Monthly Archives: March 2018

CRE Loans Threaten Regional Banks

The following commentary is from The National Bureau of Economic Research (NBER). The NBER claims that “about 44% of office loans appear to have negative equity.” “Furthermore: A 10% (20%) default rate on CRE loans – a range close to what one saw in the Great Recession on the lower end — would result in about $80 ($160) billion of additional bank losses.” Interestingly, they note the importance of interest rates. They say that not one of those CRE loans would default if interest rates were back to early 2022 levels.

With that, consider the pie charts below from Goldman Sachs. There are approximately $1 trillion in maturing CRE loans this year. Not only will the debt reset at significantly higher interest rates, but in the case of office space, the financial support backing the loans will be compromised due to high vacancy rates and declining building valuations. If rollover financing isn’t secured, bankruptcy is the likely outcome. Now, consider that regional banks, with less financial wherewithal than large banks, are on the hook for many maturing office loans. On the brighter side, the NBER authors argue the Federal Reserve could stave off further distress with lower interest rates. 

goldman sachs cre loan data

What To Watch Today

Earnings

  • No notable earnings releases today

Economy

Economic Calendar

Market Trading Update

Last week, we discussed whether this is a short-term market top or a bubble. In that discussion, we noted that the ongoing bullish trend remains intact, with the market trading from the top of the trendline to the 20-DMA. After a rally to all-time highs, the market again traded lower on Thursday and Friday to finish at the 20-DMA.

Market Trading Update

However, some differences this week suggest we may see a further correction next week. The market was trading in a very defined bullish trend channel. Over the last two weeks, the advance has begun to taper off, and a more rounded top may be forming. While the 20-DMA continues to act as support, a violation of that level could well trigger additional selling. Momentum and relative strength have also shown continued weakness, and both registered “sell signals” on Friday.

As we stated last week:

“While we have become increasingly cautious over the last few weeks, as the market continues to rise, we have suggested taking profits and rebalancing portfolio risks. If you have not done so, such remains a recommended course of action. However, this does not mean to reduce equity allocations aggressively.”

That recommendation remains again this week. While we have done some “trimming” to portfolios over recent weeks, we have not aggressively reduced risk. However, if the market does show evidence of a corrective phase, we will become more attentive to risk management. While we are never sure about the timing of market corrections, that is a part of the normal market cycle. With bullish exuberance getting a bit extreme, something will likely catalyze a reversal of sentiment. As shown, professional managers are notorious for buying the tops of markets. The red highlights are when professional manager’s allocations exceed 97%.

NAAIM allocation levels vs the S&P 500 market index.

The Week Ahead

Wednesday’s Fed FOMC meeting will be this week’s key event. Investors will seek signals on when the Fed may consider cutting rates. More likely, they will announce that they are reducing the monthly amounts of QT or set a timetable to do so. The quarterly economic projections will also help guide us. Assessing changes versus those from last December can clue us into their thoughts on inflation, unemployment, and, most importantly, the Fed Funds rate. Jerome Powell will shed additional light on monetary policy during his press conference following the release of the minutes.

The economic calendar will be relatively light this week. Housing starts and permits will help us ascertain if the recent increase in interest rates is affecting homebuilder plans. After Friday’s weak New York Fed manufacturing survey, investors will focus on the Philadelphia Fed survey to see if they report a similar decline in employment, prices, and overall sentiment as the New York Fed.

Equal vs. Cap Weighted S&P Hints At Better Days For RSP

Over the past year, the market-cap-weighted S&P 500 (SPY) has beaten the equal-weighted index (RSP) by 11%. At the end of February, the outperformance reached 18%. The blue line below graphs the one-year over/underperformance of RSP versus SPY in standard deviations. The recent underperformance of RSP vs. SPY reached three standard deviations. The orange line represents the forward one-year return at each point.

If the relative underperformance troughed a few weeks ago and if the relationship normalizes, RSP should decently outperform SPY. However, that doesn’t mean RSP will rise. If the market declines, the normalization may result in the SPY leading the way lower while the RSP is still down but less than SPY. This graph, however, signals decent odds of RSP outperforming SPY over the next year.

rsp vs spy perfromance

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Household Equity Allocations Suggests Caution

Household equity allocations are again sharply rising, as the “Fear Of Missing Out” or “F.O.M.O.” fuels a near panic mentality to chase markets higher. As Michael Hartnett from Bank of America recently noted:

“Stocks are up a ferocious +25% in 5 months, which has happened just 10 times since the 1930s. Normally, such surges occur from recession lows (1938, 1975, 1982, 2009, 2020), but, of course, we did not have a recession in 2023, according to the Biden administration. These surges also occur at the start of bubbles (Jan’99).”

25% increase in 10-months.

As discussed in the recent Bull Bear Report, we can only identify bubbles in hindsight. Such is the problem with trying to “time” a market top, as they can last much longer than logic would predict. George Soros explained this well in his theory of reflexivity.

Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.

Every bubble has two components:

  1. An underlying trend that prevails in reality and; 
  2. A misconception relating to that trend.

When positive feedback develops between the trend and the misconception, a boom-bust process gets set into motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception get reinforced. Eventually, market expectations become so far removed from reality that people get forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend gets sustained by inertia.” – George Soros

In simplistic terms, Soros says that once the bubble inflates, it will remain inflated until some unexpected, exogenous event causes a reversal in the underlying psychology. That reversal then reverses psychology from “exuberance” to “fear.”

What will cause that reversion in psychology? No one knows.

However, the important lesson is that market tops and bubbles are a function of “psychology.” The manifestation of that “psychology” manifests itself in asset prices and valuations that exceed economic growth rates.

Once again, investors are piling into equities and “writing checks that the economy can’t cash.”

An Economic Underpinning

To understand the problem, we must first realize from which capital gains are derived.

Capital gains from markets are primarily a function of market capitalization, nominal economic growth, plus dividend yield. Using John Hussman’s formula, we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, IF we assume that GDP could maintain 2% annualized growth in the future, with no recessions ever, AND IF current market cap/GDP stays flat at 2.0, AND IF the dividend yield remains at roughly 2%, we get forward returns of:

But there are a “whole lotta ifs” in that assumption. Most importantly, we must also assume the Fed can get inflation to its 2% target, reduce current interest rates, and, as stated, avoid a recession over the next decade.

Yet, despite these essential fundamental factors, retail investors again throw caution to the wind. As shown, the current levels of household equity ownership have reverted to near-record levels. Historically, such exuberance has been the mark of more important market cycle peaks.

Household equity ownership vs SP500

If economic growth is reversed, the valuation reduction will be quite detrimental. Again, such has been the case at previous peaks where expectations exceed economic realities.

Household equity vs valuations

Bob Farrell once quipped investors tend to buy the most at the top and the least at the bottom. Such is simply the embodiment of investor behavior over time. Our colleague, Jim Colquitt, previously made an important observation.

The graph below compares the average investor allocation to equities to S&P 500 future 10-year returns. As we see, the data is very well correlated, lending credence to Bob Farrell’s Rule #5. Note the correlation statistics at the top left of the graph.”

The 10-year forward returns are inverted on the right scale. This suggests that future returns will revert toward zero over the next decade from current levels of household equity allocations by investors.

Household equity allocations vs 10-year forward returns

The reason is that when investor sentiment is extremely bullish or bearish, such is the point where reversals have occurred. As Sam Stovall, the investment strategist for Standard & Poor’s, once stated:

“If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”

Everyone is very optimistic about the market. Bank of America, one of the world’s largest asset custodians, monitors risk positioning across equities. Currently, “risk love” is in the 83rd percentile and at levels that have generally preceded short-term corrective actions.

Global Equity risk

The only question is what eventually reverses that psychology.

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A Disappointment Of Hopes

In January 2022, Jeremy Grantham made headlines with his market outlook titled “Let The Wild Rumpus Begin.” The crux of the article is summed up in the following paragraph.

“All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.

Today in the U.S. we are in the fourth superbubble of the last hundred years.”

While the market corrected in 2022, the reversion needed to reverse the excess deviation from the long-term growth trends was not achieved. Therefore, unless the Federal Reverse is committed to a never-ending program of zero interest rates and quantitative easing, the eventual reversion of returns to their long-term means remains inevitable.

Such will result in profit margins and earnings returning to levels that align with actual economic activity. As Jeremy Grantham once noted:

Profit margins are probably the most mean-reverting series in finance. And if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.” – Jeremy Grantham

Historically, real profits have always eventually reverted to underlying economic realities.

Cumulative change in profits vs the market

Many things can go wrong in the months and quarters ahead. Such is particularly the case at a time when deficit spending is running amok, and economic growth is slowing.

While investors cling to the “hope” that the Fed has everything under control, there is a reasonable chance they don’t.

The reality is that the next decade could be a disappointment to overly optimistic expectations.

MicroStrategy Investors Are Buying Bitcoin At A Massive Premium

Microstrategy (MSTR) provides its customers with business intelligence, mobile software, and cloud-based services. Despite losing money and zero growth in revenues over the last ten years, investors can’t seem to buy enough of MicroStrategy. The rationale is not based on prospects for their core technology businesses but on their massive accumulation of Bitcoin since 2020. For many investors, MicroStrategy is a Bitcoin surrogate. Instead of dealing with crypto exchanges and the potential of losing your key, Bitcoin investors flocked to the ease of owning MicroStrategy stock. On the surface, the trade makes sense. However, with the advent of Bitcoin ETFs, it’s worth appreciating what MicroStrategy investors are truly buying.

We constructed the table below to show how MicroStrategy investors are paying a 43% premium to own Bitcoin. To quantify that, we stripped the value of its Bitcoin holdings from its market cap, leaving us with a market cap for the true technology company. With that adjustment, MicroStrategy trades with a P/E of 95 and a P/S of 19. If we assume it should trade with a P/E of 25 and P/S of 5, the stock, including the value of its Bitcoin, should be 1238, well below the current price of 1766. More concerning, the valuation ratios we assume below are high, considering the company has exhibited zero growth in ten years. Further, we use their highest level of earnings and sales for the calculation, not the lower current figures. Accordingly, the real Bitcoin premium is likely well north of our estimate.

microstrategy valuations

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As discussed yesterday, the market’s momentum continues to wane, particularly in small capitalization companies. While the S&P 500 is up 8.58% YTD, small caps are negative for the year. While mid-capitalization and international stocks caught a bid this year, they still lag the S&P by a wide margin. Such is particularly the case with both emerging markets and the Russell 2000.

Market Trading Update

For investors, it remains a chase for a handful of momentum stocks that have surged this year. As noted by YahooFinance yesterday, it has been a rotation in the “Magnificent 7” from the original to the new breed. To wit:

“Taking out the three clear laggards — Tesla, Apple, and Alphabet — improves the returns of the Magnificent Seven over the longer term. And as a purely intellectual exercise, Yahoo Finance’s Head of News, Myles Udland, reshuffled the Magnificent deck. He’s keeping the Mag Four outperformers, losing the three laggards, and adding a couple “diversified” stocks — Costco (COST) and Eli Lilly (LLY) — to the list.”

Magnificent 7

The point here is that the market is still being primarily driven by a handful of large-capitalization names while the rest of the market lags. While such doesn’t mean that you can’t make money in other areas of the market, the narrowness of the breadth continues to remain a concern, along with the more extreme concentration of market-capitalization-weighted stocks in the index.

Market Capitalization of Momentum Stocks

While none of this means that the market will crash any time soon, historically, it does suggest lower future returns as markets eventually correct its imbalances.

Retail Sales and PPI

Retail Sales were a little weaker than expected. Monthly sales in February grew by +0.6%, worse than the +0.8% consensus and much better than last month’s -1.1 %. The control group, which feeds GDP, was zero, compared to -0.3 % last month. The graph below, courtesy of Charlie Bilello, shows that both retail sales and real retail sales are moderately below their historical averages.

retail sales

PPI, like CPI, was a little hotter than expected. Headline PPI rose 0.6% last month, well above estimates of +0.3%. However, the core PPI was only 0.1% above expectations at +0.3%. On a year-over-year basis, the headline PPI is running at 1.6%, and the core PPI is at 2%.

Approximately a third of the increase in the PPI was driven by a 6.8% increase in gasoline prices. Such is not likely to be repeated next month, so the calls for a re-acceleration of PPI based on yesterday’s data will likely prove misleading.

More On Coming Liquidity Shortages

Last week, we wrote Liquidity Problems Are Closer Than You Think, which warns that the excess liquidity in the financial system is quickly waning. We highlighted the Fed’s reverse repurchase program (RRP) as it serves as a good gauge for the amount of excess liquidity. The graph below, courtesy of Pictet Asset Management, adds to our analysis. The blue line represents net T-bill issuance. Its y-axis to the far right is inverted to make it easily comparable to RRP balances (red). Net T-bill issuance in late 2020 and throughout 2021 turned negative. At that time, the massive T-bill issuance in early 2020 was maturing and not being fully replaced as deficits declined. As the amount of T-bills outstanding declined, money market investors needed an investment replacement. Accordingly, they invested in RRP. Please read our article for more about RRP and why the Fed offers it.

Since late 2022, net T-bill issuance has been increasing. Consequently, money market investors are, in the aggregate, buying T-bills and exiting RRP trades. Once RRP balances are negligible, the Treasury will draw liquidity from the financial system. The dots show that net Treasury funding needs may decline in the coming months. That is solely a function of incoming tax revenue. However, looking past April, net issuance will increase and likely bring RRP balances to near zero. Barring changes in Fed policy, that is when liquidity problems are most likely to surface.

liquidity rrp treasury bills

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Sticky Inflation And Fed Policy In Context

Over the last few months, the downward inflation trend has slowed appreciably. Such leads some to conclude that inflation is sticky and likely to stay around current levels instead of returning to the Fed’s 2% target. As we have noted on numerous occasions, we think inflation will continue to decline over time. The pandemic-related damage to the supply side of the economy is fixed. Further, demand for goods and services is normalizing quickly as pandemic-related savings are largely spent. Additionally, labor markets are no longer tight, meaning upward pressure on wages is diminishing rapidly.

As they always have, monetary policy and economic conditions will determine the longer-term inflation trend. With economic conditions normalizing rapidly, we should shift our attention to monetary policy. On that front, the Fed Funds rate is 2% higher than inflation. The green and red bars show this is the tightest Fed policy in well over 15 years. Even if inflation remains sticky, the Fed Funds can decline by at least 1% and still be tight. However, since 1950, tight monetary policy has, with only one exception (1995), led to a recession. A recession would likely cause inflation to fall to 2% or lower. The Fed would cut rates significantly in that circumstance.

fed funds vs cpi monetary policy and sticky inflation

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As the market continues to trade in the same narrow bullish trend since the beginning of the year, the angle of ascent is beginning to narrow to the 20-DMA, which has acted as consistent support. With relative strength continuing to diverge negatively, the risk of a correction continues to remain. Today, we are updating our Fibonacci retracement levels, which will establish potential levels of support during a corrective phase.

If the 20-DMA support line is broken, the first important support level becomes the 50-DMA at 4927. If that level fails, a bigger correction is in process, and the 38.2% retracement level is the next support, which takes the market back to the beginning of the year. However, there is very little support at that juncture. While the 50% correction retracement level should encompass the bulk of the bullish decline, by the time the market retraces to that level, such should coincide with the 200-DMA. Given the current deviation from the 200-DMA, a correction to that level, which would be around 4600, is entirely possible, as we saw in October last year.

So far, there is no evidence of a larger correction in the works. However, it is worth understanding the potential retracement levels to evaluate the risk in your portfolio. It is also important to realize that at some point, without a doubt, the market will retrace to the 200-DMA. It is only a function of time and the right catalyst. Manage your risk accordingly.

Market Trading Update

Add Cocoa To The List Of “Mooning” Assets

While everyone is following the prices of Bitcoin, Nvdia, and a handful of other assets whose prices are soaring, few appreciate the recent price action of cocoa. The graph below shows that the year-to-date performance of cocoa is nicely aligned with that of Bitcoin and Nvidia. However, unlike the prices of Bitcoin and Nvidia, cocoa is not necessarily a speculative mania. Per NPR:

Cocoa’s troubles stem from extreme weather in West Africa, where farmers grow the majority of the world’s cacao beans.

“There were massive rains, and then there was a massive dry spell coupled with wind,” says CoBank senior analyst Billy Roberts. “It led to some pretty harsh growing conditions for cocoa,” including pests and disease.

Now, cocoa harvests are coming up short for the third year in a row. Regulators in the top-producing Ivory Coast at one point stopped selling contracts for cocoa exports altogether because of uncertainty over new crops.

cocoa nvidia and bitcoin

Nvidia Put Call Skew Shows Extreme Sentiment

Option put call skew measures the pricing of puts versus calls. It uses out-of-the-money puts and calls with strike prices of equal distance to the current price. If the skew is negative, it means investors are paying more for calls than puts. Under normal circumstances, the put call skew is positive.

As we share below, the put call skew on NVDA is exceptionally negative, meaning investors are heavily buying calls and shunning puts. More simply, investors are incredibly bullish. The second graphic below, courtesy of SimpleVisor, shows Nvidia put and call option pricing for April expirations. When we clipped the screen, the circled puts were 7 points out of the money, and the circled calls were 8 points out of the money. As it shows, the calls trade for $70 while the puts are $64.35. Furthermore, the open interest in the calls dwarfs that of the puts. In more simple terms, sentiment in Nvidia is off the charts!

nvda put call skew
nvda put call skew

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Blackrock Works For Blackrock Not You

Wall Street banks, brokers, and asset managers put out market research, which can be of great value. While valuable, we read their research with skepticism and question its authenticity. Firms like Blackrock, Goldman Sachs, and others have a glaring bias. The industry makes billions in annual profits by selling stocks and bonds to investors. Consequently, at times Wall Street talks out of both sides of their mouths to push their products. For example, Blackrock recently reminded us that Blackrock is in it for themselves, not you or me.

