In its recent earnings call, Costco’s CFO gave a unique warning about the potential for a slowdown or recession. As shown below, courtesy of The Transcript, Costco warns they are seeing shifts in what customers are buying. Such consumption shifts are similar to those Costco witnessed during the 2008 and 2000 recessions. In particular, Costco says customers are shifting purchases toward cheaper meats like pork or chicken and canned meats. Further, sales from Costco’s brand, Kirkland, rose 1.2% last quarter, much greater than prior Kirkland sales growth, as customers are seeking lower-cost alternatives to the more popular name brands. In another signal that customers seek to save money, Costco’s CFO said its customers are buying apparel “in a big way.” Again, some of its customers are likely shifting purchases to Costco from the more traditional and expensive stores and name brands.

From Costco’s view, it may appear consumers are struggling. But, it is also possible consumers’ spending habits are changing. For instance, per the Census Bureau’s latest retail sales report, total retail sales are only .15% higher this past April versus April 2022. However, spending at food services and drinking places is up 8%, while clothing stores are down 4.13%. Inflation and the odd spending habits which occurred during the pandemic are still wreaking havoc on economic data. Typical economic patterns and warnings are not proving, at least not yet, reliable.

What To Watch Today

Earnings

Economy

Market Trading Update

The market pulled back a bit yesterday ahead of the vote on the debt ceiling bill by the House of Representatives. Interestingly, the market continues to confirm its bullish trend by establishing consistently higher highs and lows. So far, that trend continues with support running along with the rising 50-DMA and trend line support from the October bottom. There is also support at the 200-DMA as well.

While markets have gotten a bit overbought short-term, pullbacks to support should be bought until the technicals suggest differently. As we noted on Tuesday, there is a reasonable setup for a rotation from Technology, Discretionary, and Communications to virtually all other sectors this summer. The skew between cyclical and defensive is quite broad and is not historically sustainable. However, these deviations can last longer than logic would suggest, but the rotations do eventually occur. In other words, don’t forget to take profits.

Valuations and Momentum

The graph below, courtesy of Fidelity, shows that forward P/E valuations are at their peak in the last year. Yet, they are still well below the levels seen in the two years after the pandemic started. More interesting, note that peaks and troughs in the “lower range,” representing the last year, correspond with highs and lows in momentum (RSI). However, the current peak in the forward P/E is accompanied by a minimal number of stocks with strong momentum. The prior two peaks had a quarter to a third of stocks with high RSI scores. This graph is another indicator telling us the market’s breadth is terrible.

Stock Markets Climb a Wall of Worry

In our latest Technical Review of the Market, Lance Roberts provides fodder for the AI bulls and the fundamental bears. He reassures the bulls with the following quote and the chart below it:

However, the bulls can also make a compelling case. The technical dynamics and improving earnings are certainly supportive of the rally. Technically, the correction from January 2022 to the long-term bullish trend line of the 200-week moving average is complete. With the market holding that support and moving above the 40-week moving average provides further validation.

However, the bearish case has a lot of merit too.

The bearish case is compelling, given higher interest rates, increased debt levels, and slowing economic activity. Our Economic Composite Index (which comprises more than 100 data points) suggests the economy will enter a recession over the next 6-months.

The article ends:

While there are many reasons to be bearish on the markets, it is essential to remember that “stocks climb a wall of worry.”

The current market advance looks and feels like the Dot.com advance in 1999. How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives.This is why long-term returns tend to take care of themselves by focusing on “risk controls” in the short term and avoiding subsequent major draw-downs.

JOLTs

Our first employment gauge of the week, JOLTs, proves the labor market remains tight. The number of job openings ticked higher to 10.1 million. Job openings increased the most in retail trades, healthcare, and transportation. Further supporting what appears to be a strong labor market, the total number of separations, including those that quit, fell by 286k and stands unchanged at 3.7%.

The JOLTs report is for April, not May, like ADP and Friday’s BLS report; therefore, the aforementioned reports will be a little more timely.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

President Biden and Republicans have agreed in principle to a debt ceiling deal. While news of a deal to increase the debt ceiling is positive, it must still pass both houses of Congress. Further complicating matters, the Treasury warned over the weekend that without a deal in hand by June 5th, the government would have to stop making payments. Most pundits think the President will sign the debt cap deal as the agreement stands. However, the markets may stay on edge until Biden signs it.

