Monthly Archives: December 2019

Private REITs – The Next Liquidity Victim

As the Fed pulls liquidity from the financial system, those using too much leverage and or holding speculative assets are usually the first to feel the effects. The demise of FTX and overleveraged English pension funds are two examples. As liquidity continues to decline, liquidity and lower asset prices start to weigh on more traditional asset classes. Private REITs and their sponsors may be the next victim.

Unlike publically traded REITs, private REITs do not trade on open markets. With sporadic NAV updates, private REIT prices tend to be very stable. As a result, investors are often not alert when problems start arising. In many cases, the NAV is determined by periodic appraisals of the underlying property, resulting in higher-than-appropriate prices. Blackstone dominates the private REIT industry, reportedly raising about 70% of all capital raised for private REITs in 2021. As lower real estate prices become a reality, private REIT investors are trying to sell. Unfortunately, liquidity in the underlying real estate investments prevents Blackstone from fulfilling investor demands. Other private equity-like investments may face similar paths as liquidity continues to drain. If these investors need liquidity, they will have to sell more traditional asset classes.

starwood blackstone

What To Watch Today

Economy

  • 8:30 a.m. ET: Initial Jobless Claims, week ended Dec. 3 (230,000 expected, 225,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Nov. 26 (1.618 million expected, 1.608 million prior)

Earnings

Earnings

Market Trading Update

A couple of weeks ago, I presented the idea of some sloppy trading action in the first two weeks of December as Mutual Funds go through their annual distributions. So far, such is exactly what we have had. Yesterday, healthcare supported the market while Technology, Financials, Industrials, and Materials weighed on performance. For the day, the market ended lower, further deepening the MACD “sell signal.” Also, the 100-dma and bottoms going back to May lows, as support, remain under attack and must hold through the end of the week. A failure of the 100-dma will put the 50-dma quickly into focus. It is not too late to raise some cash and rebalance portfolio risk.

Market trading update

Bonds are now TOO overbought to add to portfolios. Bonds need a pullback to work off the 3-standard deviations extension above the 50-dma, and the overbought conditions. The MACD “buy signal” on TLT is extremely overdone. However, it now appears the bottom for bonds has been made as recessionary risk increases. Look for a pullback to support for adding to current holdings.

Bonds Trading Chart

Valuations Remain High

Other than free cash flow yield, equity valuations are still extremely high. If earnings fall next year, these valuations will likely come down, which is only accomplished through lower prices. Valuations are not in the upper 90% range as they were a year ago, but they are still way too high, especially given the Fed’s monetary policy.

equity valuations

Exodus from Private REITs

As we note in the lead section, investors are pulling money out of private REITs such as Blackstone’s BREIT. The first graph below shows that redemptions from nontraded REITs totaled $3.7 billion in Q3. Such is a significant increase versus the last few years. The second graph from FT shows redemptions from BREIT. As shown, they are picking up but below the level seen during the height of the pandemic panic. Keep in mind Blackstone is limiting withdraws from its fund to just .3% of the fund’s value. The numbers would likely be much higher if they allowed investors to redeem their investments fully. The reason to gate the funds is twofold. First, they would be forced to liquidate real estate into an illiquid market resulting in price declines and possibly more redemptions. Second, as we discuss below, they would lose significant fee income.

private REITs withdrawls exodus
breit liquidation exodus

Blackstone

Continuing on today’s private REIT theme, we now discuss how this affects Blackstone, the investment management company. The following data, regarding Blackstone’s BREIT fund, comes from Phil Bak:

Blackstone earns a selling fee of 9.06% spread out over 7 years. They also earn a performance fee of 12.5% of net profits after a 5% hurdle rate. Lastly, Blackstone receives an annual management fee of 1.25%. Per Phil, that comes to 3.62% a year, $2.46 billion a year in fees.

Any wonder why the stock was down 7% when its investors heard about BREIT’s redemption gate?

The possibility of contagion within the real estate industry and other Blackstone funds becomes apparent when considering the situation. If Blackstone liquidates some of its holdings into such an illiquid market, real estate prices could fall rapidly. While BREIT investors and Blackstone shareholders would feel the brunt of it, other public and private REITs and real estate investors would also face the consequences. Further, if investors get spooked because they can not sell their funds, private equity investors may start withdrawing from other funds.

blackstone stock

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Three Ideas to Tackle Financial Ghosts.

Is money distress part of your life? Do the dollars & cents of poor decisions past sneak up on you and rattle around your house like chains? What if I could provide three ideas to tackle 2022’s financial ghosts and put them at rest for good?

Listen, ghosts of the financial past are notorious for creeping into the present, especially when holidays roll around. Oh, and watch out for the ghosts of the financial future. They’re dark and ominous and portend to money mistakes for generations!

Perhaps, you’ve unpacked an ornament from 30 years ago or got lost in memory while watching A Charlie Brown Christmas, then you understand.

Unfortunately, the ghosts of Financial Mistakes Past are sometimes not so kind. They aren’t warm and fuzzy, either.

Rattling chains of the ghosts of financial mistakes can be uninvited guests for years to come.

Post-pandemic household financial conditions have just made ghosts stronger.

I wrongfully believed Americans would change their fiscal ways post-pandemic. The personal savings rate is currently at levels we haven’t seen since 2005. Total bank card balances are a record $866 billion for the third quarter, up 19% from last year’s period. According to Bankrate.com, the average outstanding revolving credit card balance stands at $5,474 over last year. The average credit card interest rate is 19.20% per Moneygeek.com.

December is the month to objectively review your financial history.

This month, expose the good and bad – then outline tactics to sever ominous chains and sprout wings to the beneficial for 2023.

Just because I partner with others on personal finance challenges doesn’t mean I don’t own my share of mistakes. Thankfully, my Ghosts of Financial Mistakes Past lost their power to frighten me. I, too, assess my consistent progress to slay them. As a financial professional, I remain ‘fiscally aware’ throughout the year.

Hey, it’s my job.

This month, as you prepare your favorite meals from recipes in the family for decades, watch a timeless film (White Christmas is my favorite), go through old photographs, take some time to unwrap financial gifts, and pack away the mistakes.

Here are three ideas to tackle 2022’s financial ghosts.

Calculate your household debt-to-income ratios.

I know. Math. I promise this isn’t a difficult task. As a society, we tend to base our lifestyle on the ability to meet monthly payments but rarely consider the damage to net worth by spending too much or taking on excessive debt.

I complete a couple of calculations for my household. I’ll also share with you RIA’s financial guardrails. I won’t lie: Our tenets are tough; I promise your net worth will thank me ten Decembers from now.

First, I isolate my mortgage, HOA, and homeowner’s insurance payments and divide the sum by my NET or ‘take-home’ monthly income. 

Currently, my ratio is 6.6%. The standard rule in finance is a house payment shouldn’t exceed 28% of pre-tax income. It’s a horrible rule. It’s designed to push the boundaries on cash flow and sell you more house than is necessary.

Throw it out if you desire financial flexibility, cash to cover emergencies, and save for a prosperous financial future.

Dave Ramsey suggests 25% of after-tax income. Not bad. However, you can do better.

Our rule at RIA is a total mortgage payment should not exceed 15% of after-tax income. I didn’t extract this percentage out of thin air. Over the last two decades, I’ve watched how households who utilized this rule continue to increase their wealth by thinking of a primary residence as a place to live, not an investment.

In other words, an intimidating mortgage obligation was just too painful for couples who employed long-term consideration of other important goals they sought to fund.

I then consider my household’s variable and specific fixed expenses.

Entertainment, groceries, and clothing. I also examine costs for utilities and car insurance (not cheap with a college-bound daughter driving). The general rule is 30% of after-tax income for ‘wants.’ Auto insurance is a need, not a want. However, with the ability to shop around for better rates or utilize insurance company ‘drive-pay’ programs that reward responsible drivers, I place auto insurance into the variable category.

My current variable expenses are 9% of my monthly after-tax household income. I understand I no longer have a household with young children where variable expenses are greater. However, my personal inflation rate stands at 7.7%. Want to calculate yours? Click here.

However, that doesn’t mean as a growing family, you shouldn’t create your own rules, which still allow for a robust savings rate. At RIA, we believe variable monthly expenses shouldn’t exceed 20% of after-tax income.

If you’re disappointed by your ratio results, be grateful for new awareness and schedule a meeting with your financial professional in January to create an action plan for improvement. Hence, when ratios are calculated next year, they’re much healthier.

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Openly communicate about money, especially mistakes, with loved ones.

Holidays, when there is downtime from work and family gathers, seem to allow communication flow about money.

Children: Your children are monitoring your relationship with money. What is your outward expression towards debt, savings, and general household financial management, especially when communicating with immediate family?

Your children will learn from the example if your relationship with money is positive or one of control and discipline. If your relationship with money is negative, stressful, extravagant, or reckless, the kids will pick up on that, too.

Smart money beliefs and actions can lead to smart money scripts by the younger generations around you.

Generally, if you’re a saver, your children will be too. According to a www.moneyconfidentkids.com survey from 2017, parents with three or more types of savings are more likely to have kids who discuss money with them and less likely to have kids who spend money as soon as they get it or lie about their spending.

I have found that parents who openly communicate their financial failures and how they worked through them raise fiscally intuitive children. Get the kids to help you with three ideas to tackle financial ghosts.

Kids want to know you’re human. You mess up!

Most important is how you acknowledged and changed erroneous behavior. Give the gift of wisdom this season!

Parents: Older parents are challenged to communicate final intentions with their children, or they decide to let estate planning documents speak for them. Big mistake. If you seek to create a Ghost of Future Turmoil for heirs, go ahead and remain tight-lipped about how you wish assets dispersed, including family heirlooms and whom you selected as the executor of your will and why.

Perhaps John doesn’t want great-grandmother’s fine China, but Erica does. 

Or Alan is bitter and wondering why your younger son, his brother, Edward is the executor of the estate instead of him. These are not small things. I’ve witnessed them generate irreparable family rifts. Make December the month where you communicate with the children and ask questions about the items they’d wish to inherit upon your passing. Take a moment to explain to siblings why one sibling is selected as executor and the logic that drove the decision.

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Trim the expense tree.

The evergreen fir has been a part of winter festivals for roughly 1,000 years.

Per www.whychristmas.com

The first documented use of a tree at Christmas and New Year celebrations is argued between the cities of Tallinn in Estonia and Riga in Latvia! Both claim they had the first trees; Tallinn in 1441 and Riga in 1510. Both trees were put up by the Brotherhood of Blackheads, an association of local unmarried merchants, ship owners, and foreigners in Livonia (now Estonia and Latvia).

Little is known about either tree apart from being put in the town square, danced around by the Brotherhood of Blackheads, and then set on fire. This is like the custom of the Yule Log. The word used for the ‘tree’ could also mean a mast or pole. A tree might have been like a ‘Paradise Tree’ or a tree-shaped wooden candelabra rather than a ‘real’ tree.

Year-end credit card and checking account statements should be available from your financial institutions the first week of January. Today’s statements do an excellent job of categorizing expenses. Access, print, and review all statements.

Analyze your household spending for 2022.

Many statements outline prior years’ spending by category and how it compares to the current. From there, begin to outline a spending budget for 2023 focusing on expense reduction and debt-to-income ratio improvement.

Let’s all try to make our financial ghosts the ones we don’t mind inviting into our homes at any time of year and use these three ideas to tackle 2022’s financial ghosts!

Financial Conditions Take Front and Center Stage

In Jerome Powell’s speech last week, which drove the markets 3% higher, he offered a warning that few investors picked up on. “Officials seek to reduce inflation by slowing the economy through tighter financial conditions—such as higher borrowing costs, lower stock prices, and a stronger dollar—which typically curb demand.” The graph below, courtesy of ISABEL.NET.com and Bloomberg, shows the strong correlation between financial conditions and the S&P 500. Powell’s speech, his last before next week’s Fed meeting, helped ease financial conditions via lower borrowing costs, higher stock prices, and a weaker dollar. We seriously doubt this was his intention. The Fed is in a media blackout period. Accordingly, as we noted in yesterday’s Commentary, they must resort to using WSJ reporter Nick Timiraos to speak for them. Not surprisingly, Timiraos said the Fed might be more aggressive than most investors expect.

The risk at next week’s meeting is a Fed determined to fight inflation via tighter financial conditions. Such includes using hawkish rhetoric to talk stock prices lower. Further, they likely want to erase a pivot out of investors’ forecasts for 2023. Will the markets price in the Fed’s desire for tighter financial conditions? Or will they look past Powell’s bluster and continue to dream of a mid-year pivot?

financial conditions and stocks.

What To Watch Today

Economy

  • MBA Mortgage Applications, the week ended Dec. 2 (-0.8% prior)
  • Nonfarm Productivity, Q3 final (0.7% expected, 0.3% prior)
  • Unit Labor Costs, Q3 final (3.0% expected, 3.5% prior)
  • Consumer Credit, October ($28.000 billion expected, $24.976 prior)

Earnings

Earnings

Market Trading Update

As discussed in yesterday’s commentary, the market sold off following the release of the WSJ’s commentary on the Federal Reserve’s stance on monetary policy remaining “hawkish.” After failing at the downtrend resistance line yesterday and violating the 200-dma, the “bears” regained market control. As I discussed in yesterday’s 3-minutes video, any sell-off yesterday would trigger the MACD “sell signal,” which has been a good indicator to reduce risk and raise cash. That signal did trigger yesterday.

So far, as indicated below, the market is trading within the consolidation range of the last 3-weeks. Also, the market did hold the 100-dma support level yesterday. However, if the market breaches that support, it is lower to the 50-dma. So far, the first 2-weeks of December are playing out as expected: “Sloppy Trade With A Chance Of Decline.” That action, barring an extremely hawkish post-FOMC speech from Jerome Powell next week, should set the market up for the year-end “Santa Rally.”

Market Trading Update

Recession Talk

Many economic prognosticators are forecasting a recession. This may be precisely what Jerome Powell wants in his efforts to tighten financial conditions and break inflation’s back. Is it possible that hawkish Fed actions and rhetoric, along with recession forecasts get economic activity to slow enough to stop inflation but not enough to generate a recession? Such a “soft landing” is the Fed’s ideal scenario. While we think the odds of a recession are high, a soft landing scenario is something we frequently discuss in our investment committee meetings as it potentially has big implications for our investment outlook. The following bit on CNBC is worth considering.

UNITED AIRLINES CEO: “If I didn’t watch @CNBC in the morning — which I do — the word ‘recession’ wouldn’t be in my vocabulary. You just can’t see it in our data.”

A Very Cohesive Fed

Jerome Powell seems to have formed a strong and unified front against inflation within the FOMC. As Pictet Asset Management shows below, on average, there is only one dissenting Fed member per three FOMC meetings under Powell’s tenure. However, keeping a cohesive hold on Fed members will become increasingly harder as rates near their terminal level and economic activity begins to fall off. The more dissents, the tougher the Fed’s job, especially if inflation doesn’t retreat as quickly as Powell wants it to. As such, 2023 may prove much harder for Powell than 2022.

dissents at the fed

S&P 500 Is in the Danger Zone

A few months ago, we added a new technical tool in SimpleVisor. The Relative Analysis tools allow SV users to perform technical relative analysis on any two tickers as well as all of the sectors versus the S&P 500. The analysis, using 13 technical analysis models, takes the ratio of the price of two tickers and scores the pair as fair value, overbought, or oversold. We are adding another similar tool. Users can now perform the same technical analysis on individual tickers, not pairs. For SV subscribers, the Absolute Analysis tool can be found under Ideas > Absolute Analysis.

The graph below shows the absolute analysis of SPY. SPY has been in moderately overbought (orange) territory, as it is today, three other times this year. All three instances accompanied a local peak in SPY. If the market rallies from current levels and breaks upward through key resistance, we expect this overbought condition will stay overbought. That said, we offer caution, as the market is clearly in a downward trend. Overbought conditions have proven great times for reducing equity exposure and managing risk.

S&P 500 simplevisor relative absolute analysis

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Double Dog Dares and Equity Risk Premiums

Back in the day, a double dog dare was often a kid’s first introduction to evaluating risk and reward. The rarely presented double dog dare happens when one kid dares another to do something foolish. Usually, the kid being dared asks for an incentive to complete the challenge.

When assessing a double dog dare, one usually first values the reward. Maybe there are a couple of candy bars or a soda for completing the challenge. Then comes the risk assessment. Does the potential to break an arm or leg exist? Maybe worse, at least in some children’s minds, what will the punishment be for being caught? Simply, is the reward enough to compensate correctly for the risks associated with the double dog dare?

Evaluating the risks and rewards of a double dog dare are not that dissimilar to equity investing, as we explain.

Risk-Free Rates

Investors should expect compensation in the form of capital gains and/or dividends/coupons commensurate with the investment risk. To help evaluate the amount of risk compensation the market is offering, investors need a risk-free return to base the evaluation.

U.S. Treasury securities are a perfect yardstick for this task. They are considered the only risk-free asset in the world. We can debate the merits of their standing all day, but regardless of your opinion, it is a fact in almost all investors’ minds. Further, we can easily find yields for investment terms ranging from next week to 30 years upon which to compare our risky assets.

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BAAA

In our article, Goodbye TINA, Hello BAAA, we made the case that expected equity returns for the next ten years are about the same as Treasury bond yields. In the current pricing scenario, the premium paid to stock investors for taking risks is zero. Accordingly, the article makes the case that Bonds Are An Alternative to stocks.  

The graph below from the article shows that five popular methods for calculating equity expected returns range from 4% to -4%. At the same time, risk-free Treasury yields are near 4%.

baaa expected stock returns

Expected stock returns are on par with risk-free Treasury yields but woefully below the premium spread investors should demand. The simple conclusion is that for the entirety of the next ten years, bonds are the better bet.

Equity Risk Premium

In addition to the long-term stock-bond analysis presented in our article, there are other ways to help gauge whether stocks offer an acceptable premium to compensate investors for taking on added risk. One such model and the topic of this article is the equity risk premium. 

The equity risk premium, like the three methods we share in the article, is a valuation-based calculation. However, it tends to rely on shorter-term fundamentals. Essentially our model looks at the expected EPS in one year divided by the current price and compares it to a 1-year forward UST bond yield adjusted for inflation expectations.

The higher the equity risk premium, the more compensation equity investors receive to take on risk.

The graph below charts the S&P 500 equity risk premium using trailing and forward earnings. We offer a special thank you to Kailash Concepts for supplying the equity data for the graph.

equity risk premium
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Fair Compensation?

