not only a function of capitalism but also an offshoot of government and Fed policies, the benefits of capitalism are reduced.

For example, Elon Musk is extraordinarily wealthy and should be rewarded handsomely for everything he has accomplished. However, how much of his wealth is based on his hard work and ingenuity, and how much was gifted to him by the Fed via their stock-boosting monetary policies. While slightly off-topic, we should also question how much of his wealth is attributable to government subsidies for electric vehicles. 

Summary

President Biden’s poll numbers on economic confidence are poor despite robust economic growth and a historically low unemployment rate. While there are many reasons for the odd divergence, we think it’s fair to say that the benefits of the post-pandemic growth spurt have disproportionately accrued to those in higher-income classes and those with stocks. Those left behind, representing a large majority of the population, are not confident in Biden’s handling of the economy and suffer from higher prices.

Most Americans continue to see wages that cannot combat inflation and have little to no wealth invested in the stock market. Can you blame them for lacking confidence?

QE may have served as an emergency way to add bank reserves to the system and boost confidence. However, its continued use, even during economic prosperity periods, only makes the wealth gap wider.

Over the last two weeks, the bullish sentiment index has reversed from extreme greed to fear. The composite net bullish sentiment index, comprised of professional and retail investors, fell from 38.15 to 9.9 in two weeks. The previous drop between July and October last year was similar and marked the bottom of the correction.

While the bullish sentiment index can indeed fall further, what is notable is the sharp reversal of market “exuberance” in such a short span. However, as discussed in “Just A Correction,” there was a significant gap between buyers and sellers.

“However, at some point, for whatever reason, this dynamic will change. Buyers will become more scarce as they refuse to pay a higher price. When sellers realize the change, they will rush to sell to a diminishing pool of buyers. Eventually, sellers will begin to “panic sell” as buyers evaporate and prices plunge.”

Like clockwork, that correction came quickly, with the market finding initial support at the 100-DMA. With solid earnings from GOOG and MSFT, the market rallied to initial resistance at the convergence of the 20- and 50-DMA. It would be unsurprising if the market failed this initial resistance test and ultimately retested the 100-DMA soon. Such a pullback would solidify that support and complete the reversal of the bullish sentiment index.

In early April, we wrote:

“Whatever trigger causes a reversal in the bullish signals, we will act accordingly to reduce risk and rebalance exposures. But one thing is sure: investor sentiment is extremely bullish, which has almost always been a good “bearish signal” to be more cautious.

While we have warned of a potential correction over the past few weeks, it reminds us much of June and July last year, where similar warnings for a 10% correction went unheeded. We are now seeing many individuals ‘jumping into the pool’ in some of the most speculative areas of the market. Such is usually a sign we are closer to a market peak than not. As such, we want to make adjustments before the correction comes.”

Very quickly, as supported by the bullish sentiment index, those bulls are turning bearish and are now calling for a more profound decline.

While such is possible, I suspect most of this correction is complete for two reasons.

Earnings Continue To Remain Strong

The first reason is that despite higher interest rates, earnings growth continues to remain robust, at least among the “Magnificent 7,” where Google (GOOG) and Microsoft (MSFT), in particular, exceeded estimates by a wide margin. However, overall, and most importantly, earnings growth has continued since the October lows of 2022. Notably, the support for improving earnings comes from the increased fiscal policies such as the Inflation Reduction Act and CHIPS Act.

While those policies will eventually fade, making forward estimates subject to downward revisions, the current earnings environment remains relatively robust. Furthermore, forward estimates remain optimistic that the Federal Reserve will cut rates later this year, lowering borrowing costs and supporting economic activity.

Notably, the increase in earnings, at least for now, remains a strong indicator of rising asset prices. The risk of a deeper market correction (greater than 10%) is significantly reduced during previous periods of improving earnings. While such does not mean a deeper correction can not happen, historically, corrections between 5% and 10% in an earnings growth environment tend to be buying opportunities and limit deeper reversal in the bullish sentiment index.

Improving earnings also precedes improving CEO confidence, which has provided pivotal support to financial markets since 2000.

Buybacks Returning

We discussed the most critical reason we expected a market correction in mid-March. To wit:

“Notably, since 2009, and accelerating starting in 2012, the percentage change in buybacks has far outstripped the increase in asset prices. As we will discuss, it is more than just a casual correlation, and the upcoming blackout window may be more critical to the rally than many think.” – March 19, 2024

Furthermore, the “blackout” of corporate buybacks coincided with more extreme readings in the bullish sentiment index. Buybacks are crucial to the market because corporations have accounted for roughly 100% of net equity purchases over the last two decades.

Here is the math of net flows if you don’t believe the chart:

• Pensions and Mutual Funds = (-$2.7 Trillion)
• Households and Foreign Investors = +$2.4 Trillion
  • Sub Total = (-$0.3 T)
• Corporations (Buybacks) = $5.5T
  • Net Total = $5.2 Trillion = Or 100% of all equities purchased

Unsurprisingly, that blackout window coincided with a sharp contraction of more than $367 billion in buybacks over the last 4-weeks. Consequently, when you remove a critical “buyer” from the market, the ensuing correction is unsurprising.

However, corporate share buybacks will resume in the next couple of weeks, and with more than $1 trillion slated for 2024, many buybacks remain to complete. Such is particularly the case with Google adding another $70 billion to that total.

As noted above, improving earnings and a decent outlook for the rest of this year also boost CEO confidence. (If you don’t understand why buybacks benefit insiders and not shareholders, read this.)

With robust economic activity supporting earnings growth, that improvement boosts CEO confidence. As CEOs are more confident about their business, they accelerate share buybacks to increase executive compensation.

The liquidity boost from buybacks and stronger earnings will likely provide a floor below the market. This doesn’t mean the current correction doesn’t have more work to do. However, it is unlikely that it will resolve into something more significant.

At least for now.

Year to date, the yen has fallen by 10% versus the U.S. dollar. Consequently, the decline is catching the market’s attention. Trading seemed to get out of hand on Sunday night when the yen whipsawed in a 5% range. It opened trading down 2%, falling to its lowest level since 1990. Despite being a Japanese holiday, the BOJ responded aggressively by buying yen. Within hours, the yen surged versus the dollar. The yen opened on Monday morning, New York Time, up about 5% from its lows set only hours before. Until Sunday night, the BOJ had been taking a hands-off approach to the depreciating yen. That changed as the market may have weakened the yen beyond the BOJ’s line in the sand. The graph below charts the yen and its daily price range using standard deviation (sigma). Monday’s price action was nearly an 8-sigma move.

In May 2022, we wrote an article on Japanese inflation and the potential pitfalls for global liquidity if Japan were forced to take drastic actions to support the yen. To wit:

However, as the BOJ tries to stop rates from rising, they weaken the yen. Japan is in a trap. They can protect interest rates or the yen but not both. Further, its actions are circular. As the yen depreciates, inflation increases and the Japanese central bank must do even more QE to keep interest rates capped.

The markets are pushing Japan into a corner. Certainly, their actions significantly impact Japan’s economy and markets. Equally important, the BOJ can have consequences for global stock and bond markets due to the yen carry trade. Stay tuned!

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the market’s first hurdle is the 50 and 20-DMA’s initial challenge. Unfortunately, that test was inconclusive, with the market trading into it but failing to break above it. The market’s fate remains in the “bear’s hands” until that resistance is breached. Today, earnings from Amazon (AMZN), Ely Lilly (LLY), and AMD (AMD) will likely determine the direction of the market tomorrow, given their market cap weightings and importance to the “thematic” trades of “weight loss” and “A.I.”

If you haven’t already done so, use the current rally to rebalance portfolio risk as needed. In addition to earnings, the Fed meeting announcement on Wednesday and employment on Friday will determine the market’s next direction.

Shale Oil Becoming Costlier To Produce

The chart below potentially has significant implications for the price of oil. The Dallas Fed recently surveyed energy companies and found the breakeven point on new shale wells in the Permian Basin has recently risen by $10-$15 a barrel. Hence, since shale oil is among the cheapest to drill for, a higher breakeven price should translate into higher oil prices. Consequently, if prices fall below breakeven, energy companies pull back on drilling, which can push the price higher. The data appears to be annual. Therefore, the recent surge of breakevens is likely a function of inflation for employees and machinery.

The Health Of Small Businesses Continues Downward

Two weeks ago, we wrote Economic Warnings From The NFIB to share the most recent survey data on small businesses. To wit:

While recent government data on economic growth and employment remain robust, the NFIB small business confidence survey declined in its latest reading. Not only did it fall to the lowest level in 11 years, but, as far as an economic warning goes, it remained at levels historically associated with a recessionary economy.

In addition, the graph below, courtesy of Alignable, adds to our concern for small businesses. Small business owners have the highest national delinquency rate in over three years. Further, the 4% increase was the largest in over a year. Per Alignable:

It highlights what many small business owners have shared with us — that all of the economic issues following the COVID Era were as bad, if not worse on many businesses than the pandemic itself. Those post-COVID economic hurdles have prevented many small businesses from recovering fully financially. 

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Yesterday, the Bureau of Economic Analysis (BEA) reported that real GDP grew by 1.6%, putting the nominal size of the US economy at $28.2 trillion. While growth in the most recent quarter was below estimates, the US economy has been more robust than other leading economies over the last few years. It is worth contextualizing the US economic position within the global economy. To help us, we share a recent WSJ article by Greg Ip entitled Americas Economy Is No. 1.

For starters, the graph below from Ip’s article shows that since 2010, the US share of global GDP has risen by about 5% and now accounts for over a quarter of the world’s economy. It’s not just stronger growth in the US driving our gains. Consider that Japan, Europe, and the UK are growing much slower and therefore losing share. Further, China’s economic growth has slowed considerably. India is growing rapidly but only represents a minor share of the global economy.

While economic growth is helping the US, so are higher levels of inflation than the countries shown below. The author shares a critical caveat: “These figures are based on current prices and exchange rates. Using purchasing power parity, which adjusts for different price levels across countries, the U.S. share of world GDP would be lower and that of big emerging markets—such as China and India—much higher.”

What To Watch Today

Earnings

Economy

Market Trading Update

Last week, we noted that a short-term stock rally was likely after the 5.5% selloff from the recent peak. To wit:

“While it took longer than expected, that correction process arrived last week and continued earnestly, with the market falling to the 100-DMA. With the market short-term oversold, a reflexive rally in the next week is likely, with the 50-DMA being notable resistance. Investors should use any market rally toward 5100 to rebalance risk and hedge portfolios.“

On Friday, following blowout earnings from Google and Microsoft, the market challenged the intersection of the 20- and 50-DMA. With the market not overbought yet and the MACD “buy signal” approaching, the bullish case is building. However, the initial resistance of the 50-DMA could prove challenging.

Given the slate of economic data and the Fed meeting, this is a good spot to rebalance risks as needed, as we will likely see some selling pressure next week. The market is NOT overbought yet, which gives it some run to push higher, but the upside is likely limited this week unless the Fed unexpectedly cuts rates.

The Week Ahead

Between the Fed meeting on Wednesday and earnings and jobs data this week, market volatility could rise.

The Fed is expected to keep rates unchanged and will likely push back the timing of rate cuts to later in the year. However, a reduction in the amount of QT would not surprise us. As we wrote in Commentary from April 12:

Wednesday’s release of the Fed minutes implies the Fed will likely reduce the amount of QT as early as their next meeting. Currently, the Fed lets $60 billion of U.S. Treasury securities and $35 billion in mortgage-backed securities roll off their books each month. The minutes indicate that most officials favor reducing the Treasury rolloff amount by “roughly half.” Further, “the vast majority of participants judged that it would be prudent to begin slowing the pace of runoff fairly soon.”

Payrolls are expected to rise by 210k. While this is a good pace, it is below last month’s strong +303k. ADP and JOLTs will further illuminate the labor market situation. The graph below shows that last month’s +303k, matching the May 2023 number, is the highest in a year.

This will be the last big week of Q1 earnings announcements. Amazon, AMD, and Eli Lily will announce on Tuesday, and Apple will report on Thursday. In addition, as we saw last week, many smaller companies will also announce earnings throughout the week.

PCE Inflation

The month-over-month PCE price index and the core index were in line with estimates at +0.3%. Both figures were the same as last month. So, while progress on inflation has been limited recently, the PCE data is much less worrying than the CPI data earlier in the month. Bond yields fell slightly on this news. The chart below from the BEA shows that over the last six months, higher prices are almost entirely due to service prices (orange). Other than in February, goods prices (blue) in aggregate have been declining.

Trump Could Drastically Change The Fed

A Wall Street Journal article released Friday morning starts as follows:

Donald Trump’s allies are quietly drafting proposals that would attempt to erode the Federal Reserve’s independence if the former president wins a second term, in the midst of a deepening divide among his advisers over how aggressively to challenge the central bank’s authority.

The article should be taken with a grain of salt. Political candidates offer up many ideas. But, as we often find out, few come to fruition. However, given that Trump’s odds of winning the election are about 50/50 and the incredible importance of Fed policy on the markets and economy, it’s worth appreciating what he may be thinking about the Fed. The following paragraph describes Trump’s potential role in setting monetary policy.