There are a few key takeaways from the proposal. The debt ceiling will be raised for two years, putting the next round of negotiations past the presidential election. Unlike prior increases, the current deal expires in two years and doesn’t put a specific ceiling on the amount of outstanding debt. This means that the amount of debt issuance is unlimited for the next year and a half. In the current environment, that likely means spending will be constrained. However, in the event of a recession, we could see another fiscal stimulus bonanza, as we witnessed during the pandemic. The other important thing to note is that once the President signs the bill, the Treasury will remove liquidity from the markets as it must issue significant amounts of short-term debt. Our Commentary from last Thursday provides more details on what this might mean for the well-followed Fed liquidity gauge.

What To Watch Today

Earnings

Economy

Market Trading Update

The market continues to trade bullishly for the moment, but as we have discussed previously, that performance remains substantially narrow. As discussed in an upcoming post, breadth remains the most troubling currently.

The chart below shows every stock in the S&P 500 and whether it is positive or negative for the year. As shown, quite a few stocks are positive for the year, but more than half are not. The horizontal red line shows the number of stocks with a return of greater than 10% year-to-date. This data is clearly different than what the Advance-Decline line suggests.

However, let’s drill down into the data a bit more. The next chart shows only the stocks in the S&P 500 that have positive returns (as of the end of May) for the year. (Click the chart to enlarge) As noted above, out of 500 stocks in the index, less than half are positive for the year, and many are just barely positive.

However, on a year-to-date basis, less than 25% of stocks are sporting returns greater than the market as of the end of May.

Of course, the mega-cap stocks are leading the returns for the year by a large margin. Such is an important fact when you consider the weights of these mega-capitalization companies within the S&P 500 index. Each percentage point gained in those stocks has an outsized impact on the index as a whole. As shown, each point gained by the top 10 companies in the index has the same impact as that gained by the bottom 426 stocks.

If the bottom 426 stocks gained one point each, but the top 10 stocks were flat, the market advance would be zero. In other words, the market breadth, as determined by the advance-decline line, would be strong, but the market would not advance.

See the problem?

The Nasdaq 93 Breaks Out

The graph below shows the Nasdaq 100 has been on a tear, led by a small handful of stocks. While its performance is very bullish, many technicians worry about the breadth of the market. The second graph shows the Nasdaq 93. These are the 93 other companies not leading the market higher. While its performance has been much weaker than the index, it is breaking out in a bullish pattern. Such bodes well for the market. Especially if the “others” in the S&P 500 and Russell also show bullish tendencies.

Citi Economic Surprise Index Back to 2022 Highs

The Citi Economic Surprise Index, shown below in blue, is back to levels last seen in January 2022, when the S&P 500 was at record highs. The index, which tends to oscillate, measures how economic forecasters over or underestimate economic data. A higher reading, as we have now, says forecasters have been underestimating economic activity. While at its highest level in a year and a half, the underestimating trend can continue.

Two key factors make this index hard to assess. First, economic data is often revised, and the new data does not affect the Citi index. For example, a key economic indicator, real personal income excluding government transfer payments (graph courtesy of EPB Research), as shown in the second graph, highlights that what was initially reported at 1% growth was, has been revised since to show no growth. If an economist predicted flat growth, their forecast would have counted as a positive surprise in the index. In reality, such a forecast was not a surprise.

The second point is that high inflation skews many data points. Some economic data, like retail sales, do not account for inflation. Thus forecasting can be extremely difficult as an economist must forecast actual sales and inflation for many goods and services. Similar complications occur with data that do adjust for inflation. The third graph from Charlie Bilello shows retail sales adjusted for inflation have been much lower than the nominal data reported by the BLS.

Student Loan Payments Restart

If the debt cap deal passes, student loan payments, which have been suspended for over three years, will resume on July 31st. That would be a month earlier than the previously announced date. Economists estimate that interest payments on the $1.6 trillion of student debt will account for approximately $5 billion in monthly interest payments. Think of this as another form of stimulus that will be taken away. The new debt payments are not necessarily large. Still, they are another financial burden for consumers, with record credit card balances, higher balances of other debt forms, and diminished savings accounts.

Through the fourth quarter of 2022, the New York Fed’s Report on Household Debt and Credit shares the following:

• Total household debt rose by $394 billion, or 2.4 percent, to $16.90 trillion.
• Credit card balances, shown below, are nearly $1 trillion, about 20% higher than pre-pandemic levels.
• Mortgage balances rose to $11.92 trillion.
• Auto loan balances increased to $1.55 trillion.
• Student loans are $1.60 trillion.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Before you read our thoughts on Central Bank Digital Currencies (CBDC), pull out your wallet and count the cash in it. Then, add any cash under a mattress or in a bank vault to that amount. That total, be it $12 or a couple of thousand dollars, is the only cash you have.