Based on the graph, are equity investors fairly compensated for owning stocks? We can answer the question in a few different ways.

One way is to compare the current risk premium to recent pre-pandemic averages. As shown, outside of a few short-term instances, premiums have not been as low as they are today in 20 years. Further, those instances similar to today occurred after recessions, when the risk of another downturn was minimal, and earnings had significant upside growth potential as the economy recovered. While the premium was lower than average in those instances, the earnings and economic outlook were brighter, possibly justifying a low-risk premium.

Another way to consider the premium is to assess the risk associated with the current financial and economic environment and compare it to the premium. Today, given the potential market turmoil due to a possible recession, higher interest rates, inflation, an aggressively hawkish Fed, and the geopolitical situation in Ukraine, we should be paid more, not less compensation for taking on risk. The other consideration: playing it safe in bonds pays us a comfortable 4% with no risk.

Given the riskier-than-normal outlook and tighter-than-average risk premiums, bonds deserve more attention. BAAA!

How Equity Premiums May Normalize

Three key factors are used to calculate the equity risk premium: earnings, stock prices, and risk-free rates.

For the premium to rise to a more acceptable level, the numerator needs to increase, and/or the denominator falls. In other words, there must be some combination of higher earnings, lower stock prices, and declining yields. We could create a complex table showing the many combinations, but instead, it best to focus on the elephant in the room – recession risk.

If we are indeed entering a recession, earnings are likely to fall. The graph below shows that earnings often decline significantly during recessions. If they do fall, the equity risk premium will also drop. Therefore, stock prices must also decline to keep the earnings yield stable.

earnings equity risk premium

However, the onus is not just on earnings and stock prices. If yields fall appreciably, the premium may rise.

All three factors will change. Appreciating what may change and to what degree, given various economic scenarios, will help you better appreciate how and when the equity risk premium may normalize.

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Portfolio Management

The model presented above is for the S&P 500. Each stock has its own risk premium. While we may not think the market is compensating us properly, many stocks and some sectors have potential earnings growth rates well above market levels with potentially less earnings volatility in a recession.

Portfolio management involves holding stock and bond assets. We believe in active management in which the allocations to stocks and bonds change as their risk-reward calculus changes. Lower risk premiums in a risky environment are leading us today to reduce equity risk.

Summary

“There is no analog. Today’s starting points are like none we have seen. The biggest risk is extrapolating to the future from a past that feels comfortable, confirmed by recent data. Disequilibrium is the new equilibrium.” Erik Peter One River Asset Management

The economic, financial, and geopolitical risks are outsized! Shouldn’t the equity risk premium reflect the situation?  

If we double dog dare you to buy stocks, you should ask for a return that compensates for the additional risk in today’s market environment.

Diverging Sentiment Readings Raise Recession Risk

MarketWatch recently pointed out that two well-followed measures of consumer sentiment are diverging and possibly confusing investors. While investors may prefer one index over the other, a more robust economic and market forecast may occur when the indexes are diverging. The MarketWatch graph below shows the difference between the Conference Board (CCI) and the University of Michigan Consumer Sentiment (UM) Indexes. CCI measures broad economic sentiment. On the other hand, UM is more personal, focusing on individuals’ unique financial situations. When CCI was much more optimistic than UM, like today, a recession followed. When the difference is in the highest 10% of readings, the S&P averaged a 5-year annualized return of -3.1%. Conversely, when the divergence was in the lowest 10%, returns over the same period averaged +14.8%.

The article concludes as follows: “The bottom line? It’s not good news, for the economy in general or the U.S. stock market in particular, that consumers are so much more upbeat about the overall economy than they are about their immediate financial circumstances.”

two consumer sentiment measures

What To Watch Today

Economy

  • 8:30 a.m. ET: Trade Balance, October (-$77.0 billion, $73.3 billion expected)

Earnings

Earnings

Market Trading Update

The market opened slightly weaker yesterday morning but sold off after Nick Timiraos for the Wall Street Journal published commentary ahead of the upcoming FOMC meeting. Nick, known as the Fed whisperer, is the official “Fed leak” when the FOMC is in its blackout period ahead of a policy meeting. The comments yesterday were an attempt to jawbone back the market’s dovish perception.

Federal Reserve officials have signaled plans to raise their benchmark interest rate by 0.5 percentage point at their meeting next week, but elevated wage pressures could lead them to continue lifting it to higher levels than investors currently expect.

…brisk wage growth or higher inflation in labor-intensive service sectors of the economy could lead more of them to support raising their benchmark rate next year above the 5% currently anticipated by investors.

Specifically, Timiraos confirms what most Fed speakers have been saying:


They want to guard against raising rates too little and allowing inflation to resurge, or raising them too much and causing unnecessary economic weakness, according to recent public comments and interviews.

Some officials could seek to push through another half-point rate rise in February because they see a greater risk that inflation won’t decline enough next year. Without signs of slower hiring, they could worry that inflation could pick up again.

Not surprisingly, that hawkish language took the “wind out of the bull’s sails,” sending the market back below the 200-dma. The market is holding support at the 20-dma, and the 100-dma is sitting just below that. Importantly, the MACD signal is very close to turning lower, suggesting the market may struggle between now and next week’s FOMC meeting. We remain risk-averse until we get a better opportunity to increase equity risk.

Market Trading Update

A Second Opinion on the Health of the Jobs Market

The jobs market is weakening between the JOLTS and the BLS employment report but remains historically strong. However, two recent data points are diverging from the more traditional reports. The first graph shows the BLS survey of household job growth is well below its well-followed establishment survey. Since March, the household survey has shown zero job growth. Over the same period, the establishment survey points to 2.7 million new jobs. The growing gap, as shown in the second graph, is palpable. Of concern, the household survey tends to lead the establishment survey, although not usually to the degree it is today.

The third graph shows a spike in the number of announced job layoffs in November per the Challenger report. Interestingly, a large percentage of the job losses are in the technology sector. Of the nearly 80k pending job losses, 52k are in the technology sector. The next largest sector was consumer products at 4.1k. The Fed will want to see widespread job losses across multiple industries before the employment picture becomes a concern.

jobs survey diverging
household vs establishment jobs
challenger job cuts

Small Cap Stocks Might Win the Next Decade

The Russell small cap index trades with a forward P/E of 12.4. That compares favorably with 20 for the S&P 500. Using 35+ years of data, forward P/Es provide a decent forecast of forward returns. As the graph shows, we might expect the index to post double-digit annualized returns for the next ten years. That compares very favorably with the forecast for the S&P 500 to return 5% annualized. More importantly, as our friends at Kailash Concepts have been preaching, more promising returns may be possible within the value stocks of the Russell 2000.

russell small cap expected returns
large cap expected returns

How Much Longer Can the Bear Market Persist

While it may feel like the 2022 bear market is growing long in the tooth, it pales compared to other downtrends. The S&P 500 has gone just over 230 days without returning to its prior high. The last such dip was in 2016. If we enter a recession, the streak may extend considerably longer, as witnessed in the 2000 and 2008 recessions. The recession of 1990 and the short-lived 2020 pandemic recession provide hope this downward trend is closer to an end than the beginning.

bear market persistance

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The Bull Case Has Two Problems

Since the beginning of October, the market has performed better as a “Fed Pivot” bull case pushed investors into the market. We previously laid out the case for a strong “short squeeze” around the lows of September, stating:

“Currently, everybody is bearish. Not just in terms of ‘investor sentiment’ but also in ‘positioning.’ As shown, professional investors (as represented by the NAAIM index) are currently back to more bearish levels of exposure. Notably, when the level of exposure by professionals falls below 40, such typically denotes short-term market bottoms.

As a contrarian investor, excesses get built when everyone is on the same side of the trade. 

Everyone is so bearish that the reflexive trade will be rapid when sentiment shifts.

short squeeze, The Big Short Squeeze Is Coming

The ensuing short squeeze ultimately produced one of the most significant gains on record, with the S&P 500 surging over 5% single day. As we noted, such gains have two primary features. First, they are generally only seen during bear markets. Secondly, while they tend to come in the latter stages of bear markets, they don’t historically denote THE bottom.

As noted, we expected the rally from the September lows, as discussed in that previous post. However, what was critical was our concluding statement.

“There are plenty of reasons to be very concerned about the market over the next few months. We will use rallies to reduce equity exposure and hedge risks accordingly.

A ‘short squeeze’ is coming, but we aren’t out of the woods yet.”

That remains our positioning currently, as there are two primary issues plaguing the “bull case.”

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The Fed…And The Fed

While investors chased the market, hoping the Federal Reserve will “pivot” concerning its monetary policy, the reality is likely substantially different. Such was a point we discussed in “The Policy Pivot May Not Be Bullish.”

“The bullish expectation is that when the Fed finally makes a ‘policy pivot,’ such will end the bear market. While that expectation is not wrong, it may not occur as quickly as the bulls expect.

Historically, when the Fed cuts interest rates, such is not the end of equity ‘bear markets,’ but rather the beginning.

The reason is that the policy pivot comes with the recognition that something has broken either economically (aka ‘recession’) or financially (aka ‘credit event’). When that event occurs, and the Fed initially takes action, the market reprices for lower economic and earnings growth rates.”

Fed funds rate vs market

Notably, the bull case for a pivot is built on the idea of the Fed ceasing its rate hikes. However, a “pivot” that would support higher asset prices would require two primary monetary policy changes.

  1. Dropping the Fed Funds rate toward the zero bound; and,
  2. Reversing “Quantitative Tightening” to “Easing” provides market liquidity.

As the chart shows, these periods of zero rates and monetary accommodation fuel asset prices higher. Periods of balance sheet contraction and higher rates lead to market sell-offs.

Fed Balance Sheet vs Fed Funds and Market

Currently, even if the Fed does slow or stops hiking rates, there is NO indication they are about to reverse course from a “tightening” policy regime to an “accommodative” one.

In fact, just yesterday, Nick Timiraos from the Wall Street Journal confirmed the same. To wit:

“Federal Reserve officials have signaled plans to raise their benchmark interest rate by 0.5 percentage point at their meeting next week, but elevated wage pressures could lead them to continue lifting it to higher levels than investors currently expect. Brisk wage growth or higher inflation in labor-intensive service sectors of the economy could lead more of them to support raising their benchmark rate next year above the 5% currently anticipated by investors.

In other words, the most significant challenges to the bull case remain the Fed not cutting interest rates and the Fed not engaging in “Quantitative Easing.”

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Playing The Probabilities

While the history of financial interventions and market performance is quite evident, there is always a possibility “this time could be different.”

Yes, it is possible the bull case could mature if the economy avoids a recession, earnings stabilize, and inflation falls. However, given the lag effect of restrictive monetary policy (i.e., higher rates) and demand destruction, the risk of a recession is elevated. As such, earnings have not adjusted nearly enough to account for the reduction in consumer demand.

Earnings drawdowns

More importantly, the “lag effect” of monetary tightening has yet to reflect in the economic data. While the economy is slowing somewhat, employment has yet to contract. Already, we are seeing a sharp decline in CEO confidence as more companies lay off workers and institute hiring freezes. As shown, such eventually translates into higher unemployment, slower economic growth, and reduced expectations for future earnings.

CEO confidence vs jobless claims.

As noted, anything is possible. However, as investors, we must “play the probabilities” for the current economic environment. The Fed hikes rates to quell inflation by creating “demand destruction” in the economy. Such will lead to higher unemployment, slower economic growth, and reduced earnings. All of which are not supportive of higher asset prices or elevated valuations.

Yes, the market could defy fundamental realities and front-run the Federal Reserve to the next round of monetary accommodation. However, given that strong market rallies curtail the Fed’s efforts, the bull case may keep the Fed in a restrictive mode longer than anticipated.

It seems to us that the bull case may be too far ahead of reality. If that is true, being a little more cautious and selling rallies may hedge the risk one final leg lower in 2023.

Job Growth Will Keep Powell Anxious

Last Wednesday Powell stated: “wage growth remains well above levels that would be consistent with 2 percent inflation over time.” The Fed believes that the tight job market is fueling rising wages which is inflationary. As such, they want to see weakness in job growth to fight inflation. Friday’s unemployment data will not ease the Fed’s concerns. Per the BLS, the number of jobs grew by 263k, well above estimates of 200k. More importantly, average hourly earnings were up .6% monthly, following a .5% increase last month. The labor participation rate fell to 62.1, further indicating a very tight labor market. The graph below shows the recent relationship between the participation rate and hourly earnings.

Powell’s fears stem from the growing odds of a price-wage spiral. He appears determined to squash such a spiral before it takes hold by weakening the labor market and economy. While inflation is showing promising signs of falling, it will take much longer to return to the 2% Fed target if the jobs market remains robust. We wouldn’t be surprised if Powell specifically addresses his worries about the labor market at the December 14th FOMC meeting press conference.

average hourly earnings of all employees and labor force participation rate

What To Watch Today

Economy

  • 9:45 a.m. ET: S&P Global U.S. Services PMI, November final (46.1 expected, 46.1 prior)
  • 9:45 a.m. ET: S&P Global U.S. Composite PMI, November final (46.3 prior)
  • 10:00 a.m. ET: Factory Orders, October (0.7% expected, 0.3% prior)
  • 10:00 a.m. ET: Durable Goods Orders, October final (1.0% prior)
  • 10:00 a.m. ET: Durables Excluding Transportation, October final (0.5% expected, 0.5% prior)
  • 10:00 a.m. ET: Non-defense Capital Goods Orders Excluding Aircraft, October final (0.7% prior)
  • 10:00 a.m. ET: Non-defense Capital Goods Shipments Excluding Aircraft, October final (1.3% prior)
  • 10:00 a.m. ET: ISM Services Index, November (53.3 expected, 54.4 prior)

Earnings

Earnings

Market Trading Update

The surge in the market last week was interesting as bearish sentiment was crushed following a perceived “dovish” twist to Jerome Powell’s Brookings Institution speech.

It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting.”

However, this is not “new news,” but rather what the markets have been rallying on for the last several weeks. The market overlooked the much more hawkish statement, as we will discuss momentarily, of “higher for longer.” More importantly, inflation-adjusted policy rates are now around -90 basis points, far below where the Fed will look to stop. 

In other words, if key surveys about short-term inflation expectations stay around current levels, there is just no way the Fed can afford to stop before rates get to 5.25%. And that would probably be the lowest possible level. In other words, the current terminal rate of around 4.90% is not quite where it needs to be. The Fed has never really been able to wind down its tightening before real rates went significantly higher — which has been circa 200 basis points on average.” – Ven Ram, Bloomberg

Real interest Rates Fed

Regardless, the market rally sent the volatility index below 20, which has historically denoted market peaks rather than the beginning of a bullish rally.

Stock market trading update

However, on Friday, a much stronger-than-expected employment report initially took some of the steam out of the rally, but as shown, the market hung onto support at the 200-dma. If the market can look past the employment report next week and rally, we will have a successful first test of the 200-dma as support.

This week will be key as to the durability of the bull rally.

The Week Ahead

The Fed’s blackout period begins this week as the Fed prepares for next week’s FOMC meeting. As such, economic data will take center stage. Friday’s PPI report is at the top of the list regarding importance. We expect it to rise by 0.3% monthly and 7.3% yearly. PPI will help investors form expectations for the CPI report on Tuesday. Given the importance of the jobs market to the Fed and their monetary policy actions, jobless claims on Thursday will be closely followed. Jobless claims have ticked up slightly over the past few months. Still, continuing jobless claims have been rising steadily since September. Continuing claims are one of the most current indicators of the labor market. For more on the indicator, please read our Commentary from November 25th.

continuing unemployment claims

Confusing Market Signals

This week we shared two indicators, the 10yr/3m yield curve and the Chicago PMI, which are at levels that preceded each of the last eight recessions. While those two indicate potential bearish price action, the graph below from Carson Investment Research gives us optimism. It shows the S&P 500 has had two consecutive 5% monthly gains 13 times. On all 13 occasions, the following 1-year return was positive and, on average, by 22.2%. Even in shorter time frames, this set of criteria portends a high likelihood the market will do well in 2023.

This time is different than most prior environments in the chart below. Inflation is raging, the Fed is firmly running a very aggressive hawkish monetary policy, and the economy is still trying to return to normal. So while the chart below may provide comfort, caution should be taken.

market optimism

Dow vs. Nasdaq

The graph below shows the Dow Jones Industrial Average is beating the Nasdaq by about 20% this year. To better appreciate the divergence, we present the second graph showing the percentage each index allocates to each sector and the sector’s year-to-date price change. The three highlights draw attention to the sectors which account for a large chunk of the return differential. For example, the Dow holds 3.5% of Chevron (+58%), while the Nasdaq has zero exposure to energy stocks. The communications sector is the worst-performing sector this year, with a -34% return. The Dow only holds 2.6% of communications stocks, while the Nasdaq has 15.4%.

price dow vs nasdaq
dow vs nasdaq by sector

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Timiraos Pours Cold Water on Powell Bulls

Stocks shot higher on Wednesday after Chair Powell’s speech. Looking for good news, the bulls heard the Fed is moderating its policy stance. Further, it appears the Fed is now concerned about over-tightening. Powell’s comments were very similar to previous comments of many Fed speakers. Wall Street Journal reporter Nick Timiraos followed Jerome Powell’s “bullish” speech with words of caution.

Nick Timiraos makes two critical points. For starters, he quotes Powell. “Officials seek to reduce inflation by slowing the economy through tighter financial conditions—such as higher borrowing costs, lower stock prices, and a stronger dollar—which typically curb demand.” Timiraos follows up on Twitter- “Powell may not have intended to ease financial conditions, but his comments about avoiding unnecessary weakness overshadowed his concerns about labor-market imbalances.” The stock and bond market rallies are not conducive to fighting inflation and likely not the result Powell wants. This has potentially bearish implications for how Powell addresses reporters after the December 14th Fed meeting.