Several people who have spoken with Trump about the Fed said he appears to want someone in charge of the institution who will, in effect, treat the president as an ex officio member of the central bank’s rate-setting committee. Under such an approach, the chair would regularly seek Trump’s views on interest-rate policy and then negotiate with the committee to steer policy on the president’s behalf. Some of the former president’s advisers have discussed requiring that candidates for Fed chair privately agree to consult informally with Trump on the central bank’s decisions, the people familiar with the matter said. Others have made the case that Trump himself could sit on the Fed’s board of governors on an acting basis, an option that several people close to the former president described as far-fetched.

Again, we caution you not to read too much into this article. First of all, these changes may not be the views of Trump but just those of his aides. Second, even if he wishes to enact them, Congress would likely have a say in the matter.

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Meta shares fell almost 20% following a better-than-expected earnings report. The day before, Tesla shares rose 15% despite missing earnings and sales estimates and reporting a massive decline in its free cash flows. The sections below provide more specifics on Meta and Tesla earnings. Their earnings are important for investors, but it is equally critical to appreciate how the intersection of technicals and narratives plays into their confusing stock performance.

Tesla shares are down 33% year to date, including the 15% increase on Wednesday. The narrative pushing the stock lower was that the EV industry is losing ground to hybrid models. Significant EV competition is further hurting Tesla. While the narrative was dour, the fact of the matter is that the stock was grossly oversold. Even if you think Tesla is still significantly overvalued, the stock fell too far too fast. Elon Musk’s hopeful comments pushed the stock higher, forcing shorts to cover. Meta is the opposite story. It is up 110% over the last year, including yesterday’s decline. The benefits of AI pushed this relatively cheap stock much higher in a very short period. While we can debate Meta valuations, it’s hard to argue that its stock wasn’t grossly overbought.

Narratives can drive a stock much higher or lower than many think possible. However, it doesn’t take much to reverse a trend when a narrative pushes a stock to grossly overbought or oversold levels. Further, part of the reason ascribed for the Meta selloff is their investment in AI. Months ago, any company mentioning AI would surge higher. Might the AI narrative be fading or at least taking a pause?

What To Watch Today

Earnings

Economy

Market Trading Update

One of the factors contributing to the recent selloff, besides just the reversal of ebullient investor sentiment, was a sharp contraction in liquidity. As shown in the Liquidity Index chart below, while liquidity tends to ebb and flow from one week to the next, the trend has supported recent market gains. However, last week, there was a sharp contraction in liquidity coinciding with the contraction in asset prices.

The key factor in that liquidity change was a sharp increase in the Treasury General Account (TGA). While the Fed’s balance sheet declined from $7.43 trillion to $7.40 trillion, the TGA surged from $675 billion to $930 billion last week. This was due to the rather large auctions by the Treasury to fund current expenditures.

As Alfonso Peccatiello recent noted:

“Over the next 6 months, we might experience (another) huge liquidity injection in markets and the economy! How. By having Yellen drain the Treasury General Account (TGA).

You can think of the Treasury General Account (TGA) as the checking account the US Government holds at its bank – which is the Federal Reserve. Every time the US government has accumulated excess money through taxes or bond issuance that it doesn’t intend to immediately channel into spending, they will park it at the TGA account at the Fed.

As you can see from the chart above, the TGA generally sits around 250-350 USD billions and it occasionally increases towards USD 1 trillion only to be subsequently drained back to its standard size.
After the ongoing tax season, Yellen will soon have around USD 1 trillion in the TGA – that’s quite high, and hence we should expect a drainage to follow.

On top of it, the US debt ceiling suspension only lasts until the end of 2024 and at some point the US will ”run out of room” to issue new bonds which means the only way to facilitate spending will be through using the money sitting in the TGA – great political cover to move ahead with a TGA drainage.

But why does draining the TGA matter that much for markets and the US economy?

That’s because draining the TGA is akin to throwing fresh money at the economy (similar to deficit spending) and also adding new liquidity to the interbank system (similar to QE).”

Of course, as that money finds its way into the economy, it also supports company earnings growth, leading to higher asset prices.

As such, the potential liquidity boost will likely contain the recent correction, keeping it from becoming a “sucker’s rally” to a larger decline. At least for the next few months, anyway.

The second reason why this is likely not a “sucker’s rally” to a larger correction is that the blackout window for corporate share buybacks is close to ending.

Before the current correction, we wrote:

“As we have discussed for the last month, the market is exceptionally bullish, extended, and deviated from long-term means. With the beginning of the “buyback blackout,” removing an essential buyer of equities is a risk worth watching.” – Buyback Blackout – March 19th

Unsurprisingly, that blackout window coincided with a sharp contraction of more than $367 billion in buybacks over the last 4-weeks.

However, corporate share buybacks will resume in the next couple of weeks, and with more than $1 trillion slated for 2024, there remain many buybacks to complete.

Tesla Rallies On Bad Earnings

Tesla reported weaker than expected EPS (.45 vs .52) and revenues falling short of estimates by $1 billion. Further troubling, the Wall Street Journal graph below shows its quarterly free cash flow plummeted by $2.5 billion. So why did the stock rally over 15% on the earnings announcement? The answer is hope. Per Tesla:

“We have updated our future vehicle line-up to accelerate the launch of new models ahead of our previously communicated start of production in the second half of 2025.” 

The company is committing to mass-producing more affordable cards. In theory, cheaper cars will attract a wider audience of potential buyers. Tesla will reduce costs by using existing factories to produce the new models. The Wall Street Journal sums it up nicely:

“In other words, Tesla is trading radicalism for speed of delivery and capital efficiency, at least in the medium term. It is a sensible decision from a company that has historically preferred to take the heroic road. Institutional investors will likely love it; the Tesla fan base perhaps less so.”

Elon Musk’s renewed commitment to self-driving cars is further fueling the stock price. He states, “If somebody doesn’t believe Tesla is going to solve autonomy, I think they should not be an investor in the company.” Tesla has a forward P/E of 42 and other valuations that are much more expensive than those of its competitors, as shown in the table below. Investors are clearly betting that TSLA has a significant advantage in this new technology.

META Falls On Good Earnings

META shares were 20% lower on Wednesday night, erasing over $240 billion of market cap. Meta’s revenue and earnings beat estimates. Further, their monthly active users (MAU), an important website metric, beat estimates by 5%.

The earnings call is the rationale for the largest one-day drop in META/FB history. CEO Mark Zuckerberg told its investors that AI is the future. While this is the same message he has been conveying, investors are suddenly concerned they do not have a clear path to profit from AI. Meta is also linking AI capabilities to its Metaverse product. The problem with that is the company’s Meta Reality Labs has had a net loss of $46 billion since its inception in 2020, as shown below.

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The latest retail sales data suggests a robust consumer, leading economists to become even more optimistic about more robust economic growth this year. To wit:

“It has been two years since forecasters felt this good about the economic outlook. In the latest quarterly survey by The Wall Street Journal, business and academic economists lowered the chances of a recession within the next year to 29% from 39% in the January survey. That was the lowest probability since April 2022, when the chances of a recession were set at 28%.

Economists don’t think the economy will get even close to a recession. In January, they, on average, forecast sub-1% growth in each of the first three quarters of this year. Now, they expect growth to bottom out this year at an inflation-adjusted 1.4% in the third quarter.” – WSJ

According to the March retail sales data, consumer spending added “fuel” to economists’ exuberance about this year.

Rising inflation in March didn’t deter consumers, who continued shopping at a more rapid pace than anticipated, the Commerce Department reported Monday. Retail sales increased 0.7% for the month, considerably faster than the Dow Jones consensus forecast for a 0.3% rise though below the upwardly revised 0.9% in February, according to Census Bureau data that is adjusted for seasonality but not for inflation.” – CNBC

The chart below shows the monthly change in the retail sales data over the last two years.

While mainstream economists trumpeted the strength of the consumer, the March retail sales data had some interesting points worth noting.

First, retail sales data was extraordinarily weak from October to January, the traditionally strongest shopping months of the year. That period included Halloween, Thanksgiving, Christmas, and NYear’sr’s. So, to some degree, the strength of spending over the last two months is unsurprising as, eventually, consumers need to buy goods or services previously postponed.

Secondly, while the March retail sales data was strong, it was weaker than February. However, March contained two significant spending periods, Spring Break and Easter, which generally don’t occur. Since Spring Break and Easter are considerable travel and shopping periods, it is unsurprising that the retail sales data increased with oil prices rising. As shown below, there is a very high correlation between nominal retail sales and oil prices.

Paying More For The Same Amount

Economists often overlook another important point about the retail sales data. As noted above, the March retail sales report was NOT adjusted for inflation. Furthermore, the report is in nominal “dollar volume” and not the amount of goods or services sold. Oil and gasoline prices are an excellent example of the issue with the retail sales data.

Let’s assume you own a car with 18-gallon fuel tank. Your daily activities are mostly going to work, going to the grocery store, eating out, having entertainment, etc. As such, you consume one tank of gas each week. Here is the math:

Week 1: 18-gallons of gas @ $3/gallon = $54.

That week, the store adds $54 to the monthly retail sales total for selling 18 gallons of gasoline. However, the price will increase to $4 per gallon next week.

Week 2: 18-gallons of gas @ $4/gallon = $72.

Here is the question.

While the retail sales data increased by $18 in week two, did the consumer purchase more gasoline? In other words, if the economy’s strength is ultimately measured by how much we produce (gross domestic product), then does spending more for the same amount of goods or services equate to a stronger economy?

The picture is quite different if we adjust the nominal retail sales data for inflation. Again, it is unsurprising that even on an inflation-adjusted basis, retail sales rose in February after declining for four months previously. However, with March containing Spring Break and Easter, the data suggests a weaker consumer that headlines tout.

It is worth noting that retail sales data is not very useful in determining whether the economy is nearing a recession. As shown below, an annual growth rate of 2% has been a good marker for economic growth. As such, retail sales should grow at roughly 2% annually as well, given that personal consumption expenditures comprise approximately 70% of the economic equation. However, other than 2007, retail sales did not clarify economic strength.

In other words, spending more for the same amount of goods and services is not a sign of economic strength.

Economic Forecasts Tend To Be Erroneous

Furthermore, while the recent nominal sales data was robust, it is crucial to remember the economic data has a significant lag. Each of the dates below shows the economy’s growth rate immediately before the onset of a recession. You will note in the table that in 7 of the last 10 recessions, real GDP growth was running at 2% or above. In other words, according to the media, there was NO indication of a recession. But the next month, one began.

Crucially, I am not saying a recession is starting next month. However, I suggest that relying heavily on one month’s retail sales data to claim the economy avoided a recession is not likely ideal. Let’s revisit that chart of the WSJ economic forecast. I have added two notations: the start and end of recessions and when the NBER officially dated that period. As shown in both previous recessions, WSJ economists had a very low probability of the economy entering a recession just before it occurred.

The reality is that on an inflation-adjusted basis, the retail sales data suggests the consumer remains weak. While spending more to buy the same amount of goods or services may look good on paper, the average household has less money to spend elsewhere. As shown, the annual rate of change in real retail sales is near some of the lowest levels outside of a recession.

Lastly, consumer credit supporting retail sales will become more problematic with rising interest rates. Higher interest rates tend to reduce the average growth rate of retail sales data.

Our advice is to remain cautious about economic exuberance. Those forecasts are often disappointing.

The U.S. Treasury now has $930 billion in cash in its Treasury General Account (TGA) held at the Federal Reserve. The influx of cash into the Treasury account at the Fed is the result of April 15 tax payments. As shown in the top graph, this is the third highest level it has been and is still increasing. So you are probably asking why I should care. For starters, the surplus of cash means the Treasury can draw from the funds in its Fed account and, therefore, issue fewer Treasury bills, notes, and bonds. For context, in its latest borrowing estimate, the Treasury expects to borrow $202 billion between April and June. That is well below their expectations of $760 billion for the first quarter.

The importance of issuing fewer securities is that it should provide a temporary boost to liquidity. Our best gauge of excess liquidity is the Fed’s Reverse Repurchase Program (RRP), shown in the lower graph. At its peak, RRP was over $2.4 trillion. However, it dipped below $400 million as the excess liquidity is rapidly leaving the system. Further, excess liquidity fell at a quicker pace into the April 15 tax payment date as investors withdrew cash from money markets to pay their taxes. Now, the money sits in the TGA, and the liquidity will essentially return as the Treasury issues fewer securities. Consequently, this should stall the decline in the RRP for a couple of months. However, come June or July, the RRP will likely start declining, and with it, we should be on alert for new liquidity problems, barring any actions from the Fed between now and then.

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, the market is in a reflexive rally, likely limited to initial resistance at the 50-DMA. However, as noted, there isn’t significant buying volume until between 4700-4800, which coincides with a retest of the 200-DMA. While the market did sell off some yesterday morning, we saw buying in the late afternoon to bring the market back to even. However, Meta (META) missed earnings after the close and will likely add some selling pressure to the market today. If the market can shrug off the impact of META and rally, then this rally likely still has some life left in it. However, I suspect we are getting closer to the end of this initial reflex, and we will likely see some further liquidation before the next buying opportunity arrives. Tread cautiously for the moment.