Monday’s Wall Street Journal led with a story on Blackrock that started as follows: “CEO Larry Fink’s U-turn illustrates Wall Street’s growing desire to capitalize on a market long considered the Wild West of finance.” Conversely, Larry Fink said this a few years ago: “Let me just say one thing on Bitcoin. Bitcoin is an index for how much demand for money laundering there is in the world. That’s all it is.

Not surprisingly, with the recent introduction of bitcoin ETFs and the promise of massive profits, Fink finds value in Bitcoin. As highlighted below, Blackrock’s Bitcoin ETF is the second largest at $13.5 billion. Want more evidence that their wallets drive their opinions? Blackrock leads the market in ESG ETFs. Fink and Blackrock couldn’t speak highly enough of the value of investing for the “good” of society. However, recently, ESG has fallen out of favor with investors. Not surprisingly, Blackrock is dissolving ESG funds and downplaying the value of ESG investing.

blackrock bitcoin ishares etf

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Another day….another rally within the bullish trend channel. Such has been the case since the October lows. The low volatility advance continues with the 20-DMA acting as critical support. The algos continue to buy any declines to the 20-DMA and sell at the top of the channel. Despite yesterday’s stronger than expected core CPI reading, the market overlooked the report to focus on when the next Fed rate cut will come. That information may be exposed at the upcoming FOMC meeting.

Nonetheless, despite a continuing deterioration in momentum and relative strength, the market keeps moving toward the 5200 target following the recent breakout. As noted in yesterday’s commentary, there are certainly evident signs of exuberance in the market. Deviations from long-term means remain, and speculative action has returned. However, such environments can remain much longer than logic would predict. Continue to remain long equities for now. There is no evidence that the current bull run will end soon.

market trading update

CPI Remains Sticky

As we have seen over the last few months, inflation declines have been put on hold. Headline monthly CPI rose 0.4%, in line with estimates but 0.1% above last month’s reading. Likewise, Core CPI rose 0.4%, a tenth above estimates. The graph below, courtesy of Charles Schwab, shows which sectors added to CPI year-over-year and which took away from it.

contribution to cpi

The graph above highlights a flaw in CPI that we have discussed numerous times. Shelter costs, including Owners’ equivalent rent and Rent of primary residence, accounting for 40% of CPI, are the biggest drivers of inflation. Year over year, shelter costs are running near 6%, well above the near zero percent that many market-based indicators point to. As a result, if you adjust CPI shelter costs to market, the headline and core CPI would be below 1%. The graphs below, courtesy of Wisdom Tree, show that CPI is well below the Fed’s 2% target when using real-time shelter costs.

Shelter CPI has moved down for 11 consecutive months. It stood at 8.2% a year ago, the highest in forty years. Given its long lag versus market-based rent data, we think CPI shelter costs will continue to contribute less to CPI. Consequently, the trend in CPI will also likely be lower.

cpi inflation less shelter

The Labor Outlook Is Deteriorating

Yesterday morning, the NFIB small business survey fell to 89.4. As a result, it has been below the average (98) for over two years. Small businesses account for over half of employment. Therefore, some of the comments and stats in the report are concerning. Per the survey:

  • Reports of labor quality as the single most important problem for business owners decreased five points to 16%, the lowest reading since April 2020.
  • Small business owners’ plans to fill open positions continue to slow, with a seasonally adjusted net 12% planning to create new jobs in the next three months, the lowest level since May 2020.
  • Thirty-seven percent (seasonally adjusted) of all owners reported job openings they could not fill in the current period, down two points from January and the lowest reading since January 2021.
labor small business hiring plans

Further evidence of the deteriorating jobs market is found below in the Tweet of the Day.


Tweet of the Day

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Bougie Broke The Financial Reality Behind The Facade

Social media users claiming to be Bougie Broke share pictures of their fancy cars, high-fashion clothing, and selfies in exotic locations and expensive restaurants. Yet they complain about living paycheck to paycheck and lacking the means to support their lifestyle.

Bougie broke is like “keeping up with the Joneses,” spending beyond one’s means to impress others.

Bougie Broke gives us a glimpse into the financial condition of a growing number of consumers. Since personal consumption represents about two-thirds of economic activity, it’s worth diving into the Bougie Broke fad to appreciate if a large subset of the population can continue to consume at current rates.

The Wealth Divide Disclaimer

Forecasting personal consumption is always tricky, but it has become even more challenging in the post-pandemic era. To appreciate why we share a joke told by Mike Green.

Bill Gates and I walk into the bar…

Bartender: “Wow… a couple of billionaires on average!”

Bill Gates, Jeff Bezos, Elon Musk, Mark Zuckerberg, and other billionaires make us all much richer, on average. Unfortunately, we can’t use the average to pay our bills.

According to Wikipedia, Bill Gates is one of 756 billionaires living in the United States. Many of these billionaires became much wealthier due to the pandemic as their investment fortunes proliferated.

To appreciate the wealth divide, consider the graph below courtesy of Statista. 1% of the U.S. population holds 30% of the wealth. The wealthiest 10% of households have two-thirds of the wealth. The bottom half of the population accounts for less than 3% of the wealth.

the wealth divide

The uber-wealthy grossly distorts consumption and savings data. And, with the sharp increase in their wealth over the past few years, the consumption and savings data are more distorted.

Furthermore, and critical to appreciate, the spending by the wealthy doesn’t fluctuate with the economy. Therefore, the spending of the lower wealth classes drives marginal changes in consumption. As such, the condition of the not-so-wealthy is most important for forecasting changes in consumption. 

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Revenge Spending

Deciphering personal data has also become more difficult because our spending habits have changed due to the pandemic.

A great example is revenge spending. Per the New York Times:

Ola Majekodunmi, the founder of All Things Money, a finance site for young adults, explained revenge spending as expenditures meant to make up for “lost time” after an event like the pandemic.

So, between the growing wealth divide and irregular spending habits, let’s quantify personal savings, debt usage, and real wages to appreciate better if Bougie Broke is a mass movement or a silly meme.

The Means To Consume 

Savings, debt, and wages are the three primary sources that give consumers the ability to consume.

Savings

The graph below shows the rollercoaster on which personal savings have been since the pandemic. The savings rate is hovering at the lowest rate since those seen before the 2008 recession. The total amount of personal savings is back to 2017 levels. But, on an inflation-adjusted basis, it’s at 10-year lows. On average, most consumers are drawing down their savings or less. Given that wages are increasing and unemployment is historically low, they must be consuming more.

Now, strip out the savings of the uber-wealthy, and it’s probable that the amount of personal savings for much of the population is negligible. A survey by Payroll.org estimates that 78% of Americans live paycheck to paycheck.

personal savings

More on Insufficient Savings

The Fed’s latest, albeit old, Report on the Economic Well-Being of U.S. Households from June 2023 claims that over a third of households do not have enough savings to cover an unexpected $400 expense. We venture to guess that number has grown since then. To wit, the number of households with essentially no savings rose 5% from their prior report a year earlier.  

Relatively small, unexpected expenses, such as a car repair or a modest medical bill, can be a hardship for many families. When faced with a hypothetical expense of $400, 63 percent of all adults in 2022 said they would have covered it exclusively using cash, savings, or a credit card paid off at the next statement (referred to, altogether, as “cash or its equivalent”). The remainder said they would have paid by borrowing or selling something or said they would not have been able to cover the expense.

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Debt

After periods where consumers drained their existing savings and/or devoted less of their paychecks to savings, they either slowed their consumption patterns or borrowed to keep them up. Currently, it seems like many are choosing the latter option. Consumer borrowing is accelerating at a quicker pace than it was before the pandemic. 

The first graph below shows outstanding credit card debt fell during the pandemic as the economy cratered. However, after multiple stimulus checks and broad-based economic recovery, consumer confidence rose, and with it, credit card balances surged.

The current trend is steeper than the pre-pandemic trend. Some may be a catch-up, but the current rate is unsustainable. Consequently, borrowing will likely slow down to its pre-pandemic trend or even below it as consumers deal with higher credit card balances and 20+% interest rates on the debt.

credit card debt

The second graph shows that since 2022, credit card balances have grown faster than our incomes. Like the first graph, the credit usage versus income trend is unsustainable, especially with current interest rates.

consumer loans credit cards and wages

With many consumers maxing out their credit cards, is it any wonder buy-now-pay-later loans (BNPL) are increasing rapidly?

Insider Intelligence believes that 79 million Americans, or a quarter of those over 18 years old, use BNPL. Lending Tree claims that “nearly 1 in 3 consumers (31%) say they’re at least considering using a buy now, pay later (BNPL) loan this month.”More telling, according to their survey, only 52% of those asked are confident they can pay off their BNPL loan without missing a payment!

Wage Growth

Wages have been growing above trend since the pandemic. Since 2022, the average annual growth in compensation has been 6.28%. Higher incomes support more consumption, but higher prices reduce the amount of goods or services one can buy. Over the same period, real compensation has grown by less than half a percent annually. The average real compensation growth was 2.30% during the three years before the pandemic.

In other words, compensation is just keeping up with inflation instead of outpacing it and providing consumers with the ability to consume, save, or pay down debt.

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It’s All About Employment

The unemployment rate is 3.9%, up slightly from recent lows but still among the lowest rates in the last seventy-five years.

the unemployment rate

The uptick in credit card usage, decline in savings, and the savings rate argue that consumers are slowly running out of room to keep consuming at their current pace.

However, the most significant means by which we consume is income. If the unemployment rate stays low, consumption may moderate. But, if the recent uptick in unemployment continues, a recession is extremely likely, as we have seen every time it turned higher.

It’s not just those losing jobs that consume less. Of greater impact is a loss of confidence by those employed when they see friends or neighbors being laid off.   

Accordingly, the labor market is probably the most important leading indicator of consumption and of the ability of the Bougie Broke to continue to be Bougie instead of flat-out broke!

Summary

There are always consumers living above their means. This is often harmless until their means decline or disappear. The Bougie Broke meme and the ability social media gives consumers to flaunt their “wealth” is a new medium for an age-old message.

Diving into the data, it argues that consumption will likely slow in the coming months. Such would allow some consumers to save and whittle down their debt. That situation would be healthy and unlikely to cause a recession.

The potential for the unemployment rate to continue higher is of much greater concern. The combination of a higher unemployment rate and strapped consumers could accentuate a recession.

Digital Currency And Gold As Speculative Warnings

Over the last few years, digital currencies and gold have become decent barometers of speculative investor appetite. Such isn’t surprising given the evolution of the market into a “casino” following the pandemic, where retail traders have increased their speculative appetites.

“Such is unsurprising, given that retail investors often fall victim to the psychological behavior of the “fear of missing out.” The chart below shows the “dumb money index” versus the S&P 500. Once again, retail investors are very long equities relative to the institutional players ascribed to being the “smart money.””

Dumb money index vs market

“The difference between “smart” and “dumb money” investors shows that, more often than not, the “dumb money” invests near market tops and sells near market bottoms.”

Net Smart Dumb Money vs Market

That enthusiasm has increased sharply since last November as stocks surged in hopes that the Federal Reserve would cut interest rates. As noted by Sentiment Trader:

“Over the past 18 weeks, the straight-up rally has moved us to an interesting juncture in the Sentiment Cycle. For the past few weeks, the S&P 500 has demonstrated a high positive correlation to the ‘Enthusiasm’ part of the cycle and a highly negative correlation to the ‘Panic’ phase.”

Investor Enthusiasm

That frenzy to chase the markets, driven by the psychological bias of the “fear of missing out,” has permeated the entirety of the market. As noted in This Is Nuts:”

“Since then, the entire market has surged higher following last week’s earnings report from Nvidia (NVDA). The reason I say “this is nuts” is the assumption that all companies were going to grow earnings and revenue at Nvidia’s rate. There is little doubt about Nvidia’s earnings and revenue growth rates. However, to maintain that growth pace indefinitely, particularly at 32x price-to-sales, means others like AMD and Intel must lose market share.”

Nvidia Price To Sales

Of course, it is not just a speculative frenzy in the markets for stocks, specifically anything related to “artificial intelligence,” but that exuberance has spilled over into gold and cryptocurrencies.

Birds Of A Feather

There are a couple of ways to measure exuberance in the assets. While sentiment measures examine the broad market, technical indicators can reflect exuberance on individual asset levels. However, before we get to our charts, we need a brief explanation of statistics, specifically, standard deviation.

As I discussed in “Revisiting Bob Farrell’s 10 Investing Rules”:

“Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

The idea of “stretching the rubber band” can be measured in several ways, but I will limit our discussion this week to Standard Deviation and measuring deviation with “Bollinger Bands.”

“Standard Deviation” is defined as:

“A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of the variance.”

In plain English, this means that the further away from the average that an event occurs, the more unlikely it becomes. As shown below, out of 1000 occurrences, only three will fall outside the area of 3 standard deviations. 95.4% of the time, events will occur within two standard deviations.

Standard Deviation Chart

A second measure of “exuberance” is “relative strength.”

“In technical analysis, the relative strength index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can read from 0 to 100.

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.” – Investopedia

With those two measures, let’s look at Nvidia (NVDA), the poster child of speculative momentum trading in the markets. Nvidia trades more than 3 standard deviations above its moving average, and its RSI is 81. The last time this occurred was in July of 2023 when Nvidia consolidated and corrected prices through November.

NVDA chart vs Bollinger Bands

Interestingly, gold also trades well into 3 standard deviation territory with an RSI reading of 75. Given that gold is supposed to be a “safe haven” or “risk off” asset, it is instead getting swept up in the current market exuberance.

Gold vs Bollinger Bands

The same is seen with digital currencies. Given the recent approval of spot, Bitcoin exchange-traded funds (ETFs), the panic bid to buy Bitcoin has pushed the price well into 3 standard deviation territory with an RSI of 73.

Bitcoin vs Bollinger Bands

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.

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It’s All Relative

We can see the correlation between stock market exuberance and gold and digital currency, which has risen since 2015 but accelerated following the post-pandemic, stimulus-fueled market frenzy. Since the market, gold and cryptocurrencies, or Bitcoin for our purposes, have disparate prices, we have rebased the performance to 100 in 2015.

Gold was supposed to be an inflation hedge. Yet, in 2022, gold prices fell as the market declined and inflation surged to 9%. However, as inflation has fallen and the stock market surged, so has gold. Notably, since 2015, gold and the market have moved in a more correlated pattern, which has reduced the hedging effect of gold in portfolios. In other words, during the subsequent market decline, gold will likely track stocks lower, failing to provide its “wealth preservation” status for investors.

SP500 vs Gold

The same goes for cryptocurrencies. Bitcoin is substantially more volatile than gold and tends to ebb and flow with the overall market. As sentiment surges in the S&P 500, Bitcoin and other cryptocurrencies follow suit as speculative appetites increase. Unfortunately, for individuals once again piling into Bitcoin to chase rising prices, if, or when, the market corrects, the decline in cryptocurrencies will likely substantially outpace the decline in market-based equities. This is particularly the case as Wall Street can now short the spot-Bitcoin ETFs, creating additional selling pressure on Bitcoin.

SP500 vs Bitcoin

Just for added measure, here is Bitcoin versus gold.

Gold vs Bitcoin

Not A Recommendation

There are many narratives surrounding the markets, digital currency, and gold. However, in today’s market, more than in previous years, all assets are getting swept up into the investor-feeding frenzy.

Sure, this time could be different. I am only making an observation and not an investment recommendation.

However, from a portfolio management perspective, it will likely pay to remain attentive to the correlated risk between asset classes. If some event causes a reversal in bullish exuberance, cash and bonds may be the only place to hide.

Miners Fail To Keep Up With Gold And Bitcoin Rally

Gold and Bitcoin have been among some of the best-performing assets recently, yet despite their outperformance, the companies that mine for gold and bitcoin lag well behind their respective products. The lower two graphs show the price ratio of gold versus gold miners and bitcoin versus bitcoin miners. Over the last two years, gold has outperformed gold miners by about 25%, while bitcoin has been beating its miners by over 50%. What gives?

Often, the performance of producers or miners of a good or commodity behaves vastly differently than the price of the goods. The product/commodity and the miners are two different investments. Miners use a great deal of resources to produce a good or commodity. Accordingly, they are subject to variable expenses. For example, interest rates are at fifteen-year highs, the cost of labor has risen significantly over the prior few years, and inflation has made the cost of machinery, tools, and transportation soar. Further, working against miners, they tend to be highly leveraged with debt. So, while a good or commodity being mined sells for a higher price, the cost of producing said good may have risen even more.

We advise that if you like gold or bitcoin, buy gold or bitcoin. Miners may be good investments, especially when the price of their product rises, but understand that the selling price of their product is just one of many aspects that account for their profitability.

gold, bitcoin and their miners

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Since Michael touched on Bitcoin and gold miners, I wanted to share a section of today’s article on the speculative correlation in the market.

There are a couple of ways to measure exuberance in the assets. While sentiment measures examine the broad market, technical indicators can reflect exuberance on individual asset levels. However, before we get to our charts, we need a brief explanation of statistics, specifically, standard deviation.

As I discussed in “Revisiting Bob Farrell’s 10 Investing Rules”:

“Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

The idea of “stretching the rubber band” can be measured in several ways, but I will limit our discussion this week to Standard Deviation and measuring deviation with “Bollinger Bands.”

“Standard Deviation” is defined as:

“A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of the variance.”

In plain English, this means that the further away from the average that an event occurs, the more unlikely it becomes. As shown below, out of 1000 occurrences, only three will fall outside the area of 3 standard deviations. 95.4% of the time, events will occur within two standard deviations.

Standard Deviation Chart

A second measure of “exuberance” is “relative strength.”

“In technical analysis, the relative strength index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can read from 0 to 100.