Second, Powell blames early retirements and deaths due to covid and reduced immigration for making the job market tighter than normal. As a result, Timiraos tweets that rates may stay higher for longer and the “(Fed’s) ability and room to ease is less than before since inflation will return quickly in an undersupplied labor market.” Translation- it may take longer for the Fed to ease, and the rate of easing may not be as aggressive as in the past.

stocks powell bulls

What To Watch Today

Economy

  • 8:30 a.m. ET: Change in Nonfarm Payrolls, November (200,000 expected, 216,000 prior)
  • 8:30 a.m. ET: Unemployment Rate, November (3.7% expected, 3.7% prior)
  • 8:30 a.m. ET: Average Hourly Earnings, month-over-month, November (0.3% expected, 0.4% prior)
  • 8:30 a.m. ET: Average Hourly Earnings, year-over-year, November (4.6% expected, 4.7% prior)
  • 8:30 a.m. ET: Average Weekly Hours All Employees, November (34.5 expected, 34.5 prior)
  • 8:30 a.m. ET: Labor Force Participation Rate, November (62.3% expected, 62.3% prior)
  • 8:30 a.m. ET: Underemployment Rate, November (60.8% prior)

Earnings

Earnings

Market Trading Update

Following Wednesday’s 3.1% surge, the market flirted around breakeven yesterday with a rotation out of yesterday’s big gainers. The big winner yesterday was long-duration bonds, with the 10-year Treasury Yield falling by 4.7% to 3.53%. That yield is down sharply from the 4.25% reading just over a month ago, suggesting investors are starting to realize the risk of a recession is increasing.

Not much changed from yesterday’s market action. The MACD buy signal remains intact, suggesting the bullish rally still has room to run. The bullish upward trend keeps the trading range bound fairly tightly above the 20-dma. On a more bullish note, the 20-dma has crossed above the 100-dma, AND the 50-dma has started to turn higher. However, we have seen these bullish improvements previously, only to ultimately be disappointed. Therefore, we suggest trading this rally cautiously and taking profits as needed.

Market trading update.

Misleading Economic Data

Math and data presentation can make measuring economic normalization very difficult. The culprit is the excessive fiscal and monetary actions in 2020 and 2021 and the economic data anomalies they created. We look at used car prices to help appreciate the problems investors are encountering.

If you only look at the orange line showing the year-over-year change in used car prices, you may proclaim that prices of used cars have normalized. Such a statement, however, would be grossly misleading. The blue line shows the used car price index is still well above the trend of the last ten years. While used car prices are not adding to inflation anymore, they are still almost 50% above where they would have been in a more normal economic cycle. Simply, a significant price correction is required to normalize car prices back to their long-term average.

used car economic data

Are Rates High Enough For Powell

Continuing with Powell’s speech is another comment he made about interest rates.

For starters, we need to raise interest rates to a level that is sufficiently restrictive to return inflation to 2 percent. There is considerable uncertainty about what rate will be sufficient, although there is no doubt that we have made substantial progress, raising our target range for the federal funds rate by 3.75 percentage points since March. As our last postmeeting statement indicates, we anticipate that ongoing increases will be appropriate. It seems to me likely that the ultimate level of rates will need to be somewhat higher than thought at the time of the September meeting and Summary of Economic Projections.

What is sufficiently restrictive? In the past, Powell has alluded to real rates (rates less inflation) that are significantly positive. Does that mean interest rates are .5% or 1% or more above PCE? We do not know. But, as Jim Bianco points out below, real rates are still negative and will likely stay negative for at least two more months. The question facing the Fed is how much they have to raise rates and how much inflation will fall in the coming months. The next few months of inflation data will be critical to assessing when the Fed will stop hiking rates.

rates powell inflation

Eight for Eight on Recession Calls

In Tuesday’s commentary, we state: Since 1965, the 10yr-3m curve has inverted eight times, and a recession followed in all cases. The graph below shows that the Chicago PMI also has a perfect track record of predicting recessions. The last time the Chicago PMI index dipped below 40, as it did yesterday, a recession began in short order. Once again, we must ask, is time different?

recession call chicago pmi

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Lessons From The “Nifty Fifty”

Recently, Bank of America discussed the “5-Lessons From The Nifty Fifty.” Of course, if you are unfamiliar with the importance of “The Nifty Fifty,” it is worth explaining.

The “Nifty Fifty” refers to the fifty most popular large-cap stocks in the 1960s and 70s. These “household” names traded at extreme valuations and included household names such as Xerox (XRX), IBM, Polaroid, and Coca-Cola (KO). Many of these Nifty-Fifty stocks had price-to-earnings (P/E) ratios as high as 100 times earnings. Despite high valuations, investors bought shares due to their proven growth records and dividend increases. Such occurred as inflation weighed on everything else.

Wall Street touted the “Nifty Fifty” stocks to investors as “one-decision” picks, just “buy and never sell.”

“The greater fool in growth stocks isn’t the one who buys them but the one who sells them.” – Carl Hathaway, SVP at Morgan Guaranty, March 1973

Those stocks propelled the bull market of the early 1970s. But, unsurprisingly, as investors repeatedly learn, overpaying for value eventually reverts to the mean. The 1973-74 bear market became known as the “Black Bear Market,” as the massive decline convinced investors “equities were dead.”

As Michael Hartnett of BofA notes, there are some critical macro parallels between 1965-1980 and today:

  • 1965-68: Government spending on the Vietnam war and Great Society policy platform combined with unionization and an accommodative Fed to stoke inflation. Asset winners were small caps and tech stocks.
  • 1969-73: Volatility and inflation surged with the end of Bretton Woods and the failure of wage/price controls. Stocks and bonds underperformed in real terms.
  • 1974-79: Oil price shocks, power shortages, food price shocks, wage-price spirals, and budgetary pressures led to stagflation.

We’re seeing evidence of all these phenomena today, albeit over a shorter period. Notably, the 60-70s were marked by repeating surges in inflation, recessions, and bear markets. For roughly 15 years, from 1965 to 1980, investors’ return after inflation was nearly a negative 10% annualized.

That 70s show stocks, crisis, and inflation.

The Fed Repeating Itself

Today, we are seeing many market parallels. Investors are buying a handful of industry-leading stocks amid high inflation and an aggressive rate-hiking campaign by the Federal Reserve.

During the 70s, the Federal Reserve was entrenched in an inflation fight. The end of the Bretton Woods and the failure of wage/price controls combined with an oil embargo sent inflation surging. That surge sent markets crumbling under the weight of rising interest rates. Ongoing oil price shocks, spiking food costs, wages, and budgetary pressures led to stagflation through the end of that decade.

What was most notable was the Fed’s inflation fight. Much like today, the Fed is hiking rates to quell inflationary pressures resulting from exogenous factors. In the late 70s, the oil crisis led to inflationary pressures as oil prices fed through a manufacturing-intensive economy. Today, inflation resulted from monetary interventions that created demand against a supply-constrained economy.

The Fed repeatedly took action to slow inflationary pressures throughout the 60s and 70s. Such resulted in the repeated market and economic downturns. Most notable was the period from 1973-1974. As the Fed hiked rates from 5.5% to 13% to break inflation, the market tumbled by nearly 50%.

That 70s show, stocks, inflation, Fed funds.

The Fed is once again fighting spiking inflation at a time when wages are also rising. Unsurprisingly, the problem is that while wages are rising and impacting corporate profit margins, they are not keeping up with the pace of inflation.

Inflation vs wages

Much like the period of “The Nifty Fifty,” market leadership is ultimately vulnerable to rising costs, margin pressures, and earnings revisions. Such is why valuations remain the key to the end of the current bear market.

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Valuations Remain Key

From 1960 to 1982, investors repeatedly suffered significant market declines as valuations reverted to substantially lower levels. As noted, the Federal Reserve steadily fought repeated bouts of inflation. The resulting market volatility pounded investors with bear markets and economic recessions. While many focus on the final 1974 bear market, most don’t realize there were three preceding bear markets. On an inflation-adjusted basis, real returns for investors over the entire period were substantially negative. Unfortunately, by the time 1982 arrived, and valuations had fallen from 23x earnings to 7x, the “Nifty Fifty” was no longer the portfolio of choice.

S&P 500 index, inflation adjusted, and valuations - That 70s show.

Unfortunately, despite the correction so far in 2022, valuations remain well elevated above historical bull market peaks. While the Federal Reserve is fully engaged in its inflation fight, earnings and margins have yet to adjust for slower economic growth rates in 2023. Such suggests that as that occurs, we may be another period where markets continue to underperform Wall Street expectations.

Real S&P 500 index vs valuations 1980 to present

Given the high valuation levels, inflation, and an aggressive Fed emulating “Paul Volker,” it is possible a period of stagflation persists and markets trade in a fairly broad but frustrating range over an extended period. As Michael Hartnett suggests:

“Valuations are also key. Today’s 60/40 turmoil looks like historical episodes where markets overextend and ultimately correct with a vengeance. Peaks in the S&P 500 CAPE ratios have coincided with 60/40 tops that can take years to reset. The ‘Nifty Fifty’ experience saw valuations reset gradually, more like a slow burn than the flash in the pan we’ve become accustomed to in the last decade.”

5-Lessons From The Nifty Fifty

If we are indeed repeating some form of that “1970s show,” there are several things that investors should consider.

Risk management will become crucial to navigating what could be more volatile markets over the next decade than what we witnessed over the last. Such would be; historically consistent with a valuations reversion period and potentially a period with fewer monetary policy interventions by the Federal Reserve.

However, risk management also means there are “no safe strategies,” particularly when stocks and bonds may be more correlated than in the past. “Buy and hold” and “passive indexing” will most likely give way to more active strategies, and performance and capital preservation demands become key.

Most importantly, investors should begin to prioritize companies that have, and continue to have, strong balance sheets, resilient cash flows, and high levels of visibility into future growth. Companies with solid business models and a focus on shareholder stewardship (read dividends) will play a more critical role than companies with outsized future growth promises.

Let me conclude with Michael’s five lessons from the “Nifty Fifty.

Two are bearish:

1) Don’t buy the leadership dip when the Fed is fighting inflation; and,

2) “Deep value” can be a value trap.

Three are bullish:

3) Active asset allocation is essential;

4) Growth stocks can age gracefully, maturing into dividend-paying value stocks; and,

5) Even bear markets have some big winners.

Just something to think about as we head into a New Year.

S&P 500 Monthly Valuation & Analysis Review – 11-30-22

S&P 500 Monthly Valuation & Analysis Review: 11-30-22

Also, read our commentary on why low rates don’t justify high valuations.


J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you with their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long-term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.

Positioning or Sentiment- Diverging Investor Logic

According to the most recent AAII sentiment poll, bears have outnumbered bulls for 35 consecutive weeks. Such is the longest streak going back to at least 1987. While the sentiment is historically poor, which many construe as bullish, investor positioning is not following suit. The graph in the upper left shows the AAII’s extreme bearishness. The three other graphs point to bullish investor positioning. Investor logic is at a crossroads as sentiment and positioning are worlds apart. Before we would be comfortable claiming that the bear market is over, we would like to see poor sentiment and, similarly, negative positioning reflecting investors are indeed scared.

The bottom two graphs show that SPY’s short positioning and the VIX are near the year’s lows. The top right graph highlights that flow into equity funds remain near all-time highs. Further, they are well above any point in the last 12 years.

bearish sentiment bullish positioning

What To Watch Today

Economy

  • 7:30 a.m. ET: Challenger Job Cuts, year-over-year, November (48.3% prior)
  • 8:30 a.m. ET: Personal Income, October (0.4% expected, 0.4% prior)
  • 8:30 a.m. ET: Personal Spending, October (0.8% expected, 0.8% prior)
  • 8:30 a.m. ET: PCE Deflator, month-over-month, October (0.5% expected, 0.3% prior)
  • 8:30 a.m. ET: PCE Deflator, year-over-year, October (6.0% expected, 6.2% prior)
  • 8:30 a.m. ET: PCE Core Deflator, month-over-month, October (0.3% expected, 0.5% prior)
  • 8:30 a.m. ET: PCE Core Deflator, year-over-year, October (5.0% expected, 5.1% prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended Nov. 26 (235,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Nov. 19 (1.5701 million prior)
  • 9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, November final (47.6 expected, 50.2 prior)
  • 10:00 a.m. ET: Construction Spending, month-over-month, October (-0.2% expected, -0.2% prior)
  • 10:00 a.m. ET: ISM Manufacturing, November (49.7 expected, 50.2 prior)
  • WARDS Total Vehicle Sales, November (14.60 million expected, 14.90 prior)

Earnings

Earnings.

Market Trading Update

With Powell signaling that the Fed would slow the pace of interest-rate increases, starting as soon as at its Dec. 13-14 meeting (read: 75bps hike are dead), stocks soared on Wednesday, keeping the MACD “buy signal” from crossing.

While Powell did have his hawkish moments, like when he repeated that it’s likely that interest rates will need to go “somewhat higher” than what policymakers had forecast in September, he was more dovish than hawkish and omitted language from Nov 2 when he said that “we have a ways to go with interest rates before we get to the level that is sufficiently restrictive.”

And despite Powell’s saying that history has taught him “loosening policy prematurely would be a mistake” and that the Fed is going to stay the course until its job is done, stocks exploded when he echoed Brainard saying that “If you are waiting for inflation to go down, it’s very difficult not to overtighten.”

In response to Powell’s dovishness, the S&P 500 soared 2.9% higher, crossing above the 200-dma and sending the VIX plummeting back toward its lows. Despite tighter monetary policy coming, the rally will certainly excite the bulls near term and could send the markets higher. However, just because the market is currently above the 200-dma, we need a successful retest and confirmation of that break before increasing equity exposure. The last time we broke above the 200-dma, it was short-lived.

Market Trading Update

Job Growth is Finally Slowing

The ADP report shows a gain of 127k jobs in November, well below the +200k estimate and +239k in October. As shown below, +127k is the lowest increase in almost two years. The second table, courtesy of Zerohedge, shows that the leisure and hospitality industry grew the most, while significant job losses occurred in manufacturing and professional and business services. Further, small and large businesses lost jobs, but companies with 50-249 employees saw significant job growth. From the Fed’s perspective, this may be the first labor report that shows their actions are finally weighing on the labor markets. Per ADP’s Chief Economist:

Turning points can be hard to capture in the labor market, but our data suggest that Federal Reserve tightening is having an impact on job creation and pay gains. In addition, companies are no longer in hyper-replacement mode. Fewer people are quitting and the post-pandemic recovery is stabilizing.

adp jobs data
adp jobs industry

Yesterday’s JOLTS data seems to confirm ADP. The number of job openings fell to 11.3 million. While still extremely high, it has been trending lower over the last six months. Chicago’s PMI fell sharply to levels that occur at the peak of recessions. However, the employment gauge within the report rose by 1.5 points to 47.1. The number still points to a contraction in the labor force but not to a meaningful degree.

Yield Curve Update

Yesterday we focused on the 10yr/3m yield curve and the potential implication of inversion for stock prices. Today we take a broader look at many yield curves to better appreciate the recession warning being signaled. The graphs show an inversion in 70% of yield curves and in some cases at levels not seen in 40 years. Each time this many yield curves were inverted, a recession soon followed. Note, however, the recession typically occurs after the yield curve un-inverts. In the same vein, it is common for the stock market to roll over once the yield curves start to un-invert.

multiple yield curves
percent yield curves inverted

One Monetary Policy Fits All

Why are U.K. pension funds requiring bailouts? Any wonder Japan is capping interest rates despite rising inflation? Does the Fed have anything to do with the FTX failure? These questions and many others are best assessed with understanding the dollar’s role in the global economy. As such, our latest two-part article (Our Currency, The World’s Problem, and One Monetary Policy Fits All – Part II) helps readers appreciate the dollar, higher interest rates, QT, and the role the Fed plays globally. To summarize the two articles- in economic terms, demand for the dollar increases while supply falls. The result is the asset classes most dependent on liquidity, often the more speculative of assets, are starting to show stress.

The world is dependent on dollars for trade. Further and more importantly, it is estimated there is at least $13 trillion in foreign dollar-denominated debt outstanding. For these borrowers, dollar strength results in higher coupon payments and payments at maturity. As a result of the strong dollar, demand for the dollar increases, creating a vicious spiral. As QT continues, the supply of dollars will likely decline. Further stress in speculative markets and on foreign borrowers will occur. More concerning, stress will slowly but surely move toward more traditional markets highly dependent on leverage.

The key takeaway we hope to impart is that Fed policy is the de facto monetary policy for the world.

dollar monetary policy usd

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Rosso’s Top Five 2023 Reads and Gift Book Ideas

As most know from the RIA blog, books are my passion and all about gifting knowledge for the holiday season.

There’s nothing more exciting to me than to peruse used book outlets and antique stores that sell ancient reads for pennies on the dollar. Also, new book releases excite me. My reading topic interests vary. However, most tend to be business or macroeconomic trend related. 

With that:  Here are my top five reads for 2023 and gift book ideas for all the voracious readers.

“You don’t have to burn books to destroy a culture. Just get people to stop reading them.” – Ray Bradbury.

On many weekends, I can be found nose-deep in dusty volumes that rot on used bookstore shelves. Or I’ll rummage through boxes in poorly-lit corners of small-town Texas antique stores in search of books written, in many instances, over 100 years ago by authors most of us never knew existed.

There are many great choices this year. The following books made the most significant impact on me, although I could share another ten titles!

My top five 2023 reads may take a while to finish. Many of the topics are heady, and the volumes are thick. However, I assure you the following selections will please and teach you a few things.

And with that, here you go:

Book one on Rosso’s top five reads for 2023 and gift book ideas list. 

Life Force by Tony Robbins.

I’ve been reading and listening to Tony Robbins since 1989. As a broker in training making cold calls at J.T. Moran (the subject of the film Boiler Room – Vin Diesel portrayed my boss), I was discouraged that my lifetime career choice was destined to be a formidable bust.

With guidance from Tony’s cassettes and books, I decided to stick with the industry.

This book is part motivation but mostly about how artificial intelligence will dramatically change the face of preventative care and the battles against all cancers. There’s also an extensive chapter on how health-conscious consumers can benefit today from innovative preventive health procedures. Inspiring are all the innovations yet to come. Tony also includes guidance about small actions readers can initiate now to unlock the harness of healthier living.

One of my best money ideas for 2023 is to take on a health regimen, pay for and stick with it.

Whether a gym membership or increased food and lifestyle expenses, long-term investing in health has a high return on investment. Don’t feel guilty for spending on a treadmill if you’re going to use it consistently. When people cut expenses, gym memberships are always one of the top three categories on their chopping blocks. Seemingly, I add it back to the budget!

Most likely, if you’re a good steward of financial health, you’re also proactive in maintaining your financial health. A study from 2014 in the Journal of Psychological Science titled Healthy, Wealthy and Wise: Retirement Planning Predicts Employee Health Improvements by Timothy Gubler and Lamar Pierce outlines how the same underlying psychological factors drive poor physical and financial health.

This book is over 750 pages so take your time. Reread. The health innovations coming within the next decade will floor and encourage you!