Tonight’s NFL Draft Speaks Teaches Us About Investor Behaviors

Tonight, the NFL will hold its annual draft. Especially notable in this draft is that four quarterbacks are likely to go in the top five picks. The GMs selecting these quarterbacks must be very confident they have the ability to draft a top-ten NFL quarterback. While many experts say this quarterback class is a sure thing, history shows that first-round quarterbacks are often busts. Not only are GMs overconfident in their selection abilities, but they suffer from groupthink. It turns out first first-round quarterbacks selected since 2011 have produced a sub-500 win/loss record.

As we share in our latest article, Overconfidence in NFL Drafts: A Lesson For Investors, investor traits are similar to those of NFL GMs. Per the article:

We quantified the odds of GMs picking above-average quarterbacks earlier. Per DFA Funds, the odds of an investor outperforming the market are even more daunting.

We saw from the data above that an investor has about a 75% chance of underperforming the market in any given year, which means you have a 25% chance of beating the market in any given year.

The message to take away from that statistic is to leave your confidence at the door!

In addition to pointing out similar traits to help you appreciate your investment biases, we also share some tools to combat as follows:

• Zig, while others zag
• Take profits
• You have options
• Let winners run
• “Most importantly, remember that you are only human. The Patrick Mahomes of the investment world are few and far between. At times, overconfidence is a good trait, but it can also be a critical flaw.“

Costco’s Biggest Loss Leader Is A Winner

In 2023, Costco sold 137 million rotisserie chickens and 156 million hot dog combos. The prices, $4.99 for the chicken and $1.50 for the hot dog combo have remained the same for over 25 years. Therefore, you might be asking how they profited from this. They don’t. In fact, last year, they lost over $50 million on rotisserie chickens.

Costco uses chickens and hot dogs as loss leaders. In addition, the company spends significant effort and dollars quantifying its sales, margins, and returns. In the case of chickens, they can determine how receipts containing a chicken led to other sales and contributed to its return on investment. The chart below shows Costco’s (COST) stock, handily beating the top two grocery chains (Krogers and Albertsons) and Walmart.

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Most NFL general managers (GMs) are optimistic and displaying overconfidence today as they prepare for tomorrow’s NFL draft. The draft is a once-a-year opportunity for GMs to acquire talent.

Like investors, GMs often think they are smarter than their competitors, aka the market. Yet, they frequently have similar mindsets and follow the same narratives that drive their competition.   

As we will share, overconfidence and groupthink among football GMs and investors are behavioral flaws that often harm performance. Having the tools and strategies to mitigate our behavioral traits is extremely valuable and can lead you to better returns.

Overconfidence In The NFL

Four of the first five picks in the draft are expected to be quarterbacks. Not only is the quarterback the most important position on the field but this year’s draft is hyped as having several future greats.

Based on data from Warren Sharp, an NFL analyst, most of the quarterbacks taken in the early rounds will be average. His Fox Sports article entitled The success rate of first round QBs makes Lamar Jackson’s case for him, quantifies just how poor the odds are of drafting the next Super Bowl-winning quarterback. 

There have been 38 quarterbacks drafted in the first round since 2011, the year the NFL changed the collective bargaining agreement.

These 38 first-round quarterbacks have made a total of 1,909 starts. Their record? 1034-1035-7.

He claims that of those 38 quarterbacks, only one, Patrick Mahomes, has won a Super Bowl. Furthermore, of the 28 from that group who are no longer on their initial contracts, the average time they were a starter was a mere 3.4 years.

Despite the proven mediocrity of quarterbacks taken in the first round, we have little doubt that overconfidence will be on full display by the GMs drafting quarterbacks with their top picks after they make their selections.

Groupthink In The NFL

This behavioral trait arises when people seeking conformity think and act similarly. Typically, groups reach a consensus opinion without proper evaluation and with minimal alternative viewpoints.

For instance, it is widely accepted that the four quarterbacks likely to go in the top five, Williams, Daniels, Maye, and McCarthy, will be excellent pros. Most NFL analysts offer differences between the quarterbacks but praise the physical and mental traits they believe will make them NFL starts. Very few analysts have poor ratings on any of those four quarterbacks.

Choosing one of the four quarterbacks is comforting. Simply, GMs have cover if their pick is a dud. Who could have known? Every expert thought he would be a superstar!

Investor Overconfidence And Groupthink

Replace players with investment ideas and GMs with investors. The overconfidence and groupthink mentality impacting GM draft day decisions are similar to those investors always face.

We quantified the odds of GMs picking above-average quarterbacks earlier. Per DFA Funds, the odds of an investor outperforming the market are even more daunting.

We saw from the data above that an investor has about a 75% chance of underperforming the market in any given year, which means you have a 25% chance of beating the market in any given year.

The message to take away from that statistic is to leave your confidence at the door!

Regarding groupthink, most investors, like GMs, find comfort in knowing that many other investors are doing the same thing. Market narratives are a form of groupthink. Narratives help explain market movements and trends. Often, a narrative develops after a trend has started. In other words, rightly or wrongly, the narrative is the rationale.

Today, narratives appear to be quicker to form and longer lasting. Maybe the advent of social media has allowed for their quicker dissemination and growth.

Narratives describe the mindset of a group of investors. When you unknowingly invest based on a narrative, you are likely setting yourself up for failure.

Strategies To Combat Behavioral Traits

Appreciating that GMs have a one in three chance of successfully using a precious top-five draft pick on a quarterback or that only a quarter of investors will beat the market, we best have tools to manage our behavioral traits and improve our odds of success.

Zig

Warren Sharp advises GMs to “zig while others zag.”

To zig is to have a contrarian mindset. For instance, it’s important for your portfolio to have popular stocks leading the market higher. But at the same time, understand that confidence can wane quickly, and a new set of stocks will take the throne soon enough. Don’t overstay your welcome in a narrative.

It wasn’t that long ago that the Magnificent Seven stocks were all the rage. Their returns handily beat almost every stock and index. Holding a meaningful subset of the seven stocks was vital to keep up with the broad market indexes. However, the Magnificent Seven’s period of outperformance has either ended or is on pause. But, the narrative still thrives, and whether it’s already happening or will occur shortly, investing in the aged groupthink will catch many investors offside.

Take Profits 

It’s hard to sell when others are buying. Still, when the narrative-driven stocks fall out of favor, the prior profits and reduced position sizes will bolster returns and lessen the risk of underperforming the market.

Appreciating what the market, and not popular narratives, tell you is equally vital. For instance, have you noticed that utilities and energy are the best-performing sectors lately? Those solely holding the Magnificent Seven and neglecting other sectors are falling behind.

The SimpleVisor table below shows the relative performance of the Magnificent Seven stocks and XLU, the utility ETF, versus the S&P 500 over various time frames. Other than NVDA, most of the seven have been underperforming the market as of late. Also, the once poorly performing utility sector has been beating the market for the last 45 days. Selling the Magnificent Seven 45 days ago to buy utilities would go against groupthink, but it was a smart call.

Appreciate Your Options

The GMs with the top five picks have a precious option. Instead of picking a quarterback with limited odds of success, they can trade the pick to another team. In exchange, they might receive multiple high-level draft picks, boosting the odds of success.

Other positions in the NFL draft have much better success rates than quarterbacks. If a GM can set aside their confidence in their ability to pick the right quarterback, they can increase the odds that they could easily land at least two very good players and possibly a pro bowler. Maybe they can even use one of the picks to get a quarterback in the later rounds. Let’s not forget Brock Purdy, the San Francisco quarterback who led the 49ers to the Superbowl, was Mr. Irrelevant, the last person taken in the draft.

Investors have options, too. Many stocks, sectors, and factors will likely outperform the market but do not fit the narrative du jour. While buying what others aren’t may be uncomfortable, it may be more profitable.

The other lesson is to diversify. Putting most of your eggs in one basket can significantly impact your relative performance. You will underperform if you are proven wrong, as is most common.

Let Winners Run

One of the most popular Wall Street sayings is, “Cut your losses short and let your winners run.”

If our chances of beating the market are one in four, doesn’t it make sense to trade your portfolio actively? Many investors do the opposite. Their confidence and the attraction of groupthink keep them in underperforming stocks. At the same time, alternative stocks that are less followed may be the best bets.

It can be appropriate and profitable at times to follow the crowd. However, at all costs, don’t ignore alternative views.

Summary

We risk underperforming the market by falling victim to our natural behavioral traits. Therefore, we owe it to ourselves to entertain and understand alternative views. As odd as it may seem these days, we need to watch FOX News and read the New York Times. We must challenge ourselves to understand better things that may not be comfortable.

Seek out and study the views of others with whom you disagree. By better understanding opposing opinions, you will strengthen your existing views or better recognize flaws in your current logic. Either way, an investment thesis is better for it.

Most importantly, remember that you are only human. The Patrick Mahomes of the investment world are few and far between. At times, overconfidence is a good trait, but it can also be a critical flaw.

The Wall Street Journal posted an article on bank rule changes entitled A Century-Old Lending Lifeline for Troubled Banks Has a Major Flaw. The Fed Wants to Fix It. The article discusses the Fed’s Discount Window and rule changes to bolster banks in times of need. This bank safety will also conveniently help the Treasury fund the deficit. The Fed’s Discount Window is a direct borrowing line for banks experiencing a cash crunch. It is infrequently used because it signals to banks, depositors, and stockholders that the bank is in trouble. The graph below shows the discount window was used extensively during the financial crisis. Besides two other smaller instances, it has barely been used.

If enacted, the new bank rules would force all banks to “preposition billions more in collateral” at the Fed to support future discount window borrowing. The article estimates that the Fed would require collateral matching up to 40% of a bank’s uninsured deposits, accounting for about 45% of the $17.5 trillion commercial bank deposits. Further, the new rules would require the banks to borrow from the window numerous times a year to help remove the program’s stigma.

In addition to bolstering the banking safety net, it would also force banks to hold significant collateral balances at the Fed. Collateral for Fed loans is quite often U.S. Treasury securities. Accordingly, this new bank rule is another way to help the Treasury fund its massive deficits and stock of outstanding debt from years past. This is just one plan for the Fed to help the Treasury fund its growing debts. Our Commentary about QE Light sheds light on a second rumored proposal.

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the reflexive rally remains intact, bouncing nicely off support at the 100-DMA. The market has not returned to overbought, so a further rally toward the 50- and 20-DMAs remains possible. From a bullish perspective, the 5.5% pullback was needed to “reset” the market following an exhaustive rally from the October lows. An attempt at previous highs is likely if the market can clear resistance. However, I suspect that we will likely see a retest of some support before that final push higher happens. Continue to remain long equities and look for opportunities to add to positions opportunistically. When the MACD issues its next buy signal, it will coincide with an improvement in the overall market and provide a better entry point for investors.

Yields and Inflation Expectations

The Fed pays close attention to inflation expectations and the real yield on Treasury securities. One of their recent concerns is that higher inflation expectations result in consumers and corporations buying today instead of tomorrow because they fear prices will rise. Real yields, or the difference between the current yield and inflation expectations, tell the Fed how restrictive or easy their policy is. The graph combines all of this to help us appreciate the Fed’s mindset.

Inflation expectations have risen from mid-2023 lows and are about half a percent higher than the ten years leading to the pandemic. However, despite expectations only being .50% higher, the two-year yield is about 4% higher than that same ten-year period. As a result, 2-year real yields are over 2% and on par with those in 2007. The graph helps explain why the Fed is ok with cutting rates despite the strong economy and higher inflation. Essentially, with inflation expectations stable, albeit higher than they prefer, real yields are too high. The economic headwind from such a high real yield will be problematic in time. The Fed wants to get in front of that potential problem.

UPS Earnings

FedEx and UPS earnings are always interesting as they provide reliable information about personal and business consumption. UPS posted mixed results yesterday. EPS beat estimates by ten cents but came up a little short on sales ( $21.71 billion versus $21.91 billion). Due to weaker business conditions, UPS fired 12K employees in the quarter. FedEx laid off a similar number of workers in its most recent report.

UPS was up slightly on the news. The graph below shows that FedEx and UPS shares have been flat since 2021. While consumers and corporations continue to ship more, UPS and FedEx are increasingly losing market share to Amazon.

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Over the last few weeks, the market tone has changed. The S&P 500 is no longer tracking a steadily rising trend line higher. Further, the most recent market outperformers are very different from the Magnificent Seven, which led the way higher over the last six months. For investors, the changes lead to important questions. For instance, are the Magnificent Seven taking a break before retaking the outperformance throne? If not, which stocks, sectors, and factors may outperform the market? To help us answer these questions, we share analysis from the newly upgraded SimpleVisor.