The bank holding your savings or checking account does not have a pile of cash in a large vault with your name on it. It resides in the ethernet as a series of digital 1s and 0s.

In addition to most of your non-physical cash, your stocks, bonds, and other assets are mostly or entirely stored digitally. Whether you write checks or pay bills online, your credit card, mortgage, and car payments occur digitally. Like it or not, we have evolved into a digital financial system.

Given this reality, it’s worth exploring the trepidation some have about the eventual rollout of CBDC.

Key Takeaways

• Fractional Reserve banking allows for economic growth but does have its risks.
• Advantages of CBDC
• Heightened surveillance and traceability of CBDC are highly concerning.
• CBDC gives the Fed even more power.
• The banking system will change, hopefully for the better.

Banking and Fractional Reserve Magic

There are $17.2 trillion in deposits at commercial banks. In addition, other types of banks, credit unions, brokerage accounts, and financial institutions hold cash deposits. Compare that to the nation’s monetary base of $5.5 trillion.

Under our fractional reserve system, the amount of money in the banking system is far less than the amount people and businesses think they have. In Bank Stocks, Do the Rewards Warrant the Risk, we share the example below to highlight how fractional reserve banking creates money.   

Under the fractional reserve banking system, on which America’s financial system operates, money is “created” via loans. Here is a simple example:

• You deposit $1,000 into a bank.
• Your neighbor borrows $900 from the same bank to buy a TV from Costco.
• The bank holds the remaining $100 as reserves.
• Costco deposits the $900 into its account at the same bank.
• The bank turns around and lends $810 of Costco’s $900 deposit.
• The cycle continues as money multiplies despite the actual cash in the financial system remaining at $1,000.

Whether or not your neighbor pays back the $900, you and Costco have a combined $1,900 in your accounts. In this case, the $900 the bank created via the loan to your neighbor is new money out of thin air. 

Given a good percentage of “money” is simply a figment of our imagination, why are people so trusting of today’s financial system but so wary of CBDC?

Pros of CBDC

We elaborate on the cons in this article, but appreciating digital currency’s advantages is worthwhile.

• Digital transactions are more efficient and often more secure, thus are less costly
• The Fed can more effectively conduct monetary policy if they choose. As we will discuss, some may also view this as a con. We are in that camp.
• Instaneious transactions and settlements.
• Reduces the need for middleman banks, further lowering the economic costs of banking.
• Illegal financial activity is easier to trace.
• They can provide financial inclusion for those without a bank or reside where banking services are limited.

Cons of CBDC

Monetary Policy

In 2020 and 2021, the U.S. government wrote stimulus checks directly to its citizens. Never has the nation witnessed such a quick and impactful stimulus. The government can do the same with CBDC but even quicker and more impactful. In seconds the government could credit your CBDC bank account. Further, the government could put a “use by” date on said stimulus. Use it in three weeks, or it vanishes. They might also decree that stimulus deposits can only be used on specific goods or services they want to help. CBDC help ensures that stimulus effectively generates economic activity in a timely and directed fashion.

Of course, the likely abuse of such a system, which is inevitable, is a significant flaw. As we have been learning, showering citizens with cash can be very inflationary. Further, it can result in an unfair distribution of funds and potentially where the stimulus is spent.

Unfortunately, the MMT cat is out of the bag. Whether it’s a physical check or CBDC, the government discovered the holy grail of stimulus during the pandemic.

The other monetary policy concern is that the Fed can administer negative rates and not worry about cash fleeing the banking system. Negative rates stimulate economic activity as they disincentivize savings in favor of consumption. Money-like surrogates that offer liquidity, like gold and bitcoin, maybe more valuable in such an environment.

Tracability & Surveillance

Many people fear that with CBDC, the government can more easily monitor and control your transactions. Such should be a big concern. However, they can watch all your non-cash transactions today and are likely doing it. Further, the government can access more information than you can imagine between cameras on many street corners and our devices like phones, computers, and many home products.

With CBDC, the government could theoretically freeze your bank account or even take your money. While also a concern, this already happens at banks. It would just be more efficient.