The End of the World is just the Beginning – Peter Zeihan.

Book two on Rosso’s top five 2023 reads and gift ideas list is a real eye-opener.

Peter Zeihan documents the step-by-step dismantling of globalization, and the process isn’t pretty. There are clear winners and losers. Deglobalization is fraught with social unrest, displacement, worsening global weaknesses, and weakening global strengths. This will compel sovereigns to dig deeper and revisit revised models of mercantilism and even imperialism.  

The world is running out of workers; poor demographics are one of the primary drivers of long-term global stagnation. Ultimately, demographics and the aging of society is deflationary. Per Peter: We aren’t simply looking at a demographically induced economic breakdown; we are looking at the end of a half millennium of economic history. 

You may need to study the information provided multiple times (I’m on reading number three). Similar to The Fourth Turning, The End of The World makes a compelling case for a global tectonic fracture of commerce, sentiment, and social norms. The path will be problematic, but thankfully, the United States stands out as a survivor due to plenty of natural resources, including a viable Midwest that can feed the country.

Overall, deglobalization equals shrinkage. As Peter outlines, deglobalization will shrink the global whole and shatter what remains into segregated markets. Global aging is collapsing the skilled labor supply. Economic shrinkage will make everything more expensive and more complex.

Perhaps the worst aspect will be that as capital and labor supplies shrink, the projects that get funding will be those that can slim down their employment profile the most—particularly when it comes to the sort of manufacturing that would typically be outsourced to low-labor-cost locations.

How we invest, fund retirements, and define economic security will shift.

Ostensibly, financial advisors should be open to outliers that can negatively affect clients’ financial goals.

An uneasy and eye-opening read that will shift your worldview just a bit, enough to re-think how the tenets that served us well during globalization will need to change.

I consider Peter’s book the most important of Rosso’s top five 2023 Reads and gift book ideas.

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Permanent Distortion by Nomi Prins.

The Fed’s easy money cancer hit our economy in 2008. To date, the cheap money syndrome has only metastasized. Nomi is a Ken Burns-like Fed documenter. She’ll return you to the formational events that ultimately sparked economic malinvestment, greater wealth inequality, and the ongoing negative consequences of the Fed’s actions on the average worker.

In my book Random Thoughts of a Money Muse from 2012, I was concerned about how global bank policies would encourage social and civil unrest if not controlled or reversed. Sadly, international economist Nomi Prins validates my fears in her writings. The research is well-sourced and, overall, a deep-dive education into irresponsible global banking policies.

For me, an unfriendly reminder of the financial alchemy that fostered excessive risk-taking. No book outlines clearer how detached stock market performance is from the economy.  Unfortunately, the monetary distortion of our Fed and other central bank policies will resonate with us for decades, perhaps permanently.

Not My First Rodeo – Lessons From The Heartland by Kristi Noem.

Rosso’s top five 2023 reads and gift book ideas go west!

The first female governor of South Dakota, her life story is almost like a Yellowstone series back story. Raised on a ranch, Kristi Noem lost her father to a horrific grain accident leaving the family to pull together to continue the operation.  

Her personal story is one of self-responsibility, faith, and perseverance. Her leadership skills and ability to buck against mainstream bromides have led to one of the most prosperous states in the nation. She blends her past with the present to lay out the plan for South Dakota’s future.

Last, governor Kristi Noem is considered a formidable role model, especially for young women. 

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Woke, Inc: Inside Corporate America’s Social Justice Scam by Vivek Ramaswamy.

Well-sourced, insightful, and an impressive deep dive into the underlying hypocritical motivations of corporate Woke Culture. What is corporate America’s dirty little secret? Pretend as if you care about something other than profit and power precisely to gain more of each. Call it the ultimate do-good smoke screen

Vivek’s book outlines how America’s democracy and values are falling into the hands of a small group of capitalists and away from American citizens. Many corporations are involved in a  clever game of criticizing injustice, broadcasting virtue over social media, all the while reaping enormous profits for Wall Street and themselves.

For example, Wall Street now regulates itself. We see it with most ESG investing: poorer returns, higher fees, and more significant profit margins for firms like Blackrock, all with the full support of the DOL.

Many corporate giants look to divide the American people into tribes to make money. Woke, Inc. exposes how this disaster unfolded and what we can do as citizens to stop it. Vivek documents his experiences in academia and business over the last 15 years to show readers how to flank, not fight wokeness. In other words, directly fighting wokeness gets one canceled quickly. Flanking is a process to rebuild a vision for a shared American identity so powerful that it dilutes wokeism to irrelevance. 

Beware of Wokenomics!

Big business uses progressive-friendly values to deflect attention from its own monolithic pursuit of profit and power.

The strategies Vivek lays out to regain democracy aren’t easy but doable. Diversity within the brain, not in the skin or genetics, is valuable in boardrooms or cubicles. Financial success and good citizenry can be empowering when combined with diverse thoughts. Vivek is all about diversity of thought. 

The new model of capitalism Vivek exposes is a dangerous expansion of corporate power that threatens to subvert American democracy. A force where the elites make the rules behind closed doors and push them on the rest of us through moral messaging, ultimately to make a profit, not benefit citizens. 

I don’t want my values defined by clandestine meetings in the corner offices of corporate America. Do you? Vivek shows readers how companies should not use their market power to establish moral rules as they squelch out most citizens. 

I found this book informative but the most disturbing. Sadly, our once apolitical sanctuaries are crumbling, placing certain employees in economic jeopardy and ultimately ostracizing a specific class of consumers.

Are you sharing books? Not a fan

Someone asked me if I share my books – Rarely do I share books.

Frankly, I’m selfish and don’t care to risk never seeing them again, especially my highlights and notes. However, I happily purchase copies for friends who ask and gift them on birthdays and holidays!

Rosso’s top five 2023 reads and gift ideas will get you thinking.

I hope you and your lucky gift recipients enjoy and, most importantly, learn something new from them. 

Flattening The Curve – Fed Style

At 1:30, Jerome Powell will update the public on his views. This will be his first speech since the last FOMC meeting. We think Powell will follow the lead of Fed President Bullard on Monday and many other Fed members over the last three weeks. In particular, we believe Powell will persuade the market to “flatten the curve.” This time, flattening the curve is not about covid. By flattening the curve, we allude to the Fed Funds curve. In particular, market expectations for rate hikes and rate cuts in 2023. As we share below, the Fed Funds futures market is pricing 1.18% in cumulative rate hikes by June. This likely equates to 50bps in December, followed by 25bps at the following two meetings, and a 72% chance of another 25bps rate hike in the spring.

The market and the Fed are on the same page with rate hikes. However, second-half 2023 rate cuts are where opinions between the Fed and the market differ. We think the Fed wants investors to believe they will hike rates to around 5% and leave them there for the remainder of the year. To accomplish this, flattening the Fed Funds expectations curve will be a priority. In other words, they will steer markets to back out the 33 basis points of rate cuts priced into the second half of 2023. Remember, what the Fed says and what the Fed ultimately does are often different.

FED’S BULLARD: THE MOST IMPORTANT THING IS THAT WE REACH A SUFFICIENTLY RESTRICTIVE LEVEL AND THAT FINANCIAL MARKETS UNDERSTAND IT.

fed funds expecations

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended Nov. 25 (2.2% prior)
  • 8:15 a.m. ET: ADP Employment Change, November (200,000 expected, 239,000 prior)
  • 8:30 a.m. ET: GDP Annualized, QoQ, Q3 second estimate (2.8% expected, 2.6% prior)
  • 8:30 a.m. ET: Personal Consumption, QoQ, Q3 second estimate (1.6% expected, 1.4% prior)
  • 8:30 a.m. ET: GDP Price Index, QoQ, Q3 second estimate (4.1% expected, 4.1% prior)
  • 8:30 a.m. ET: Core PCE, quarter-over-quarter, Q3 second estimate (4.5% prior)
  • 8:30 a.m. ET: Advance Goods Trade Balance, September (-$90.6 billion expected, -$92.2 billion prior)
  • 8:30 a.m. ET: Wholesale Inventories, MoM, October preliminary (0.5% expected, 0.6% prior)
  • 8:30 a.m. ET: Retail Inventories, month-over-month, October (0.5% prior)
  • 9:45 a.m. ET: MNI Chicago PMI, November (47.0 expected, 45.2 prior)
  • 10:00 a.m. ET: Pending Home Sales, month-over-month, October (-5.7% expected, -10.2% prior)
  • 10:00 a.m. ET: JOLTS Job Openings, October (10.250 million expected, 10.717 million during prior)
  • 2:00 p.m. ET: U.S. Federal Reserve Releases Beige Book

Earnings

Earnings

Market Trading Update

The market traded lower again yesterday but held on to short-term support at the bottom of the recent trading range. The good news is the 20-dma is close to crossing the 100-dma, but the market needs to rally soon to get that bullish cross. The not-so-good news is the MACD “buy signal” that triggered our rally call almost 6-weeks ago is very close to triggering a “sell.” With nearby support, the market could trade sideways for a couple of weeks and work off the overbought condition. However, a break below the 100-dma sets up a quick test of the 50-dma and then September lows following that. Continue to take profits and rebalance risks accordingly for the moment.

Market trading update

Inflation in Perspective

The graph below from Ed Yardeni shows why the Fed is concerned with inflation. As it shows, U.S. inflation is likely peaking but remains well above the Fed’s 2% target. Further, inflation in Japan and Europe hasn’t peaked yet. Given our large trade deficits, the Fed must consider the influence of higher prices abroad. Additionally, if markets think the Fed is close to its terminal rate, but foreign central banks still have more rate hikes to do, the dollar may weaken, which introduces inflationary effects. The counter-argument to a weaker dollar is that the Fed is removing liquidity via QT and has no plans to stop QT. As such, the supply of dollars is declining. Given the growing need for dollars abroad for trade and maintaining foreign dollar-denominated debt, increasing demand for dollars alongside a falling supply may keep the dollar bid despite a relatively less hawkish Fed.

cpi inflation rates

Yield Curves and Stock Market Drawdowns

The graph below sheds light on the recent inversion of the 10yr/3m UST curve and what we might expect from the stock market. Here are a few key takeaways:

  • Since 1965 the 10yr-3m curve has inverted eight times, and a recession followed in all cases.
  • We should expect the maximum drawdown for this bear market to occur after the curve re-inverts and is closer to peaking.
  • It can take two years between the most negative inversion and the stock market trough.
  • The current inversion is approaching similar levels as in 2000 and 2008. The curve will likely further invert until the market starts pricing in the Fed easing of rates.
yield curves and market drawdowns

Home Prices Slide For 3rd Straight Month

Home prices fell in September from the prior month, marking the first time prices have declined for three straight months in nearly four years. The S&P CoreLogic Case-Shiller National Home Price Index, which measures home prices across the nation, fell 1% in September from August. Home prices in many major cities had been booming for years before the pandemic-fueled home buying spree pushed prices even higher. That surge reversed abruptly this year due to a rapid rise in mortgage rates, which made home-buying far less affordable and pushed many buyers out of the market, Nicole Friedman reports” – WSJ

Home prices

Credit Card Interest

Yesterday we mentioned many consumers’ sharply rising use of credit card debt to help make ends meet. The graph below, courtesy of Kailash Concepts, points out another important consideration with credit card debt. The average interest rate on credit cards is now over 18%, the highest in at least 25 years. The high-interest rate on credit card debt will further limit the ability of many consumers to consume. Think of the surge of credit and the rising interest rates as a future tax on consumption. Once again, we remind you that consumption accounts for about two-thirds of economic growth.

credit card interest charges

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One Monetary Policy Fits All – Part II

In Part one of this series, Our Currency The World’s Problem, we discuss the vital role the U.S. dollar plays in the global economy. With an understanding of the dollar’s role as the world’s reserve currency, it’s time to discuss how the Federal Reserve’s monetary policy machinations influence the dollar and, therefore, the global economy and financial markets.

Given the Fed’s recent extreme monetary policy actions, which haven’t been seen in over 40 years, it is more important now than ever to appreciate the potential global consequences of the Fed’s stern fight against inflation.

Triffin’s Paradox

In Part 1, we highlight the following two lines, which help describe Triffin’s paradox.

“To supply the world with dollars, the United States must consistently run a trade deficit. Running persistent deficits, the United States would become a debtor nation.”

“Simply the growing divergence between debt and the ability to pay for it, GDP, is unsustainable.”

Increasingly borrowing without the means to pay it off is unsustainable. The terms zombie company or Ponzi Scheme come to mind when considering such a system. That said, because the printer of the currency and taxer of its citizens is in charge, we can only ask how long the status quo can continue.

The answer is partially up to the Fed. The Fed can use QE and low-interest rates to delay the inevitable. As we now see, the problem is that those tools are detrimental when there is high inflation. Fighting inflation requires higher interest rates and QT, both of which are problematic for high debt levels.

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Financial Tremors

The Bank of England is bailing out U.K. pension funds. The Bank of Japan uses excessive monetary policy to protect its currency and cap interest rates. China encourages its banks to buy stocks. The dollar, the world’s currency, is on a tear, interest rates are surging, and the financial world is fracturing.

As we noted in Part 1, financial tremors are providing early warnings that hawkish Fed actions are starting to lead to serious problems.

Most foreign nations’ economic and financial well-being is closely dependent on the value of the dollar and the supply of dollars. As such, the Fed’s actions in expanding or contracting dollar liquidity can ripple through the global financial markets. The Fed’s monetary policy is the monetary policy for the world, whether anyone agrees with it.  

ECB’S PRESIDENT LAGARDE: WE HAVE TO BE ATTENTIVE TO SPILL-OVERS FROM THE FED POLICY.

The strong dollar is a problem for some countries- Jerome Powell

2020-2022

Over the past few years, the Pandemic drastically changed the course of monetary and fiscal policy. Since 2020 the U.S. government has accumulated over $10 trillion in debt. To help markets absorb the enormous supply of bonds, the Fed bought nearly $5 trillion in debt. As a result of fiscal spending, the money supply surged higher, and inflation soon followed.

cpi money supply 2022

Prices spiraled higher due to weakened supply lines and massive fiscal handouts. Despite economic normalization and signs of brewing inflation in 2021, the Fed continued buying bonds and kept interest rates pinned at zero.

The ultimate time to fight inflation was before it was a problem. Being late to the game makes the inflation fight harder. In 2022, after inflation became entrenched, the Fed finally started acting.

To their credit, they have been highly forceful, raising rates by 3.75% in just ten months and commencing an aggressive QT program in June. The Fed was the first major central bank to combat inflation vigorously. While other countries sat idly by, the Fed became extremely hawkish.

Money gravitated toward dollars in large part due to Fed aggression. Confidence was growing among currency traders that the Fed was taking inflation seriously. Adding considerable strength to the dollar was that most other central banks were doing nothing about inflation. 

usd 2022

Big Macs and Why Exchange Rates Change

Purchasing power parity (PPP) explains why currencies move against each other. In 1986, the Economist magazine popularized PPP with its Big Mac Index.

The theory underpinning the Big Mac index and PPP states that the exchange rate between two currencies should equalize the prices charged for a Big Mac or an identical basket of goods.

Simply, as prices rise by more in one country versus another currency, the exchange rates between the two must change to offset the difference. Not surprisingly, with the Fed leading the charge against inflation, currency traders flocked to the dollar. Based on PPP and two other currency measures, the dollar is now the most overvalued currency.

big mac index ppp dollar
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Why Does Dollar Strength Matter to Foreign Nations?

There are two primary reasons. For starters, many foreign borrowers borrow dollar-denominated debt. Second, changing currency exchange rates impacts the costs of goods bought and sold with other nations.

Foreign Borrowing

The BIS estimates over $13 trillion of foreign dollar-denominated debt outstanding. This debt poses a unique problem for its borrowers.

In Dollar Appreciation Threatens The Global Economy, we provide an example via the hypothetical Loonie Tire Company to help readers appreciate the impact of dollar strength. The table below from the article shows that a five-cent appreciation of the U.S. dollar versus the Canadian dollar has a significant effect on the firm’s debt terms.

inflation dollar appreciation debt

Because the debt’s repayment occurs in dollars, the loan amount and the interest payments increase with the USD/CAD exchange rate. In our example, it boosted the company’s funding costs by roughly seven percent.

The current dollar strength is significantly raising borrowing costs for unhedged foreign borrowers. Dollar strength resulting from aggressive Fed policy is forcing the Fed’s hawkish policy upon the world.

Importing Inflation

Most commodities and other goods are traded in U.S. dollars. As such, price changes for said goods in foreign nations are due to the combination of supply/demand dynamics and changes in the currency exchange rate.

We present the graph below to help appreciate how dollar strength impacts foreign prices. It shows the price of crude oil rose 11% more when priced in euros versus U.S. dollars since January. 

inflation by exchange rate

Again, dollar strength resulting from the Fed’s more aggressive policy is generating more inflation in foreign nations.

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Summary

“We are addicted to our reserve currency privilege, which is in fact not a privilege but a curse.” –James Grant, Grant’s Interest Rate Observer.

The key takeaway we hope to impart is that Fed policy is the de facto monetary policy for the world. Whether foreign nations want or need tightening or easing, they are stuck with the monetary policy that the Fed decides America needs.

Today, aggressive Fed policy is creating havoc abroad. Like Japan, nations with slower economic growth and more debt can ill afford a monetary-tightening Fed policy. They are trying to counteract the Fed with zero interest rates and QE, but the result is a plunging yen and increasing inflation. Europe, China, and almost all other countries face variations of the same theme.

The world is finally facing Triffin’s Paradox.

Crude Oil is Plunging, Will Energy Stocks Follow?

Crude oil prices are now down on the year, despite almost doubling in the first three months. Undeterred by plummeting crude oil prices, energy stocks are sitting near record highs. As the graph shows, crude oil and energy stocks tend to be well correlated. In fact, as shown in the lower graph, the 100-day rolling correlation between the two is rarely negative. The correlation is currently negative as the prices of XLE and crude oil are diverging significantly. Early 2014 was the last time the prices were significantly negatively correlated. The correlation normalized with steep declines in both prices in the second half of 2014.