The table below shows the relative performance of the Magnificent Seven stocks versus the S&P 500. Their performance has been dreadful over the last five days, but in the previous 20 days leading up to last week, they beat the market. NVDA and TSLA had last week’s worst relative performance, giving up over 10% to the S&P 500. However, NVDA has been consistently grossly outperforming the market over prior periods, while Tesla has been giving up ground since last July. If you notice, we added XLU, the utility sector ETF, to the list of the Magnificent Seven stocks. Suppose utilities are on the cusp of leading the market for a stretch of time. In that case, the SimpleVisor analysis we share further below will help us appreciate its performance and that of its underlying stocks versus the Magnificent Seven and the rest of the market.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, the market tried to rally early but sellers emerged early in the day. However, with the market has been down 6-consecutive days, a decently long stretch by historical standards, the rally into the close was unsurprising. Notably, as bearish sentiment rises, the odds of a decent reflexive rally increases. However, the first rally to resistance, which will likely fail at the 50-DMA will be an opportunity to reduce risk rather than adding exposure.

As noted yesterday, there are many “trapped longs,” that were swept up in the selloff and are now looking for an exit. The market will likely have another decline to retest current lows, or set new lows, before this correction is over. That second low will likely be a better entry point for adding exposure into year-end. As always, there are no guarantees in the market. While we expect another decline to buy into, things can and will change and we will update you accordingly.

The New SimpleVisor

We are thrilled to announce that SimpleVisor has a new look and feel as of Monday. Please let us know if you are a subscriber and have any questions. If you want to try SimpleVisor, give it a shot with a free 30-day trial. We share a little analysis of the utility sector to appreciate its value.

Utilities Are In Charge

The SimpleVisor proprietary Absolute and Relative analysis uses many technical studies and assigns a relative (versus the S&P 500) and absolute score. We sorted by relative scores below. Note that utilities (XLU) are now the sector with the most overbought score versus the S&P 500 and the second most on an absolute basis, behind the energy sector. The graph on the right charts the daily absolute and relative scores over the last nine months. Accordingly, it went from decently oversold on both measures to overbought territory.

The second graphic breaks the sector down by its top ten holdings and performs a similar analysis. PEG, D, and NEE have the highest relative scores, while DUK and D have the best absolute scores. The third graph provides a relative analysis study using each utility stock against each other. This allows us to see better which utility stocks are leading the way and which are lagging.

Lastly, the fourth screenshot shows the relative performance of each sector over various time frames going back a year. Over the last five days, utilities gained 4.99% on the S&P 500. While its relative performance has been good for the previous 45 days, it was atrocious from April 2023 through mid-January. The SimpleVisor data show how the market has clearly rotated since January from the mega-cap technology-oriented companies to those stocks left behind. If the market continues to decline, we expect this to continue. However, if this is a consolidation before another rally, it will be interesting to see if megacap stocks lead the way again or if the conservative sectors and factors will continue to lead.

Tesla Continues to Slip

Our Daily Commentary from April 16th and others prior discussed the recent auto industry trend away from EVs. Tesla, like smaller EV makers and lithium producer shares, has been under significant pressure. As we share in the opening graphic, Tesla has been grossly underperforming the market, as well as the other Magnificent Seven stocks. Let’s look at its graph to better assess Tesla from a technical perspective.

For starters, note that the stock has fallen by over 50% since peaking in November 2021. The blue line highlights the downward resistance trend line that has kept a cap on rallies since November 2021. The horizontal bars on the right axis depict the volume occurring at each price interval. As it shows, a majority of buyers bought the stock at $75 or below or between $170 and $260. The stock is trading at $140, meaning that many holders are losing money, while those who bought it at much lower prices still have sizeable gains but are watching them erode. If Tesla continues lower, many trapped longs with losses may give in to their emotions and sell. Further, those with gains may be willing to sell to walk away with profits.

The MACD and RSI below the graph show that the stock is currently oversold, but it can certainly get more oversold. A corrective rally would not be surprising, but there is little indication that a low is in. For those inclined, the blue horizontal line at $108 may be a good place to start nibbling on Tesla shares.

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Is this just a correction after a strong bullish advance from November, or is the bull market ending? If you read some of the headlines, you would suspect the latter. As noted by MarketWatch last week:

“For the first time since early November 2023, less than 30% of S&P 500 stocks are trading above their 50-day moving average — a clear indicator of the current poor market’s breadth. This significant drop from the 85% observed in late March and 92% at the beginning of January highlights a dramatic reversal in market dynamics.

The 50-day moving average is often seen as a barometer for the short-term health of stocks. Falling below this level en masse suggests that a broad swath of the market is facing downward pressure. This shift comes amid escalating geopolitical tensions in the Middle East and renewed concerns over inflation, which have collectively nudged traders towards a more guarded stance in April.”

Of course, there are many “reasons” lately for the drop in stock prices. Geopolitical stress between Israel and Iran and hotter-than-expected inflation data that paused Fed rate cuts brought sellers into the market. However, none of this is shocking, as we previously noted in “Blackout Of Buybacks:”

“Notably, since 2009, and accelerating starting in 2012, the percentage change in buybacks has far outstripped the increase in asset prices. As we will discuss, it is more than just a casual correlation, and the upcoming blackout window may be more critical to the rally than many think.” – March 19, 2024

Furthermore, the “blackout” of corporate buybacks coincided with an aggressively bullish investor sentiment. As we noted in that same article:

“Investor sentiment is once again very bullish. Historically, when retail investor sentiment is exceedingly bullish combined with low volatility, such has generally corresponded to short-term market peaks.”

We will return to this chart momentarily, but given that corporate share buybacks have accounted for roughly 100% of net equity purchases over the last two decades, the blackout period combined with aggressive bullish sentiment was the recipe for a decline in asset prices.

Here is the math of net flows if you don’t believe the chart:

• Pensions and Mutual Funds = (-$2.7 Trillion)
• Households and Foreign Investors = +$2.4 Trillion
  • Sub Total = (-$0.3 T)
• Corporations (Buybacks) = $5.5T
  • Net Total = $5.2 Trillion = Or 100% of all equities purchased

Such is crucial to understand as we head into the rest of the year. It will determine whether this is just a correction within a bullish trend or something more significant.

Buyers Live Lower

In “No Cash On The Sidelines,” we discussed the importance of understanding that “market prices” are set by the demand and supply between buyers and sellers. To wit:

“As noted above, the stock market is always a function of buyers and sellers, each negotiating to make a transaction. While there is a buyer for every seller, the question is always at “what price?” 

In the current bull market, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own.

Such is the very definition of the “greater fool” theory.

However, at some point, for whatever reason, this dynamic will change. Buyers will become more scarce as they refuse to pay a higher price. When sellers realize the change, they will rush to sell to a diminishing pool of buyers. Eventually, sellers will begin to “panic sell” as buyers evaporate and prices plunge.”

In other words, “Sellers live higher. Buyers live lower.“

We can see where the buyers and sellers “live” in the following chart, which shows where the highest volume occurred.

This current correction is becoming increasingly oversold (bottom panel), which suggests a bounce is likely toward the previous support of the 50-DMA. For comparison, we can look at last year’s market correction. As noted, the bullish rally into July peaked late that month. As the market corrected, it bounced from oversold conditions, allowing investors to reduce risk and hedge portfolios. The markets will likely present investors with that opportunity soon.

Then, like today, many investors began to believe it wasn’t just a correction but something much more. However, the reality was that the “buyers lived lower.” Buyers stepped in as prices approached the October lows, coinciding with the return of corporate share buybacks.

Sentiment Is Reversing Quickly

As I said, we need to revisit the sentiment chart above. Investors’ more frothy, bullish sentiment is reversing quickly on many fronts. The chart below, the same as above, is the composite net bullish sentiment index of retail and professional investors divided by the volatility index (VIX). If this is just a market correction, the index tends to bottom between zero (0) and negative (20). With a current reading of 4.15, down from 25.99 just two weeks ago, bullish sentiment has significantly reversed.

Notably, professional investor allocations to equities recently peaked at 103.88%, which has collapsed in just two weeks to just 62.98% exposure. (Professional investors are notorious for buying market peaks.)

Also, the number of stocks on bullish “buy signals” has dropped from 80.2 to 48.2.

Furthermore, the number of stocks trading above the 50-DMA has fallen from over 80% to 37%, with money flows hitting levels lower than previous market bottom lows. Notably, with just a 5.5% correction from the recent peak (as of last Friday), much of the work of clearing the previous overbought conditions is completed.

Given the significant reversal in sentiment and short-term oversold conditions, we highly suspect the markets will provide a reflexive rally soon. However, with the number of bullish investors who got “trapped” in the selloff, any rallies will likely be met with further selling.

However, despite the current “panic” in the media headlines, this is likely just a correction within an ongoing bullish market. Such is particularly the case given that corporate share buybacks will resume in May, providing critical support for the markets heading into summer.

With that said, this correction, when complete, likely won’t be the last we see this year. Market history suggests we could see another “bumpy ride” heading into what many expect will be a somewhat contentious election.

But that is an article we will write when we get there.

Investors tend to prefer periods of stability. However, as we share below, politicians’ promises appear to offset the potential instability associated with changes in the White House and/or Congress. We present the graph below to help appreciate how seasonal patterns may affect stock prices this election year. Since 1972, only three of the thirteen election periods had negative returns between January and the election. The 1984 election was slightly negative, although from January to July, the S&P 500 fell 13% but fully recovered by November. 2000 and 2008 were the worst years for returns.

The range of returns throughout the series of ten-month periods is also important to appreciate. Of the thirteen periods, only five had a maximum drawdown of 5% or worse. All but four of the years saw at least one point within the period in which the S&P 500 posted double-digit gains. The average gain for all election year periods is 4.65%, with an average maximum drawdown of 9.86% and an upside of 12.76%. The outsized losses in 2008 certainly skew the data. Excluding that year, the average gain is nearly 8%. While we are only four months into the current election period, the return is already 2% above the average, and the maximum return this year matches the average. Might we have already seen the best performance of the year, or do years like 1980, 1996, and 2016 provide hope for even better returns in the coming months?

What To Watch Today

Earnings

Economy

Market Trading Update

Last week, we discussed the market’s break of the bullish trend. To wit:

“The market did break below the previous low on Friday after failing to reclaim that previous support at the 20-DMA. The failure to reclaim that support turns the previous 20-DMA into resistance and makes the 50-DMA new critical support over the next few days. (Note: If the market makes a confirmed break of the 50-DMA, the 100- and 200-DMAs become the following logical targets.)”

Over the two months, we repeatedly warned that a correction process was likely. As noted in “Market Top or Bubble:”

“As noted, the market remains in a bullish trend. The 20-DMA, the bottom of the trend channel, will likely serve as an initial warning sign to reduce risk when it is violated. That level has repeatedly seen ‘buying programs’ kick in and suggests that breaking that support will cause the algos to start selling. Such a switch in market dynamics would likely lead to a 5-10% correction over a few months.“

While it took longer than expected, that correction process arrived last week and continued earnestly with the market approaching the 100-DMA. With the market short-term oversold, a reflexive rally in the next week is likely, with the 50-DMA being notable resistance. Any rally toward 5100 should be used to rebalance risk and hedge portfolios as needed.

Notably, this has been a very orderly correction. While there has certainly been selling in the markets, particularly in some of the previous “momentum” names, volatility has risen in a controlled manner. Such suggests that this correction process is just a normal correction within an ongoing bullish trend. You will note very similar actions during the decline last summer.

As noted last week:

“The confirmed break of support suggests reviewing portfolio allocations and taking profits in well-performing positions. However, while some stocks have only begun to correct from previously overbought conditions, many have already corrected by 10% or more over the last few weeks. Those companies may see inflows as a rotation trade in the market occurs.

In other words, as is always the case, be careful “throwing the baby out with the bathwater.” Opportunities to acquire better-priced companies always exist, even during a corrective process.”

The Week Ahead

Earnings from the largest technology companies will be a big focus this week. Verizon will kick off earnings on Monday, followed by Visa, Tesla, Meta, Microsoft, Google, Amazon, and Exxon. Apple and AMD will post earnings next week. There are a significant number of earnings announcements from other large companies that we do not mention.

PCE prices on Friday will help us decipher if the hotter-than-expected CPI or relatively benign PPI inflation data is accurate. The Fed prefers PCE, so we expect market volatility if PCE is above or below expectations. Economists expect PCE and Core PCE to be 0.3%, which is in line with last month’s readings.

The Escalation Between Israel and Iran Sends Markets On A Rollercoaster To Nowhere

Later Thursday night, it was reported that Israel bombed Iran near areas where they house its nuclear capabilities. The market reaction was decidedly risk-off as traders assumed this action would further escalate their ongoing conflict. As it turns out, cooler heads prevailed, and Iran alluded that it would not retaliate. While nothing is off the table, the roller coaster ride in many asset classes tells us the market fears of escalation evaporated by Friday morning. Consider the following table showing the Thursday close, Friday open, and the maximum percentage gain or loss at the peak of panic.

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The latest National Federation of Independent Business (NFIB) survey was an economic warning that departed widely from more robust governmental reports. In a recent analysis of small businesses, we discussed the importance those business owners play in the economy.

“It is crucial to understand that small and mid-sized businesses comprise a substantial percentage of the U.S. economy. Roughly 60% of all companies in the U.S. have less than ten employees.