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.” – Investopedia

With those two measures, let’s look at Nvidia (NVDA), the poster child of speculative momentum trading in the markets. Nvidia trades more than 3 standard deviations above its moving average, and its RSI is 81. The last time this occurred was in July of 2023 when Nvidia consolidated and corrected prices through November.

NVDA chart vs Bollinger Bands

Interestingly, gold also trades well into 3 standard deviation territory with an RSI reading of 75. Given that gold is supposed to be a “safe haven” or “risk off” asset, it is instead getting swept up in the current market exuberance.

Gold vs Bollinger Bands

The same is seen with digital currencies. Given the recent approval of spot, Bitcoin exchange-traded funds (ETFs), the panic bid to buy Bitcoin has pushed the price well into 3 standard deviation territory with an RSI of 73.

Bitcoin vs Bollinger Bands

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.

Japan Exiting Negative Interest Rates Risks Carry Trade Unwind

The Japanese yen and its 10-year bond yield continue to rise as there is growing speculation the BOJ may exit its negative interest rate policy shortly. The negotiation results will likely help the BOJ decide whether to hike rates next week or at the following meeting in late April. The Bloomberg graph below shows the BOJ has held its benchmark rate below zero since 2016 despite significant hikes by the Fed and ECB. In addition to possibly raising rates to zero percent or even a positive rate, there are rumors they may scrap its yield curve control program. The second graph shows that the yen has depreciated to its lowest levels compared to the dollar in the last 25 years.

For the last 20 years, investors have been borrowing yen, converting it to dollars, and investing in funds. The so-called yen-carry trade has worked out well, as their interest rates are below the U.S.’s, and the yen has declined. However, higher rates and the potential for the yen to appreciate versus the dollar may cause some investors to get out of the yen-carry trade. Such could have negative implications for those stocks and bonds investors have purchased with carry trade funds.

bank of japan boj benchmark rate vs fed and ecb
yen vs dollar

Asking Vs. In-Place Rents

In the current environment, CPI may be the most critical data point for the Fed and, therefore, markets. Therefore, it’s worth revisiting rental prices, which account for about 40% of the inflation number. We lean on Jay Parsons, a rental housing economist, to explain why CPI rental prices lag the market. The graph below goes a long way to understanding the difference. The asking rents are for new renters or those with expiring rents looking to roll their rent for a new term. In-place rents are the contractual rents being paid. They are based on existing agreements. The following commentary is from Jay.

Like the CPI’s shelter measure of “contract rents,” in-place rents lag asking rents because they include all active leases. And rents don’t change month-to-month for the vast majority of leases, so in-place rents will always lag asking rents. Ultimately, though, in-place rents have to follow asking rents (which is why we know CPI Shelter will trend further down).

As of Feb’24, in-place rents were up 2.7% year-over-year… meaning the average market-rate renter with an active lease was paying 2.7% more than the year earlier.

Compare that to this time a year ago, in Feb’23, in-place rents were up 10% YoY.

And in three major markets, in-place rents fell over the last year… meaning the average renter is paying LESS. That list: Austin, Phoenix and Las Vegas. And the list will grow– with a smattering of soft-demand California and high-supply Sun Belt markets nearing negative territory.

As in-place rents come up for renewal, new rental contracts will primarily be at similar prices or even lower. Consequently, rents, which account for 40% of the CPI number, will continue to decline, quite possibly to near zero percent growth.

asking rents vs in place rents cpi fed

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Household Versus Headline- Which Employment Report Is Right?

Friday’s employment data from the BLS was a mixed bag. The closely followed nonfarm payrolls number grew by 275k jobs, decently above expectations of +190k. Despite the seemingly strong number, the unemployment rate rose by 0.2% to 3.9%. Last month’s scorching gain of 353k jobs was revised lower to 229k. You may wonder why the unemployment rate ticked up if the number of jobs increased. Typically, this occurs because the labor participation rate, or the number of people in the workforce, changes. That was not the case in Friday’s report. The culprit is the difference between the household survey, which is used for the unemployment calculation, and the establishment survey, also known as the headline survey, which feeds the headline payroll number.

Historically, the two data points move in lockstep. However, since August, the household survey shows the economy lost 532k jobs, while the headline survey shows the addition of 1,328k jobs. A clue as to which survey, household, or headline might be correct can be found in the hourly wages and ADP data. A robust jobs market, as portrayed by the headline number, should lead to good wage growth. Wage growth inched higher by 0.1%, the lowest in over two years. ADP is consistently reporting job growth of 100-125k. Both data sets reflect a growing but sub-par job market, not what the household or headline surveys tell us.

household vs headline jobs surveys

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable economic reports

Market Trading Update

Last week, the ongoing “can’t stop, won’t stop” bullish trend remained firmly intact. As we noted then:

“That remains the case this past week. While the overall market traded higher into the end of the week, setting new all-time highs, the bullish November trend remains intact. While the market remains confined to that narrow rising trend channel, the MACD “buy signal” remains elevated, and an apparent deterioration in the market’s momentum remains.”

That was the case again this week, as the market tested the 20-DMA, the bottom of the trend channel, early in the week, which sparked buyers to push the index to all-time highs by the week’s end. At the same time, volatility remains compressed, with the deviation from the 200-DMA growing. As shown, the breadth of the market and momentum are both negatively diverging from the rising market, which historically serves as a warning.

Market Trading Update

While we have become increasingly cautious over the last few weeks as the market continues to rise, we have suggested taking profits and rebalancing portfolio risks. If you have not done so, this remains a recommended course of action. However, this does not mean aggressively reducing equity allocations.

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 violating 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. At that point, we will reduce equity positioning and aggressively implement hedging strategies.

The Week Ahead

With employment in the rearview mirror, investors will turn their focus to inflation, retail sales, and the Fed. The all-important CPI data, coming out tomorrow, is expected to show an increase of 0.4%. Economists expect PPI on Thursday to rise 0.3%. The holiday season hangover resulted in a 0.8% decline in retail sales last month. Expectations are that Thursday’s retail sales report will show a gain of 0.5%.

In addition to digesting CPI, PPI, and retail sales alongside harboring any consternation about what the Fed may say at its upcoming March 20th meeting, bond investors will absorb a fresh round of 10 and 30 bonds from the U.S. Treasury.

The Fed will go on a media blackout this week.

Expect More Underwhelming Economic Data

Economic data over the last few weeks has generally underwhelmed economists’ expectations. Consequently, as we share below, the Atlanta Fed GDPNow estimate for Q1 GDP growth has shrunk from over 4.0% to 2.5%. We should begin to consider whether recent data is an early sign that economic activity is weakening or just a few bad numbers affected by seasonal factors.

The second graph below may help us answer the question. The Citi Economic Surprise measures how economic data compares to economists’ estimates of said data. As we share in the second graph, the index tends to cycle reliably higher and lower. It appears to be turning lower. Accordingly, we may be in for a spate of weak economic data until economists adjust their forecasts. Bouts of weaker-than-expected economic data are common in robust economies and recessions, so try not to read too much into it. On the other hand, the Atlanta Fed GDPNow graph will be more concerning if it continues to decline.

atlanta fed gdp now
citi economic surprise index

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Why Are Financial Conditions Easing?

The Fed is doing QT and keeping interest rates at 15+ year highs. Mortgage rates are 7%, credit cards are around 20%, and auto loans are between 7% and 10%. As the graph below on the right shows, consumer loan growth, excluding the pandemic, has fallen to levels last seen over ten years ago. Loan growth to companies (C&I) is declining and, again, excluding the pandemic, at rates last seen during the 2008 recession. So why, as the Bloomberg chart on the left highlights, are financial conditions so easy?

Few appreciate the big difference between financial conditions and borrowing conditions. Financial conditions predominately measure markets. The St. Louis Fed defines financial conditions as follows: “Measures of equity prices (also commonly referred to as stock prices), the strength of the U.S. dollar, market volatility, credit spreads, long-term interest rates, and other variables.” In the short term, markets are fueled by liquidity and sentiment. As we describe in Liquidity Problems, despite QT and high rates, there remains an abundance of liquidity in the financial system. Furthermore, market sentiment is sky-high. For now, markets do not care about borrowing conditions, but at some point, maybe they will.

financial conditions and borrowing conditions

What To Watch Today

Earnings

  • No notable earnings releases today

Economy

Economic Calendar

Market Trading Update

As noted yesterday, the market continues trading within its very confined range. Dips are quickly bought, which should be expected given the market sentiment. As noted above, financial conditions remain supportive of rising asset prices. Bank reserves also remain supportive despite the drop in liquidity, as noted by the decline in the repo programs. History suggests that the markets will participate as long as bank reserves continue to rise. However, if bank reserves come under pressure due to a liquidity event in the financial system, a market correction becomes much more likely.

Bank reserves and the market

There is no evidence of that weakness yet. For investors, it is important to understand that markets are likely entering a topping phase. Simon White at Bloomberg had a excellent comment on this point.

“The stock market is entering its topping phase. That’s not necessarily a reason, however, to hit the sell button as market tops typically persist long after fundamentals have ceased to support them, making them fraught with risks. The current market has yet to display the majority features present at previous tops, suggesting it can keep grinding higher — perhaps even culminating in a blow-off in prices — despite growing skepticism in the rally.

Markets exhibit asymmetric behavior at tops and bottoms. The latter are points in time, but tops are a process, often lasting many months. The most recent ones: the pandemic in 2021, the subprime crisis in 2007, the 2000 tech bubble and the savings and loan crisis in 1990 lasted many months – with the exception of the pandemic – and endured mounting disbelief before they finally gave way.

The stark difference between market tops and bottoms can be seen in the following chart. It shows the median bull market and the median bear market of the last 70 years. We can see clearly that market tops take many months to build, forming an inverted U-shape, and spending a significant amount of time within 20% of their peak price.

Market Tops are A process

Trade accordingly.

NYCB Is Given A Lifeline, But Not By Uncle Sam

NYCB was on the ropes. The bank was downgraded to junk status and in desperate need of capital. Consequently, its stock was halted as it fell almost 50% on Wednesday due to concerns that it could fail without new capital. It turns out the bad news expected after the trading halt was good news. A group of investors led by former Treasury Secretary Mnuchin and Fortress Capital provided the bank with $1 billion of capital. The stock opened Wednesday at $3.64, traded as low as $1.70, and closed up on the day.

For now, it appears NYCB is stable. Furthermore, the capital providers require the removal of NYCB’s entire management. We do not know whether NYCB will survive, but we like that the bailout will occur by the private sector without the government’s or Fed’s financing. This is how the system should work.

nycb bank stock

More On The JOLTs Quit Rate

Yesterday’s Commentary stated:

The quit rate, a good measure of job mobility, is now below pre-pandemic levels.

The quit rate is a great predictor of employment and wages. The first graph, courtesy of Albert Edwards, shows the robust correlation between the quit rate and the unemployment rate. While it is currently diverging, the quit rate tends to be a leading indicator, meaning that unemployment may increase soon. In like manner, the second graph shows a strong correlation between wages and the quit rate. In this graph, the quit rate leads by two months. Assuming the relationship holds, wage growth should continue falling, which should make the Fed more comfortable in its quest to reduce inflation.

quit rate and labor market
quit rate and employee compensation

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Presidential Elections And Market Corrections

Presidential elections and market corrections have a long history of companionship. Given the rampant rhetoric between the right and left, such is not surprising. Such is particularly the case over the last two Presidential elections, where polarizing candidates trumped policies.

From a portfolio management perspective, we must understand what happens during election years concerning the stock market and investor returns.

Since 1833, the S&P 500 index has gained an average of 10.03% in the year of a presidential election. By contrast, the first and second years following a Presidential election see average gains of 6.15% and 6.94%, respectively. There are notable exceptions to positive election-year returns, such as in 2008, when the S&P 500 sank nearly 37%. (Returns are based on price only and exclude dividends.) However, overall, the win rate of Presidential election years is a very high 76.6%

Since President Roosevelt’s victory in 1944, there have only been two losses during presidential election years: 2000 and 2008. Those two years corresponded with the “Dot.com Crash” and the “Financial Crisis.” On average, the second-best performance years for the S&P 500 are in Presidential election years.

Presidential Election Stock Market Cycle

For investors, with a “win ratio” of 76%, the odds are high that markets will most likely finish the 2024 Presidential election year higher. However, given the current economic underpinnings, I would caution completely dismissing the not-so-insignificant 24% chance that a more meaningful correction could reassert itself. Given the recent 15-year duration of the ongoing bull market, the more extreme deviations from long-term means, and ongoing valuation issues, a “Vegas handicapper” might increase those odds a bit.

Deviation of SP500 from 200-DMA

That deviation is more significant when looking at the 1-year moving average. Current deviation levels from the 52-week moving average have generally preceded short-term market corrections or worse.

Deviation of market from 52-Week M/A

However, as stated, while the market will likely end the year higher than where it started, Presidential election years have a correctional bias to them during the summer months.

Will Policies Matter

The short answer is “Yes.” However, not in the short term.

Presidential platforms are primarily “advertising” to get your vote. As such, a politician will promise many things that, in hindsight, rarely get accomplished. Therefore, while there is much debate about whose policies will be better, it doesn’t matter much as both parties have an appetite for “providing bread and games to the masses” through continuing increases in debt.

GDP growth vs debt issuance

However, regarding the financial markets, Wall Street tends to abhor change. With the incumbent President, Wall Street understands the “horse the riding.” The risk to elections is a policy change that may undermine current trends. Those policy changes could be an increase in taxes, restrictive trade policies, cuts to spending, etc., which would potentially be unfriendly to financial markets in the short term.

This is why markets tend to correct things before the November elections. A look at all election years since 1960 shows that markets did rise during election years. However, notice that the market tends to correct during September and October.

Average election year market performance.

Notably, that data is heavily skewed by the decline during the 2008 “Financial Crisis,” also a Presidential election year. If we extract that one year, returns jump to 7.7% annually in election years. However, in both cases, returns still slump during September and October. The chart below shows that 2024 is running well ahead of historical norms.

Election year performance ex-2008 compared with YTD.

Lastly, while policies matter over a longer-term period, as changes to spending and regulation impact economic outcomes, market performance during SECULAR market periods varies greatly. During secular (long-term) bull markets, as we have now since 2009, Presidential election years tend to average almost 14% annually. That is opposed to secular bear markets, which tend to decline by 7% on average.

Election Year Performance bull and bear periods

However, one risk that has taken shape since the “Financial Crisis” could have an outside effect on the markets in 2024.

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The Great Divide

While you may feel strongly about one party or the other regarding politics, it doesn’t matter much regarding your money.

Such is particularly the case today. As we head into November, for the third election in a row, voters will cast ballots for the candidate they dislike less, not whose policies they like more. More importantly, most voters are going to the polls with large amounts of misinformation from social media commentators pushing political agendas.

Notably, the market already understands that with the parties more deeply divided than at any other point in history, the likelihood of any policies getting passed is slim. (2017 was the latest data from a 2019 report. Currently, that gap is even more significant as Social Media continues to fuel the divide.)

Political Division in the US

The one thing markets do seem to prefer – “political gridlock.”

“A split Congress historically has been better for stocks, which tend to like that one party doesn’t have too much sway. Stocks gained close to 30% in 1985, 2013 and 2019, all under a split Congress, according to LPL Financial. The average S&P 500 gain with a divided Congress was 17.2% while GDP growth averaged 2.8%.” – USA Today

Gridlock stock market performance

What we can derive from the data is the odds suggest the market will end this year on a positive note. However, such says little about next year. If you go back to our data table above, the 1st year of a new Presidential cycle is roughly a 50/50 outcome. It is also the lowest average return year, going back to 1833.

Furthermore, from the election to 2025, outcomes have been overly dependent on many things continuing to go “right.”

  1. Avoidance of a “double-dip” recession. (Without more Fiscal stimulus, this is a plausible risk.)
  2. The Fed drastically expands monetary policy. (Such won’t come without a recession.)
  3. The consumer will need to expand their current debt-driven consumption. (This is a risk without more fiscal stimulus or sustainable economic growth.)
  4. There is a marked improvement in both corporate earnings and profitability. (This will likely be the case as mass layoffs benefit bottom-line profitability. However, top-line sales remain at risk due to items #1 and #3.)
  5. Multiple expansions continue. (The problem is that a lack of earnings growth in the bottom 490 stocks eventually disappoints)

These risks are all undoubtedly possible.

However, when combined with the longest-running bull market in history, high valuations, and excessive speculation, the risks of something going wrong have risen.

So, how do you position your portfolio for the election?

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Portfolio Positioning For An Unknown Election Outcome

Over the last few weeks, we have repeatedly discussed reducing risk, hedging, and rebalancing portfolios. Part of this was undoubtedly due to the exaggerated rise from the November lows and the potential for an unexpected election outcome. As we noted in “Tending The Garden:” 

“Taking these actions has TWO specific benefits depending on what happens in the market next.

  1. If the market corrects, these actions clear out the ‘weeds’ and allow for protection of capital against a subsequent decline.
  2. If the market continues to rally, then the portfolio has been cleaned up, and new positions can be added to participate in the next leg of the advance.

No one knows for sure where markets are headed in the next week, much less the next month, quarter, year, or five years. What we do know is not managing ‘risk’ to hedge against a decline is more detrimental to the achievement of long-term investment goals.”

That advice continues to play well in setting up your portfolio for the election. As outlined, the historical odds suggest that markets will rise regardless of the electoral outcome. However, those are averages. In 2000 and 2008, investors didn’t get the “average.”

Such is why it is always important to prepare for the unexpected. While you certainly wouldn’t speed down a freeway “blindfolded,” it makes little sense not to be prepared for an unexpected outcome.

Holding a little extra cash, increasing positioning in Treasury bonds, and adding some “value” to your portfolio will help reduce the risk of a sharp decline in the months ahead. Once the market signals an “all clear,” you can take “your foot off the brake” and speed to your destination.