Yesterday, we sold our remaining energy exposure. The action follows reductions and profit taking trades over the last few months. With economic activity slowing, we fear energy stocks may catch down to crude oil prices. We may look to reenter our positions at lower prices.

crude oil energy stocks

What To Watch Today

Economy

  • 9:00 a.m. ET: FHFA Housing Pricing Index, September (-1.2% expected, -0.7% prior)
  • 9:00 a.m. ET: House Price Purchasing Index, Q3 (4.0% prior)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite, MoM, September (-1.20% expected, -1.32% prior)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite, YoY, September (10.45% expected, 13.08% prior)
  • 9:00 a.m. ET: S&P CoreLogic Case-Shiller U.S. National Home Price Index (12.99% prior)
  • 10:00 a.m. ET: Conference Board Consumer Confidence, November (100.0 expected, 102.5 prior)

Earnings

Market Trading Update

As I noted yesterday, last week’s rally followed the release of the FOMC minutes, which read more “dovish.” 

“While there was no mention of a “pivot” or a “stall,” investors seem to like the idea of a slower pace of rate hikes. However, traders overlooked the Fed’s statement they will increase rate hikes in 2023.”

While the bulls ignored the Fed, the Fed quickly reminded them yesterday that they are not done with their inflation fight.

“There is still a heavy degree” of expectations that inflation will go away naturally.” – James Bullard, MarketWatch

Bullard reiterated his view that the Fed needs to reach the bottom of the 5% to 7% range to meet policymakers’ goal of being restrictive enough to stamp out inflation near a four-decade high.

The Fed “has a ways to go to get to” restrictive rates, adding that markets are underestimating the risk that the FOMC will be more aggressive and will have to go higher on rates in 2023.” – Bullard

On Wednesday, the markets will receive a message from Mr. Powell. I am confident his message will likely echo Mr. Bullard putting further downward pressure on stocks. Such is why we have continued to recommend profit-taking on this rally. There is some strong support at the 20- and 100-dma, as well as the 50-dma just below.

However, watch our MACD “buy signal,” which is elevated and looking to cross along with a rise in the volatility index. As noted in the newsletter, these two signals consistently show market peaks.

chart of the day

Black Friday- Appearances Can be Deceiving

Preliminary results for Black Friday are positive. Retail analysts estimate that sales rose above $9 billion for the first time and are 1% higher than last year. While the headlines may appear strong, they do not account for inflation. If we assume prices rose 7% versus last year, Black Friday sales are lower by about 6% on a real basis. As such, retailers are not necessarily Black Friday winners. Instead, it may be the credit card companies. They benefit from inflation as they earn a fixed percentage of inflation-boosted sales. Further, with savings rates at 20-year lows, consumers rely heavily on credit cards to keep up with inflation. MasterCard reported 12% year-over-year usage growth on Black Friday. The graph below shows that credit card debt outstanding is growing at 20+ year high rates, while the savings rate is near 20-year lows.

black friday credit and savings

BlockFi Files for Bankruptcy

Another major cryptocurrency custodian failed on Monday. BlockFi holds FTX assets and made loans to the failed Alameda hedge fund, which is closely linked to FTX. BlockFi is the latest crypto firm to fall as a result of the failure of FTX. Before filing for bankruptcy, BlockFi was already not allowing its customers the ability to withdraw funds and limiting their trading activity. As the FTX dominoes continue to fall, we must stay alert to the possibility that a larger bank is involved and may be sitting on significant losses. Thus far, it does not appear to be the case.

More Concern for Energy Stocks

As we note in the intro, the divergence between falling crude oil prices and strong energy stock prices makes us temporarily cautious about the energy sector. The long-term graph of XLE below strengthens our concerns. The graph, using monthly prices, shows the price of XLE is bumping up against a trend line that rebuffed the prior two peaks. In those instances, the price of XLE fell to the support line at the bottom end of the channel after hitting the upper resistance trend line. Further problematic, XLE is almost 100% above the 50 and 200-month moving averages. Lastly, the RSI (upper graph) points to a bearish divergence. The RSI is currently lower than it was in early 2022 despite the higher price today.

energy stocks xle

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The Next Secular Bear Market May Be Upon Us

After 12 years of a liquidity-fueled, Fed-induced bull market, are the markets set to start another “secular” bear market? In an interview with the Financial Times, Boaz Weinstein, founder of Saba Capital Management, suggested such.

“There isn’t a rainbow at the end of all this. There’s no reason that this difficult economic period will only last two to three quarters and no reason to think we’ll have a soft landing or a shallow recession.”

Before you dismiss his opinion as hyperbole, Saba Capital was one of the world’s top-performing hedge funds in 2020 and is up by almost a third in 2022.

Before we go further with our analysis, we must distinguish between a cyclical and secular market cycle.

“A secular market trend is a long-term trend which lasts 5 to 25 years and consists of a series of primary trends. A secular bear market consists of smaller bull markets and larger bear markets; a secular bull market consists of larger bull markets and smaller bear markets.”

The prevailing trend in a “secular bull” market is “bullish” or upward-moving. In a “secular bear,” the market tends to trend sideways with severe drawdowns and sharp rallies.

The chart below shows the market from 1871 to the present, with secular bull market cycles highlighted.

S&P 500 CAPE Valuations vs price

Notably, as an investor, only 5-periods are secular bull markets (where prices are increasing) over the last 150 years. Those five periods account for 100% of all the index gains. In other words, the outcome was disappointing if you invested on a buy-and-hold basis during any other period.

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Valuations & Earnings

Three items drive secular bull markets: 1) valuation expansion, 2) earnings growth, and 3) falling interest rates. The most prominent driver of secular returns are periods of valuation expansion and contractions.

S&P 500 index CAPE Valuations vs Price and cycles

The chart above shows the history of secular market periods going back to 1871 using data from Dr. Robert Shiller. You will notice that secular bull markets begin with CAPE valuations around 10x earnings or even less. Secular bear markets tend to start with valuations of 23-25x earnings or greater. (Over the long-term, valuations do matter.) Most notably, secular BEAR market periods are defined by near-zero returns during the valuation contraction process.

It is imperative to remember valuations are very predictive of long-term returns from the investment process. However, they are horrible timing indicators. Because valuations, and fundamentals in general, take a long-time to play out in the markets, it is not surprising investors dismiss them during a secular bull market.

As noted, what drives long-term secular “bear” markets is “valuation contraction.” Such is driven by investor re-evaluation of earning power by companies due to changes in interest rates, inflation, and, most importantly, prospects for economic growth. Unfortunately, forward prospects for more robust economic growth remain challenging due to high debt levels, which is a deflationary headwind.

Economic growth vs debt

The problem of overvaluation in a slow-growth economic environment is problematic. The massive surge in earnings during the pandemic-driven shutdown is unsustainable as the economy normalizes. Massive stimulus programs, combined with enormous unemployment, led to surging profits that are not replicable in the future. As shown, earnings are one of the most mean-reverting data series in existence, and ultimately if earnings don’t revert, capitalism is no longer functioning correctly.

S&P 500 vs Earnings

The most obvious indication that a secular bear market may be upon us is the deviation of earnings from their underlying growth trend. Earnings can not, over the long term, outgrow the economy. Such is because it is economic activity that creates corporate revenues. The eventual reversion in economic growth and corporate earnings suggests that asset prices are vulnerable to a much more significant repricing to reflect future economic realities.

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Don’t Be Afraid. Just Be Aware Of The Bear

As stated above, the stock market reflects the underlying economic activity over the long term. Personal consumption makes up roughly 70% of that activity. The consumer is more heavily leveraged than ever, making it doubtful they can become a significantly larger chunk of the economy. With savings low, income growth lagging inflation, and debt back at record levels, the fundamental capacity to re-leverage to similar extremes is no longer available.

Let’s also not forget the singular most important fact.

Following the two previous bear markets, the breakout of the markets in 2013 was NOT one based on organic economic fundamentals. Instead, it was from massive monetary interventions by Central Banks globally. All previous secular bull markets were a function of extreme under-valuations, washed-out financial markets, and falling interest rates.

Such is not the case currently.

Hopefully, I am wrong, and the secular bull market that began in 2013 has years of life left in it. However, given high debt levels, a rise in socialistic policies, and the shift from capitalism to corporatism, there is a risk of a reversion.

Such doesn’t mean you can’t make money in a secular bear market. You can, as there will be fantastic rallies. However, those rallies will likely get repeatedly met with disappointing declines. Such means that market returns will probably be exceptionally low on a “buy and hold” basis. However, investors with a bit of skill, a little luck, and a lot of work can likely continue to build wealth as the market reprices to a slow economic growth environment.

One thing is sure. Until Central Banks revert to all-out monetary accommodation, investors will face a challenging investment environment as valuation contraction continues to drive future returns.

Junk Bonds Have No Fear

A recession is very unlikely if the only recession gauge one was following is the spread of junk bond yields to U.S. Treasuries. Typically, leading up to a recession, junk bond spreads versus Treasuries increase as earnings waver and the risk of default increases. Despite a very aggressive Fed, higher borrowing costs, and weakness in equities, junk bond spreads are hovering near their pre-pandemic averages. The graph below shows the yield spread of BB-rated junk bonds to U.S. Treasuries is nearly 1% above its 2021 lows but slightly below its pre-pandemic average. Further, as shown in blue, the average spread between junk and investment-grade (BB and BBB) bonds is also near historical averages.

There is no stress in the corporate bond markets. As we saw in 2020 and 2015, financial stress and instability can happen quickly, and junk bond yield spreads can rise rapidly. Investment grade and junk bond spreads to Treasuries are an important gauge the Fed closely follows. Seeing that spreads are normal likely gives the Fed confidence that they can continue to raise rates.

junk bond breadth spreads

What To Watch Today

Economics

  • Dallas Fed Manufacturing Activity, November (-23.0 expected, -19.4 prior)

Earnings

  • No notable earnings reports

Market Trading Update

This past week, the market jumped to the top of its recent trading range and continues to work in a consolidative manner. While the MACD “buy signal” is overbought, the market’s momentum is still bullish. The 200-dma will provide the next level of serious resistance.

Market Trading Update

Most notably, the number of stocks trading above their respective averages continues improving. While this is bullish, it is also typical, at these levels, to align with short-term market peaks.

Market Breadth stocks above moving averages

One issue challenging this rally remains the drop in the volatility index. As noted last week, net bullishness rose to the highest level since the July rally. That bullish increase coincides with a sharp decline in the volatility index as investors think the “bottom is in. So far this year, a reading of 20 or below has provided a good signal to take profits and reduce risk.

Market vs volatility index

As noted, the Wednesday rally followed the release of the FOMC minutes, which read more “dovish.” While there was no mention of a “pivot” or a “stall,” investors seem to like the idea of a slower pace of rate hikes. However, traders overlooked the Fed’s statement they will increase rate hikes in 2023.

The rally reversed a majority of the previous oversold conditions and net bearishness. Therefore, some profit-taking and risk reduction in portfolios remain prudent. While the expectation for a rally into year-end remains, we could see some selling in the first half of December from tax loss harvesting and portfolio rebalancing. Such will likely provide a tradeable opportunity into year-end and the beginning of 2023.

The Week Ahead

The next two weeks will be important as the Fed and investors will see the latest inflation and employment data. ADP on Wednesday and the BLS Jobs Report on Friday are expected to show the labor force grew by about 200k jobs in November. Besides the recent uptick in jobless claims, nothing leads us to believe labor data will be disappointing. However, there are an increasing number of corporate layoff actions. Therefore a lower-than-expected number and increase in the unemployment rate should not come as a total surprise.

The Fed’s preferred inflation gauge, PCE, will be released on Thursday. Expectations are for the monthly core PCE to remain the same as last month at 0.5%. The year-over-year rate is expected to decline to 4.9% from 5.1%. Investors hope PCE comes in below expectations, as CPI did a few weeks ago.

Chairman Powell will speak at 1:30 PM ET on Wednesday. He has been quiet since the last Fed meeting, so this engagement allows him to update investors on the Fed’s path ahead.

Improving Market Breadth

The graph below from Bank of America provides a little optimism. Breadth is improving, and a bottom might be forming in the S&P 500. Throughout the decline in 2022, the percentage of S&P 500 stocks trading above their 200dma was trending lower, similar to the index. With the recent rally, the percentage of stocks trading above their 200dma is now above the prior peak. The higher high in the breadth indicator introduces a positive divergence. Ideally, we want to see the S&P 500 trade above the 200dma to confirm this signal. The 200dma capped the prior rally. Caution is warranted as the S&P 500 rose above it for a short period during the April rally, but it turned out to be a trap for bulls.

S&P 500 market breadth

Fed Tightening Cycles

The graph below compares the current Fed tightening cycle to the previous four. The recent 3.75% increase in nine months is more aggressive than the previous four. However, when assessing the amount of tightening, we must also consider the rate itself. Even with the sharp increase in Fed Funds, Fed Funds only stands at 3.75%. That is decently higher than the prior hiking cycle ending in 2018, when the terminal rate hit 2.5%. But it remains well below the prior three. Fed Funds topped at 6.0%, 7.0%, and 5.5% in chronological order from 1994 to 2006.

fed tightening cycles

Tweet of the Day

rosenberg tweet um sentiment

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Continuing Jobless Claims and Recessions

The most closely followed measures of employment tend to be lagging indicators. However, there is one indicator that assesses the labor market in near real-time. Initial and continuing jobless claims, published weekly, provide up-to-date information on the number of employees recently fired and their ability to find new jobs. While understanding how many people are being let go is important, the health of the labor market is best gauged by how quickly those recently unemployed find new work. Therefore, continuing jobless claims provide valuable and current insight into the labor market’s health.

Continuing jobless claims have been ticking higher since May but are still below pre-pandemic levels. Weekly data can be volatile, especially around the holidays. Therefore, we present the graph below, which shows the three-month percentage change in continuing jobless claims. As noted by the dotted line, a recession occurred each time the percentage change in continuing jobless claims rose above 10%. Since June 2020, the three-month change in the number of continuing claims has been negative. In July, that number flipped to positive. It is now quickly creeping up to 10%. The number of claims and continuing jobless claims remains low, but the rate of change in both is picking up and bears watching closely in the coming months.

continuing claims

What To Watch Today

Economy

  • The market is only open until 1 pm Eastern Time.

Earnings

  • No Notable Earnings Releases

Market Trading Update

The market traded nicely higher on Wednesday ahead of the Thanksgiving holiday. Again, don’t read too much into it, as the volume was light, and professional traders were mostly absent. However, the market dipped ahead of the release of the FOMC minutes and then rallied back to the day’s highs on some “dovish” reads that the Fed will now reduce the pace of rate hikes. However, the Fed did suggest they could hike rates more than expected next year, which seems to bypass traders that this was NOT a pivot in monetary policy. The Fed is still hiking rates which will negatively impact economic activity in 2023.

Nonetheless, market action remains bullish but is now getting extended. Take profits for now. If the market can break above the 200-dma, we will reassess our positioning but will need confirmation of that breakout before increasing risk exposure.

Market Trading Update

S&P 500 – The Moment of Truth

Heading into year-end, the S&P 500 faces tough resistance. The top graph shows the strong downward-sloping resistance line starting at the late 2021 record high. Conversely, the lower chart shows that the VIX volatility index has followed an opposite path, bouncing off a rising support line. A definitive breakthrough in both lines, and the S&P 500 rising above key moving averages, would provide a little comfort that the 2022 downward trend may be over. However, if both indexes repel the technical lines, new lows on the S&P 500 are certainly possible.

S&P 500 VIX

Divergence at the Fed

Based on the most recent FOMC minutes, there may be a growing divergence of policy thinking at the Fed. Per Bloomberg:

There may be signs of growing divisions on the (FOMC) committee. A group led by Fed Vice Chair Lael Brainard- the most dovish committee member, in our view – still believes inflation is largely transitory, and is more concerned about the employment outlook. Another group believes inflation is more persistent and the Fed still has a long way to go on rates. We think Chair Powell is in the second group.

Powell leads the Fed and will push his views as those of the Fed. However, his job as the Fed Chair is to align the members’ policy prescriptions and find common ground. We may see Powell become a little less hawkish to keep a large majority on the same page.

Shrinking Margins Ahead

The graph below shows that companies are finding it increasingly harder to pass on inflation to their customers. Sales remain near record highs in large part due to inflation. However, earnings are no longer keeping pace with sales. As a result, corporate earnings margins are slipping. Our Tweet of the Day also eludes to the possibility of shrinking margins.

margins earnings sales

Tweet of the Day

corporate margins

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Financial Stability or Is Something Breaking?

Recently we have noted that the odds are increasing that financial instability, or as we say, “something breaks,” is the likely culprit to force the Fed to reverse course. Given the strong link between Fed policy and asset prices, it’s valuable to appreciate how the Fed monitors financial stability. The illustration below categorizes the four factors the Fed assesses in its Financial Stability Report. The red-shaded areas provide a current update on the four financial stability categories. While conditions can change rapidly, there are few signs of financial instability rearing its ugly head.

Some may argue that stock and bond prices are down 15-20%, which does not portend financial stability. However, as noted, they have been offset to some degree by rising home prices. If stock and bond prices stay down and house prices start falling as many expect, we might see one of the four financial instability measures trigger a warning. However, such would likely not be enough for a pivot unless stock and or bond prices decline further from current levels. As for the three other categories, there is nothing concerning at the moment, but conditions can change quickly.

financial stability

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended Nov. 18 (2.7% prior)
  • 8:30 a.m. ET: Durable Goods Orders, October preliminary (0.4% expected, 0.4% prior)
  • 8:30 a.m. ET: Durables Excluding Transportation, October preliminary (0.0% expected, -0.5% prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended Nov. 19 (225,000 expected, 222,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Nov. 12 (1.520 million prior)
  • 9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, November preliminary (50.0 expected, 50.4 prior)
  • 9:45 a.m. ET: S&P Global U.S. Services PMI, November preliminary (48.0 expected, 47.8 prior)
  • 10:00 a.m. ET: University of Michigan Consumer Sentiment, November (55.0 expected, 54.7 prior)
  • 10:00 a.m. ET: New Home Sales, October (570,000 expected, 603,000 prior)
  • 10:00 a.m. ET: New Home Sales, month-over-month, October (-5.5% expected, -10.9% prior)
  • 2:00 p.m. ET: FOMC Meeting Minutes, November 1-2

Earnings

Earnings

Market Trading Update

Yesterday, the market traded all day positively, building on the gains from the morning open. As noted previously, there is little volume this week due to the holiday-shortened trading week, so don’t read too much into yesterday’s action. The market has been trading in a consolidation pattern for the last two weeks, and a rally tomorrow will set up a test of the 200-dma, which has acted as important resistance to the market all year. A confirmed break above the 200-dma would suggest a continued rally higher, but there are still many headwinds currently facing asset prices.