Small businesses drive the economy, employment, and wages. Therefore, the NFIB’s statements are highly relevant to the economy’s current state compared to the headline economic data from Government sources.”

While recent government data on economic growth and employment remain robust, the NFIB small business confidence survey declined in its latest reading. Not only did it fall to the lowest level in 11 years, but, as far as an economic warning goes, it remained at levels historically associated with a recessionary economy.

The decline in confidence should be unsurprising given the largest deviation of interest rates from their 5-year average since 1975. Higher borrowing costs impede business growth for small businesses, as they don’t have access to the bond market like major companies.

Therefore, as the economy slows and interest rates rise, small business owners turn to their local banks for operating loans. However, higher rates and tighter lending standards make access to capital more difficult.

Of course, given that capital is the lifeblood of any business, decisions on hiring, capital expenditures, and expansion hang in the balance.

Economic Warning – Capital Expenditures

It should be unsurprising that if the economy were expanding as quickly as headline data suggests, business owners would be expending capital to increase capacity to meet rising demand. However, in the most recent NFIB report, the percentage of business owners planning capital expenditures over the 3-6 months dropped to the lowest level since the pandemic-driven shutdown.

Again, given that small businesses comprise about 50% of the economy, there is more than just a casual relationship between their capital expenditure plans (CapEx) and real gross private investment, which is part of the GDP equation.

In other words, if small businesses cut back on CapEx, this will eventually translate into slower rates of private investment and, ultimately, economic growth in coming quarters.

As shown, the correlation between small business CapEx plans and economic growth should not be dismissed. While mainstream economists are becoming increasingly optimistic about an “economic reflation,” the economic warning between real GDP and CapEx suggests caution.

Of course, if small businesses are unwilling to increase CapEx, it is because there is a lack of demand to justify those expenditures. Therefore, if CapEx is falling, we should expect economic warnings from employment and sales.

Something Amiss With Sales

Many reasons feed into a small business owner’s decision NOT to invest in their business. As noted above, tighter bank lending standards and increased borrowing costs certainly weigh on that decision. However, if “business is booming,” business owners will find the capital needed to meet increased demand. However, looking deeper into the NFIB data, we find rising concerns about the “demand” side of the equation.

The NFIB publishes several data points from the survey concerning the “concerns” small business owners have. These cover many concerns, from government regulations to taxes, labor costs, sales, and other concerns confronting business owners. When it comes to the “demand” side of the equation, there are three crucial categories:

1. Poor sales (demand),
2. Cost of labor (the most significant expense to any business), and
3. Is it a “Good time to expand?” (Capex)

In the chart below, I have inverted “Good time to expand,” so it correlates with rising concerns about the cost of labor and poor sales. What should be obvious is that the average of these concerns escalates as economic growth weakens (recessionary periods) and falls during economic recoveries. Currently, these rising concerns should provide an economic warning to economists.

Examining sales and employment figures can help us understand why business owners remain pessimistic about the overall economy. The chart below shows the NFIB members’ sales expectations over the next quarter compared to the previous quarter. The black line is the average of both with a long-term median.

Unsurprisingly, business owners are always optimistic that sales will improve in the next quarter. However, actual sales tend to fall short of those expectations. The two have a very high correlation, which is why the average of both provides valuable information. Sales expectations and actual sales are well below levels typically witnessed during recessions. With sales (demand) weak, there is little need to increase production (supply) substantially.

Here is the economic warning to pay attention to. Real retail sales comprise about 40% of personal consumption expenditures (PCE), roughly 70% of the economic growth rate. The decline in the average of actual and expected sales of small businesses suggests weaker retail sales and, by extension, a slower economic growth rate.

Employment Warning

The demand side of the economic equation is crucially important. If the demand for a business owner’s products or services declines, there is little need to increase employment. Therefore, if economic growth was as robust as headlines suggest, why are small businesses’ plans to increase employment declining sharply?

Furthermore, when demand falls, business owners look to cut operating costs to protect profitability. While cutting future employment is part of that equation, so are plans to raise worker compensation.

The last chart is crucial. The U.S. is a consumption-based economy. However, consumers can not consume without producing something first. Production must come first to generate the income needed for that consumption. The cycle is displayed below.

As employees receive fewer compensation increases (raises, bonuses, etc.) amid rising living costs, they cut consumption, which translates into slower economic growth rates. In turn, business owners cut employment and compensation further. It is a virtual spiral that historically ends in recession.

While this time could certainly be different, the economic warnings from the NFIB survey should not be dismissed. The data could explain why the Fed is adamant about cutting rates.

The narrative de jour scaring bond investors is reflation. The recent stickiness and even uptick in prices have investors worried that inflation is headed higher again. The concern is not without merit, as several items in the inflation reports are increasing in price. However, before buying into the narrative, we want to share our research that argues CPI could be much lower in the coming nine months to a year.

We have often written about how the surge in shelter costs within the CPI inflation calculation grossly distorts CPI. The problem is not necessarily whether shelter costs, primarily rent and imputed rent, should be over a third of CPI. Instead, we bemoan the lagging nature of the BLS’ CPI shelter data. The price of bread, cell phones, and every other good and service in CPI is based on current prices. Rents, however, are based on surveys. Given that only about 1/12ths of rents are reset in any given month, 11/12ths of the data is old. Unlike the prices of other goods and services, the BLS effectively uses rent and imputed rental prices that are about six months stale on average.

With this lag in mind, we focus on the Cleveland Fed’s All Tenants Regressed Rent Index (ATRR) and its New Tenant Rent Index (NTR) along with the BLS’ CPI, CPI-Shelter, and CPI-less Shelter. Our analysis of this data exposes the lag and, more importantly, forecasts how current rental prices will impact CPI later this year. For starters, we share the graph below. CPI Shelter costs are well above CPI, and CPI excluding Shelter Costs are below CPI. After the Market Update below, we continue this discussion.

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, the market has been under decent selling pressure and declined for four consecutive days. With markets decently oversold, yesterday’s early bounce was unsurprising, but, as has been the case over the last several days, the rally failed. Notably, however, the market did close off the lows after an initial test of the 23.6% retracement from the previous peak. The market is oversold enough for a reflexive bounce that could last a few days. However, with the MACD on a solid “sell signal,” we should suggest using rallies to rebalance equity risk until a new “buy signal” is triggered.

The one thing to note is that the WEEKLY money flow signal is close to triggering a “sell signal.” The last time the weekly signal was triggered was in August of last year, preceding the sell-off into October. That signal suggests that we are likely not done with the current correction process, so we will want to navigate markets carefully until we know.

Shelter Costs Are Headed Lower

The graph below charts the Cleveland Fed’s Average Tenant Rentals (ATRR) and their New Tenant Rentals (NTR) alongside BLS CPI-Shelter. We pushed the NTR data forward nine months to better show how well it leads the ATRR and CPI Shelter prices. There are a few essential takeaways from the graph. First, the ATRR and CPI-Shelter are nearly identical. Second, NTR is more volatile than the other two rent indicators because it’s not an average. Third, and most importantly, NTR tends to lead CPI Shelter and ATRR by nine months.

The scatter plot below highlights the strong correlation between NTR nine months in advance and CPI Shelter. The outliers are a function of the volatility of the NTR data. If we presume the relationship holds and, to be conservative, ATR is closer to zero than negative, we should expect inflation to be nearing 2% by year-end.

The NTR data is volatile from quarter to quarter, but it is in line with other private measures of rent. For example, the graphs below the scatter plot show that RedFin’s and Apartment List’s proprietary rent price indexes are also declining on a yearly basis.

When CPI Shelter catches up with market prices, we should see inflation figures decline again. With it, we suspect the market will start pricing in more rate cuts for later this year, and the Fed will likely become more dovish.

Mortgage Refinancings Are Picking Up…Why?

The Mortgage Bankers Association (MBA) mortgage refinance index just posted its highest point in nearly a year, as shown below. Given that mortgage rates have not fallen significantly, the rise in the index is troubling. Most likely, an increasing number of mortgage holders are draining equity from their houses at higher rates than their prior mortgage rate. Typically, customers would rely on credit cards to meet short-term crunches. Might those be maxed out?

While the refi index has been climbing over the past few months and is near the highs going back to late 2022, it is still well below levels when mortgage rates were much lower. From 1990 to the present, the average for the index is 1844, over three times higher than the current reading.

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Yesterday’s Commentary discussed the coming halving of Bitcoin and its pros and cons for Bitcoin miners. While mining for gold is an entirely different endeavor, a couple of readers asked us to opine on the differences between holding gold and gold miners. One common thread between gold and Bitcoin miners is that the easiest, cheapest gold or Bitcoin is mined first. Each additional ounce of gold or bitcoin becomes more expensive to mine.

From a gold miners perspective, their labor and equipment expenses have risen considerably with inflation. Further, as it becomes more difficult to find gold, they must mine in more remote places. That comes with higher costs and less yield. While the added expenses of finding new gold are a slow upward trend, the inflation surge is hitting miners now. Accordingly, even though gold prices are up significantly, mining costs have also risen appreciably. If you want to own gold, we think buying gold bullion or an ETF is the best way to express such an investment. Suppose you want leverage on the price of gold. Further, you are willing to be subject to the costs of running a mining operation, including bad management decisions. In that case, gold miners may be a suitable investment. As with any stock, there are efficient and non-efficient gold miners. Do your due diligence.

The graph below shows that since 2020, gold has risen by 60%, while Newmont (NEM), the largest holding of the popular GDX gold mining ETF, is flat. The lower graph shows the correlation between gold and NEM has been close to zero for the last two months.

What To Watch Today

Earnings

Economy

Market Trading Update

The market continues its current correction process. This correction, which we discussed was coming for the last two months, is in process. We noted previously that “sellers live higher, buyers live lower,” which is why the market is declining to try and find where buyers are currently “living.”

As shown, there is a fairly sizable gap between the current and next levels, where most of the volume occurred. However, if that is where the market is ultimately headed, it most likely won’t do it in a straight line. With the market decently oversold and following several consecutive days of selling, a decent bounce toward the 50-DMA is likely. Use that bounce to reduce risk and add hedges as needed.

Given that algorithms and programmatic trading do a large chunk of daily trading activity, it is difficult to know exactly where those programs will turn from “selling rips” back to “buying dips.” However, we have been through these corrections before, and they will end. While corrections are never fun, they provide investors with a great opportunity to buy positions they want at cheaper prices.

Housing Starts Like Multifamily Building Permits Normalize

Yesterday, we discussed the decline in multifamily building permits and the expected soon-to-come decline in multifamily construction projects. We also shared how the reductions will result in job losses in the construction industry and become a headwind for inflation. Similarly, new housing permits show weakness. Per the Census Bureau, housing starts plunged 14.7% month-over-month in March to an annualized rate of 1.321 million. That was well below forecasts of 1.48 million. It is the lowest reading since August and the biggest decline since April 2020. As we share below, housing starts are now close to pre-pandemic levels.

Wall Street Sticks With 2 Cuts While Powell Buys Time

Per BofA, 76% of institutional fund managers polled still expect two or more Fed interest rate cuts in 2024, while 8% project no rate cut at all. The survey was conducted in early April before comments from Jerome Powell on Tuesday. The first graph below shows that Goldman Sachs forecasts that inflation’s rate of decline may be slowing, but it should reach the Fed’s 2% target in early 2025. The second table, courtesy of the CME, shows the market is mixed as to whether there will be one or two cuts by year-end. However, Fed Fund futures imply a zero chance of rate hikes.

On Tuesday, Jerome Powell confirmed what other Fed speakers have been saying. The expected rate cuts are still on the table but will likely be pushed back. Further, Powell raises some doubt about whether the Fed may cut at all this year. However, despite what appears to be a more hawkish tone, we are not hearing anything from Powell regarding the possibility of rate hikes. The recent tightening of financial conditions via higher bond yields and weaker stock prices may also provide the Fed a little comfort in their projections.

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On Saturday, April 20, Bitcoin will be halving. Halving is an essential part of what makes Bitcoin unique. The halving process means that bitcoin miners will receive half as many bitcoins for verifying blockchain transactions. Currently, they receive 6.25 bitcoin for every 210,000 network blocks they verify. After April 20, they will only get 3.125. The process is similar to the actual mining of precious metals and some other commodities. As the mineable supply of a commodity declines, mining costs rise. Similarly, the algorithms to verify transactions get more complex, and at the same time, the reward for mining is less. The mechanism is designed to keep a lid on the supply of Bitcoin. Remember that the number of Bitcoin is capped at 21 million tokens.