Of course, it never hurts to always “wear your seatbelt.” 

Bitcoin Declined 13% Intraday Again

From Monday’s close to its low point on Tuesday, Bitcoin declined by over 13%. While a 13% decline in one day may seem enormous for almost any asset class, it’s not that out of the ordinary for Bitcoin traders and investors. As we graph below, Bitcoin has fallen by 13% or more intraday 59 times over the last ten years. On average, such a drastic move occurs about six times a year. In fact, Bitcoin has declined by twice that amount, on an intraday basis, six times in just the last ten years! As of Wednesday morning, Bitcoin recovered over half of its losses. Furthermore, Ethereum, which was down over 15% intraday, erased the entire decline within 12 hours, as shown in our Tweet of the Day below.

The surge and recent decline in Bitcoin are not just confined to Bitcoin. The whole crypto sector is posting enormous gains. Furthermore, as we have mentioned in numerous Commentary, speculative fervor permeates many markets. Often, bubbles or periods of significant gains end with a bout of two-way volatility. Big gains are followed by sharp declines, another price surge, etc. Typically, such volatility marks a period when the number of sellers or those shorting becomes numerous and more aggressive. Further, buyers and sellers are often heavily convicted at these points. Consequently, sellers will pile on any downward movement, and buyers consider any dip a gift. Hence, we must ask- is this week’s bout of volatility a warning or a speed bump on the way to higher prices?

bitcoin drawdowns

What To Watch Today

Earnings

Earnings calendar

Economy

Economic Calendar

Market Trading Update

Just like clockwork, the market traded lower on Tuesday, testing the 20-DMA for a quick second before rebounding higher into the close. The market followed through on that rally yesterday, with Nvidia again leading the way even as Microsoft, Apple, Google, and Tesla lagged.

The story remains the same. An “unstoppable bull market” that continues to trend higher. The bulls are getting more bullish, and the bears….well….they are hard to find. Sentiment is rising, and investor positioning is getting very long. As we have repeated over the last several weeks, there is no reason to be overly cautious on the markets. However, WHEN the market takes out the 20-DMA, expect a sharp move lower as all the computer algos are now keyed to that level.

Remain long but continue to manage portfolio risk accordingly.

Market Trading Update

Jerome Powell Testifies To Congress

Powell testified to the House in his quarterly monetary policy and economic update yesterday. He did not break much new ground. However, of most importance, he stated that the forward guidance regarding rate cuts has changed little. With the market and Fed rate expectations much more closely aligned, the market is less prone to volatility as market expectations change. For example, the table below shows the Fed Funds futures market now expects the Fed to cut three to four times by year-end. Based on his testimony, he thinks rate cuts are more likely in the second half of the year, as they want “more confidence inflation is moving sustainably to 2%.” The market is pricing a 58% chance that the first cut will occur on June 12.

Powell is aware of the risks the Fed faces as he notes they need to thread the needle with rate cuts. Cutting rates too soon could “result in a reversal of progress” in reducing inflation, or cutting them “too late or too little” could weaken the economy and hiring. He is aiming for a Goldilocks soft landing.

The stock and bond markets’ reaction to his comments was muted, as he pretty much said what most market participants were thinking.

fed fund futures probability analysis

JOLTs And ADP Point To A Moderating Labor Market

Leading into Friday’s employment report, we can try to gather some clues from yesterday’s ADP and JOLTs reports. ADP was slightly lower than expectations at +140k. Once again, leisure and hospitality added the most jobs. We caution that these tend to be lower-paying jobs and are often temporary.

The JOLTs report, like ADP, points to a normalization of the labor market. The quit rate, a good measure of job mobility, is now below pre-pandemic levels. When the odds of finding a new, higher-paying job decline, so does the quit rate. The number of job openings was slightly below the prior level, as it has been for four months running. As shown in the third graph, the trend remains lower, but it still lies decently above pre-pandemic levels.

The fourth and fifth graphs provide an excellent summary of the labor markets, in our opinion. The fourth graph shows that the hiring rate is down to 7-year lows, yet layoffs remain well below pre-pandemic levels, as highlighted in the fifth graph. The two data sets, in combination, point to a stagnant labor market in which companies are not laying off employees or hiring new employees.

ADP new jobs
jolts quit rate
jolts job openings
jolts hire rate
jolts layoffs

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Paul Volcker Warns The Fed

Paul Volcker, Fed Chairman from 1979 to 1987, passed away in 2019. However, poignant words from his book Keeping At It, The Quest for Sound Money and Good Government may haunt the Fed today. In his book published in 2018, Paul Volcker offers the following advice.

The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.

Paul Volcker’s advice is crucial today. Inflation has retreated from levels last seen during Volcker’s reign but remains high. Furthermore, some economists are concerned it may be sticky or drift higher. At the same time, an “easy money” market perception of the Fed is fueled by expectations the Fed will cut rates and reduce QT. Accordingly, “extreme speculation and risk-taking” is occurring in specific sectors. Getting inflation to target remains the Fed’s priority, but they are worried that excess liquidity is dwindling. Accordingly, they are torn between easy money policies and tough monetary medicine. Paul Volcker posthumously argues that focusing on price stability and reducing speculation is Powell’s “responsibility.”

paul volcker

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Like clockwork, the sellers showed up yesterday to push stocks lower after testing the upper end of the trading range. As noted yesterday, the trading range has remained confined to slightly higher highs as resistance and the 20-DMA as support. While the underlying deterioration in momentum continues and is something we are watching closely, there is no need for extensive action until the 20-DMA is violated.

Market Trading Update

The one chart we remain focused on is our weekly money-flow index. While the buy signal is still firmly intact, we see some weakness emerging from the lower indicator. The spread in the MACD is beginning to close, which is a potential precursor to a more significant market decline. When this weekly indicator triggers a sell signal, that will be the time to reduce equity exposures and hedge risk more aggressively.

Money Flow Weekly Index

Target Shares Jump But It Has A Lot Of Catching Up Versus Walmart

In its Monday quarterly earnings report, Target reported EPS of $2.98 a share, well above last year’s $1.89 and estimates of $2.42. Sales continued to decline, but they were better than expected. The stock responded nicely to earnings, rising 11% in the pre-market. Fueling the gains is a positive outlook for the consumer. They expect sales for the coming year will be up 1% on average, slightly above expectations.

As shown below, Target has been grossly underperforming Walmart, its chief rival. However, Target has recovered nicely since December. Target is still down almost 50% from its late 2021 peak, while Walmart trades at record highs. The difference is also evident in their evaluations. Walmart trades at a P/E of 31, while Target is close to 20. Clearly, investors expect more growth from Walmart than from Target.

target and walmart stock

ISM – Service Sector Showing Declining Inflationary Pressures

With the service sectors driving economic growth and contributing to sticky prices, yesterday’s latest ISM service sector survey was of particular interest to the market. The headline index fell from 53.4 to 52.6, below expectations of 53.0. More importantly, prices paid fell appreciably from 64.0 to 58.6. Employment dropped from 50.5 to 48.0, pushing it into economic contraction territory. On the positive side, new orders rose from 55.0 to 56.1.

The graph below, courtesy of Longview Economics, shows that their blended ISM price indexes are turning lower. The correlation between CPI and the ISM price gauges tends to be robust. The price indexes have been ticking up over the last few months, so it will be interesting to see if the recent decline continues with the longer-term lower trend in prices or if it is on a one-month hiatus for its shorter-term trend higher.

ism prices and cpi

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Liquidity Problems Are Closer Than You Think

In 2019, the Fed cut interest rates and restarted QE despite a healthy economy. Today, inflation is higher than the Fed’s target, economic growth is above historical trends, and financial markets display complacency and exuberance. Yet, the Fed is talking about cutting rates and reducing QT. The only rationale for them in such an environment must be a concern with potential liquidity problems, as the declining balances in the Fed’s Reverse Repurchase Program (RRP) suggest.

Before discussing RRP and what it might foretell, it’s worth appreciating that a good understanding of the Fed’s policy tools is vital for investors.

Why The Fed Is So Important For Investors

Twenty to thirty years ago, very few investors needed to understand the Fed’s monetary plumbing. The Fed was undoubtedly important, but its actions were not nearly as closely followed or impactful as they are now. Investor success, whether in real estate, stocks, bonds, or almost any other financial asset, now hinges on understanding the Fed’s inner workings.

Total debt is growing much faster than the economy’s collective income. To facilitate such a divergence and try to avoid liquidity problems, the Fed has increasingly employed lower interest rates and balance sheet machinations (QE). Numerous bank and investor bailouts have also helped.

 As the country becomes more leveraged, the Fed’s importance will increase.

fed, total debt vs personal income
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What is the RRP?

A repurchase agreement, better known as a repo, is a loan collateralized by a security. The Fed’s RRP is a loan in which the Fed borrows money from primary dealers, banks, money market funds, and government-sponsored enterprises. The term of the loan is one day.

The program provides money market investors with a place to invest overnight funds.

What Does RRP Accomplish?

Think of RRP as money market supply offered to help balance the supply-demand curve for overnight funds.

During the pandemic, the Fed bought about $5 trillion of Treasury and mortgage bonds from Wall Street. As a result, a massive amount of liquidity was injected into the financial system. Since banks did not use all the liquidity to make loans or buy longer-term assets, financial institutions had excess liquidity that needed to be invested in the money markets. The result was downward pressure on short-term yields.

The Fed raised its Fed Funds overnight rate to help combat inflation. But, with the excess funds sloshing around the market, hitting their target rate would prove difficult. RRP allowed the Fed to meet its target.

The Current Status Of RRP

At its peak, the RRP facility reached $2.5 trillion. Since then, it has decreased steadily. Currently, it is half a trillion dollars and will likely fall to near zero in the coming months. Essentially, the market is absorbing excess liquidity. Over the last year, excess liquidity has been needed by the Treasury to fund its swiftly growing debt and to help the market absorb the bonds coming off the Fed’s balance sheet via QT.

fed RRP reverse repurchase program

Excess Liquidity Is Vanishing

It’s difficult to experience liquidity problems when liquidity is abundant. The extreme actions of the Fed in 2020 and 2021 made it much easier for the banking system, financial markets, and economy to handle much higher interest rates and $95 billion a month of QT.

However, excess liquidity is diminishing rapidly.

So, what type of problems occur when the excess liquidity is gone? For starters, banks will still have to use their reserves to help the Treasury issue debt and absorb the Fed’s balance sheet decline. Such actions will force liquidity to migrate from other parts of the financial system to the Fed and Treasury. Without RRP to draw funds from, banks will have to tighten lending standards for consumer and corporate loans. Further, they may likely pull back on margin debt offered to speculative investors.

The cost of higher interest rates and QT will likely be felt at this point.

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Revisiting 2019

In 2019, Treasury-backed repo interest rates between banks and other investors were trading well above uncollateralized Fed Funds. Such a circumstance didn’t make sense.

As a hypothetical example, JP Morgan was lending Bank of America money overnight at 5.50% with no security (collateral) despite a hedge fund willing to borrow at 5.75% fully secured with Treasury bonds. Yes, Bank of America has a better credit rating and lower default risk, but the hedge fund is pledging risk-free collateral. While small, the odds of JP Morgan losing money in this example are greater for the Bank of America loan than the hedge fund repo trade.

At the time, the Fed was raising rates and reducing their balance sheet for the prior year and a half. Liquidity was becoming a big problem. There was no RRP to draw liquidity from to offset QT. Simply, liquidity was lacking.

To combat the liquidity shortage, the Fed added liquidity by reducing the Fed Funds rate and re-engaging in QE. It’s important to remind you that they took these actions while the economy was in good shape and broader financial markets showed little to worry about.

The graph below highlights when the Fed quickly reversed course.

fed funds, fed balance sheet, liquidity shortage of 2019

2019 is very relevant because similar problems may arise as the excess liquidity from the pandemic finally exits the system.

The Fed Is Prepping For Liquidity Problems

The Fed appears to be aware of potential liquidity shortfalls. Over the last month, they have started discussing reducing their monthly amounts of QT. A formal announcement could come as early as the March 20th FOMC meeting.

Such discussions and planning occur even though inflation is still above target, the economy is growing faster than the trend, and the stock market is near record highs. Under those circumstances, one would think the Fed would maintain its tight monetary policy.

The Fed is aware that large institutional investors have to sell assets to reduce leverage if there isn’t sufficient liquidity. Such collective actions could significantly weigh on financial asset prices and, ultimately, the economy.

To wit, consider a recent article by the New York Fed. In The Financial Stability Outlook, author Anna Kovner states the following:

Achieving a strong U.S. economy and stable prices is paramount, and remaining aware of the impact of policy choices on the financial system is a key ingredient to maintaining the ability to execute policy. To close with the snow metaphor I began with, if there is a blizzard in March, we will be prepared to dig out quickly, plow the streets, and get back to work.

March is not just a random date. March is when the RRP program is expected to fall to near zero!

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Will The Fed Know When Liquidity Is No Longer “Ample”?

No magic number or calculation tells the Fed when excess liquidity is gone. Furthermore, they will only know when liquidity becomes insufficient after the money markets have reacted negatively.

Dallas Fed President Lorie Logan recently made that clear. Per a speech she gave on March 1, 2024:

The challenge today is knowing how far to go in normalizing the balance sheet. In 2019, the FOMC decided that it would operate in the long run with a version of the floor system where reserves are “ample.” The word “ample” suggests comfortably but efficiently meeting banks’ demand. As I’ve argued elsewhere, the Friedman rule provides a guide to the efficient supply of reserves in the ample-reserves regime. Banks’ opportunity cost of holding reserves should be approximately equal to the central bank’s cost of supplying reserves.

Further, she notes:

So, I don’t think we can identify the ample level in advance. We’ll need to feel our way to it by observing money market spreads and volatility.

Summary

Excessive amounts of debt support our economy and asset valuations. Therefore, the Fed has no choice but to keep the liquidity pumps flowing to support the leverage.

As in 2019, the Fed will likely take stimulative policy actions to provide liquidity despite an economic and inflation environment where policy should remain tight. 

Keep a close eye on the excess liquidity gauge RRP and be aware of irregular activity in the money markets.

Valuation Metrics And Volatility Suggest Investor Caution

Valuation metrics have little to do with what the market will do over the next few days or months. However, they are essential to future outcomes and shouldn’t be dismissed during the surge in bullish sentiment. Just recently, Bank of America noted that the market is expensive based on 20 of the 25 valuation metrics they track. As BofA’s Chief Equity Strategist stated:

“The S&P 500 is egregiously expensive vs. history. It’s hard to be bullish based on valuation

BofA Valuation Measures

Since 2009, repeated monetary interventions and zero interest rate policies have led many investors to dismiss any measure of “valuation.” Therefore, investors reason the indicator is wrong since there was no immediate correlation.

The problem is that valuation models are not, and were never meant to be, market timing indicators.” The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level, it means that:

  1. The market is about to crash, and;
  2. Investors should be in 100% cash.

Such is incorrect. Valuation metrics are just that – a measure of current valuation. More importantly, when valuation metrics are excessive, it is a better measure of “investor psychology” and the manifestation of the “greater fool theory.” As shown, there is a high correlation between our composite consumer confidence index and trailing 1-year S&P 500 valuations.

Consumer confidence vs valuations

What valuations do provide is a reasonable estimate of long-term investment returns. It is logical that if you overpay for a stream of future cash flows today, your future return will be low.

 I previously quoted Cliff Asness on this issue in particular:

“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.

If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”

We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.

Valuations and forward returns

Asness continues:

“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view, the critics have not provided a good reason this time around — I think you are making a mistake.”

Which brings me to Warren Buffett.

Market Cap To GDP

In our most recent newsletter, I discussed Warren Buffet’s dilemma with his $160 billion cash pile.

The problem with capital investments is that they take time to generate a profitable return that accretes to the business’s bottom line. The same goes for acquisitions. More importantly, concerning acquisitions, they must both be accretive to the company and reasonably priced. Such is Berkshire’s current dilemma.

“There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Some we can value; some we can’t. And, if we can, they have to be attractively priced.”

This was an essential statement. Here is one of the most intelligent investors in history, suggesting that he cannot deploy Berkshire’s massive cash hoard in meaningful size due to an inability to find acquisition targets that are reasonably priced. With a $160 war chest, there are plenty of companies that Berkshire could either acquire outright, use a stock/cash offering, or acquire a controlling stake in. However, given the rampant increase in stock prices and valuations over the last decade, they are not reasonably priced.

One of Warren Buffett’s favorite valuation measures is the market capitalization to GDP ratio. I have modified it slightly to use inflation-adjusted numbers. The simplicity of this measure is that stocks should not trade above the value of the economy. This is because economic activity provides revenues and earnings to businesses.

Market Cap to GDP Ratio

The “Buffett Indicator” confirms Mr. Asness’ point. The chart below uses the S&P 500 market capitalization versus GDP and is calculated on quarterly data.

Market Cap to GDP ratio to S&P 500 market correlation

Not surprisingly, like every other valuation measure, forward return expectations are substantially lower over the next ten years than in the past.

Market Cap To GDP Ratio vs forward 10-year Returns

None of this should be surprising. Logics suggests that overpaying for any asset in the present inherently will generate lower future expected returns versus buying assets at a discount. Or, as Warren Buffett stated:

“Price is what you pay. Value is what you get.”

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F.O.M.O. Trumps Fundamentals

In the “heat of the moment,” fundamentals don’t matter. In a market where momentum drives participants due to the “Fear Of Missing Out (F.O.M.O.),” fundamentals are displaced by emotional biases. Such is the nature of market cycles and one of the primary ingredients necessary to create the proper environment for an eventual reversion.

Notice, I said eventually.

As David Einhorn once stated:

“The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

Furthermore, as James Montier previously stated:

Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance workhorses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.

As BofA noted in its analysis, stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, return expectations for the next ten years are as likely to be close to zero or negative. Such was the case for ten years following the late ’90s.