Market Trading Update

While the bulls are getting excited short-term by the action, the longer-term picture remains challenging, with numerous weekly moving averages sitting just above the market. We still suspect a rally into year-end, but the beginning of next year will likely be more challenging. Continue to use rallies to raise cash and rebalance positions heading into year-end.

Market trading update weekly.

Another Day, Another Recession Warning

The graph from Charles Schwab shows that the Conference Board’s Leading Economic Indicators (LEI) is -2.7%, below -2.2%, the average start of recessions since 1960. The second chart shows the factors that make up the LEI. It shows that market indicators for a recession portend flat growth. Non-financial indicators are flashing red. Of note, the biggest drag to the LEI index is Consumer Expectations. Consumer consumption accounts for almost two-thirds of GDP, so it is not surprising consumers’ dour outlook raises the odds of a recession.

lei recession alert
recession indicators

Inflation Set To Plummet

The graph below shows the robust correlation between the NFIB (small business owners survey) and CPI. Assuming the correlation holds up as it has for the last 20 years, we should expect inflation to normalize quickly. It is worth caveating that the reasons for inflation today are unlike any prior experiences of the last 20 years. While we think inflation will decline, we are not sold it will be as much or as fast as the graph portends.

inflation nfib

Crypto vs. Sub-Prime, Perspective Matters

Joe Weisenthal of Bloomberg, in his daily commentary, reminds us there is a vast difference between the popping of the cryptocurrency bubble and the subprime/mortgage meltdown of 2007-8. People need housing. Nobody needs cryptocurrency. Accordingly, there is a natural bottom to home prices and, therefore, a limit to losses for mortgage debt investors. In contrast with crypto, “There’s no obvious circuit breaker or curb to stem the decline.”

Tweet of the Day

tweet 200 week moving average

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Coinbase Bankruptcy Risks Rise

On April 14, 2021, shares of Coinbase, a cryptocurrency broker/custodian, were first publically traded. The shares peaked at $429.50 a share that day, well above the reference point of $250 set the night before. Since peaking in its first hours of trading, Coinbase has grossly underwhelmed expectations. Coinbase shares are now down nearly 90% from the intraday peak and under severe pressure due to FTX’s bankruptcy and the poor performance of cryptocurrencies.

Further stoking concerns, Coinbase bonds are under similar pressure. The graph below charts the price of a 2028 Coinbase bond issued with a coupon/yield of 3.375%. The bond is now trading at 54 cents on the dollar, making its yield north of 15%. Accordingly, the bond market is pricing in a decent chance of bankruptcy. While removing FTX as a competitor may be good for Coinbase, evaporating confidence and skepticism in crypto and its infrastructure are weighing on the entire industry.

coinbase bonds

What To Watch Today

Economy

  • 10:00 a.m. ET: Richmond Fed Manufacturing Activity Index, November (-8 expected, -10 prior)

Earnings

Earnings

Market Trading Update

With the holiday-shortened trading week upon us, the market drifted sideways yesterday, still holding above key support of the 100-dma. The 20-dma is rapidly approaching the 100-dma, which provides additional support at that level. We reduced some additional risk yesterday in portfolios and raised some more cash, as we have suggested for the last couple of weeks. The rally is getting a bit long, and after the holidays, we could see some tax loss harvesting and mutual fund rebalancing lower stocks a bit. However, this week, don’t pay too much attention to the overall action as it is low volume and will likely have little direction.

Market Trading Update

Spinning Tops and the Latest Rally?

A spinning top is a technical pattern using candlestick charts. The illustration below shows that a spinning top denotes a period where the market opens and closes at similar levels. Still, within the period, it witnesses significant upward and downward volatility. A spinning top represents indecision and tends to be more relevant in trending markets. Per Think Markets:

In a strong uptrend or downtrend, the spinning top shows there is a new balance of forces in the price action. Unlike the previous sessions, where one side dominated the market and pushed the price action in its desired direction, a spinning top signals that the opposite side of the market is now growing in the game, and the short-term outcome is uncertain.

As with almost all candlestick patterns, the role of the next candle is important.

In case of a reversal, the candle next to the spinning top should be opposite of the prevailing trend, while for continuation patterns, you look for a candle that goes in the same direction to confirm that the price action is continuing in the same direction.

bullish bearish spinning tops

We introduce spinning tops as they have marked the peaks in the recent trend channel, as shared below. After setting a record high in late 2021, the S&P 500 proceeded lower in downward movements and sharp relief rallies. The first two rallies, using weekly charts, were capped by spinning tops. Does last week’s spinning top candle signify the recent bounce is over?

spinning tops s&p 500

Bullish and Bearish Market Analogs

Market analogs compare chart patterns from two periods to help forecast the future. Some believe that prior trends and patterns often repeat themselves. One popular analog today is a comparison of 2008 to current conditions. The first chart below shows that the year’s sell-off remains similar to 2008. This bearish analog suggests a significant decline ahead.

The second set of graphs presents a more bullish analog. The decline this year has formed a declining trend channel. The top resistance line connects the three lower highs. Support is formed by connecting the two lower lows. 1981-1982 played out similarly, with three peaks and troughs defining the channel. Ultimately the third low was the final low, and the market broke upward through the channel. By mid-July 1982, when it broke out of the channel, inflation was still hot at 6.5% but well below the recent high of 14.5%. Inflation is showing signs of peaking and declining, albeit at much lower levels than in 1981. Analogs can be helpful at times but are often right until proven wrong.

2008 market analog
1982 analog
1982 analog 2022

Crude Oil Keeps Falling

Crude oil fell over 5% Monday morning on a report that OPEC may boost production by half a million daily barrels. Within hours the report was rebuked, and crude oil erased the morning’s decline. While trading has generally been bearish over the last few weeks, President Biden may supply a bid to the market as he seeks to replenish the Strategic Petroleum Reserves (SPR).

crude oil

Tweet of the Day

small cap tweet

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More Bearish Market Action Before The Bull Can Run

Following the weaker-than-expected October inflation report, stocks surged on hopes the Fed will pivot” sooner than later. As we discussed recently, a “policy pivot” is not necessarily bullish but instead suggests more bearish market action will come first. To wit:

“Such leaves only two trajectories for monetary policy. The first option is for central banks to pause rates and allow inflation to run its course. Such would potentially lead to a softer landing in the economy but theoretically anchor inflation at higher levels. The second option, and the one chosen, is to hike rates until the economy slips into a deeper recession. Both trajectories are bad for equities. The latter is substantially riskier as it creates an economic or financial “event” with more severe outcomes.

While the U.S. economy has absorbed tighter financial conditions so far, it doesn’t mean it will continue to do so. History is pretty clear about the outcomes of higher rates, combined with a surging dollar and inflationary pressures.”

Monetary conditions index vs market

The “monetary policy conditions index” measures the 2-year Treasury rate, which impacts short-term loans; the 10-year rate, which affects longer-term loans; inflation which impacts the consumer; and the dollar, which impacts foreign consumption. Historically, when the index has reached higher levels, it has preceded economic downturns, recessions, and bear markets.

Not surprisingly, the tighter monetary policy conditions become, the slower economic growth tends to be.

Graph of monetary policy conditions index vs. GDP

The bullish expectation is that when the Fed finally makes a “policy pivot,” such will end the bear market. However, while that expectation is not wrong, it may not occur as quickly as the bulls expect.

Notably, the monetary policy conditions index suggests that more bearish action is likely before the next bull market cycle can begin.

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Outlook Remains Bearish For Now

Investors are dealing with a bearish market for the first time in over a decade. Such is something that many investors in the stock market today have never witnessed firsthand. Nonetheless, it has been a challenging year on many fronts, given the enormous number of negative days and increases in daily volatility.

However, we warned this could be the case in 2021 when we discussed that “low volatility begets high volatility.”

“Hyman Minsky argued that financial markets have inherent instability. As we saw in 2020-2021, asymmetric risks rise in market speculation during an abnormally long bullish cycle. That speculation eventually results in market instability and collapse.

We can visualize these periods of ‘instability’ by examining the daily price swings of the S&P 500 index. Note that long periods of “stability” with regularity lead to “instability.”

(I have updated the chart to the present.)

Graph of daily point change of S&P Index

While periods of high volatility eventually subside, the bearish period for stocks is ultimately tied to the monetary conditions present in the economy at the time. If we invert our monetary conditions index and compare it to the annual changes in the price of the S&P 500 index, the correlation becomes apparent.

Graph of annual change in S& P 500 earnings vs monetary policy conditions index

As should be expected, with the Federal Reserve aggressively hiking rates and the US dollar index surging in 2022, monetary conditions are extremely tight. Such suggests that until those monetary conditions reverse, the market will continue to trade within a bearish trend. Such is because, as should be apparent, tighter monetary conditions reduce corporate earnings and profit margins.

Graph of annual change in S&P 500 earnings vs. monetary conditions index

The strong dollar alone is problematic for companies with foreign sales, which account for nearly 40% of corporate revenue. However, adding to that risk, higher borrowing costs, wages, input prices, and the ability to maintain margins in a slower economic environment becomes exceedingly difficult.

Therefore, it should be unsurprising that stocks will need to reprice lower in the coming year to adjust for slower earnings growth.

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7-Rules To Navigate The Final Leg Of A Bearish Market

While anything is possible in the near term, complacency has quickly returned to the market. Investors are very optimistic that the Fed will pivot and the next bull market will start. However, there are numerous reasons to remain mindful of the risks.

  • Earnings and profit growth estimates are too high.
  • Deflation will become more prevalent
  • The Fed will continue to hike rates.
  • Economic data will surprise on the downside.
  • Consumer spending will slow.
  • Inventory overhang will impact manufacturing.
  • Valuations remain high by many measures.
  • The risk of a credit-related event is rising.

So what do you do?

We remain optimistic about the markets due to share buybacks, seasonality, and bullish sentiment. As we have repeatedly stated, the market could rise to between 4000 and 4100 by year-end. However, as we enter 2023, we remain concerned about the broader macro risks and the risk the Federal Reserve will “break something” by hiking rates too much. Such keeps us cautious, so we continue reiterating the importance of remaining unemotional and focusing on managing portfolio risks.

  1. Move slowly. There is no rush to make dramatic changes. Doing anything in a moment of “panic” tends to be the wrong thing.
  2. If you are overweight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move. Again, after significant declines, individuals feel like they “must” do something. Think logically about where you want to be and use the rally to adjust to that level.
  3. Begin by selling laggards and losers. These positions were dragging on performance as the market rose, and they led on the way down.
  4. Add to sectors, or positions, that are performing with or outperforming the broader market if you need risk exposure.
  5. Move “stop-loss” levels up to recent lows for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
  6. Be prepared to sell into the rally and reduce overall portfolio risk. You will sell many positions at a loss simply because you overpaid for them to begin with. Selling at a loss DOES NOT make you a loser. It just means you made a mistake.
  7. If none of this makes sense to you, please consider hiring someone to manage your portfolio. It will be worth the additional expense over the long term.

Everyone approaches money management differently. Our process isn’t perfect, but it works more often than not.

The important message is that this bearish cycle will end, and the next bull cycle will begin.

Remember, if you “run out of chips” beforehand, you are out of the game.

Will The World Cup Kick Off Weakness?

Markets were spared when the Houston Astros won the world series. As we highlighted in the 10/12/2022 Commentary, markets tumbled every time a Philadephia professional baseball team won a championship. Should we be anxious as the 2022 World Cup kicks off?

To see how the World Cup may sway markets, we share research from Is There a Correlation Between World Cups and the S&P 500? written by Ralph Baddour. He uses four trading strategies, which vary slightly by the starting and ending trade dates. The S&P 500 return for the four strategies ranged from -1.86% to -2.47%, with a mean return of -2.11%. Baddour’s World Cup trading advice:

Therefore, the ideal trading strategy for the S&P 500, as suggested by these empirical results, is to short the index prior to the start of a World Cup and cover the position immediately following the tournament’s final match.

The World Cup, like Philadelphia baseball, has zero effect on the fundamental or technical underpinnings of markets. However, as Baddour writes:

Whether it’s the potential for worker and investor distraction, or effects on investor morale (positive or negative, depending on which team one is supporting) spanning multiple weeks, there is clearly the possibility of a calendar effect tied to the World Cup, scheduled every four years.

world cup

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What To Watch Today

Economy

  • No Notable Releases Today

Earnings

Earnings.

Market Trading Update

This week, the market touched our initial objective of 4000, but as we will discuss momentarily, tough talk from Federal Reserve officials knocked the markets back a bit. However, despite those comments, the sell-off was mild, holding above key supports heading into the holiday-shortened and light volume trading week where the “inmates will run the asylum.”

Market Trading Update.

The good news is that the market tested, and held, 100-dma with the 20-dma crossing above the 50-dma. With the market contained in a rising trend channel, this all suggests the bulls remain in control for the time being. Speaking of “inmates,” the net bullishness of investors is now at the highest level since the July market peak.

Net investor bullishness

With next week a holiday-shortened trading week, a continued advance through the end of the month is likely.

The Week Ahead

The week ahead will be quiet heading into the Thanksgiving holiday. A slew of data will be released on Wednesday, including jobless claims, durable goods, new home sales, and the University of Michigan Consumer Sentiment Index. We will focus on jobless claims and, in particular, continuing claims. This data point helps us understand how quickly recently laid-off people can find new employment. The figure remains historically low, but it has been rising since June. Of all employment indicators, this is often the first to signal changes in the labor market.

We suspect a few more Fed members will emphasize the Fed’s hawkish position. Further, the FOMC minutes, due on Wednesday, from the last meeting will likely stress the Fed’s sole intention to fight inflation with an extremely tight monetary policy.

continuing jobless claims

Housing Market Standstill

The housing market has ground to a halt as many sellers are unwilling to drop prices enough to compensate potential buyers for higher mortgage rates. With mortgage rates around 7%, mortgage payments have risen sharply. Consider the graph below to stress how mortgage rates have affected homebuyers’ payments. As it shows, a homebuyer wanting to buy a median-priced home with a mortgage payment equal to 30% of their income must have an income of $107,000. At the start of 2021, less than two years ago, the same buyer would only have needed about $62,000 to buy the same house. The combination of higher prices and mortgage rates puts the real estate market at a standstill. This will likely continue until house prices and mortgage rates decline to more economically feasible levels.

Housing market standstill

A Bearish Signal with Bullish Implications

The graph below plots the number of positive trading days per the prior 252-day periods going back 50 years. Over the last 252 trading days, only 111 days, or 44%, have been positive. The red diamonds highlight that such a low occurrence has only happened three other times, two of which were over 40 years ago. From oldest to newest, the annual return for the next 252 trading days following those highlighted lows are as follows: +28.02%, +57.73%, and +40.36%. Therefore, we may have quite a rally in the coming year if this indicator proves worthy.

bearish bullish trading days positive

Tweet of the Day

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Tech Layoffs, Who Cares?

Meta cut 11,000 jobs. Twitter let 3,700 employees go. Stripe, Coinbase, and Microsoft all fired about 1,000 employees. The list of tech layoffs continues, and the media is hyping it. While the number of announcements of tech-related layoffs seems problematic, should we care about it from a broader macroeconomic viewpoint?

Per the BLS, information technology jobs constitute 1.8% of the workforce. Even in a depression where half of those jobs could be lost, the unemployment rate would only rise by 0.9%. During the 2008 recession, the unemployment rate increased by 4.5%. So while tech layoffs make for great headlines and likely attract many readers, they do not represent a big enough part of the economy to overly worry about. Further, many tech companies overstaffed over the last two years. Some of these layoffs are not necessarily economic warnings but a normalization of staffing to better match normalizing demand for tech products.

tech layoffs

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What To Watch Today

Economy

  • 10:00 a.m. ET: Existing Home Sales, October (4.40 million expected, 4.71 million prior)
  • 10:00 a.m. ET: Existing Home Sales, month-over-month, October (-6.6% expected, -1.5% prior)
  • 10:00 a.m. ET: Leading Index, October (-0.4% expected, -0.4% prior)

Earnings

Earnings

Market Trading Update

Tough talk from Fed officials (Daly and Bullard) put investors in a sour mood yesterday as the “pivot” was pushed out. While the market ended lower yesterday, the was buying in the early afternoon, with the market almost returning to breakeven before selling off into the close. This kind of action is bullish from a short-term standpoint and suggests that buyers continue to bid for stocks even on down days.

After running into the top of the rising trend channel, the market is seemingly in a healthy correction process. The market held support at the 50-dma, and the 20-dma is just below, which also defines the current uptrend. If these supports hold, another rally attempt into month-end will not be surprising. However, we suggest using any such rally to reduce risk and rebalance portfolio exposures. We suspect we could see some heavier selling in the first two weeks of December, which could retest recent lows.

Market trading update

December 15th- Dot Plot Warning

The Fed has numerous ways to convey its policy expectations to the market. The FOMC meetings, associated press conferences, and speeches and articles garner significant attention and alert investors to what the Fed is thinking. Not followed as closely are the quarterly Fed “dot plots.” The dot plots are each Fed member’s expectations for the Fed Funds rate, GDP, unemployment, and inflation. The September Fed Funds dot plot below is the latest release. The median estimate for year-end 2022 was 4.4%. The rate increases to a peak of 4.6% in 2023. Note that six members, at the time, thought Fed Funds would peak at 4.875% in 2023. As we share below, we believe the December 15th dot plots have the potential to stun the markets.

fed dot plots

The Fed Funds futures market is in line with the September dot plots. The implied Fed Funds curve peaks in April at 4.91 and falls to 3.60 in two years. Recent comments by Fed President Esther George, shown below, make us think the Fed might use the dot plots in December to shock the markets. Pay close attention to the second paragraph. If the Fed takes this route, they might raise the terminal rate well above 4.91% and or increase 2024’s expectation to convey the Fed will not be pivoting anytime soon.

esther george dot plot

Bullard Piles on to the Hawkish Rhetoric

St. Louis Fed President Jim Bullard sent shivers through the markets on Thursday. In his presentation, he states:

“The policy rate is not yet in a zone that may be considered sufficiently restrictive.”

The graph below, from his discussion, claims a rules-based approach to monetary policy suggests the Fed Funds terminal rate should be above 5%. That rate may be as high as 7%. Stocks immediately fell upon learning that Fed Funds may increase more than anyone expects.

bullard fed fomc

Foreigners Selling Treasury Bonds

We have noted in the past the likelihood that foreign nations are selling their holdings of U.S. Treasury bonds to help support their currencies versus the dollar. The latest round of data shows that this is indeed occurring. Foreign holdings of U.S. Treasuries fell to $7.297 trillion in September from $7.571 trillion a year ago. The largest holder, Japan, shed $179 billion of Treasury bonds. China, the second largest holder, sold $113 billion.