From an investor’s point of view, there is much discussion about what the halving may mean for prices. The easy takeaway is that halving removes incentives to mine Bitcoin, which, in theory, should reduce supply. However, the halving is a known event, and the market has plenty of time to price the event before it occurs. As the graph below shows, at the last halving in May 2020, Bitcoin rose 25% in the 30 days leading up to the event and another 15% in the following 30 days. The prior halving in 2016 saw Bitcoin increase by 13%, 30 days in advance, but it gave up 10% in the 30 days following. With Bitcoin already up 48% year to date, this coming halving may look more like the 2012 event than the last one.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we touched on the strong retail sales data that may not be as strong as headlines suggest. Nonetheless, while this may have longer-term implications for the market, it is all about the technical analysis in the short term. On Monday, the market broke below the 50-DMA, confirming the recent break of the 20-DMA as the start of a correction phase. Yesterday, the market attempted to rally, but selling pressure remained. As shown, money flows remain negative, suggesting lower prices in the near future, with the number of stocks below their 50-DMA dropping sharply. With the market down nearly 4% from the recent peak, we are likely close to a reflexive rally before the correction phase continues. Use any such rally to reduce equity risk as needed for now.

Crucially, this is likely the 5-10% correction we have written about previously. With still very bullish sentiment on the overall market, this will likely be a buying opportunity in the months ahead.

How Will The Halving Effect The Miners

Bitcoin miners will see some positive and negative effects from the coming halving. On the bright side, the higher cost of mining should reduce the competition. Additionally, larger, more efficient firms may be able to purchase the assets of lesser competitive smaller firms at a discount. However, the miners will essentially be paid less to do the same work they are currently doing. Therefore, they will have to increase their capital expenditures to upgrade to more efficient equipment and find ways to reduce their energy costs. Buying up smaller miners may also provide economies of scale to help further. Technology will advance over time, which should lead to more profitability. Still, the initial effect will be a drag on earnings for the largest miners and possibly bankruptcy for smaller, less productive miners.

The bar graph below shows investors putting large short bets on Bitcoin miners in anticipation of the event. The second graph compares the price of Bitcoin to the three largest publicly traded miners. As shown, they have recently traded much weaker than Bitcoin, and as seen in the lower graph, the correlation between Bitcoin and the miner’s prices is now negative.

The Multifamily Construction Boom Is Ending

The graph below points to both a boom in new multifamily structures being built as well as a normalization going forward. The blue line shows that there are almost one million multifamily buildings that will soon be finished. That is about 400k more than before the pandemic. The construction boom helped increase construction payrolls and impacted construction materials’ prices. The red line shows that permits for new multifamily projects have now fallen entirely back to pre-pandemic levels. Therefore, we should expect the number of new buildings hitting the market to decline toward pre-pandemic levels. Equally important, the upward impact on payrolls and prices will also normalize.

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We recently wrote Japan’s Lost Decades to appreciate better why Japan’s GDP is smaller than it was in 1995 and why it took 35 years for its stock market to set its recent record high.

Many pundits claim the U.S. is following Japan’s path. The path includes a stagnant economy, massive government debt, and a central bank that must dominate financial markets to keep the economy and financial markets afloat.

There is merit to that opinion. The U.S. government has excessive debt and is increasingly negligent in managing its budget. Also, the nation’s economic growth rate has been trending lower for thirty years, and fiscal dominance is becoming the norm, not the exception.

While we may be on a similar path as Japan, we are not nearly as far along. There are many differences between Japan and the United States worth considering.

All Asset Bubbles Are Not Alike

At the heart of Japan’s current problems were its massive real estate and stock bubbles that popped in 1989.

To appreciate the enormity of their bubbles, consider the following from Ben Carlson’s article The Biggest Asset Bubble In History.

From 1956 to 1986 land prices in Japan increased by 5000% even though consumer prices only doubled in that time.

By 1990 the Japanese real estate market was valued at 4x the value of real estate in the United States, despite being 25x smaller in terms of landmass and having 200 million fewer people.

Tokyo itself was on equal footing with the U.S. in terms of real estate values.

The grounds on the Imperial Palace were estimated to be worth more than the entire real estate value of California or Canada at the market peak.

There were over 20 golf clubs that cost more than $1 million to join.

In 1989 the P/E ratio on the Nikkei was 60x trailing 12-month earnings.

Japan made up 15% of world stock market capitalization in 1980. By 1989 it represented 42% of the global equity markets.

From 1970-1989, Japanese large cap companies were up more than 22% per year. Small caps were up closer to 30% per year. For 20 years!

Stocks went from 29% of Japan’s GDP in 1980 to 151% by 1989.

Japan was trading at a CAPE ratio of nearly 100x which is more than double what the U.S. was trading at during the height of the dot-com bubble.

The aftershock could have been dealt with in many ways, but at its core, it came down to whether to pay a dear price over a short period or draw out the costs over decades. They elected the latter, saving their banks and relying on massive government spending to insulate the economy.

Over the last 25 years, the U.S. dot com and subprime bubbles have popped. While economically costly, the bubbles were minor compared to Japan’s. Accordingly, when they popped, the economic and financial consequences paled compared to Japan’s.

Banking Sector

The real estate and stock bubbles were supported with massive leverage via bank loans. When the asset values plummeted, the debt supporting them was often worthless. The banking system would have collapsed if the banks had written off the bad loans. The government aimed to keep the banking system out of harm’s way. Essentially, the banks didn’t have to recognize the losses. However, the non-performing loans were still on their books, significantly impeding their lending capabilities. 

Further crippling the banks were the BOJ monetary policies which pinned interest rates at zero and below zero for long periods. The result was a flat yield curve. In addition to having a limited ability to lend, BOJ policies severely reduced the financial incentive to lend. Japan’s private sector economy could not contribute to growth nearly as much as possible if the banking sector were healthy and incentivized to lend.

Conversely, U.S. banks are healthy and well-capitalized. Additionally, the Fed is very in tune with the amount of reserves in the banking system and stands ready to provide more when needed. Reserves are the fodder banks require to make loans.

The graph below compares the net interest margin for Japanese and American banks to show how much more financial incentive to lend versus their Japanese competitors.

Barring a significant financial crisis, there is no reason to expect U.S. banks to be as restricted as Japanese banks have been.

State-Led Capitalism

As noted in the prior section, Japanese banks have had a minimal ability to lend for much of the last 35 years. As a result of their zombie-like status, the government was heavily obligated to promote economic growth. Accordingly, the government played a much more significant role in managing the economy than is typical in a capitalistic economy.

A key tenant of capitalism states that when the free market sets prices based on the supply and demand for goods and services, it can most efficiently allocate resources to their most productive uses. Commonly, the most productive use of resources benefits economic growth and allows for higher wages and a broad distribution of wealth. Government interference reduces capitalism’s value as capital is often not put to its most productive uses.

Post-World War II Policies

Following World War II, Japan followed a path of capitalism, but it was state-led. Such was probably necessary in the decade or two after the war as the country was physically and emotionally devastated. Japan benefited immensely from the government’s push for rapid industrialization and economic development. But through loose monetary policy, financial deregulation, tax incentives, and infrastructure spending, its policies played a crucial role in inflating the real estate and stock bubbles.

After the bubble, the government was called upon to stimulate the economy. Their interference ultimately resulted in the unproductive allocation of resources, which, in the long term, likely reduced economic activity, thereby prolonging their weakness.

The United States form of capitalism is not as pure as it could be, but it is not nearly as dictated to the same degree as Japan. The Fed and government do reduce the value of capitalism and certainly foster speculation and leverage. But, they have yet to create policies that induce bubbles to the degree Japan saw in the 1980s.  

The Yen Versus The World’s Reserve Currency

The U.S. dollar is the world’s reserve currency, and enormous rewards and complications come with it. In our article, Our Currency The World’s Problem we discuss the value of the reserve currency to the U.S.

Foreign nations accumulate and spend dollars through trade. They keep extra dollars on hand to manage their economies and limit financial shocks. These dollars, known as excess reserves, are invested primarily in U.S.-denominated investments ranging from bank deposits to U.S. Treasury securities and a wide range of other financial securities. As the global economy expanded and more trade occurred, additional dollars were required. As a result, foreign dollar reserves grew and were lent back to the U.S. economy.

Making the world even more dependent on the dollar, many foreign countries and companies issue U.S. dollar-denominated debt to better facilitate trade and take advantage of America’s liquid capital markets.

The bottom line is that the U.S. has a constant source of capital to fund our debts, support our asset markets, and buoy the economy. The Japanese Yen provides no such benefits to Japan.

Other Factors

In Japan’s Lost Decades, we discuss Japan’s demographic challenges. To summarize, Japan has an aging population with low birth rates and a meager immigration rate. These factors and others have resulted in a declining population, which weighs on economic growth. While the United States also faces demographic headwinds that are and will negatively impact economic growth, they are not nearly as pronounced as those in Japan.

The United States has a much larger and more diverse economy. This is in part because we are rich in natural resources. The U.S. economy encompasses a wide range of industries, including technology, finance, manufacturing, agriculture, and services. In contrast, Japan’s economy focuses heavily on manufacturing and exports.

Various cultural differences also shape economic policies and affect consumer and corporate behaviors. The business culture in Japan is characterized by lifetime employment contracts and close relationships between corporations and banks (keiretsu). Japan’s population emphasizes consensus and harmony. In contrast, the United States has a more competitive culture centered more on the individual than the nation.

Summary

Fiscal dominance, whereby the Federal Reserve must help the Treasury fund their debts at reasonable costs, is upon us. Japan has relied on fiscal dominance for 35 years. This is one of a few clues that the U.S. is on Japan’s path.

However, as we have written, our nations have significant differences. While we may be on a similar path as Japan, our paths will differ. Since we have not traveled as far on the path as Japan, we have time to learn their lessons and fix them. Will this happen?

In our article Is Toyota The Next Tesla, we discuss recent trends in the automobile industry. In particular, EV sales growth has been declining as hybrid vehicles become more popular, and concerns specific to EVs are growing. With more competitors in the EV market and new hybrid models hitting the market, Tesla’s market share of total auto sales is at risk. In fact, its sales declined in the first quarter. To counteract the trend toward lower growth, Tesla has made some sacrifices. For starters, Tesla cut prices. Per Cox Automotive, “Tesla’s average transaction price was $52,315 in Q1, down roughly 13.5% year over year. However, lower prices did not generate higher volume.“

Since lower prices amid growing competition and waning demand aren’t spurring sales, Tesla announced it would cut 15,000 jobs or about 10% of its staff on Monday. As we wrote in our aforementioned article, EVs will gain market share but not likely at the pace they have, barring new technology. The Tesla job cuts and weakening sales greatly impact the producers of the metals used to make EVs. Consider the quote below from the Wall Street Journal.

Producers of lithium and nickel, which are used in lithium-ion batteries for EVs, have been stalling projects and closing mines to save cash after a painfully quick fall in commodity prices. Prices of lithium are down as much as 90% since the start of last year, while the price of nickel has roughly halved- The Boom In Battery Metals For EVs Is Turning To Bust

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the market is sitting on support at the 50-DMA and is oversold. Yesterday morning, the market opened up decently strong on cooling tensions between Iran and Israel, and stronger than expected retail sales data suggesting the consumer remains strong. However, it didn’t take long for the market to see through the sales data and realize that while sales were strong, it included Spring Break and Easter. Of course, both events require travel, hotels, food, and clothing. It is quite likely April will be substantially weaker as a payback for the pull-forward of spending in March. As shown, retail sales remain weak, and this is on a nominal basis, which is crucial as it means consumers are paying more for the same amount of goods.

Furthermore, the 12-month average of the non-seasonally adjusted spending data should be examined, removing all the seasonal adjustments and manipulations. We find that retail sales growth is substantially weaker than reported. Given that the reported numbers follow the unadjusted average, we will likely see weaker sales numbers heading into summer.

Notably, if retail sales slow down as they appear, interest rates will continue to follow. The chart below compares the 12-month average of retail sales to the annual change in interest rates. Over the months ahead, as retail sales and the overall economy continue to slow, interest rates will follow.

While interest rates are rising due to speculative market actions, the sustainability of higher rates is problematic for consumers and a heavily indebted economy.

Industrial Metals Rally On Russian Sanctions

In further efforts to reduce Russia’s sources of military funding, the U.S. and British governments are banning Russian exports of nickel, aluminum, and copper. Further, the Chicago Mercantile Exchange (CME) and London Metal Exchange (LME) will make deliveries of the three metals produced by Russia ineligible for futures contracts. For context, Russia accounts for about 5% of the production of all three metals. On the margin, the ban may further add to price pressures. But keep in mind the markets for these metals are global. Therefore, China will buy more metals from Russia, while the U.S. and Britain buy more from other producers. Accordingly, the sanctions should have little effect on prices in the long run.

The prices of the metals spiked on the news but have since given back some of the gains. The graph below shows that Copper prices were up by about 4% when the news was released. However, it has retreated since then. Aluminum is up 2.5% but also down decently from Sunday night’s highs.

Healthcare Stocks Are Very Oversold, But…

The SimpleVisor graph below shows our proprietary SimpleVisor relative technical score (green line) for the healthcare sector (XLV). The black and blue lines in the lower chart show the prices of XLV and SPY. The red bars show XLV’s relative performance. The top chart highlights the two prior instances when XLV was as oversold as it is today versus the S&P 500.

Given the significant oversold level, is it worth adding to healthcare on a relative basis?