CBDC will make it a little easier for the government to infringe on our privacy and freeze our spending. But, with technology and the proliferation of the Internet of Things, such privacy and rights have already been lost with or without CBDC. The surveillance ship has sailed.

Banking Sector Difficulties

People do not need to hold CBDC at a bank. As such, deposits, a cheap source of bank funding, will vanish. As we see with the banking sector today, bank assets must decline as deposits exit the banking system.

If CBDC results in fewer bank deposits, the supply of bank-originated loans may decrease. In step, interest rates on mortgage, auto, corporate, and all other loans would likely increase. Other entities may replace banks, but it will probably come at a higher cost to the borrower.

Summary

With technology comes fear. The traceability and expanded government powers that accompany CBDC are alarming.

Given the inflation outbreak and the widening gap between wealth classes, giving the Fed expanded monetary policy latitude is concerning.

However, like it or not, while CBDC provides the government with more access to surveillance and more powerful monetary policy tools, they will likely attain those abilities with or without CBDC.

CBDC are the next step in financial innovation. Regardless of what we think, the government will do what it deems in its best interests. CBDC will replace physical currency; it’s just a question of when.

The PCE Price Index is the Fed’s preferred inflation gauge, and it’s the inflation reading used by the BEA to calculate real GDP. On Friday, the PCE Price Index was 0.1% higher than expectations on the monthly and year-over-year readings. The core PCE Price Index, excluding food and energy, was also 0.1% higher than expectations and last month’s reading. Also, within the report, personal expenditures rose 0.8%, well above expectations of 0.3%. The data point to solid consumption, which in turn is keeping inflation sticky at relatively high levels.

The Fed recently said the decision to hike or not at the coming meeting would highly depend on recent data. Consequently, the PCE Price Index and consumption data will sway them toward hiking rates. Employment this week and CPI/PPI data next could certainly change the outcome. The table below shows that the Fed Funds futures market is now pricing in a 58% chance the Fed will hike rates in June. Further, it implies a 26% chance they will do a cumulative of 50bps in rate hikes by the July meeting. Also, traders have greatly diminished the odds of a rate cut by year-end.

What To Watch Today

Earnings

Economy

Market Trading Update

Following the breakout Friday before last, the market declined early last week, sparking concerns of a “fake out.” The market initially tested the rising bullish trend line from the October lows sparking concerns of more selling pressure. However, following Nvidia’s stellar earnings report on Thursday, the market staged a strong comeback and confirmed the breakout on Friday by setting a new closing high. This is a classic breakout of the consolidation range over the last couple of months.

This breakout is very bullish for two reasons. First, the market has completed a 50% retracement of the 2022 decline, which sets the stage for a further advance. Secondly, the breakout confirms the bullish trend that started from the October lows.

While many reasons exist to bearish, the market clearly suggests those concerns are misplaced. At least for now. The next resistance level for the market is the 61.8% Fibonacci retracement level at 4332 which is slightly above the July 2022 high of 4306. A break above those levels, and there is only some minor resistance to fully recovering from the 2022 decline.

The Week Ahead

Jobs data will be the focus of the economic calendar this week. JOLTs on Wednesday, ADP and Jobless Claims Thursday, and the BLS Labor report on Friday will update us on the state of the labor markets. Current expectations are for a slight weakening of data but nothing of concern.

Fed speakers will be vocal as it’s their last chance to speak before their self-imposed media blackout, heading into the June 15th FOMC meeting, which starts on Saturday. Based on comments and their minutes from the last meeting, it seems the Fed wants to retain the option to increase rates but does not want the market to think they will lower them. Per the May 2nd minutes:

Some participants stressed that it was crucial to communicate that the language in the postmeeting statement should not be interpreted as signaling either that decreases in the target range are likely this year or that further increases in the target range had been ruled out.

7% Treasury Yields are Not Concerning

The yields on very short-term Treasury bills rose over 7% as worries about the debt crisis and delayed interest, and principal payments loom. The graph below shows the yield of the Treasury bill maturing on June 6.

Some media outlets offered the high yield as evidence that the market is pricing in a default. They are wrong! What is occurring is that bill investors are worried interest and principal payments from the Treasury could be delayed.

Yields are presented on an annualized basis. Therefore a small yield change for a bill maturing in a week or two can greatly exaggerate its annualized yield. If we de-annualize the 2% difference between a 7% and 5% two-week bill, the yield pickup is four basis points or $40 per $100,000. On an annualized basis, each day of delayed coupon payment on a two-week bill equates to .40% of yield. As such, the market implies the Treasury could be five days late on Treasury bill payments. Remember that includes the potential for weekends when the Fed can’t make a payment even if the cap is resolved.