The problem is not just their selling. They are selling while the supply of bonds is increasing rapidly. Total debt outstanding rose by $2 trillion over the last year. Further, the Fed has added another $200 billion in its actions to reduce its balance sheet. We are bullish bonds because we think the Fed ultimately breaks something and causes economic deterioration and much lower inflation. However, we are mindful that the supply outlook is a factor working against us.

bond foreign holdings

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Hard Landing Coming? Investors Don’t Think So.

Is a “hard landing” coming, economically speaking, as the Fed continues its most aggressive rate hike campaign in 40 years? Investors don’t seem to think so as investors continue to chase economically sensitive stocks despite the underlying economic deterioration. Such was a point made recently by Jesse Felder, noting:

“The cyclicals-to-defensives ratio has yet to really react even to the slowdown in the economy we have already seen over the past year or so as indicated by the reversal in the ISM Manufacturing PMI. If the latter continues to deteriorate in the months ahead, cyclicals (like the tech and consumer discretionary sectors) could have a great deal of pain still in front of them.

Manufacturing vs the market

His point is worth noting because investors have piled into stocks historically sensitive to economic changes. This year, however, has been a bit of a conundrum as the Energy sector, normally the most sensitive to economic weakness surged due to the Russia/Ukraine war, supply challenges, and political restrictions that keep oil prices elevated.

Such is notable because while corporate earnings have declined this year, much of the weakness is masked by the exceptionally strong results from the energy sector.

Earnings with and without energy

However, the risk going into 2023 is that those “cyclically sensitive” sectors catch down to economic realities as the impact of the Fed’s rate hikes begins to affect consumers.

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Economic Hard Landing Very Likely

As noted previously, the Federal Reserve has never entered into a rate hiking campaign with a ” positive outcome.” Instead, every previous adventure to control economic outcomes by the Federal Reserve has resulted in a recession, bear market, or some “event” that required a reversal of monetary policy. Or, rather, a “hard landing.”

Federal Reserve vs financial crisis

Given the steepness of the current campaign, it is unlikely that the economy will remain unscathed as savings rates drop markedly. More importantly, the rate increase directly impacts households dependent on credit card debt to make ends meet. This has been the case over the last 30 years as the rise in consumption, which is ~70% of economic growth, was supported by an increasing debt as wages failed to keep up.

consumption vs debt

Such is why, as seen in the last National Federation Of Independent Business (NFIB) survey, the number of businesses with souring economic outlooks continues to rise. Of course, if business owners expect weaker economic growth, they won’t invest in business expansion or increasing employment.

NFIB capital expenditures vs economic expectations

Since employment is one of the highest costs to business profitability, reductions in employment become initially concentrated at firms where higher prices reduce sales quickly. As the “hard landing” becomes more evident, firms will reduce headcount more rapidly as high wages are corrosive to earnings and corporate margins.

PPI CPI inflation vs GAAP earnings

While investors may not think a hard landing is coming, the risk to consumption due to indebtedness and surging rates suggest differently. Importantly, what matters most for investors is the coincident repricing of assets as earnings decline due to the contraction in consumption.

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Economic Recessions Leads To Earnings Recessions

We previously discussed that estimated earnings for the S&P 500 companies remain highly elevated. Such gives investors a false sense of security by assuming “forward valuations” suggest stocks are priced fairly. In reality, many companies in the index remain overvalued despite the price decline in 2022. More importantly, earnings have not accounted for a potential “hard landing” economically. In 2019, earnings declined by more than 30%. Even the “soft landing” in 2015 saw earnings decline by more than 10% compared to current estimates.

Earnings annual percent change vs market

More importantly, despite recent downward revisions, current estimates still exceed the historical 6% exponential growth trend. That trend has contained earnings growth since 1950. Currently, earnings estimates exceed that trend by one of the most significant deviations ever. The only two previous periods with similar deviations are the Financial Crisis and the Dot.com bubble.

Earnings vs deviation of growth trend

More significant is that earnings estimates DO NOT SURVIVE economic “hard landings.

As shown, the composite economic index (EOCI) is already signaling that earnings will decline further as the economy slows. The deeper the recession, the deeper the earnings decline will be.

Economic composite vs market annual percent change

The “forward” earnings estimate annual change also suggests even a “mild recession” will push estimates substantially lower. During every previous recessionary period, forward estimates declined to a negative 20% annual rate of change.

Annual change in earnings vs market

The whole point of the Fed hiking rates is to slow economic growth, thereby reducing inflation. As such, the risk of a recession rises as higher rates curtail economic activity. Unfortunately, with the economy slowing, additional tightening could exacerbate the risk of a recession.

Therein lies the risk. Since earnings remain correlated to economic growth, earnings decline as rate hikes ensue. Such is especially the case in more aggressive campaigns. Therefore, market prices have likely not discounted earnings enough to accommodate a further decline.

Fed funds vs earnings growth

In other words, “fair value” for the market could still be substantially lower.

A “hard landing” will likely reveal how much lower that could be.

Target FedEx and Amazon Caution About The Holidays

Tar­get reported poor earnings ($1.54 versus $2.13 expected) and revised its outlook lower. They claim con­sumers are pulling back on spend­ing in re­cent weeks, which hurt sales and prof­its in Q3, and will continue to do so going forward. Along with Target’s warnings, recent actions from FedEx and Amazon do not bode well for the coming holiday shopping season.

Adding industry-wide concern for Target’s statements are recent actions from FedEx and Amazon. FedEx plans to furlough freight workers through the holiday season. At the same time, Amazon will lay off 10,000 employees starting this week. Typically both companies are aggressively hiring going into their busiest time of the year. While the warnings from Target and other companies keep coming, retail sales are seemingly strong. Retail Sales for November rose 1.3%, above expectations for a 1% increase. The problem, as Charlie Bilello shares below, is that the gains are solely due to inflation. Strip-out inflation and total retail sales are slightly below their March 2021 peak. Further, as we learned on Tuesday, credit card debt outstanding is surging. It is helping keep many consumers afloat. We share more on this below.

retail sales

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What To Watch Today

Economy

  • 8:30 a.m. ET: Housing Starts, October (1.411 million expected, 1.439 prior)
  • 8:30 a.m. ET: Building Permits, October (1.515 million expected, 1.564 million prior)
  • 8:30 a.m. ET: Housing Starts, month-over-month, October (-2.0% expected, -8.1% prior)
  • 8:30 a.m. ET: Building Permits, month-over-month, October (-3.2% expected, -1.4% prior)
  • 8:30 a.m. ET: Philadelphia Fed Business Outlook Index, November (-6.0 expected, -8.7 prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended Nov. 12 (228,000 expected, 225,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended Nov. 5 (1.510 prior)
  • 11:00 a.m. ET: Kansas City Fed Manufacturing Activity, November (-8 expected, -7 prior)

Earnings

Earnings 111722

Market Trading Update

After strong retail sales data this morning, the market traded lower on profit-taking after the recent spurt higher. The strong retail numbers suggest the economy is doing just fine and would not halt the Fed from hiking rates further. Also, comments from the Fed suggesting the same took some of the “wind out of the sails.” Given that a big chunk of the retail sales data for October came from Halloween spending and California stimulus payments, we will likely get some clawback in the November report.

For now, the market tested the upper rising trend line, got overbought, and is now correcting to some degree. Initial support is the 100-dma. The 20-dma has crossed above the 50-dma, which is bullish and will increase support for any short-term correction. Take profits and rebalance risks. We will likely get another trading opportunity in the next week or two.

Market trading update

Loading Up On Credit Card Debt

Just as Target, FedEx, and Amazon warn about the coming holiday season, the recent Federal Reserve data on credit card debt offers another signal that consumers are in trouble. Consumers borrow heavily to fuel purchases as their incomes fail to keep up with inflation. Revolving credit, primarily outstanding credit card balances, increased at an annual rate of 8.7% to a record $1.162 trillion in September.

Confronted with negative real wage growth and dwindling savings, many consumers resort to credit to keep up their consumption. The graph below from Fabian Wintersberger shows a robust correlation between real wages and credit card debt. Given credit card limits and the likelihood of increased unemployment, real retail sales will likely remain under pressure. The scenario is likely fueling worries of Target, FedEx, Amazon, and many other retailers.

credit card debt

Just How Much Credit Card Debt Are We Talking About?

“American household debt has hit a new high, with the collective tab rising $351bn in the latest quarter, taking the total owed by households to more than $16.5 trillion. There are not many comparisons to give that number context, but it is roughly 5x the size of the UK economy, or just shy of 7x what Apple is worth.

All told, household credit card debt grew 15% year-on-year, the largest annual jump for more than 20 years. A group of Federal Reserve researchers, hardly known for their sensationalist exaggeration, said the increase ‘towers over the last 18 years of data.’

With over 500 million accounts open in the US, credit cards are a staple of consumer spending — more than 190 million Americans have at least one account, and 13% reported having five or more cards.” – Chartr

Credit Card Debt

Short Covering Rally Ahead In Bonds?

The current speculative trader net short positions in 2yr UST futures are at a record level. Looking at the graph below, we see the prior record short position in November of 2018 preceded a nearly 3% decline in two-year yields. Can that happen again?

To help understand the bet the short traders are making and answer our question, we review what speculative traders think will happen. The price of Fed Funds futures denotes where traders believe the Fed Funds rate will be in each future month. The two-year yield tends to track Fed Funds futures closely. Therefore, given the strong correlation, we can take the average of the next 24 monthly Fed Fund futures contracts and compare it to the 2-year yield. The second graph below shows the 24 individual Fed Fund contracts comprising the lifetime of a current two-year note. The average of the 24 contracts is 4.33% on top of the 4.34% two-year note yield.

Short sellers are betting that Fed Funds futures are underestimating the Fed’s resolve. They must believe that Fed Funds will peak above 4.91 and or not decline as much as futures imply.

two year bonds specs
bonds fed funds

Fed President Esther George Targets Labor

“I’m looking at a labor market that is so tight, I don’t know how you continue to bring this level of inflation down without having some real slowing, and maybe we even have contraction in the economy to get there.”

The following quote from a WSJ article offers insight into the resolve of many Fed members to bring down inflation. Not surprisingly, they appear somewhat bewildered that their aggressive actions have had minimal economic and labor market impact. George and other members appear resigned to the fact that a recession is inevitable. She further states:

“I have not in my 40 years with the Fed seen a time of this kind of tightening that you didn’t get some painful outcomes.”

Therefore, it appears labor is in the Fed’s crosshairs.

“we’re really looking at labor as the driver here.”

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New York Fed Points to Higher Inflation Expectations

In addition to CPI, PPI, and PCE data, the Fed relies on consumer inflation expectations to guide its actions. The most recent round of data from the New York Fed’s Survey of Consumer Expectations should concern those who think the latest CPI and PPI reports warrant a change in the Fed’s mindset. The New York Fed survey points to higher inflation expectations. Per the survey: “Median inflation expectations increased at both the one- and three-year-ahead horizons in October, by 0.5 and 0.2 percentage points, respectively, to 5.9% and 3.1%. Both increases were broad-based across age, education, and income groups.” Equally concerning, the difference between the expectations of the top and bottom quartile of those surveyed decreased. There is less disagreement among consumers about higher inflation expectations.

The graph below shows the recent uptick in inflation expectations using New York Fed data. Further, consumers remain very uncertain of how much inflation to expect. Uncertainty, or fear that inflation remains high, will drive consumers to demand higher wages. The Fed remains fearful of a wage-price spiral, and the New York Fed survey data only heightens its concerns.

inflation expectations new york fed

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What To Watch Today

Economy

  • 8:30 a.m. ET: Retail Sales, October (1.0% expected, 0.0% in September)
  • 8:30 a.m. ET: Import Price Index, October (-0.4% expected, -1.2% in September)
  • 8:30 a.m. ET: Export Price Index, October (-0.3% expected, -0.8% in September)
  • 9:15 a.m. ET: Industrial Production (0.1% expected, 0.4% in September)
  • 9:15 a.m. ET: Capacity Utilization (80.4% expected, 80.3% in September)
  • 10:00 a.m. ET: Business Inventories (0.5% expected, 0.8% in September)
  • 10:00 a.m. ET: NAHB Housing Market Index, November (36 expected, 38 in October)
  • 4:00 p.m. ET: Net Long-term TIC Flows, September ($197.9 billion in August)
  • 4:00 p.m. ET: Total Net TIC Flows, September ($275.6 billion in August)

Earnings

Earnings 111622

Market Trading Update

The market traded up strongly at the opening yesterday as the Producer Price Index (PPI) confirmed the inflation peak is likely behind us. However, the market sold off at about midday as missiles hit Poland, sending concerns about expanding Russia/Ukraine conflict. Russia quickly rejected the allegations, and the market recovered somewhat into the day’s close.

The market has now rallied to the top of the rising bullish trend channel and, while not extremely overbought, is approaching our initial 4000 targets. Notably, we see a little exhaustion in the rally as morning rallies fail to hold. Also, the MACD “buy signal” is moving toward the top of its channel range. All of this suggests that the rally could have some additional upside, but it is most likely becoming more limited. Continue to take profits and rebalance risk accordingly.

We sold half of our AMD and NVDA positions ahead of earnings tomorrow, so we will see how NVDA reports and plan our next trades.

Market trading update

Another Good Inflation Reading

PPI, following last week’s CPI, was better than expected. Monthly PPI only rose 0.2% versus expectations of 0.5%. The year-over-year rate of producer inflation fell from 8.5% to 8.0%. Excluding food and energy, PPI was flat for the month. The data add credence that inflation is peaking. The bigger question, however, remains how fast inflation will fall to get the Fed comfortable it is no longer a problem.

Based on the CPI and PPI reports, a 75bps rate hike is likely off the table. Implied Fed Futures rates agree. They assign an 86% chance of a 50bps at the mid-December meeting. The next relevant inflation reading will be the monthly PCE report on December 1st.

inflation ppi

Macro Alf and the Recent Rally

@MacroAlf, Alfonso Peccatiello, puts out some great work with his publication The Macro Compass. In his most recent article, Bear Market Rally or Turning Point (Again)?, Alfonso highlights a couple of charts that are worth considering. The first graph below shows the ratio of the implied volatility of out-of-the-money (OTM) puts versus calls. The ratio is now over two standard deviations cheap. Per Alf-

“In other words, at this point of the year, incentive schemes drive people to be much more willing to pay and chase upside moves than they are to chase downside moves.”

Option activity helped fuel the market higher last week. With calls now so expensive versus puts, it will be hard for options traders to continue to fuel the rally. That said, the current level is at a similar point as the beginning of the 2020 bull run.

put vol ratio rally

Alf’s second graph shows that last week’s rally drove the S&P 500 equity risk premium to its lowest level in over a year. The equity risk premium (the implied extra yield stock investors should expect to earn versus buying bonds) is about 1% below the average for the last fifteen years. Given the market’s economic and monetary uncertainty, investors should demand an above-average risk premium for buying stocks. In Goodbye TINA, Hello BAAA, we also noted that expected stock returns are too low versus guaranteed bond yields. To wit:

Expected stock returns are on par with risk-free Treasury yields but woefully below the premium spread investors should demand.

equity risk premium rally

Stagflation Says BofA

The chart below from BofA shows that stagflation is the expectation of professional fund managers. The last time such an expectation occurred was in mid-2008. In July 2008, CPI peaked at 5.50% and a year later was -2%. Profession investors were wrong about inflation at that time. However, they were correct that economic activity would slow appreciably. We think inflation will continue to fall from its peak, and economic activity will likely slow. While the circumstances today are very different from 2008-2009, we expect the light blue line, signifying below-trend growth and inflation, will become the new expectation as it did then.

stagflation

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Our Currency, The World’s Problem Part 1

The Bank of England is bailing out U.K. pension funds. The Bank of Japan uses excessive monetary policy to protect its currency and cap interest rates. China encourages its banks to buy stocks. The dollar, the world’s currency, is on a tear, interest rates are surging, and the financial world is fracturing.

Unlike any other currency, the U.S. dollar drives the global economy and financial markets. Because of the dollar’s status as the world’s reserve currency, the Fed’s monetary policy actions play a critical role in steering the U.S. economy and all global economies and financial markets.

To foresee the next crisis, it is imperative to understand the dollar’s role in global finance and economics and the resulting role that the Fed plays in influencing international monetary policy. To do so, we start with insight from Triffin Warned Us, an article we published in 2018.   

These “cliff notes” for the article lay the groundwork for Part 2. Following this article, we will discuss the risks investors face as the Fed attempts to quell inflation.

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The Bretton Woods Agreement

In 1944, the United States and many nations forged a significant financial arrangement in Bretton Woods, New Hampshire. The agreement has paid enormous economic dividends to the United States. However, it has a flawed incongruity with a dear price that is rearing its ugly head today.

Per the terms of the 1944 Bretton Woods Agreement, the U.S. dollar supplanted the British Pound to become the world’s reserve currency. The agreement assured a large majority of global trade would occur in U.S. dollars, regardless of whether the United States was participating in such trade. Additionally, it set up a system whereby other nations would peg their currency to the dollar. This arrangement is akin to the global currency concept made popular by John Maynard Keynes. Keynes’s brainchild was Bancor, a supranational currency.

Within the terms of the agreement was a supposed remedy for one of the abuses that countries with reserve currency status typically commit, running continual trade and fiscal deficits. The pact discouraged such behavior by allowing participating nations to exchange U.S. dollars for gold. Therefore, other countries that were accumulating too many dollars, the side effect of American trade deficits, could exchange their excess dollars for U.S.-held gold. As a result, a rising price of gold, indicative of a devaluing U.S. dollar, would be a telltale sign that America was abusing her privilege.

London Gold Pool

The agreement started fraying shortly after. In 1961, the world’s leading nations established the London Gold Pool. The objective was to fix the price of gold at $35 an ounce. The action was an attempt to maintain the Bretton Woods status quo. By manipulating the price of gold, an important gauge of the size of U.S. trade deficits was broken. Therefore, there was less incentive to swap dollars for gold.

Seven years later, France broke the ranks. France withdrew from the Gold Pool and demanded large amounts of gold in exchange for dollars. As a result, in 1971, President Richard Nixon, fearing the U.S. would lose its gold, suspended the convertibility of dollars into gold.