Investors would do well to remember the words of the then-chairman of the SEC, Arthur Levitt. In a 1998 speech entitled “The Numbers Game,” he stated:

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

Regardless, there is a straightforward truth.

“The stock market is NOT the economy. But the economy is a reflection of the very thing that supports higher asset prices: earnings.”

The economy is slowing down following the pandemic-related spending spree. It is also doubtful the Government can continue spending at the same clip over the next decade as it did in the last.

While current valuations are expensive, it does NOT mean the markets will crash tomorrow, next quarter, or even next year.

However, there is a more than reasonable expectation of disappointment in future market returns.

That is probably something investors need to come to grips with sooner rather than later.

Nvidia Is Aiming For Apple and Microsoft

Mooning“- When the value of an asset skyrockets, exceeding investors’ expectations. The phrase mooning, often used in crypto investor circles, is equally appropriate to describe Nvidia’s recent price action. The Bloomberg graph below shows that Nvidia’s market cap just eclipsed $2 trillion and surpassed Saudi Arabian oil giant Aramco. Consider that a little more than a year ago, Nvidia had a market cap of about $400 billion.

It’s no secret that semiconductor and other technology companies whose predominant focus is on AI have been mooning. Over the last twelve months, Nvidia has increased by 261%. Other AI-focused companies like AMD, AVGO, and KLAC have 100+% gains over the same period. Nvidia’s moonshot still leaves it about $1 trillion behind Apple and Microsoft in market cap, but if it can continue to climb at its recent pace, Nvidia could be the largest company by market cap.

nvidia overtakes Aramco's market value

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As noted yesterday, the overall market continues within its bullish trend that started in November. While the market remains confined to that narrow rising trend channel, the MACD “buy signal” remains elevated, and a clear deterioration in the market’s momentum remains. As noted on Twitter/X yesterday, the market has been positive for 16 of the last 18 weeks. That is the longest such stretch of consecutive gains since 1970.

Weekly Performance of Market

However, as we noted previously, the breakout of the “cup and handle” formation gave the market the lift it needed as investors piled into equities. That breakout suggests that the markets could rally into the 5200s before the breakout levels are retested.

Cup and Handle Formation

As we have discussed, there is nothing “bearish” about the current market dynamics in the near term. Yes, valuations and deviations from long-term means are certainly noteworthy, but those are dynamics that will come into play over the next several months. The chase for “Meme” stocks, cryptocurrency plays, and A.I. investments is reminiscent of the 2021 speculation-driven markets.

While “this too shall pass,” it may take longer than logic would predict. Continue to remain long-biased equities for now, but don’t forget to continue managing risk accordingly.

Survey Fatigue Can Mar Important Economic Data

With the JOLTs and the BLS employment report due out later this week, it’s worth considering their findings are based on surveys, not actual data like ADP or jobless claims. Survey data can be skewed in many ways. For example, in a recent Commentary, we shared a graph showing the significant differences in consumer sentiment based on political party affiliation in the University of Michigan Consumer Confidence Survey.

In addition to survey flaws from personal biases, another risk is the number and breadth of those surveyed. Are the surveyors getting a representative cross-section of the economy and population? Furthermore, are they surveying enough people and or companies to make the data statistically relevant? The graph below shows the number of those surveyed, and therefore, the breadth of those surveyed for essential employment and personal spending data may be less than robust. Furthermore, the trend toward lower response rates is worsening. Unfortunately, these trends result in less reliable data.

survey response rates employment data

SMCI And The Russell Small Cap Index (IWM)

Last Friday, after the market closed, S&P Global announced they were adding Super Micro Computer Inc (SMCI) to the S&P 500. SMCI is a big beneficiary of the AI boom as it manufactures AI-supportive servers. Like Nvidia, SMCI is mooning! Not only did the inclusion of SMCI to the S&P 500 benefit the share price by about 15%, but it is already up over 200% year to date. However, as part of the addition to the S&P 500, it is being removed from the small-cap Russell 2000 (IWM). Mott Capital estimates that SMCI has contributed about 16 points or roughly 8% to the index this year. The index is up approximately 8%, meaning that SMCI is responsible for 100% of the index’s gains this year. Further, due to its meteoric rise over the last few months, SMCI now contributes about 1.5% to the index, which is 3x the second-largest contributor.

So, how will SMCI affect the S&P 500 and IWM going forward? When SMCI is removed from IWM, there will be no immediate effect other than slight changes to the contributions of the remaining stocks. However, the volatility, up and down, which SMCI has been contributing to the index will go away. If AI stocks continue to lead the market higher, IWM will not participate as much as it was. Regarding the S&P 500, SMCI’s volatility will be muted as its contribution will only be about .15%. It will be approximately the 165th-ranked company by market cap. This will align it with companies like 3M, Ross Stores, and Ford.

super micro computer SMCI

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Junk Bonds And Bitcoin Scream Wild Exuberance

It’s not just a handful of AI-related stocks that signal a speculative investment atmosphere. Many other stocks and markets are exhibiting similar behavior. For instance, Bitcoin and junk-rated corporate bonds show complacency and wild speculation. While both markets are inherently very different, traders and investors of bitcoin and junk bonds tend to behave similarly.

The top graph on the left shows the yield premium for holding a BB-rated corporate junk bond versus a similar maturity risk-free Treasury bond is below 2%. That is the lowest spread since the eve of the financial crisis. Similarly, the spread between junk and investment-grade bonds is also at the tightest levels since the financial crisis. Yield spreads on junk bonds imply that investors believe there is minimal credit risk. Therefore, they likely believe a recession of any consequence is not in the cards. Given the high debt loads of junk-rated companies and the level of interest rates, such complacency seems misplaced.

Bitcoin has been on a tear recently. Since the start of the year, it’s up 42%. Some of the gain is attributable to new spot bitcoin ETFs. However, the recent surge is not new. Since the start of 2023, bitcoin has been up nearly 300%. Since it has no calculable fundamental value, bitcoin tends to attract speculators. Accordingly, it provides an excellent gauge of speculation and exuberance in the financial markets.

junk bond spreads and bitcoin

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable reports are due today.

Market Trading Update

Last week, we discussed the ongoing bull rally following Nvidia’s blowout earnings report. To wit:

“The rally continued this past week, spurred higher by Nvidia’s blowout earnings report Wednesday night. After a brief test of the 20-DMA, the market surged to new all-time highs on Thursday, confirming the ongoing bullish trend. As shown, the 20-DMA continues to act as crucial support for the market.”

That remains the case this past week. While the overall market traded higher into the end of the week, setting new all-time highs, the bullish November trend remains intact. While the market remains confined to that narrow rising trend channel, the MACD “buy signal” remains elevated, and a clear deterioration in the market’s momentum remains.

Market Trading Update

With sentiment very stretched, as shown, the risk of a short-term correction to relieve price extensions remains the most probable outcome.

Sentiment Indicator Goldman Sachs

Furthermore, as noted in our Daily Market Commentary on Thursday:c

“The negative relationship between the VIX and stocks is the norm, but any deviations in the correlation and, therefore, irregular behaviors of some investors can provide market signals.”

The correlation is above +.75 on a monthly chart. The current level is on par with some of the bigger market corrections since the Financial Crisis. While this analysis provides a reason for caution, like any indicator, it is imperfect, and the market could move higher before a correction ensues. Therefore, we must know the risks and navigate the market accordingly.

S&P 500 index market vs VIX with technical indicators.

While I realize this has been a consistent message over the past few weeks, it is tempting to throw caution to the wind and assume that this bull trend will last indefinitely. I assure you that will not be the case. While we maintain our long exposure, the level of discomfort in that positioning continues to grow.

The Week Ahead

Last week’s PCE prices gauge showed an uptick in services prices. Accordingly, Tuesday’s ISM Services survey will be closely followed. In particular, the price component, which remains high. Jobs data will also be followed closely, starting with JOLTs on Wednesday, and followed by ADP on Thursday, and the BLS jobs report on Friday. Current expectations are for an increase of 190k, well below last month’s sizzling 353k gain.

Jerome Powell will testify to Congress on Wednesday and Thursday. We will closely listen for thoughts on how the speculative market environment may affect his policy forecast. Further, might he take this opportunity to discuss plans to reduce QT?

The Bank of England May Exit QE

The Bank of England (BOE) appears to be taking a different approach to its balance sheet than the Fed. Based on recent comments, including the one below, courtesy of Bloomberg, the BOE could entirely rid its balance sheet of bonds.

BOE Deputy Governor Dave Ramsden, who oversees financial markets, said officials may continue running down the QE portfolio, which peaked at £895 billion, even after hitting the “preferred minimum range of reserves.”“The Monetary Policy Committee could unwind the APF fully, if it judged necessary for policy reasons, and the level of the PMRR should not affect this judgment,” Ramsden said.

While the comments make it appear the BOE is exiting the bond-buying business, they are not. Per Ramsden:

“It’s important to normalize our balance sheet when we can to ensure we have sufficient headroom to respond to future shocks,”

It appears the BOE is considering exiting for now but will employ QE when needed. Such a threat, as we see with rate caps by the Bank of Japan, may allow the BOE to manage interest rates without directly intervening in the markets. Words/threats instead of actions may do the job for them. We do not expect the Fed to follow as its $7.5 trillion holdings would overwhelm the stock and bond markets, ultimately forcing them to add significant reserves via QE.

fed assets QT and QE BOE

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Stock Buybacks Provide A Tailwind For Large Stocks

Stock buyback authorization announcements are soaring this year. As shown in the graph on the left, the $207 billion in 2024 stock buyback announcements is already on par with the annual totals for 2020 and 2021 and only 29% behind the record-setting $293 billion last year. Mind you, there are still ten months to go in 2024. Stock buybacks provide a tailwind for the market. Not only does a company that buys back its stock reduce the supply of its shares, but in doing so, it increases its earnings per share. Earnings don’t change, but the denominator, the number of shares, declines.

Our latest article, Apple’s Magic, reviews Apple. In particular, it shows how Apple’s earnings growth does not support its high valuations. Instead, stock buybacks are the culprit behind its high valuations. The graph to the right shows Apple’s EPS as reported and if they had not repurchased shares. Assuming the P/E were to remain at current levels had they not bought back shares, Apple’s share price would be nearly 50% less than it currently is! “Unlike most “growth” companies, a bet on Apple is a bet on their ability to buy back shares.” Indeed, our analysis shows Apple can keep up its buyback magic.

share buybacks apple eps

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As we end the month of February and enter into March, a look at the average return cycle of Presidential election years suggests some near-term weakness is likely. With the market already off to a ferocious start to begin the year, a respite seems likely before the remainder of the seasonality into summer. It is worth noting that in the two months prior to the election, weakness also sets in as markets tend to derisk ahead of the election. With this year’s contest set to be contentious and with a risk of social unrest as well, some derisking will likely be warranted.

Presidential election year returns.

However, another reason we continue to expect some corrective actions soon is the more extreme deviation from the 225-day moving average. While these deviations can last for quite some time, they always eventually revert.

Deviation from 225-DAY moving average

The same is evident with the current deviation from the 1-year moving average as well. These more extreme deviations are unsustainable.

Deviation from 1-year MA.

We have no idea what will trigger such a reversion or how soon it will occur. However, there is no outcome where one doesn’t eventually occur. As such, we continue to suggest rebalancing risk as needed.

Sector Dominance- Is Technology The New Railroads?

The financial media, ourselves included, are making much ado about the prominence of the Magnificent Seven and the Tech Sector. As we share below, such dominance by one sector or small group of stocks is not new. Furthermore, it’s not just a U.S. phenomenon.

The pie charts below show that in 1900, railroad stocks accounted for about two-thirds of the market. It’s funny to consider today, but railroads were the latest technology. Today, the markets are heavily skewed toward technology stocks but much less so than railroad stocks in 1900. The second graph below shows that many other global indexes are more heavily concentrated than the S&P 500. However, it’s worth disclaiming that many of those indexes have far fewer stocks than the S&P 500. For instance, the French CAC 40 has 40 stocks. Therefore, the top ten represent 25% of the index on an equal-weighted basis. Conversely, the top ten of the S&P 500 only represent 2% of the index.

2024 vs 1900 market sector dominance
global market sector dominance

PCE Inflation, Income, And Spending

Monthly PCE prices were up 0.3% in January, in line with expectations, but 0.2% higher than in December. December was revised lower by 0.1%. Core PCE prices rose 0.4% monthly and 2.8% annually. The data, like CPI and PPI, point to prices settling in around 3% inflation. Before assuming inflation is sticky, we would like to see a few more months of inflation data, as seasonal behaviors and adjustments can warp data this time of year.

Personal spending and income data showed a few interesting divergences. For example, personal incomes rose by a hefty 1%, yet spending was only +0.2%. Real spending was slightly negative (-0.1%), the lowest level in six months. Are consumers starting to save more, or are seasonal factors responsible? Dividend income was a large contributor to personal income. The graph below shows another odd divergence. Spending on services rose at its quickest pace in at least four months while goods spending fell sharply. Declining auto sales help explain some of the decline in goods. Housing, utilities, financial services, and insurance boosted service spending. To reiterate, be careful of season effects and adjustments to data.

consumer spending pce goods and services

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Dumb Money Almost Back To Even, Making The Same Mistakes

After over two years, retail investors, also known as the “dumb money,” are almost back to breakeven. A recent chart by Vanda Research shows that the average retail “dumb money” investor portfolio still sports a drawdown despite the markets making new all-time highs.

Retail investors gain loss in portfolios.

Such is unsurprising, given that retail investors often fall victim to the psychological behavior of the “fear of missing out.” The chart below shows the “dumb money index” versus the S&P 500. Once again, retail investors are very long equities relative to the institutional players ascribed to being the “smart money.”

Dumb money index vs market

The difference between “smart” and “dumb money” investors shows that, more often than not, the “dumb money” invests near market tops and sells near market bottoms.

Net Smart Dumb Money vs Market

We can confirm the “smart/dumb money” analysis by looking at the allocations of retail investors in stocks, bonds, and cash. With markets overvalued and hitting all-time highs, it is unsurprising that retail investor equity allocations are at very high historical levels with low holdings of cash and bonds.

AAII Investor Allocations

Of course, it isn’t that retail investors are chasing the markets higher; it is what the “dumb money” is chasing that is most interesting.

Chasing The Russell 2000

Last week, I discussed the relationship between the NFIB data and the Russell 2000 index. As I noted:

“The recent exuberance for small-cap equities is also unsurprising, given the long period of underperformance relative to the S&P 500 market-capitalization-weighted index. The hope of a “catch-up” trade as a “rising tide lifts all boats” is a perennial bet by investors, and as shown, small and mid-cap stocks have indeed rallied with a lag to their large capitalization brethren.”

Small and Midcap Stocks relative to the SP500 market

We see that exuberance in capital inflows into small-capitalization companies following the 2020 stimulus checks, which fueled an entire generation of “meme stock” traders on Reddit and the Robinhood app. The hopes for quick riches from a small-cap stock “going to the moon,” along with a lot of hype on social media apps, has increased the speculative craze.

Retail inflows into markets

At the same time, to leverage their bets, these retail traders have piled into call options. The risk with speculative call options is they are either a “win” or a complete “bust.” Therefore, the speculative risk in trading options is dramatically higher than buying the underlying companies.

Call options

However, retail investors are directly piling money into small-cap stocks, as shown by increasing weekly inflows.

Small cap inflows

Particularly into small-cap growth stocks versus value, with a substantial acceleration starting in November 2023 and increasing in 2024.

Cumulative flows for small cap growth

As noted above, this degree of speculative risk-taking by retail investors has always ended badly. This is why the financial market considers retail investors as “dumb money.”

Of course, this brings us to whether investors are again making the same mistakes.

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A Small Problem May Turn Out To Be Big

Over the past decade, the Fed’s ongoing interventions have led to a massive increase in the leveraging of U.S. corporations. Of course, with repeated financial interventions combined with a zero-interest policy, why would corporations increase the use of cheap debt?

Corporate debt vs GDP

The increased debt load doesn’t provide an inherent risk for large capitalization companies with massive revenues. However, for small-cap companies, it is a very different story. Weaker economic growth continues to increase in the number of “zombie firms.” What is a “zombie” in the financial world? To wit:

“‘Zombies’ are firms whose debt servicing costs are higher than their profits but are kept alive by relentless borrowing. 

Such is a macroeconomic problem because zombie firms are less productive. Their existence lowers investment in and employment at more productive firms. In short, one side effect of central banks keeping rates low for a long time is that it keeps more unproductive firms alive, which ultimately lowers the long-run growth rate of the economy.” – Axios

The chart below from our friends at Kailash Concepts shows the problem facing the “dumb money” crowding in small caps.

Russell 2000 companies with negative earnings.

With nearly 40% of the Russell 2000 index sporting negative earnings, many have issued debt to sustain operations. Unlike many companies in the S&P 500 that refinanced debt at substantially lower rates, many of the Russell 2000 were unable. The risk is that if higher interest rates remain when that “debt wall” matures, such could further impair survivability.

Debt wall for companies

Interestingly, since the beginning of the year, we are seeing borrowers return to the market for refinancing. As shown, there has been a surge in B-minus (junk) rated borrowers, who are already taking on debt at higher rates to refinance old debt. While we are very early in the cycle, the risk to underlying balance sheets is rising.

B-minus debt loan volumes

As we concluded previously:

“There are risks to assuming a solid economic and employment recovery over the next couple of quarters. With consumers running out of savings, the risk of further disappointment in sales expectations will likely continue to weigh on small business owners. This is why we keep a close eye on the NFIB reports.”

At the moment, the “dumb money” is chasing momentum amid a bullish frenzy. Unfortunately, such will likely again prove disappointing when expectations eventually collide with fundamental realities.