The answer is maybe. The boxes show that the prior deeply oversold periods only produced marginal relative outperformance. These periods of consolidation of the XLV/SPY ratio allowed the technical gauges to become more balanced. If this instance marks an actual trend change and not a consolidation in a lower trend, we may be nearing a period to buy XLV versus SPY. Breaking into overbought territory might signal such a trend change.

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Economic “reflation” is becoming the next bullish narrative as equity valuation increases continue to outpace earnings gains, at least according to Gold Sachs and Tony Pasquariello.

“If GS is correct on the big calls, the macro backdrop is set to remain friendly: the US economy should continue to grow nicely above trend — picking up speed as the year moves along — with three adjustment rates cuts along the way.  to not obscure the moral of that story: the Fed is set to ease policy … into an upswing.  while Fedspeak this week had a somewhat hawkish bent, the house view for 2024 remains intact.”

Interest rates, gold, and commodity prices have increased in the past few months. Unsurprisingly, the bullish narrative to support that rise has gained traction. Interestingly, this “reflation” narrative tends to resurface by Wall Street whenever there is a need to explain the surge in commodity prices. Notably, the last time Wall Street focused on the reflation trade was in 2009, as noted by the WSJ:

“The most talked-about investing strategy these days isn’t stuffing money in a mattress, it’s the reflation trade — the bet that the world economy will rebound, driving up interest rates and commodities prices.”

While that “reflation trade” lasted for about two years, it quickly failed as economic growth returned to 2%-ish growth along with inflation and interest rates. As shown, oil and commodity prices have a very high correlation. The critical reason is that higher oil prices reduce economic demand. As consumption falls, so does the demand for commodities in general. Therefore, if commodity prices are to “reflate,” as shown, such will depend on more robust economic activity.

As such. The reflation trade hinges on a global resurgence of economic activity, usually associated with economies recovering from a recessionary period. However, the U.S. never experienced a recession. As discussed in “Deficit Spending,” despite numerous recessionary signals, like the inverted yield curve, manufacturing data, and leading economic indicators, the economy avoided recession due to massive governmental spending. To wit:

“One explanation for this has been the surge in Federal expenditures since the end of 2022 stemming from the Inflation Reduction and CHIPs Acts. The second reason is that GDP was so grossly elevated from the $5 Trillion in previous fiscal policies that the lag effect is taking longer than historical norms to resolve.”

While economists focus on the “reflation trade,” we must answer whether the support for more substantial economic growth exists. This is the sole determining factor in whether the “reflation trade” can continue.

Is Reflation Already Behind Us?

Interest rates and inflation have ticked up recently, driving investors into gold and commodities. However, the surge in precious metals and commodities is more of a function of speculative exuberance rather than an economic resurgence. As discussed in “Speculative Warnings,”

“In other words, the stock market frenzy to “buy anything that is going up” has spread from just a handful of stocks related to artificial intelligence to gold and digital currencies.“

Notably, the gold, commodities, and interest rate surge corresponded with more robust economic growth beginning in the third quarter of last year. That uptick in economic growth defied economists’ expectations of a recession. Such was because of the massive flood of monetary support from Government spending programs. However, that monetary impulse is now reversing.

As far as the “reflation trade” is concerned, as that monetary impulse recedes, so will economic growth, as shown. Even if the economy continues to grow at 2-2.5% annualized each quarter, the annual rate of change in growth will continue to slow.

Importantly, this assumes that the Government will keep “spending like drunken sailors” over that same period. However, if they don’t, the economic growth rate will slow even more quickly without increasing monetary spending.

It is important to remember that increasing debts and deficits do not elicit stronger long-term economic growth. As debt levels rise, economic growth rates will slow as money diverts from productive investment into debt service.

That reality should be unsurprising, as this is not the first time the Government has gone “all in” on a reflation trade. As noted above, following the Financial Crisis, the Government intervened with HAMP, HARP, TARP, and a host of other spending programs to “reflate” the economy.

Let’s review what happened with interest rates, inflation, and gold and commodity trade.

Past May Be Prologue

As noted in 2009, following the “Financial Crisis” and recession, the Government and the Federal Reserve engaged in various monetary and fiscal supports to repair the economy. While the economy initially recovered from the recessionary lows, inflation, economic growth, and interest rates remained subdued despite ongoing interventions.

That is because debt and artificially low interest rates lead to malinvestment, which acts as a wealth transfer mechanism from the middle class to the wealthy. However, that activity erodes economic activity, leading to suppressed inflation and a surging wealth gap.

During that same period, commodities and precious metals rose initially as the “reflation expectation” was widespread. However, debt-driven realities quickly undermined that assessment and those investments languished relative to equities, as the flood of liquidity and low rates made equities far more attractive to investment.

While the relative performance of precious metals and commodities has picked up in recent months, this is more likely a function of “irrational exuberance” in the financial markets. As discussed previously, the surge in speculative investment activity is not uncommon to markets, and currently, many asset classes are becoming highly correlated.

However, while there is a compelling narrative around gold and precious metals from an investment perspective, those chasing that trade have had many years of terrible underperformance. While this time could be different, the “reflation narrative” will most likely fall prey to the realities of excessive debt, which will pressure Governments to cut rates once again.

If the past is potentially prologue, likely, the bullish narrative of “reflation” may once again find future disappointment. Such is particularly the case as the economics of debt and poor policy choices continue to erode the middle class further.

From a macroeconomic perspective, Friday’s bank earnings reports provide two important pieces of information. As we detail below, their profit margins are shrinking, and their economic outlook remains favorable.

JPM, C, and WFC reported paying depositors higher interest rates to retain their accounts. The consequence is a compression of their net interest income (NII), which weighs on the bank’s earnings. JPM, for instance, guided this coming year’s NII lower, blaming “deposit margin compression and lower deposit balances.” In layman’s terms, their current and future profit margins are shrinking. With banks less financially incentivized to lend to consumers and businesses, debt-driven economic growth will be less than it might have been had the banks been able to keep deposit rates lower. The inverted yield curve also pressures the bank’s NII and its earnings.

The second important macroeconomic takeaway is that bank loan loss reserves were mainly left unchanged. For example, JPM released $72 million in reserves, while WFC lowered its credit loss provision. This is an optimistic signal from the banks that they do not expect loan losses to increase in the coming quarters. Ergo, we can infer from the big bank’s earnings reports that they do not see a recession on the horizon.

What To Watch Today

Earnings

Economy

Market Trading Update

Last week, we discussed the current bullish trend’s ongoing, mind-numbing, narrow channel. We have suggested there was little to worry about until the market violates the 20-DMA. That “crack” to this “unstoppable” bullish rally was confirmed on Friday. As we noted last week:

“However, as we previously noted, just because the market breaks the 20-DMA does not mean we must take immediate action. What we need to see is a confirmation of that break with either a failed retest of previous support or a further decline. If the market is lower on Monday and takes out Thursday’s low, as shown, this would confirm the break of support and suggest lower prices. The 50-DMA will quickly become the next significant support level.”

As shown, the market broke below the previous Thursday’s low on Friday after failing a retest of the previous support at the 20-DMA. This turns the previous 20-DMA into resistance and makes the 50-DMA key support over the next few days. (Note: If the market makes a confirmed break of the 50-DMA, the 100- and 200-DMAs become the next logical targets.)

The market is oversold enough for a bounce early next week that investors should use to make further adjustments to portfolio allocations. Crucially, this signal DOES NOT mean to “sell everything and go to cash.”

The confirmed break of support suggests reviewing portfolio allocations and taking profits in well-performing positions. However, while some stocks have only begun to correct from previously overbought conditions, many have already corrected by 10% or more over the last few weeks. Those companies may see inflows as a rotation trade in the market occurs.

In other words, as is always the case, be careful “throwing the baby out with the bathwater.” Opportunities to acquire better-priced companies always exist, even during a corrective process.

The Week Ahead

This morning’s retail sales report will help shed light on personal consumption. Since September, retail sales have declined slightly while up slightly on a year-over-year basis, as shown below. The green and red bars show retail sales adjusted for inflation. As shown below, real retail sales have been declining for the better part of the last two years. Given personal consumption accounts for two-thirds of economic activity, the data set is not in sync with robust GDP growth.

Earnings will take center stage this week. Goldman Sachs, Bank of America, Morgan Stanley, and the regional banks’ earnings reports will further affirm our thoughts in the opening paragraphs. UnitedHealth, J&J, Abbot Labs, NetFlix, and Proctor & Gamble are among the largest non-financial stocks reporting this week.

Are Foreign Stocks Really That Cheap Versus American Shares?

Quite often, a financial pundit will argue that foreign stocks offer much more value than U.S. stocks. A cursory glance at valuations would certainly affirm such a view. However, what they often fail to mention is that the sector composition of foreign indexes is different from that of the S&P 500. For instance, the Japanese Nikkei stock index has an approximate 24% weighting to the technology sector, while the S&P 500 has a 30% weighting. Given that valuations are much higher for technology companies in aggregate than other industries, differences in composition, even if minor, can have a big difference.

The graph below from the Investment Strategy Group compares the valuations as they are reported and when adjusted for the S&P 500 weights. Based on the adjusted valuations, the S&P 500 is still richer than the other indexes, but not nearly as much as their unadjusted valuations would lead us to believe.

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With the latest round of inflation data in hand, it appears the Fed has two paths to consider. Nick Timiraos of the WSJ lays out the “bumpy” or “stuck” inflation scenarios the Fed faces in his latest article, Fed Rate Cuts Are Now A Matter Of If, Not Just When. Given Nick’s unique access to Jerome Powell and the Fed, his discussion of the most recent inflation data is essential in gauging what the Fed may or may not do.

The bumpy Fed path is the expectation that inflation is still trending lower but will do so in a bumpy manner. This bumpy but lower inflation theory is primarily based on prices of CPI shelter (rent). Rent prices constitute 40% of CPI. Rent is a lagging indicator that will decline; it’s just a question of when. The graph below from the article shows that core CPI is running below 2% without shelter prices. The other key point in the graph is that inflation is now concentrated and not as widespread as it was in 2022 and early 2023. The bumpy path entails the Fed will likely cut rates later in the year.

The second path is the stuck path. This case argues that inflation is stuck around 3% to 3.5%. Unless the economy slows and or the unemployment rate increases, the Fed may have to leave rates alone this year. Accordingly, this scenario makes it more difficult for the Fed to achieve a soft landing. They remain concerned that the lag effect will weigh on economic growth. If prices are indeed stuck, the Fed will find it more challenging to get ahead of a slowdown. Instead, they will have to wait for the slowdown to happen before they can react.

What To Watch Today

Earnings

Economy

Market Trading Update

Welcome to the kick-off of #MillennialEarningsSeason, where everyone gets a trophy after dropping earnings estimates that are enough for everyone to clear the bar. The major banks are the first to report starting today. Like the overall market, the banking sector has been under selling pressure lately, bounced off the 50-DMA yesterday, and decently oversold. Given that the likes of $JPM, $WFC, and $BLK will likely report better-than-expected earnings, we would not be surprised to see a bit of a countertrend rally today.

If we examine the top 10 holdings of the financial sector ETF (XLF), we find that relative to the ETF, $PGR, $GS, $WFC, and $JPM are the most overbought. Therefore, the upside may be somewhat limited in those issues. Still, we could see better potential performance from companies like $BAC, $BRK-B, $AXP, $MA, and $V, which are getting closer to oversold following recent corrections. While XLF may see some performance pickup relative to the broader market, investors may do better by being selective in their financial exposures.

However, while Financials are kicking off the reporting season today, the Healthcare sector currently has our attention. Given its broad decline in recent weeks and the strong fundamentals of the underlying companies, there appears to be a good bit of value developing in that sector. We are starting to dig in, looking for opportunities.

PPI Bodes Well For PCE

The second round of inflation data, PPI, was more market-friendly than CPI. Headline and core PPI were .10% below expectations at 0.2% and below last month’s readings of 0.6% and 0.3%, respectively.

You may be confused about why PPI and CPI send different signals. The important thing to consider is that the Fed prefers PCE prices over both measures. In that light, consider that the surge in motor vehicle insurance single-handedly boosted yesterday’s CPI number above expectations. However, auto insurance within the PPI report came in much cooler at 0.1% versus CPI’s 2.6%. Most importantly, PCE uses the PPI motor vehicle insurance figure, not the one in the CPI report. The graph below, courtesy of Ernie Tedeschi, shows the divergence between the two measures. Further, shelter prices have less of a weighting in PCE than CPI. As a result of just PPI auto insurance and the lesser contribution of shelter prices, PCE will likely be 0.2% below CPI.

The Fed Signals A Reduction In QT

Wednesday’s release of the Fed minutes implies the Fed will likely reduce the amount of QT as early as their next meeting. Currently, the Fed lets $60 billion of U.S. Treasury securities and $35 billion in mortgage-backed securities roll off their books each month. The minutes indicate that most officials favor reducing the Treasury rolloff amount by “roughly half.” Further, “the vast majority of participants judged that it would be prudent to begin slowing the pace of runoff fairly soon.”