From that point forward, the U.S. dollar was a floating currency. There was no longer the discipline imposed upon it by gold convertibility. Nixon’s actions essentially annulled the Bretton Woods Agreement. 

The following decade saw double-digit inflation, persistent trade deficits, and weak economic growth. These were signs that America was abusing its privilege as the reserve currency. The first graph below shows that, like clockwork, the U.S. began running annual trade deficits in 1971. The second graph highlights how inflation picked up markedly after 1971.

london gold pool deficits
cpi london gold pool

By the late-1970s, Fed Chair Paul Volcker raised interest rates from 5.875% to nearly 20.00% to break inflations back decisively. While economically painful, Volcker’s actions not only ended ten years of persistently high inflation and restored economic stability but, more importantly, satisfied America’s trade partners. The now floating rate dollar regained the integrity required to be the world’s reserve currency. This was despite lacking the checks and balances imposed upon it by the Bretton Woods Agreement and the gold standard.

Our article The Fifteenth of August discusses how Nixon’s “suspension” of the gold window unleashed the Federal Reserve.

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Enter Dr. Triffin

In 1960, 11 years before Nixon’s suspension of gold convertibility and the effective demise of the Bretton Woods Agreement, Robert Tiffin foresaw this inevitable problem in his book Gold and the Dollar Crisis: The Future of Convertibility. According to his logic, the privilege of becoming the world’s reserve currency would eventually carry a heavy penalty for the U.S.  

At the time, few paid attention to Triffin’s thesis. However, he was invited to a congressional hearing of the Joint Economic Committee in December of the same year. 

What he described in his book and Congressional testimony became known as Triffin’s Paradox. Events have played out primarily as he envisioned.

Essentially, he argued the reserve status forces a good percentage of global trade to occur in U.S. dollars. For trade and global economies to grow under such a system, the U.S. must supply the world with U.S. dollars. 

To supply the world with dollars, the United States must consistently run a trade deficit. Running persistent deficits, the United States would become a debtor nation.

Foreign Creditors Enable U.S. Deficits

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

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

The arrangement benefits all parties involved. The U.S. purchases imports with dollars lent to her by the same nations that sold the goods. Additionally, the need for foreign countries to hold dollars and invest them in the U.S. results in lower U.S. interest rates, further encouraging domestic consumption and providing relative support for the dollar.

For their part, foreign nations benefit as manufacturing shifted away from the United States to their countries. As this occurred, increased demand for their products supported employment and income growth, thus raising the prosperity of their respective citizens.

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A Win-Win or a Ponzi Scheme?

While it may appear the post-Bretton Woods covenant is a win-win pact, there is a massive cost accruing to everyone involved.

The U.S. has too much debt. As such, it has become increasingly dependent on low-interest rates to spur debt-driven consumption and to pay interest and principal on existing debt.

Lower than appropriate interest rates lead to unproductive debt, as can be seen with debt outstanding rising at a much faster pace than GDP. Simply the growing divergence between debt and the ability to pay for it, GDP, is unsustainable.

total leverage ponzi debt

Summary

Triffin’s paradox states that with the benefits of the reserve currency also comes an inevitable tipping point or failure.

As we see with the current instance of rising interest rates and inflation, that point of failure is closing in on the U.S. and the rest of the world.

Part two of this article will focus on the dollar and Fed monetary policy and what it may entail as the Fed continues to push interest rates higher.

Waller Reminds Investors “We’ve got a ways to go”

“The market seems to have gotten way out in front over this one CPI report. Everybody should just take a deep breath and calm down. We’ve got a ways to go ” -Federal Reserve Governor Christopher Waller.

After the market’s powerful reaction to CPI, investors woke to words of warning from Christoper Waller. In addition to the quote above, he added the Fed has a “long, long way to go to get inflation down.” Waller believes rate hikes will continue until inflation falls consistently over many months and nears the Fed’s 2% target. The important takeaway from Waller’s comments and Chair Powell’s FOMC press conference is the Fed has significant concerns about taking its foot off the monetary brakes too early. Waller said the worst possibility is that Fed stops raising rates and inflation reignites. Powell and Waller are looking to the 1970s and 1980s inflation outbreaks for guidance. Such a mindset leads us to believe the market may be getting ahead of itself in thinking the Fed is anywhere close to a policy pivot.

The graph circles the first two outbursts of inflation in 1968-1970 and 1973-1975. In both cases, the Fed hiked aggressively but eased equally aggressively once inflation peaked. The box covering the third instance of high inflation highlights the Fed kept Fed Funds above 10% for three years after inflation topped. Since then, Paul Volcker has preached the Fed’s extremely tight policy for an extended period, ultimately slayed the inflation problem.

waller, cpi, fed

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What To Watch Today

Economy

  • 8:30 a.m. ET: Empire Manufacturing, November (-6.0 expected, -9.1 prior)
  • 8:30 a.m. ET: PPI Final Demand, month-over-month, October (0.4% expected, 0.4% prior)
  • 8:30 a.m. ET: PPI Excluding Food and Energy, MoM, October (0.3% expected, 0.3% prior)
  • 8:30 a.m. ET: PPI Excluding Food, Energy, and Trade, MoM, October (0.3% expected, 0.4% prior)
  • 8:30 a.m. ET: PPI Final Demand, year-over-year, October (8.4% expected, 8.5% prior)
  • 8:30 a.m. ET: PPI Excluding Food and Energy, year-over-year, October (7.2% expected, 7.2% prior)
  • 8:30 a.m. ET: PPI Excluding Food, Energy, and Trade, YoY, October (5.6% expected, 5.6% prior)
  • 9:00 a.m. ET: Bloomberg Nov. United States Economic Survey

Earnings

Earnings

Market Trading Update

Unsurprisingly, the market traded off yesterday after a strong advance last week. The 100-dma is now important support for the market to hold. The 200-dma is important resistance. Such suggests that while there is some upside currently, it is limited, and we could see more volatile trading into the end of November.

We have recommended using the rally for the last several weeks to raise cash and reduce equity risk. We did that again yesterday by reducing equity exposure to 38% of the portfolio (our target allocation is 35%, and increasing cash to 17.5%. The rest of the portfolio is most short-duration fixed income for now. While we still expect some short-term upside to the market, we suspect next year will be challenging, at least initially, as tighter Fed policy takes effect.

Market trading update

Quantifying The Lag Effect

Over the years, economic activity has become increasingly reliant on debt. As evidence, the Fed’s primary monetary policy to increase or slow economic growth and inflation is the cost of borrowing money- interest rates. However, as we have been consistently warned, Fed policy changes take a long time to fully affect the economy.

The graph below from Pictet Asset Management provides strong evidence that the lag time between interest rate changes and economic activity may be as long as four quarters. It shows it can take a year before actual bank lending reacts to tighter or looser bank lending standards. The second graph below from MacroCompass similarly shows it takes four to five quarters for a decline in credit conditions to weigh on inflation and earnings growth.

The Fed started aggressively raising rates about a year ago, when bank lending standards tightened. As such, we should expect lending, the gasoline fueling economic growth, will slow significantly in the coming months.

lag effect and bank lending
credit lag

Put Call Ratio Hits 2022 Lows

The put-call ratio (number of puts as a ratio to the number of calls) is trading at a 2022 low. Viewing this through a bullish lens may provide relief that positive sentiment is finally returning to markets. The bearish camp would counter it signals investors are too complacent and ignoring the plethora of macroeconomic and liquidity risks. Unlike in 2021, when the ratio was very low, today, the volatility index (VIX) remains well above levels seen throughout most of 2021. Are we in a regime change, or are investors getting ahead of themselves?

put call ratio

Crypto and Liquidity

The recent FTX news should raise deep concern for crypto investors. Your assets are only as good as the custodian of said assets. The FTX event calls into question the infrastructure backing how many investors hold crypto assets.

For non-crypto investors, there is also an important takeaway. Changes in liquidity are often most appreciable in the riskiest asset classes. As we saw with Bernie Madoff and Jon Corzine, removing liquidity often uncovers fraud and unsustainable market schemes. While we are not overly concerned the FTX crisis will infect more traditional asset markets, we harbor concerns that the instance highlights that QT and higher rates are slowly taking liquidity from the markets. In time, the lack of liquidity, if it continues, will likely creep into the stock market.

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Midterm Elections Are Bullish Even In A Bear Market

With the midterm elections behind us, does the market outlook improves given a now gridlocked Congress? Historically speaking, such is the case. As noted by Michael Cannivet via Forbes:

“Before you hit the panic ‘Sell Everything’ button, though, it’s worth considering at least one bullish catalyst on the horizon—voters head to the ballot box on November 8th.

The data is clear: Midterm elections are historically bullish for the stock market.”

While garnering less attention than a presidential election, midterm elections are important because they could lead to a change in control of the U.S. Senate and House of Representatives. Such can significantly impact policy, laws, and foreign relations. Historically, markets tend to favor “gridlock” in Washington as it dramatically reduces the risk of an adverse policy change regarding taxation, geopolitical conflict, or substantive changes to spending and debt.

Since 1950, there have been 18 midterm election cycles, and in the twelve months following each of those cycles, the stock market has had positive returns. Over the subsequent 12 months, stocks delivered an 18.56% average annualized gain compared to just 10.6% over all other years.

Midterm Election Returns

Over a more extended 24-month period, stocks returned an average of 33.7% after a midterm election.

Midterm 12 and 24 month returns.

However, while the data above goes back to 1958, the last time the S&P 500 produced a negative return over the 12 months following a midterm election was 1939. Of course, there was a massive economic contraction and uncertainty at that time as the U.S. battled the Great Depression and World War II began in Europe.

Another period of interest is the late 1960s and 1970s, marked by slow economic growth, high unemployment, rising energy prices, and significant inflation. Given the similarities currently, the bearish pre-midterm market returns and an un-accommodative Federal Reserve, the outlook, while bullish, is less clear.

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Getting Back To Even Is Not The Same Thing

There are a couple of caveats to this analysis that must be considered. The first is that while returns tend to be positive post-midterm elections, several times, it coincides with when the midterm elections fell. The chart below shows the S&P 500 with the years of midterm elections marked and significant events.

For example, in 1966, 1970, and 1974 the midterm elections coincided with the bottom of the three recessionary bear market cycles. Coincidence? Probably. More importantly, on a longer-term basis, returns on a “buy-and-hold” basis were negative as the secular bear market continued. We see the same effect between 1998 and 2014, midterm elections yielded positive short-term results, but long-term returns were near zero.

SP500 mid-term elections

The second caveat to the historical data is the difference between making money and getting back to even. While the mainstream analysis suggests investors should buy the midterm elections for positive 12-month returns, most are already invested. In a year where the midterm elections fall in the middle of a bear market, like 1974, 2002, or 2022, most investors used those returns to “get back to even.”

The chart below shows the S&P 500 for 2022, starting at 4796. It will require a return of 26% over the next 12 months for investors to break even. Notably, that does not include the rate of return necessary to meet their financial goals. For example, if your financial plan requires 6% annualized returns, the 26% advance still leaves you another 12% short of your annual return goals (6% for 2022 and 2023). Given the average yearly return post-midterm elections is 18.6%, investors will fall short of their goals.

Getting back to even

While I am not discouraging you from taking advantage of a robust post-midterm election rally, there is a vast difference between “getting back to even” and “making money.”

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The Difference This Time May Be The Fed

While the history following midterm elections is bullish, there is a difference this time that could produce a less-than-optimistic outcome. That difference is Fed and their current fight against inflation. We have previously discussed the “lag effect” of monetary policy and its impact on economic growth and earnings. To wit:

As the Fed continues to hike rates, each hike takes roughly 9-months to work its way through the economic system. Therefore, the rate hikes from March 2020 won’t show up in the economic data until December. Likewise, the Fed’s subsequent and more aggressive rate hikes won’t be fully reflected in the economic data until early to mid-2023. As the Fed hikes at subsequent meetings, those hikes will continue to compound their effect on a highly leveraged consumer with little savings through higher living costs.

Given the Fed manages monetary policy in the “rear view” mirror, more real-time economic data suggests the economy is rapidly moving from economic slowdown toward recession.”

Currently, the Fed is still tightening monetary policy to further slow economic growth. As shown, when the Fed has previously stopped hiking rates, forward stock returns tended not to be robust.

Fed rate hikes, stock market, and crisis

Another difference is that previous market lows, which coincided with bear markets and midterm elections, were low valuations. Despite the market decline in 2022, valuations remain elevated relative to historic market bottoms.

S&P 500 vs valuations CAPE

Given the more extreme negative market sentiment, a substantial rally is undoubtedly possible through year-end and early 2023.

However, we suspect following that, the market environment will become more challenging. Particularly as the Fed’s monetary tightening becomes more evident in slower economic activity, declining inflation, and slower earnings growth. If that is the case, asset prices, and ultimately valuations, will need to drop before the final market low.

There are no guarantees in the financial market. While history certainly supports the bullish outlook, it should not be considered gospel. Bull markets happen in bear markets. However, many factors could negatively impact returns over the next 12- to 24 months. As such, investors should measure and manage their risk accordingly.

The good news is the negative backdrop will pass, and longer-term returns will become evident. Of course, to participate in the next bull market, you must ensure you survive the bear market.

This returns me to my main point. Spending the next bull cycle “getting back to even” is not the same as making money.

A Sigh of Relief for Bulls

Bulls released a huge sigh of relief last week after encouraging inflation data prompted a sharp move lower in bond yields and the USD. This allowed stocks to rally nearly 1% into the close Friday after surging 5.5% on Thursday. With the USD approaching three standard deviations oversold, a short-term retracement would not be surprising. This would put the rally in equities on hold for now, but given the volatility crush following CPI, we could drift higher for a few more weeks.

The chart of the Euro/USD exchange rate shows the extremely overbought condition of the Euro relative to the USD currently. While the Euro could rise further relative to a weakening USD, a much-needed relief for weaker European countries, a reversion first would not be surprising.

Euro USD Exchange

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What To Watch Today

Economy

  • No notable economic data is scheduled for release.

Earnings

earnings

Market Trading Update

From a technical perspective, the market tested and held crucial support again at the 20-dma after the FTX (cryptocurrency) blowup on Wednesday. The subsequent rally off support turned our MACD “buy signal” higher, keeping it intact, and the market cleared critical resistance at the 100-dma. Such now sets the stage for a rally to the 200-dma between 4000 and 4100.

Market Trading Update

The surge in asset prices also cleared levels that are now forcing short-sellers to cover positions which will add “fuel to the rally” over the next few days. As noted by Goldman Sachs, CTAs bought $43BN last week and $79BN the previous month. Now that we are above the short-term trigger, Goldman calculates a whopping $38 billion to buy over the next week and substantially more (green line) if the market is up big. The chart below shows that the bank expects more than +$79 billion of net buying over the month.

CTA fund flows and levels to cover in the market

While weaker inflation was evident in the latest report, such does not mean the Fed will stop hiking interest rates. However, as discussed last week following the FOMC meeting, the Fed has already clarified that they will slow the rate hike pace. Such was a point made by Philadelphia Fed President Patrick Harker on Thursday:

“In the upcoming months, in light of the cumulative tightening we have achieved, I expect we will slow the pace of our rate hikes as we approach a sufficiently restrictive stance.”

Moving from 75bps rate hikes to 50bps in December is still a significant “aggressive action” that will impact economic growth in 2023.

The surge in markets, while much needed, is likely another opportunity to reduce risk and rebalance portfolios as we head into 2023. Slower economic growth and falling inflation do not support currently elevated earnings and profit margins.

The Week Ahead

This week starts with another year-ahead consumer inflation expectations survey this morning. While the University of Michigan’s survey is trending higher lately, expectations, as measured by this survey, have not. Its year-ahead expectations for inflation have decreased for three consecutive months, most recently falling to 5.4%. The market will shift focus to October PPI on Tuesday now that CPI is out of the way. As we’ve written previously, the relationship between the two can provide insight into what to expect from profit margins. The consensus estimate is an increase of 0.5% MoM, compared to the October CPI growth of 0.4% MoM.

We’ll get October retail sales on Wednesday, and Thursday will bring an update on the state of the housing market with housing starts and building permits. Estimates bet on housing starts falling again in October to an annualized 1.41 million. Friday, we’ll end the week with existing home sales data for October. The consensus is for another decline to 4.39 million annualized as Fed policy roils the housing market.

Labor Market May Not be As Tight as We Think

According to an article published by the Harvard Business Review, the labor market may not be as tight as we think. Three researchers at LinkedIn created a new measure of labor market tightness by leveraging the company’s vast data. The authors explain:

“The ratio of job openings to unemployment is over 1.85 today, suggesting that there are nearly two job openings for every unemployed individual looking for a job. This ratio is considerably higher than its pre-pandemic level and higher than the historical norm of about 0.7 since 2000. But if the job openings to unemployment ratio is indicative of a very tight labor market, then why does real wage growth continue to be so tepid? One potential reason for this anomaly is that the labor market is not actually that tight — that is, the standard measures of slack might not be telling the whole story.”

The LinkedIn model of tight labor market conditions attempts to account for active job openings and job seekers. It analyzes the ratio of active job openings posted directly on LinkedIn to active applicants.

“Active applicants are members who submit at least one application to a job opening in a given month. We measure active job openings as the stock of open job positions on the last business day of the month multiplied by an index of recruiting intensity. The idea behind recruiting intensity is to measure how actively employers are looking to fill vacant jobs.”

The chart below plots labor market tightness measured by the JOLTS survey against LinkedIn’s new measure. The stark but plausible difference raises the question of whether the Fed is walking into a trap, given its focus on the labor market.

Labor Market

The Technicality That Bolstered the CPI Report

Last week’s inflation data looked great from a high level prompting a sigh of relief for many— but digging into the numbers reveals a slightly less bullish story. The CPI for health insurance contributes 0.9% of headline and 1.1% of core inflation, dove -4%. This was the largest MoM drop in the data going back to 2005, and it was due to a periodic adjustment that has little to do with actual insurance premium inflation. Without that effect, month-over-month inflation (40bps) would have been 5bps higher.

So why does it matter that this technicality juiced the report? Because the market is taking this report in a more positive light than it should. The adjustment isn’t factored in the Fed’s preferred measure of inflation, the Core PCE Price Index. Furthermore, October PCE data won’t be released until two weeks before the next FOMC meeting, December 13th-14th. The FOMC won’t even consider a quarter of the MoM CPI surprise, so the excitement may be slightly overdone.  

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