Stocks And VIX Flash A Warning

The implied volatility index (VIX) calculates the future volatility that option traders expect. The VIX tends to rise as stocks decline. At such times, investors are often more aggressive in hedging their stocks with options. Conversely, when markets are increasing, the demand for insurance tends to wane. Further, imparting downward pressure on the VIX, some investors short volatility in stable, upward-trending markets to juice their returns. Therefore, as shown in the lower graph within the top graph, the correlation of stocks and the VIX is often near -1.0.

The negative relationship between the VIX and stocks is the norm, but any deviations in the correlation and, therefore, irregular behaviors of some investors can provide market signals. For example, the red dotted lines in the top graph line up with 11 instances where the VIX/SPY correlation approached zero or became slightly positive. The highlighted circles show that each market peak over the last six years was accompanied by a correlation reading near or greater than zero.

Currently, the correlation is nearing +.50, the highest since early 2018. The second graph shows SPY and VIX have been trending higher in unison over the last few months. This analysis provides a reason for caution, but like any indicator, it is imperfect. This warning has been triggered 11 times since 2017, of which two were early, five occurred very close to the peak, and four were false alarms.

SPY stocks and VIX correlation

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Another sloppy day in the market yesterday, ahead of today’s all-important inflation report, keeps the market trapped within its current trading range. Over the last few days, Google has been a big drag on the market following its AI image-generation debacle, which shows you that “Artificial Intelligence” is only as good as the data it is fed. Or, as the old saying goes, “garbage in, garbage out.” United Healthcare was also hit yesterday by a DOJ anti-trust probe, which is interesting they picked on Healthcare heading into an election. However, let’s not worry about Amazon’s impact on the overall economy through its monopolistic positioning.

Regardless, the market continues to hold its positioning for now, but we are beginning to see the cracks of a more significant correction beginning. As noted yesterday, the 20-DMA remains critical support for now. Our suggestion to take profits and rebalance risks should have somewhat shielded portfolios, but if trend support is broken, further actions will be required. Today’s economic reports and Fed speeches will likely move markets. We will update our analysis again in the morning.

market trading update

Greg Valliere’s Thoughts On Another Government Shutdown

At 12:01 am on Saturday, the government will partially shut down if they do not agree on a funding extension. The closure would force many arms of the government to cease operations. Both sides remain optimistic that a deal, or at least a CR extension deal, can be reached to avert a shutdown. Both sides generally agree that the government should spend $1.7 trillion on discretionary items this fiscal year. They are also mostly in agreement on the allocation of said funds. The problem is that politics is getting in the way of a deal. Particularly, funding for border security and Ukraine is causing some politicians to hold out in hopes of a better deal.

Greg Valliere is a fixture in Washington, covering and advising investors and politicians on government affairs for the last thirty years. He is currently the Chief Political Strategist at AGF Investments. Greg publishes his daily insights, sharing thoughts on current political events. Not surprisingly, his recent missives have discussed the possibility of a government shutdown. Greg generously allows us to share a few snippets from his latest commentary.

WE THOUGHT YESTERDAY THAT AN EXTENSION was the most likely option, and sure enough — there were reports last night that House Speaker Mike Johnson is suggesting a CR to extend the first deadline from March 1 to March 8, and for the second deadline to move from March 8 to March 22. Those dates also could slip, of course.

JOHNSON AND HOUSE CONSERVATIVES can read the polls, which show the public overwhelmingly opposes a shutdown. But voters increasingly support a border wall and aid to Ukraine, so the seeds of a compromise are apparent. 

THUS BIDEN AND THE DEMOCRATS still have a chance to prevail on foreign aid, while Johnson and the Republicans may get completion of a wall and asylum reform. All of this will take time; final deals may not come until later in March.

The following cartoon is courtesy of Ed Wexler and the Denver Post.

government shutdown valliere

Rate Hikes?

The Fed has conditioned markets to think they are done hiking interest rates and may lower them later in 2024. While the threat of rate hikes is always out there, the Fed has not used this stick to tame market expectations. Could that be changing? Fed Member Michelle Bowman stated the following recently:

I remain willing to raise the Federal Funds Rate at a future meeting should the incoming data indicate that progress on inflation has stalled or reversed.

While rate hikes are unlikely, it may be possible the Fed is growing concerned that speculative behaviors in the stock market are feeding economic activity and, ultimately, inflation. Remember, in a Washington Post op-ed in 2010, Ben Bernanke said the following:

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.

While we do not want to read too much into Bowman’s comments, it may be an early indication the Fed is trying to cool the stock market. Keep an eye out for further comments on rate hikes or even Greenspan-like comments about “irrational exuberance.”

The table below shows that the market expects the Fed to cut rates 3-4 times this year. While slightly above the Fed’s expectation, it is down from the 7-8 rate cuts expected early this year.

fed fomc rate cut probabilities

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Apples Magic- Are Buybacks Worth Paying Up For?

Apple’s valuations are near their most expensive levels of the last ten years. Now consider that today’s valuation premiums are amidst a much higher risk-free bond yield than during most of the previous ten years.

apple valuations

Apple has a market cap of $2.8 trillion. Assuming its price-to-earnings ratio and margins remain stable, Apple must sell nearly $400 billion of products and services each year to keep its share price stable. To fathom that, consider that every man, woman, and child on planet Earth must spend about $45 on Apple products yearly.

The point of sharing those statistics and the valuation premium is to contextualize whether Apple can grow at the growth rate implied by its investors. Further, if its earnings growth alone doesn’t support a valuation premium to the market’s valuation, can the continued use of stock buybacks support the premium?

Apple’s Track Record

The graph below shows Apple shares have provided its investors with a fantastic 20% annualized growth rate for the last 39 years. That is more than double the 8.7% growth rate for the S&P 500 over the same period.

apple stock price

Its exceptional outperformance versus the market is warranted. Since 1993, Apple’s earnings per share have grown at over 3x the rate of the S&P 500.

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While Apple may have an incredible record of earnings growth and share price appreciation, current investors must avoid the temptation to rest on prior trends. Instead, their focus should be on what may lie ahead.

The following graph shows the running 3-year annualized growth rates for sales, net earnings, and earnings per share. Recent growth rates are much lower than they have been. We truncated the graph to the last ten years to better highlight the more recent trends.

apple sales and earnings trends

Earnings and sales were boosted in 2021 and 2022 by the stimulus-related spending and inflation caused by the massive pandemic-related fiscal stimulus. Many companies, including Apple, saw demand increase and could expand profit margins, as inflation was easy to pass on to customers.

However, Apple’s earnings and sales growth are returning to pre-pandemic levels. To better appreciate what the future may hold, consider the five pre-pandemic years highlighted in blue. During that period, sales grew by 4.2% annually. Net earnings grew by 4.3% and EPS by 10.4%

The Magic of Stock Buybacks

The price of a stock is not meaningful. Apple stock trades for $182 a share. Its market cap is roughly $2.85 trillion. If the company repurchased all but one share, its market cap would be unchanged, but its share price would be $2.85 trillion. 

That simple example highlights how valuable buying back shares can be for investors.

Back to Apple’s recent EPS, net earnings and sales trends. Its EPS grew roughly double that of sales or net earnings. The graph below helps explain how they pulled off such a feat. Once Apple started buying back shares in late 2013, its EPS grew 4-6% more than its actual earnings.

share buybacks and eps less earnings growth apple

The following graph compares Apple’s annual EPS versus its EPS if it had not repurchased shares. The graph starts in 2013 when Apple began to aggressively buy back shares.

apple eps vs eps constant share count
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Why The Premium Versus The Market?

Apple has recently grown its earnings and sales at an approximate 5% growth rate. This is only about 1% higher than the approximate 4% nominal GDP growth from 2017 to 2019. But less than the approximate 9% EPS and sales per share growth of the S&P 500. 

So why are Apple investors willing to pay a premium for subpar growth?

Apple is an incredibly successful and innovative company with a long history of rewarding investors. Investors are willing to pay for the future potential of new products and services with enormous income potential. Such investor goodwill is hard to put a price on.

Passive investment strategies are a second reason. Apple and Microsoft are the two largest stocks by market cap. The increased popularity of passive investment strategies feeds the most extensive market cap stocks disproportionately to smaller companies.

Consider the holdings of XLK, the $52 billion tech sector ETF. Apple and Microsoft make up almost 50% of the ETF. If an investor buys $1,000 of XLK, approximately $500 will go to Apple and Microsoft, and the remaining 62 companies will get the rest.

xlk technology holdings

Finally, and most importantly, are share buybacks. While we can’t quantify what future innovation, goodwill, and passive investment strategies are worth, we can grasp Apple’s ability to continue forward with buybacks.

Future Buyback Funding

The chart below shows Apple has been spending between $60 and $80 billion per year on stock buybacks. Keep that figure in mind as we walk through its sources of cash to continue buying back shares.

apple annual buyback costs

Debt, cash, and earnings are their predominant sources to fund buybacks.

Debt Funded Buybacks

Apple came to market with its first long-term debt offering in 2013, commensurate with its initiation of share buybacks. Apple’s debt peaked eight years later at $109 billion. Using debt to fund share buybacks made sense, with borrowing rates in the very low single digits. However, the calculus has changed, with rates now at 4% and higher.

Cash and Marketable Securities on Apple’s balance sheet are at $61.5 billion, about a year’s worth of buyback potential. While a massive amount of money, it is off its peak of $107 billion.

apple cash and marketable securities

Lastly are earnings. Apple has been earning about $100 billion a year since 2021. Even if they regress to pre-pandemic levels ($50-$60 billion), earnings are enough to continue supporting its buyback program. However, if earnings are employed to buy back shares, it comes at the expense of investments toward innovations and product upgrades. Furthermore, Apple pays about $15 billion yearly in dividends, which also requires funding.

The graph below shows that from 2018 to 2020, Apple spent more on buybacks than it made. It was relying on debt and cash to make up the difference.

buybacks as a percentage of earnings

Over the last two years, buybacks only account for 60% of earnings, allowing cash to grow for future buybacks and investments. Hence, if $100 billion a year in earnings is sustainable, even without growth, $60 to $80 billion a year in buybacks is entirely possible. If earnings retreat to their pre-pandemic level, debt and cash will be required. If interest rates stay at their current levels, debt may not be financially sensible.

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Summary

Unlike most “growth” companies, a bet on Apple is a bet on their ability to buy back shares. It appears that Apple can continue to buy back its shares with earnings and cash. Such would maintain their higher-than-market EPS growth with or without above-market earnings growth.

Other than negative earnings growth and high-interest rates, a buyback tax on corporations, as is being proposed, could also reduce or eliminate their buyback program. If such a bill were to pass or Apple cuts back on buybacks for another reason, its premium valuation may wither away.

Shale Oil- Should Investors Fear The Red Queen Effect?

In a recent article, geologist Ted Cross of Novilabs eases investor concerns about the rapid depletion rate of shale oil wells. He claims investor fears are comparable to The “Red Queen Effect,” a concept from Alice in Wonderland: “It takes all the running you can do to keep in the same place.” Investors worry that new shale oil production will decline so quickly that new wells can’t offset the declining production of existing wells. Therefore, total production increases are evermore challenging to achieve. Ted acknowledges the sharp decline in new shale oil wells but notes:

Yes, shale wells decline rapidly early in life, but those declines moderate as they age, settling in somewhere between 5% and 10% per year. As the collective population of shale wells gets older and older, the “base decline” gets lower and lower.

The graph below shows total oil production keeps rising with less production, as a percentage, attributed to new shale oil wells. In 2014, shale oil production hit about four million barrels per day, with almost two-thirds coming from new wells. Ten years later, total production is more than double that rate. However, only 43% is from the output of new wells. He also adds that the rate of decline of older shale oil wells moderates even further. To wit: “The Bakken was able to post impressive growth in 2023 in part because wells in the play from 2022 and prior only declined 33% in aggregate.” The bottom line is that shale oil production declines much quicker than traditional wells, but the rate of decline is less than investors fear.

shale oil well total production and depletion by year drilled

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

The Russell 2000 jumped in yesterday’s trading again, revving up the speculative crowd. As noted on Tuesday, retail investors have been chasing small-cap stocks for a potential “catch-up” trade with the rest of the market. As shown below, the Russell 2000 still trades well below its all-time highs and is lagging the performance of the large-cap index by a significant margin. As shown, the Russell 2000 is now at a critical juncture, a break out of the downtrend could set the index up for a push higher. However, this has also been the point of previous failures over the last year.

Market Trading Update

In yesterday’s commentary, we suggested remaining a bit more cautious as the current speculative push is getting rather long in terms of duration. The S&P 500 index has been positive in 13 of the last 15 weeks, the longest stretch of gains since 1989. While retail investors are turning their attention to the more speculative names in the market, it is worth noting that hedge funds and institutions have started selling positions. As we will discuss on Friday, it is worth noting that “dumb money” is currently very allocated to risk assets. Such is usually a point where forward returns weaken significantly.

Personal Interest Rates Are Rising Rapidly

The graph below shows total personal interest payments as a percentage of total income. In the post-financial crisis era, the effective personal interest rate ranged between 1.50% and 2.00%. It is now following bond yields higher and approaching 2.50%. The rate itself is now higher than most consumers are accustomed to. However, more importantly, note that prior peaks preceded recessions. Given that personal consumption accounts for about two-thirds of GDP, the ability to borrow and borrowing terms are essential to the economy. The graph also explains the lag effect. It has taken two years since the Fed started raising rates for the effective personal rates to near prior peaks.

effective personal interest rate

More On Buffett And Market Excuberrance

Lance Roberts’s latest article, This Is Nuts- An Entire Market Chasing One Stock, discusses the poor breadth of the market and the leadership role that Nvidia plays. Per the article:

In momentum-driven markets, exuberance and greed can take speculative actions to increasingly further extremes. As markets continue to ratchet new all-time highs, the media drives additional hype by producing commentary like the following.

He supports his statement with the following graph. It shows that markets are “exceedingly overbought.” He continues:

The composite index below comprises nine indicators measured using weekly data. That index is now at levels that have denoted short-term market peaks.

technically overbought oversold readings sentiment buffett

Along the same lines, yesterday’s Commentary informed us that Warren Buffett’s Berkshire Hathaway portfolio is sitting on record amounts of cash. He does not see value and is not willing to chase the market. Today, we share another bit of advice from his speech last weekend.

“One fact of financial life should never be forgotten. Wall Street – to use the term in its figurative sense – would like its customers to make money, but what truly causes its denizens’ juices to flow is feverish activity. At such times, whatever foolishness can be marketed will be vigorously marketed – not by everyone but always by someone.”


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The Conference Board Says Smooth Sailing Ahead, But….

As we noted in our current Weekly Newsletter, Conference Board Scraps Its Recession Call, the Conference Board, publisher of the well-followed leading economic indicators (LEI), has rescinded its recession prediction. As we wrote: “According to the Conference Board, the reason for the retraction of the recession call was the improvement in underlying indicators.” While it’s tempting to think we are out of the woods on the economic front, the graph below, courtesy of @gubbmintcheese, warns of a significant divergence between LEI and the S&P 500.

The obvious takeaway from the graph is that the Conference Board’s LEI and S&P 500 are historically well correlated. Such makes a lot of sense. Corporate earnings tend to grow when the economy is doing well; thus, their stock prices rise. While the correlation is strong, there are periods where the S&P 500 leads LEI, such as 2020, 2013, and 2017. There are other times when LEI led the S&P 500, such as the lead-up to the 2008 financial crisis. Who’s leading who is a very important question today. As the graph shows, the divergence between the LEI and the S&P 500 is among the largest since 1995. Is LEI set to turn significantly positive, as the Conference Board must believe, or will the market catch down to LEI?

lei and S&p500

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

The market remains confined to a very defined trading range. With support at the 20-DMA and a clear channel that began in November. The market failed at the top of that range yesterday, and with a slew of economic data out this week, a retest of the 20-DMA is possible. The negative divergence of the MACD and RSI indicators suggests risk to the current market trend. The good news is that we are seeing some rotation in the market from the previous leaders to other sectors of the market on a relative basis. That rotation could sustain this rally a while longer. However, the rally that began in November is getting very long in terms of duration. As noted yesterday, we suspect the next big move for the market will be lower, therefore, continue to manage risk according

Market Trading Update

Warren Buffett Is Accumulating Cash

This past weekend at the Berkshire Hathaway annual meeting, Warren Buffett offered concern about high valuations in the equity markets. Consequently, as the Bloomberg graph below shows, Berkshire’s cash balance is at a new record high of $167 billion. As Warren Buffet shares in the quote below, he cannot find stocks that are both attractive and large enough for their portfolio.

“There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Outside the US, there are essentially no candidates that are meaningful options for capital deployment at Berkshire. All in all, we have no possibility of eye-popping performance,”– Warren Buffett.

buffett berkshire cash

Jim Coquitt’s Bullish And Bearish Bond Takes

Jim Colquitt of Skillman Grove Research recently published a technical outlook for Treasury bond yields to his Substack subscribers. He leads with the following long-term graph, highlighting critical technical levels. As he shows, the recent high yield of 5% matches two prior highs in 2006 and 2007, as well as a period of consolidation in 2001 and 2002.

technical bond yields

His bullish takeaway is as follows:

The Bull Case (i.e., UST 10-year yields decline) would suggest that the 5.021% we saw in October 2023 is probably the current cycle top. If so, we could be in the process of forming a Head & Shoulders topping pattern.

If we are forming a Head & Shoulders pattern, it is possible that we could see the UST 10-year trade down to the neckline (3.25%), then move higher to form the right shoulder before breaking down and through the neckline towards the target of 1.479%.

I find it fascinating how perfectly the target value matches up with other historical turning/pivot points (see green circles) thus giving further validity to the target we have computed.