The reduction would serve two purposes. The first is to help stem the recent increase in interest rates. If investors have less Fed supply to absorb, they can take more supply from the market. Second, the Fed is concerned that the level of reserves in the banking system is getting close to “ample.” Sub-ample reserves could result in a liquidity crisis, as we saw in 2019, which followed QT in 2018 and early 2019. At that time, they reduced their balance sheet by about $.5 trillion before sparking problems. The balance sheet has fallen by $1.5 trillion since QT started in 2022.

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Is immigration why employment reports from the Bureau of Labor Statistics (BLS) continue defying mainstream economists’ estimates? Many are asking this question as the U.S. experiences a flood of immigrants across the southern border. Concurrently, many young college graduates continue to complain about the inability to receive a job offer. As noted recently by CNBC:

The job market looks solid on paper. According to government data, U.S. employers added 2.7 million people to their payrolls in 2023. Unemployment hit a 54-year low of 3.4% in January 2023 and ticked up just slightly to 3.7% by December.

But active job seekers say the labor market feels more difficult than ever. A 2023 survey from staffing agency Insight Global found that recently unemployed full-time workers had applied to an average of 30 jobs only to receive an average of four callbacks or responses.”

These stories are not unique. If you Google “Can’t find a job,” you will get many article links. Yet employment reports have been exceedingly strong for the past several months. In March, the U.S. economy added 303,000 jobs, exceeding every economist’s estimate by four standard deviations. In terms of statistics, a single four-standard deviation event should be rare. Three months in a row is a near statistical impossibility.

Despite weakness in manufacturing and services, with many companies recently announcing layoffs, we have near-record-low jobless claims and employment. According to official government data, the economy has rarely been more robust.

Such a situation begs an obvious question: How are college graduates struggling to find employment while the labor market remains so strong?

We may find the answer in immigration.

Immigrations Impact By The Numbers

A recent study by Wendy Edelberg and Tara Watson at the Brookings Institution found that illegal immigrants in the country helped boost the labor market, steering the economy from a downturn. Data from the Congressional Budget Office shows a massive uptick of 2.4 million “other immigrants” who don’t fall into the category of lawful immigrants or those on temporary visas. The chart below shows how this figure has spiked from a level of less than 500,000 at the beginning of the 2020s.

The most significant change relative to the past stems from CBO’s other non-immigrant category, which includes immigrants with a nonlegal or pending status.

“We indicate our estimates of ‘likely stayers’ by diamonds in Figure 2. In FY 2023, almost a million people encountered at the border were given a ‘notice to appear,’ meaning they have permission to petition a court for asylum or other immigration relief. Most of these individuals are waiting in the U.S. for the asylum court queue, which has over a million case backlog. In addition, over 800,000 have been granted humanitarian parole (mostly immigrants from Ukraine, Haiti, Cuba, Nicaragua, and Venezuela). These 1.8 million ‘likely stayers’ in FY 2023 may or may not remain in the U.S. permanently, but most are currently living in the U.S. and participating in the economy. CBO estimates that there were 2 million such entries over the calendar year 2023, which is consistent with higher encounters at the end of the calendar year.”

According to the CBO’s estimates for 2023, the categories of lawful permanent resident migration, INA non-immigrant, and other non-immigrant equated to 3.3 million net entries. However, the number is likely much higher than estimates, subject to uncertainty about unencountered border crossings, visa overstays, and “got-aways.”

As such, this influx of immigrants has significantly added to payroll growth and has accounted for the uptick in economic growth starting in 2022. While the uptick in border encounters began in earnest in 2021, as the current Administration repealed previous border security actions, there is a “lag effect” of immigration on economic growth.

However, not all jobs are created equal.

Immigration’s Impact On Job Availability

Since 1980, the U.S. economy has shifted from a manufacturing-based economy to a service-oriented one. The reason is that the “cost of labor” in the U.S. to manufacture goods is too high. Domestic workers want high wages, benefits, paid vacations, personal time off, etc. On top of that are the numerous regulations on businesses from OSHA to Sarbanes-Oxley, FDA, EPA, and many others. All those additional costs are a factor in producing goods or services. Therefore, corporations must offshore production to countries with lower labor costs and higher production rates to manufacture goods competitively.

In other words, for U.S. consumers to “afford” the latest flat-screen television, iPhone, or computer, manufacturers must “export” inflation (the cost of labor and production) to import “deflation” (cheaper goods.) There is no better example of this than a previous interview with Greg Hays of Carrier Industries. Following the 2016 election, President Trump pushed for reshoring U.S. manufacturing. Carrier Industries was one of the first to respond. Mr. Hays discussed the reasoning for moving a plant from Mexico to Indiana.

“So what’s good about Mexico? We have a very talented workforce in Mexico. Wages are obviously significantly lower. About 80% lower on average. But absenteeism runs about 1%. Turnover runs about 2%. Very, very dedicated workforce. Which is much higher versus America. And I think that’s just part of these — the jobs, again, are not jobs on an assembly line that [Americans] really find all that attractive over the long term.“

The need to lower costs by finding cheaper and plentiful sources of labor continues. While employment continues to increase, the bulk of the jobs created are in areas with lower wages and skill requirements.

As noted by CNBC:

“The continued rebound of these jobs, along with strong months for sectors like construction, could be a sign that immigration is helping the labor market grow without putting too much upward pressure on wages.”

This is a crucial point. If there is strong employment growth, wages should increase commensurately as the demand for labor increases. However, that isn’t happening, as the cost of labor is suppressed by hiring workers willing to work for less compensation. In other words, the increase in illegal immigrants is lowering the “average” wage for Americans.

Nonetheless, in the last year, 50% of the labor force growth came from net immigration. The U.S. added 5.2 million jobs last year, which boosted economic growth without sparking inflationary pressures.

While immigration has positively impacted economic growth and disinflation, this story has a dark side.

The Profit Motive

In a previous article, I discussed an interview by Fed Chair Jerome Powell discussing immigration during a 60-Minutes Interview. To wit:

“SCOTT PELLEY: Why was immigration important?

FED CHAIR POWELL: Because, you know, immigrants come in, and they tend to work at a rate that is at or above that for non-immigrants. Immigrants who come to the country tend to be in the workforce at a slightly higher level than native Americans. But that’s primarily because of the age difference. They tend to skew younger.“

You should read that comment again carefully. As noted by Greg Hayes, immigrants tend to work harder and for less compensation than non-immigrants. That suppression of wages and increased productivity, which reduces the amount of required labor, boosts corporate profitability.

The move to hire cheaper labor should be unsurprising. Following the pandemic-related shutdown, corporations faced multiple threats to profitability from supply constraints, a shift to increased services, and a lack of labor. At the same time, mass immigration (both legal and illegal) provided a workforce willing to fill lower-wage paying jobs and work regardless of the shutdown. Since 2019, the cumulative employment change has favored foreign-born workers, who have gained almost 2.5 million jobs, while native-born workers have lost 1.3 million. Unsurprisingly, foreign-born workers also lost far fewer jobs during the pandemic shutdown.

Given that the bulk of employment continues to be in lower-wage paying service jobs (i.e., restaurants, retail, leisure, and hospitality) such is why part-time jobs have dominated full-time in recent reports. Since last year, part-time jobs have risen by 1.8 million while full-time employment has declined by 1.35 million.

Not dismissing the implications of the shift to part-time employment is crucial.

Personal consumption, what you and I spend daily, drives nearly 70% of economic growth in the U.S. Therefore, Americans require full-time employment to consume at an economically sustainable rate. Full-time jobs provide higher wages, benefits, and health insurance to support a family, whereas part-time jobs do not.

Notably, given the surge in immigration into the U.S. over the last few years, the all-important ratio of full-time employees relative to the population has dropped sharply. As noted, given that full-time employment provides the resources for excess consumption, that ratio should increase for the economy to continue growing strongly. 

However, the reality is that the full-time employment rate is falling sharply. Historically, when the annual rate of change in full-time employment dropped below zero, the economy entered a recession.

While there is much debate over immigration, most of the arguments do not differentiate between legal and illegal immigration. There are certainly arguments that can be made on both sides. However, what is less debatable is the impact that immigration is having on employment and wages. Of course, as native-born workers continue to demand higher wages, benefits, and other tax-funded support, those costs must be passed on by the companies creating those products and services. At the same time, consumers are demanding lower prices.

That imbalance between input costs and selling price drives companies to aggressively seek options to reduce the highest cost to any business – labor. 

Such is why full-time employment has declined since 2000 despite the surge in the Internet economy, robotics, and artificial intelligence. It is also why wage growth fails to grow fast enough to sustain the cost of living for the average American. These technological developments increased employee productivity, reducing the need for additional labor.

Unfortunately, college graduates expecting high-paying jobs will likely continue to find it increasingly frustrating. Such is particularly the case as “Artificial Intelligence” gains traction and displaces “white collar” work, further squeezing the demand for “native-born” workers.

Jurrien Timmer, Director of Global Macro at Fidelity, asks- “What time is it in the cycle? Now that we are 17 months into a bull market cycle, it’s worth asking how much life there is left. How long can this broadening bull continue?” To help assess how much time may be left, Jurrien shares a unique graphical perspective on how the current bullish cycle, which started September 2022, compares to prior cycles. The graph on the upper left shows the 18 bullish cycles since 1960. Currently, with a 51% gain, this bull market cycles has only elapsed two other cycles. The average gain, not including the current one, is 84%. This clock tells us there is plenty of upside left in this cycle.

The second spiral chart resembles a clock. The “hands” of the clock measure time in months and the scale within the hands path shows performance. Based on this clock the time is only 3 pm. Most bullish cycles make it past 6 pm and two went all the way to midnight. His graph on the right is similar to the clock but it is in a more traditional format. This graph shows the median duration of bull market cycles is 30 months. Additionally, the current performance is relatively in line with prior bull market cycles. Jurrien sums up his analysis: “Time is still on our side.”

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, yesterday’s hotter-than-expected inflation report did indeed add a “layer of risk to market dynamics.” After recovering the 20-DMA running support line on Friday and holding it through Tuesday’s early sell-off, that support again gave way yesterday. While that running support line has found buyers recently, the market has sent a warning sign that buyers are becoming more sparse.

In early 2023, we saw a similar rally in the market as the “A.I.” chase gained traction. Then, like today, bullish sentiment was elevated, investor allocations to equities were high, and technical indicators remained stuck in overbought conditions. As shown, in July last year, the market declined for 3-weeks straight before providing a reflexive bounce to sell into. That bit of breathing room provided an exit before the next leg of the decline through October.

We are currently in the second week of decline and have not triggered “sell signals” just yet. I suspect that will happen sooner rather than later. As such, investors have an opportunity to rebalance risks now. If the market provides a reflexive rally with a sell signal intact, further reductions can be made to offset the next leg of the correction. If the market turns back up and takes out the recent high from last week, then the bullish trend remains intact. Such is why we continue to suggest moving slowly and letting the market dictate the course of action needed in your personal portfolios.

Nonetheless, the market is waking up and it is time to start paying closer attention.

CPI Runs Hot Again

Tuesday’s Commentary shared State Streets analysis calling for 50bps of rate cuts in June. After yesterday’s CPI data, that now seems all but impossible. Both headline and core CPI were 0.1% above expectations at 0.4%. The year-over-year core CPI is 3.8%, in line with the previous month’s reading. This is the fourth month in a row with higher prices than expected. Like the last few months, shelter prices remain sticky, contributing to 40% of the total. When CPI shelter prices catch up to market shelter prices, CPI should decline significantly.

This month, a 2.6% jump in motor vehicle insurance was also seen in March. Despite airfares falling in price by 7.1% over the last year, transportation services are up 10.7%, largely driven by a 22.2% annual gain in vehicle insurance prices. CPI is levelling off and possibly upticking. However, we still believe the data is temporarily too high due to delayed shelter data and other miscellaneous data, like auto insurance, that is seasonal and potentially flawed. For example, PCE, which is the Fed’s preferred inflation gauge, uses a different source for motor vehicle insurance that’s been running much cooler, per the graph below.

The Fed Funds futures market now only implies two rate cuts, starting in September, for 2024. The graph below compares the two year U.S. Treasury yield to Fed Funds. The difference (gray bars) is the amount of rate cuts the market expects over the next two years on a time weighted basis. As it shows, the year started at 1.25% in interest rate cuts but it has receeded to slightly less than 50bps.

Inconsistency Beneath The Robust Jobs Market Data

As we have noted numerous times, recent economic data paints a robust picture. However, beneath the surface lies troubling data. For instance, the graph below shows that the economy has shed 1.347 million full-time workers over the last year. Since 1969, the annual change in full-time employment has declined in every recession. Further, other than two minimal declines occurring during the recovery from a recession, the indicator has never been negative. The dotted orange line shows the current level is on par with prior levels that existed toward the end of recessions. In all the prior cases, the change in the number of full-time jobs was positive when the recession started.

The flip side of this discussion is an increase in the number of part-time workers. 1.888 million new part-time jobs have been created in the last year, the fourth-highest annual number since 1969. One should ask why, if the economy is as strong as the data say and the jobs market is still tight, is there a major shift from full-time to part-time?

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