The “bullish” case (i.e., one where we reach the target of 1.479%) for the UST 10-year, likely happens as a result of a recessionary environment for the US economy and US equities.

ten year bond yields colquitt

Jim warns, however, that if the left shoulder is broken, “I would suggest that if we clear the high side of the left shoulder (4.335%) and sustain it, you probably want to have your antenna up for a further move higher in yields.” A break above the head argues for higher yields, in his opinion. Per Jim-

“If we break above 5.021%, the following levels are possibilities: 5.522%, 6.06%, 6.79%, and 8.033%.”

Jim favors the bullish case, but his technical road map is worth appreciating as no one can be assured of what the future holds. You can follow Jim’s work at Skilman Grove Research on Substack.

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This Is Nuts – An Entire Market Chasing One Stock

“When you sit down with your portfolio management team, and the first comment made is ‘this is nuts,’ it’s probably time to think about your overall portfolio risk. On Friday, that was how the investment committee both started and ended – ‘this is nuts.’” – January 11th, 2020.

I revisited that original post a couple of weeks ago as the market approached its 5000 psychological milestone. Since then, the entire market has surged higher following last week’s earnings report from Nvidia (NVDA). The reason I say “this is nuts” is the assumption that all companies were going to grow earnings and revenue at Nvidia’s rate.

Even one of the “always bullish” media outlets took notice, which is notable.

“In a normal functioning market, Nvidia doing amazingly is bad news for competitors such as AMD and Intel. Nvidia is selling more of its chips, meaning fewer sales opportunities for rivals. Shouldn’t their stocks drop? Just because Meta owns and uses some new Nvidia chips, how is that going to positively impact its earnings and cash flow over the next four quarters? Will it at all?

‌The point is that investors are acting irrationally as Nvidia serves up eye-popping financial figures and the hype machine descends on social media. It makes sense until it doesn’t, and that is classic bubble action.” – Yahoo Finance

As Brian Sozzi notes in his article, we may be at the “this is nuts” stage of market exuberance. Such usually coincides with Wall Street analysts stretching to “justify” why paying premiums for companies is “worth it.”

Earnings Growth Justification

We Can’t All Be Winners

Of course, that is the quintessential underpinning for a market that has reached the “this is nuts” stage. There is little doubt about Nvidia’s earnings and revenue growth rates. However, to maintain that growth pace indefinitely, particularly at 32x price-to-sales, means others like AMD and Intel must lose market share.

Nvidia Price To Sales

However, as shown, numerous companies in the S&P 1500 alone are trading well above 10x price-to-sales. (If you don’t understand why 10x price-to-sales is essential, read this.) Many companies having nothing to do with Nvidia or artificial intelligence, like Wingstop, trade at almost 22x price-to-sales.

Stocks trading above 10x to sales

Again, if you don’t understand why “this is nuts,” read the linked article above.

However, in the short term, this doesn’t mean the market can’t keep increasing those premiums even further. As Brian concluded in his article:

“Nothing says ‘investing bubble’ like unbridled confidence. It’s that feeling that whatever stock you buy — at whatever price and at whatever time — will only go up forever. This makes you feel like an investing genius and inclined to take on more risk.”

Looking at some current internals tells us that Brian may be correct.

This Is Nuts” Type Of Exuberance

In momentum-driven markets, exuberance and greed can take speculative actions to increasingly further extremes. As markets continue to ratchet new all-time highs, the media drives additional hype by producing commentary like the following.

“Going back to 1954, markets are always higher one year later – the only exception was 2007.”

That is a correct statement. When markets hit all-time highs, they are usually higher 12 months later due to the underlying momentum of the market. But therein lies the rub: what happened next? The table below from Warren Pies tells the tale.

New Highs and bear Markets

As shown, markets were higher 12 months after new highs were made. However, a lot of money was lost during the next bear market or correction. Except for only four periods, those bear markets occurred within the next 24 to 48 months. Most gains from the previous highs were lost in the subsequent downturn.

Unsurprisingly, investing in the market is not a “risk-free” adventure. While there are many opportunities to make money, there is also a history of wealth devastation. Therefore, understanding the environment you are investing in can help avoid potential capital destruction.

From a technical perspective, markets are exceedingly overbought as investors have rushed back into equities following the correction in 2022. The composite index below comprises nine indicators measured using weekly data. That index is now at levels that have denoted short-term market peaks.

Technical Gauge

Unsurprisingly, speculative money is chasing the Mega-cap growth and technology stocks. The volume of call options on those stocks is at levels that have previously preceded more significant corrections.

Stocks net call volume on Mega Cap Growth and Technology stocks.

Another way to view the current momentum-driven advance in the market is by measuring the divergence between short and long-term moving averages. Given that moving averages smooth price changes over given periods, the divergences should not deviate significantly from each other over more extended periods. However, as shown below, that changed dramatically following the stimulus-fueled surge in the markets post-pandemic. Currently, the deviation between the weekly moving averages is at levels only previously seen when the Government sent checks to households, overnight lending rates were zero, and the Fed bought $120 billion monthly in bonds. Yet, none of that is happening currently.

Weekly composite index measures.

Unsurprisingly, with the surge in market prices, investor confidence has surged along with their allocation to equities. The most recent Schwab Survey of bullish sentiment suggests the same.

More than half of traders have a bullish outlook for the first quarter – the highest level of bullishness since 2021

Yes, quite simply, “This is nuts.”

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Market Measures Advise Caution

In the short term, over the next 12 months, the market will indeed likely finish the year higher than where it started. That is what the majority of analysis tells us. However, that doesn’t mean that stocks can’t, and won’t, suffer a rather significant correction along the way. The chart below shows retail and professional traders’ 13-week average of net bullish sentiment. You will notice that high sentiment readings often precede market corrections while eventually rising to higher levels.

For example, the last time bullish sentiment was this extreme was in late 2021. Even though the market eventually rallied to all-time highs, it was 2-years before investors got back to even.

13-week net bullish sentiment vs the market

Furthermore, the compression of volatility remains a critical near-term concern. While low levels of volatility have become increasingly common since the financial crisis due to the suppression of interest rates and a flood of liquidity, the lack of volatility provides the “fuel” for a market correction.

VIX versus the market

Combining excessive bullish sentiment and low volatility into a single indicator shows that previous levels were warnings to more bullish investors. Interestingly, Fed rate cuts cause excess sentiment to unwind. This is because rate cuts have historically coincided with financial events and recessions.

Net bullish sentiment and vix composite versus the Fed.

While none of this should be surprising, given the current market momentum and bullish psychology, the over-confidence of investors in their decision-making has always had less than desirable outcomes.

No. The markets likely will not crash tomorrow or in the next few months. However, sentiment has reached the “this is nuts” stage. For us, as portfolio managers, such has always been an excellent time to start laying the groundwork to protect our gains.

Lean on your investing experience and all its wrinkles.” – Brian Sozzi

CEOs Are Exiting – Should You Follow The Smart Money?

JP Morgan CEO Jamie Dimon sold $150 million of his JPM shares, marking the first time he has sold JPM shares. Jeff Bezos has sold 50 million shares of Amazon since the beginning of the month. Furthermore, Mark Zuckerberg, CEO of Meta, has sold $1 billion worth of stock this year. Because these vast sales are from the CEOs of a few of the largest companies, it may be tempting to follow alongside them. Before pushing the sell button, there are other factors worth considering. For instance, CEOs and other insiders have limited windows in which they are allowed to sell stock. Therefore, the cluster of CEO sales in recent weeks may have more to do with said windows. Further, insiders may sell for various reasons, many of which do not include the expected stock or corporate performance. CEOs and other insiders are not allowed to trade on inside information.

The research is mixed on whether insider sales portend weak stock performance in the future. A study by Dallin Alldredge and D. Brian Blank looked at over 2.5 million insider trades from 1987 to 2019. It turns out the trades of those highest in the corporate pecking order, like the CEO, tend to be most predictive. Insider sales occur for many reasons but keep in mind that CEOs know a lot more about their company than investors. Further, Jamie Dimon has tremendous insight into the economy and the Federal Reserve. Might his $150 million sale be a warning, or is he simply taking a few chips off the table, given JPM’s recent performance?

jp morgan stock

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

The rally continued this past week, spurred higher by Nvidia’s blowout earnings report Wednesday night. After a brief test of the 20-DMA, the market surged to new all-time highs on Thursday, confirming the ongoing bullish trend. As shown, the 20-DMA continues to act as key support for the market for now.

Market Trading Update

The negative divergence in both momentum and breadth (chart below) continues to be of concern, suggesting a short-term correction is likely. With the bulk of earnings season behind us, the focus will return to the Fed and the economy.

Market Breadth

Given the more speculative action taking place in the options market, it is clear that bullish sentiment continues to remain elevated. Historically, the combination of negative divergences and bullish sentiment previously led to short-term corrections. As noted last week, we continue to suggest remaining somewhat diligent on risk management protocols.

“The 20-DMA is now the defacto “Maginot Line” for the markets. A failure at that level will likely lead to a deeper selloff. Continue to manage risk accordingly.”

We don’t know what will eventually lead to a market correction, but one will eventually occur to reverse the more extreme deviation from the 200-DMA. With the market becoming more aligned with the Federal Reserve’s expectations for rate cuts, the current outlying risk for equities is an economic slowdown that impacts earnings.

The Week Ahead

This week, the PCE prices index will be the most watched economic data point. The Fed and bond investors will look to see if PCE follows CPI and PPI higher and exceeds estimates. The estimate for headline PCE is +0.3% and +0.4% for core PCE. That compares to +0.2% for both figures last month. Additionally, regional Fed manufacturing surveys and the ISM manufacturing survey will better inform us of the state of manufacturing. Manufacturing has been in contractionary territory for over a year, but there are indications it may be improving. The prices paid and received components of these measures will also be important.

Per usual, there will be a host of Fed speakers. It has become clear most Fed members do not feel rushed to cut rates. However, with the FOMC minutes from last week alluding to reducing the amount of QT, we will look for comments on when such a reduction could start and how much it may entail.

Bad Market Breadth Can Be Dangerous To Your Wealth

Over the past year, we have written plenty on the bad market breadth. Simply, a few stocks are grossly outperforming the vast majority of stocks. The first two graphs below show the massive difference in the returns by sector and market cap. We must ask the following questions: Is the divergence extreme, and if so, what has happened in similar instances in the past?

We present the third graph below to contextualize the recent poor market breadth and assess what may happen going forward. The orange line shows the price ratio of SPY and the equal-weighted S&P 500 ETF, RSP. As shown, the ratio is approaching the prior peaks of 2008 and 2020. After each peak, RSP grossly outperformed SPY. The blue line is the standard deviation (sigma) of the ratio versus its 200-day moving average. The ratio’s sigma just topped near the two prior peaks. In 2008, the sigma and ratio peaks were aligned. In 2020, the ratio lagged the rapidly declining sigma by a few months.

Assuming the past is prescient, the recent peak should serve as a warning that the dominance of the Magnificent Seven and a few other stocks may be in its last innings. This doesn’t necessarily mean the major stock indexes will fall, but it may signal a change in market leadership.

breadth performance by sector
breadth performance by marketcap
spy rsp ratio and breadth

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Small Cap Stocks May Be At Risk According To NFIB Data

Recently, retail investors have started chasing small-cap stocks in hopes of both a rate-cutting cycle by the Federal Reserve and avoiding a recession. Such would seem logical given that, historically, small capitalization companies tend to perform best during the early stages of an economic recovery.

Market and Economic Cycles

The recent exuberance for small-cap equities is also unsurprising, given the long period of underperformance relative to the S&P 500 market-capitalization-weighted index. The hope of a “catch-up” trade as a “rising tide lifts all boats” is a perennial bet by investors, and as shown, small and mid-cap stocks have indeed rallied with a lag to their large capitalization brethren.

Small and Midcap Stocks relative to the SP500 market

However, some issues also plague smaller capitalization companies that remain. The first, as noted by Goldman Sachs, remains a fundamental one.

“I’m surprised how easy it is to find someone who wants to call the top in tech and slide those chips into small cap. Aside from the prosect of short-term pain trades, I don’t get the fundamental argument for sustained outperformance of an index where 1-in-3 companies will be unprofitable this year.”

As shown in the chart by Apollo below, in the 1990s, 15% of companies in the Russell 2000 had negative 12-month trailing EPS. Today, that share is 40%.

Companies with negative earnings.

Besides the obvious that retail investors are chasing a rising slate of unprofitable companies that are also heavily leveraged and dependent on debt issuance to stay afloat (a.k.a. Zombies), these companies are susceptible to actual changes in the underlying economy.

Rising shared of companies with debt servicing costs higher than profits.

So, is there a case to be made for small and mid-capitalization companies in the current environment? We can turn to the National Federation of Independent Business (NFIB) for that analysis.

The NFIB Report Tells A Very Different Story

The primary economic data points continue to be very robust. Low unemployment, strong economic growth, and declining rates of inflation. As I have heard recently by more mainstream analysts, “What’s not to love?”

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

Small Business Breakdown

Simply, small businesses drive the economy, employment, and wages. Therefore, what the NFIB says is highly relevant to what is happening in the actual economy versus the headline economic data from Government sources.

For example, despite Government data that suggests that the economy is strong and unlikely to enter a recession this year, the NFIB small business confidence survey declined in its latest reading. It remained at levels that have historically been associated with recessionary economies.

NFIB Small Business Confidence

Unsurprisingly, selling a product, good, or service drives business optimism and confidence. If consumer demand is high, the business owners are more confident about the future. However, despite headlines of a strong consumer, both actual and expected sales by small businesses remain weak.

NFIB Sales Expectations vs Actual retail sales.

Furthermore, if the economy and the underlying demand were as strong as recent headlines suggest, the business would be ramping up capital expenditures to meet that demand. However, such is not the case regarding capital expenditures and actual versus planned employment.

NFIB Capex Plans vs Real Private Investment
NFIB Employment plans vs actual

There is an essential disconnect between reported economic data and what is happening within the economy. Of course, this brings us to whether investors are making a mistake by betting on small capitalization stocks.

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The Potential Risk In Small Caps

In the short term, some momentum behind small-cap stocks bolsters the arguments for bets on those companies. However, over a longer time frame, earnings and fundamentals will matter.

As noted above, many companies in the Russell 2000 have little profitability and large debt loads. Unlike many companies in the S&P 500 that refinanced debt at substantially lower rates, many of the Russell 2000 were unable. If interest rates are still elevated when that “debt wall” matures, refinancing debt at higher rates could further impair profitability.

Debt wall for companies

Furthermore, the deep decline in sales expectations may undermine earnings growth estimates for these companies later in the year.

Sales Expectations vs Earnings

Of course, there are arguments for investing in small-cap stocks currently.

  • The economy could return to much more robust rates of growth.
  • Consumer demand could increase, leading to stronger sales and employment outlooks for companies.
  • The Federal Reserve could cut interest rates sharply ahead of the debt-refinancing in 2024.
  • Inflation could drop sharply, boosting profitability for smaller capitalization companies.
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Confidence Matters

Yes, any of those things are possible. If they emerge, such should quickly reflect in the confidence of businesses surveyed by the NFIB. As shown, there is a high correlation between the annual rate of change of NFIB small business confidence and the Russell 2000 index.

NFIB Confidence vs Small Caps

The apparent problem with the wish list for small-cap investors is that more substantial economic growth and consumer demand will push inflationary pressures higher. Such would either keep the Federal Reserve on hold from cutting rates or lead to further increases, neither of which are beneficial for small-cap companies. Lastly, the surge in economic growth over the last two years resulted from a massive increase in Government spending. It is unlikely that the pace of the expenditures can continue, and as monetary supply reverses, economic growth will continue to slow.

M2 as percent of GDP growth

Given this backdrop, assuming current accelerated earnings growth estimates for stocks in the future is a bit unreasonable. On a 2-year forward-looking basis, current valuations for the Russell 2000 are higher than the S&P 500 index, where the top 10 largest companies dominate earnings growth.

Current PE based on 2-year forward estimates

Conclusion

Since debt-driven government spending programs have a dismal history of providing the promised economic growth, disappointment over the next year is almost guaranteed.

However, suppose additional amounts of short-term stimulus deliver higher rates of inflation and higher interest rates. In that case, the Federal Reserve may become contained in its ability to continue to provide an “insurance policy” to investors.

There are risks to assuming a solid economic and employment recovery over the next couple of quarters. With consumers running out of savings, the risk of further disappointment in sales expectations will likely continue to weigh on small business owners. This is why we keep a close eye on the NFIB reports.

However, in the short term, there is nothing wrong with being optimistic, and small-cap stocks benefit from the ongoing speculative frenzy in the market. The optimism can last longer with the Federal Reserve set to cut rates and further ease monetary accommodation.

However, regarding your investment portfolio, keeping a realistic perspective on the data will be essential to navigating the risks to come. For small-cap investors, the time to take profits and move to “safer pastures” is likely closer than you think.

The Nikkei Finally Tops 34 Year Old Peak

Japan is in a recession, its population is shrinking, and its debt to GDP is over 250%. However, despite their economic and demographic woes, Japan’s main stock index, the Nikkei 225, just hit a new all-time high. There is much more to the story than the Nikkei stock market diverging from fundamentals. The Nikkei is not just breaking any record; it finally surpassed the prior peak set in December 1989. Over the last 34 years, the Nikkei, excluding dividends, has provided investors a 0% return. The S&P 500 has grown by 1,346% over the same period.

After rebuilding the country from the devastation of World War 2, Japan embarked on an unprecedented economic boom. It quickly became one of the world’s leading economic powerhouses. In 1970, Japan’s GDP was $217 billion. By 1990, it rose to $3.19 trillion, an astonishing 14.4% annual growth rate. Along with an expanding economy was a speculative bubble in real estate and stocks. The bubble popped in late 1989 as stock and real estate prices tumbled. Its GDP peaked in 1995 and to this day remains below that level. It turns out the “Japanese miracle” was a function of massive speculation and unruly leverage.

Their huge economic growth rate came to a halt in the early 1990s, marking the beginning of what is termed “Japan’s Lost Decades.”

nikkei and S&P 500 since 1979

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

With Nvidia’s stellar earnings report Wednesday night, the market surged higher yesterday, reaching an all-time high. As discussed yesterday, the 20-DMA continues to support the bullish trend that began in November. Our only concern continues to be the negative divergence in both momentum and breadth of the market.

Market Breadth

That lack of breadth continues to be evident. As shown, yesterday’s surge was almost entirely a function of the Mega-capitalization stocks and anything remotely related to artificial intelligence.

Heat Map 022224

Nonetheless, the bullish trend remains firmly intact, and the breakout above the recent consolidation range sets the market in place for additional gains. However, I would suspect that with such an outsized gain yesterday, we could see a little profit-taking emerge soon. The 20-DMA is now the defacto “Maginot Line” for the markets. A failure at that level will likely lead to a deeper selloff. Continue to manage risk accordingly.

Market Trading Update

Nvidia Saves The Markets

Much hype and fear surrounded Nvidia’s (NVDA) earnings announcement on Wednesday night. Some proffered that if NVDA failed to meet expectations, its shares would fall significantly and drag the market lower. Given its role in the Magnificent Seven, such turmoil could lead to a new market regime, or so some thought. Today’s Tweet of the Day shows a popular meme all over social media before their earnings. On the flip side, there was speculation the stock could soar.

NVDA again blew the doors off earnings, and its shares are up about 15%. It also provided better-than-expected guidance on future earnings. NVDA reported its earnings grew by 486% over the year on a 265% increase in sales. Its data center is its crucial driver of growth, accounting for $18.4 billion of revenue, more than 5x the amount a year ago. To put the importance of its data center chips into context, its total revenue is $22.1 billion. Lastly, the company points to solid growth ahead as it cannot satiate demand for its chips. Per its CEO Jensen Huang:

“Fundamentally the conditions are excellent for continued growth — calendar 2024 to calendar 2025 and beyond,” Huang said. “We expect that demand will continue to be stronger than our supply provides.”

nvidia stock price

What Is A Treasury Auction Tail?

The following headline scrolled across our screens this week:

Another spicy Treasury auction, this time in the 20Yr: – Tail was 3.3bps, *largest on record* for the 20Yr

Given the recent importance of Treasury auction results, we should explain what an auction tail is. The U.S. Treasury uses a Dutch Auction format to distribute its bonds. Potential buyers submit their bids with information on the desired yields and the associated amount they would buy. The Treasury orders all bids from lowest to highest and fills the orders starting with the lowest yield. Once they meet the auction size, the yield of the last bidder is then applied to all winning bids.

A tail happens when the auction yield is above the yield where the bond was trading when the auction occurred. For instance, if the market yield on a ten-year note was 4.25% when the action ended, and the calculated auction yield was 4.27%, the tail was 0.2%. The larger the tail, the “worse” the auction. Conversely, auctions can come in below the market yield. The correct terminology is “through.” For example, “the ten-year note auction traded .01% through the market yield.”

Yes, the 20-year auction was terrible, but it’s a stretch to say there is no demand for Treasury debt based on one auction. In fact, last week’s 3, 10, and 30-year bonds all traded through the market yield. The auction stats describe the supply and demand environment at the time of the auction. Many factors affect the auction statistics. However, when fat tails become the norm over extended periods, one can presume demand is weak and or supply is too plentiful.


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The Magnificent Two Leaves Five Stocks In Their Dust

The Magnificent Seven hog the headlines and are the envy of many investors. Yet since the start of 2024, only two Magnificent Seven stocks have been beating the market significantly. The graph below shows the relative performance of each stock versus the S&P 500. As shown, the Magnificent Seven traded in a unified fashion from November 1, 2023, when the market started rallying on hopes for Fed rate cuts. However, with the start of the new year, the Magnificent Seven is splintering, with only two stocks leading the way. NVDA and META are handily beating the market. Amazon is the only other stock outside of the “Magnificent Two” beating the market this year. Apple and TSLA, shall we say the “Un-Magnficent Two,” have significantly lagged the market.

The question on many investors’ minds is whether the Magnificent Seven is a bubble or whether their high valuations properly reflect the potential for higher-than-market earnings growth. To put the question in historical context, we wrote Are The Magnificent Seven In A Bubble? The article compares the mania surrounding the seven stocks to the Nifty Fifty of the late 1960s and early 1970s. Surprisingly, it turns out the high valuations of the Nifty Fifty were justified. However, the risk is not just the combination of high valuations and weaker-than-expected earnings growth but, maybe more importantly, a loss of confidence.

magnificent seven relative performance

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Despite poor guidance from Palo Alto Networks yesterday, which pulled the market lower, it continues to hold onto rising trendline support coinciding with the 20-DMA. As noted yesterday, the selloff this week did trigger a MACD sell signal. As shown, there is a negative divergence between momentum indicators, which are waning, and the rising bullish market.

While such a divergence can last for a while, they usually resolve themselves with lower asset prices and more deeply oversold conditions. With bullish sentiment still very elevated, it is likely that we have more work to do before the current correction/consolidation is complete.

We are watching the 20-DMA very closely, which is our first indication that the recent rally may end. Continue managing risk exposures for now. With Nvidia’s blowout quarter on revenue and earnings last night, the market should get a lift today, defending the bullish trend for now, so no major concerns about a risk-off environment currently.

Market Trading Update

More On The Magnificent Two And Valuations

Our article from the opening (Are The Magnificent Seven in a Bubble?) uses logic by famed investor Jeremy Seigel. 26 years after the Nifty Fifty stocks peaked, he looked back on their high valuations and subsequent earnings growth to determine which stocks were cheap, fairly valued, or expensive at the top of the bubble.

Without the benefit of hindsight, we can’t appreciate how the seven stocks will grow their earnings, but we can calculate the earnings growth that would justify current valuations. Per the article:

For example, as shown in the table below, Amazon (AMZN) has a P/E ratio of 62.30, more than three times the S&P 500 (18.90). Before forming an opinion, consider that AMZN has grown its earnings at three times the rate of the S&P 500 over the last five years. For AMZN to perform in line with the market, assuming its P/E falls to market levels, its earnings must grow annually by 19.54% over the next ten years or 11.08% over the next 26 years.

Whether you are focused on the Magnificent Two or Seven, or for that matter, any stock, the analysis we employ can help investors appreciate whether a stock’s relative valuation versus the market is fair.

implied growth of the magnificent seven using valuations

Is Consumer Confidence About Politics, Not Economics?

The graph below from Jim Bianco is very telling in trying to answer our question. As shown, confidence among Democrats and Republicans shifts with the party of the President. While confidence readings by political party tends to trend in the same direction, they move in opposite directions at the election. Per Jim Bianco:

This is why I call consumer confidence polls “the world’s most useless economic statistic.” Because it is not an economic statistic, it is a political statistic!

We do not necessarily agree with Jim. Many governmental economic statistics are incredibly complex and can not accurately capture the state of the economy or inflation. Similarly, sentiment surveys can be highly biased, as we show. However, the trends of confidence surveys do a reasonable job of telling us whether sentiment is improving or declining. Given the consumer represents about two-thirds of economic activity, changes in confidence should be an important factor in projecting economic growth.

consumer confidence by political alignment bianco

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Corporations Are Hoarding Cash

The Bloomberg graph below provides us with a reason to be optimistic about the earnings and share prices of the largest corporations. As shown, the amount of cash corporations hold is at an all-time high and double the pre-pandemic trend. Large amounts of cash are a good thing for shareholders in today’s high interest-rate environment. In the five years preceding the pandemic, corporate debt securities outstanding rose on average by 3.5% per year. In 2020, corporate debt shot higher by 11% as corporations took advantage of historically low-interest rates to fortify their cash and pre-fund future needs. Consequently, corporate debt issuance has been below average, sparing some corporations the need to borrow at higher interest rates.

Additionally, corporations with excess cash are investing at money market rates that are often higher than their borrowing costs. For shareholders, not only does the situation help the income statement, but the cash allows some companies to buy back their shares and provide an additional tailwind to their stock price. The problem is the actions of a few large companies bias the data. Investor’s Business Daily helps us better appreciate the uneven distribution of corporate cash balances. Per their article, 13 corporations held over $1 trillion of cash or a quarter of the total amount in the S&P 500. For example, in aggregate, Apple, Google, and Microsoft held almost $450 billion of cash as of last September.

Corporations are hoarding cash

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

All eyes are on Nvidia today as they report earnings. While the consensus forecast is $4.20, the forecast for revenue growth over the rest of the year will be critical. The risk of disappointment is elevated, so be ready for some volatility in the market over the next couple of days. NVDA triggered a sell signal yesterday from a very elevated level, which is why we took some profits last week. There is decent support at $600/share, so a correction could be deep and swift to work off the overbought condition.

Trading Update 1

As we noted yesterday, while the overall market remains strong, positioning is becoming very stretched on both a technical and absolute positioning basis. Yesterday’s selloff triggered a short-term sell signal from an elevated level, and the 20-DMA is currently acting as support. A break of that moving average suggests a bigger correction is at play, and we will watch closely for signs of a larger reversal at work. Regardless, the corrective process was needed and should be used as an opportunity to rebalance exposures and move allocations to target levels as needed.

Trading Update 2

Inflation Expectations

The Fed considers inflation expectations as equally important as recent inflation trends. This is a relic from inflation lessons learned in the 1970s. At the time, they failed to appreciate that if consumers thought prices would rise soon, they would buy something today instead of waiting for tomorrow. Therefore, as inflation expectations rose, so did demand. The result was a circular inflation problem.

Minneapolis Fed President Neel Kashkari published a paper last weekend affirming the importance of expectations. The following quote is from his article, Policy Has Tightened A Lot:

“If supply-side factors appear to be contributing meaningfully to disinflation, what role has monetary policy played and how is it affecting the economy now? Monetary policy has played an enormously important role in keeping long-run inflation expectations anchored. It is hard to overstate how important that is for ultimately achieving the soft landing we are all aiming for.”

The New York Fed’s latest inflation expectations survey shows inflation expectations are falling. The first graph shows that expectations for inflation a year from now are closing in on pre-pandemic levels. The three-year inflation expectations have now fallen below pre-pandemic levels, with the low range of those surveyed expecting zero inflation.

1yr inflation expectations New York Fed
3yr inflation expectations New York Fed

Citi Says $3000 Gold is Possible In 2025

Analysis by Aakash Doshi, head of commodities research at Citibank, points to three catalysts that could significantly propel the price of gold. CNBC below summarizes his justifications for a 50% increase in gold in such a short period.

  • “The most likely wildcard path to $3,000/oz gold is a rapid acceleration of an existing but slow-moving trend: de-dollarization across Emerging Markets central banks that in turn leads to a crisis of confidence in the U.S. dollar,” Citi analysts, including Doshi, wrote in a recent note.
  • Another trigger that could drive gold to $3,000 would be a “deep global recession” that could spur the U.S. Federal Reserve to cut rates rapidly. “That means the brakes have been cut, not to 3%, but to 1% or lower – that will take us to $3,000,” Doshi said, noting that this is a low probability scenario.
  • Stagflation — an increasing inflation rate, slowing economic growth, and rising unemployment — could be another trigger, though Doshi said there’s a “very low probability” of such a scenario.
long term gold price

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Are The Magnificent Seven In A Bubble? Ask The Nifty Fifty

Sometimes, a narrative dominates the financial/social media and promotes a mania among investors. Today, the Magnificent Seven is a great example. Seven stocks, including Apple, Microsoft, Google, Tesla, Nvidia, Amazon, and Meta, are media darlings that many investors favor. Fifty-plus years ago, the Nifty Fifty were the stocks to own. They held a similar place as the Magnificent Seven in investors’ minds.

None of the Magnificent Seven companies existed in the heyday of the Nifty Fifty, but a unique valuation and narrative thread aligns the companies.

The experience of the Nifty Fifty “bubble” and its longer-term resolution sheds light on high valuations, earnings growth, and future returns. For the most part, the high valuations of the Nifty Fifty were appropriate. Will we be able to say the same for the Magnificent Seven?

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The Nifty Fifty

The Nifty Fifty was the nickname for a group of highly sought-after growth stocks during the late 1960s and early 1970s. Many of these companies were household names characterized by solid earnings growth, innovative business models, and apparent invincibility. Some prominent Nifty Fifty stocks included Coca-Cola, Kodak, McDonald’s, Philip Morris, and Walt Disney.

At the time there was great optimism regarding the global post-World War 2 global economic expansion and the promise of American capitalism. Investors were enamored by the growth potential of large dominant companies and willing to pay hefty valuation premiums for their stocks. Some claim that traditional valuation metrics were ignored during the Nifty Fifty run. Instead, investors cared more about potential growth.

Investors argued that the fifty companies were so exceptional that growth trajectories could continue indefinitely, thus justifying their high valuations. As we often see, valuations detach from reality, and extreme bullish sentiment leads to speculative bubbles.

The Nifty Fifty fell out of favor during the market downturn in 1973. With economic weakness and increasing inflation and interest rates, investors began reassessing their growth outlooks and questioned expensive valuations. Many of the once-esteemed Nifty Fifty stocks suffered substantial losses.

The graph below, courtesy of YCharts and the Palm Beach Daily, shows the 40+% decline in the Nifty Fifty from 1973 to late 1974.

the market peak for the nifty fifty

The Nifty Fifty Is Not the Bubble People Thought It Was

In aggregate, valuations for the Nifty Fifty stocks were twice that of the broader market. While the stocks fell sharply and valuations corrected, many Nifty Fifty stocks were not in a bubble as was presumed. It turns out the growth outlooks implied by the valuations were close to the mark.

The following commentary and graphics are from Valuing Growth Stocks: Revisiting The Nifty Fifty by Jeremy Siegel. He leads the article with the following:

But is the conventional wisdom justified that the bull market of the early 1970s markedly overvalued these stocks? Or is it possible that investors were right to predict that the growth of these firms would eventually justify their lofty prices? To put it in more general terms: What premium should an investor pay for large, well-established growth stocks?

His conclusion:

Examining the wreckage of the Nifty Fifty in the 1974 bear market, you can find two possible explanations for what happened. The first is that a mania did sweep these stocks, sending them to levels that were totally unjustified on the basis of prospective earnings. The second explanation is that, on the whole, the Nifty Fifty were in fact properly valued at the peak, but a loss of confidence by investors sent them to dramatically undervalued levels.

In 1975 there was no way of knowing which explanation was correct. But 25 years later we can determine whether the Nifty Fifty stocks were overvalued in 1972. Examination of their subsequent returns shows that the second explanation, roundly rejected by Wall Street for years, is much closer to the truth.

He argues that the high valuations of the early 1970s and late 1960s were fair. Instead, investors suffered a loss of confidence.

Those who did not lose confidence as the market swooned and held on to the Nifty Fifty kept pace with the market over the longer term. The table below assesses the Nifty Fifty from the market peak in December 1972 to August 1998, when Siegel wrote the article.

nifty fifty valuations

The Nifty Fifty generated returns over Siegel’s 26-year period on par with the S&P 500. Furthermore, the earnings growth was 3% more annually, calibrating almost perfectly with the high valuations of the early 1970s.

The “warranted P/E ratio” column calculates what should have been an appropriate P/E in 1972 had one known the future earnings growth premium between the Nifty Fifty and the market. The warranted and actual P/E ratios are similar in aggregate, but some stocks were expensive and some cheap.

For example, in 1973, Philip Morris had a P/E of 24.0, a 33% premium to the market P/E. Philip Morris would grow earnings by 17.9% compared to 8% for the market. Given that large difference in earnings growth, Phillip Morris was a steal with a P/E of 24. At the time, the fair value P/E for Phillip Morris was 68.5. Anything less than that was cheap in hindsight.  

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Are The Magnificent Seven In A Bubble or Priced Appropriately

Unlike Siegel, we do not have the benefit of future data to tell us whether the Magnificent Seven is in a bubble or appropriately priced for future earnings growth. However, we can use his logic and appreciate the earnings growth rates implied by current valuations.

We use two time periods, 10 and 26 years, to calculate the earnings growth required to bring the P/E ratios of each stock in line with the market while attaining the same price return.

For example, as shown in the table below, Amazon (AMZN) has a P/E ratio of 62.30, more than three times the S&P 500 (18.90). Before forming an opinion, consider that AMZN has grown its earnings at three times the rate of the S&P 500 over the last five years. For AMZN to perform in line with the market, assuming its P/E falls to market levels, its earnings must grow annually by 19.54% over the next ten years or 11.08% over the next 26 years.

p/e valuations and implied growth for the magnificent seven

Can Amazon continue to grow its earnings much faster than the economy and market? Given their saturation in many markets, continued double-digit growth will become more difficult by the year.

Even if NVDA becomes the dominant AI semiconductor chip designer and maintains or grows its current market share in other products, will the future chip market be large enough for NVDA to grow 830% (24.70% annually) by 2034?

We should be asking similar questions of all the Magnificent Seven stocks.

The graph below, courtesy of FactSet, shows that the high P/E ratios of the Magnificent Seven in aggregate may not be out of line with the market when one considers their earnings growth projections.

peg ratio magnificent seven
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Summary

Siegel uses 26 years to justify his stance. Different periods will yield different earnings growth requirements. While we can quarrel with his analysis, the point is high valuations are not necessarily a warning. In fact, as we share with Philip Morris, a high valuation for a stock may not be high enough. The important question is, can a stock live up to the earnings growth implied by its valuation?

The market may be underestimating the growth potential for some of the Magnificent Seven stocks and overestimating it for others. But, Siegel states, the most significant risk in the short term may not be growth potential but confidence. Confidence can fade just as quickly as it was born.

We leave you with a quote from Benjamin Graham:

In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”