More on the Market’s Bad Breadth

We have discussed the market’s bad breadth on numerous occasions. What is important to consider is that periods like today of such narrow breadth are not sustainable. But they can last longer than you think. We share a few graphs below to highlight the current environment.

Ten stocks are responsible for nearly all of this year’s gains.

Over the last three months, only 20% of S&P 500 stocks are beating the index. Such nearly matches the low set in March 2000, on the eve of the dot com crash.

Similarly, the performance spread between the S&P 500 and the equal-weighted S&P 500 (RSP) is the widest since December 1999.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Lately, we discussed macro-related market issues such as the” A.I., chase,” but a technical review can help manage shorter-term risks. Currently, the debate is about the market rally from the October lows. Is it a resumption of the 2009 bull market trend or an extended bear market rally?

Unfortunately, I don’t have the answer.

The bearish case is compelling, given higher interest rates, increased debt levels, and slowing economic activity. Our Economic Composite Index (which comprises more than 100 data points) suggests the economy will enter a recession over the next 6-months.

However, the bulls can also make a compelling case. The technical dynamics and improving earnings are certainly supportive of the rally. Technically, the correction from January 2022 to the long-term bullish trend line of the 200-week moving average is complete. With the market holding that support and moving above the 40-week moving average provides further validation.

Fundamentally, earnings are expected to grow rapidly through the end of 2023 and break above the 2022 peak.

Of course, such a strong technical and fundamental recovery in earnings must result from an economic expansion. The problem is that view contradicts the current economic data.

So which view is correct?

Again, I have no idea which view is correct. As such, we must focus on the shorter-term technical market view to manage investment-related risks.

Bulls In Control, But Resistance Ahead

As noted, the bulls are clearly in control of the market currently. However, as we discussed last week, the market is being driven by a narrow advance in the mega-capitalization stocks. Visualizing the disparity in participation is clear between the market capitalization performance and equal-weighted indices.

The narrowness of the market advance is potentially an issue if it doesn’t broaden out. However, the rally can last longer than many expect as the Fear Of Missing Out (F.F.O.M.O weighs on bearish sentiment. The more the market rallies, the more it weighs on bearish investors until they eventually capitulate. The conversion of bearish sentiment fuels a rally in the short term. Despite the rally from the October lows, there remains a significant level of negative investor sentiment in the market.

Adding to that pessimism, as noted in “C.O.T. Extremes,” the massive level of short positions by Non-Commercial speculators against the S&P 500. Such is another source of potential buying to support a further rise.

“Since 2009, large net short positioning has denoted market bottoms. Each of the periods where the COT net short positioning became more extreme, such provided the “fuel” for the ongoing advance as traders were forced to cover their short-positioning as markets rose.”

While the still pessimistic view, and massive short position, will provide the “fuel” needed to propel the markets higher near term, multiple levels of resistance are ahead. From a technical perspective, the first significant resistance level will be the 61.8% retracement from the October lows at 4332. Following is the 78.96% retracement level, then two minor resistance levels at 4637 and 4703 before attaining the 2022 peak.

If or when each of these technical levels gets taken out, such will force more buyers into the market, driving higher prices. That cycle will repeat until something eventually breaks. Until then, the bulls are clearly in control on a technical basis.

It’s A One-Sided Argument

As noted, the risk of “something going wrong” has not been eliminated. As discussed last week, the technology trade is absorbing the bulk of inflows as every other market sector remains under pressure. Such is due to the continued economic and fundamental outlooks of weaker growth, bank stress, and higher rates.

Historically, such a wide divergence between short-term technical trends and fundamental realities doesn’t last indefinitely. Eventually, a market rotation occurs as those realities set in. Another issue for the technology-centric trade is that it is a bet on disinflation, given that technology stocks are long-duration assets. However, inflation remains “stickier” than expected, and the divergence between technology stocks and bond prices is quite extreme. Along with the bearish breadth divergence, it does give a reason for skepticism on the sustainability of the tech rally

While there are certainly reasons for concern, the bullish technicals remain supportive of the rally for now. Whether this is a “new bull market” or another “bear market rally,” we will not know until much later. However, as Callum Thomas of @TopDownCharts recently posted, bear market rallies can last much longer than many think.

While there are many reasons to be bearish on the markets, it is essential to remember that “stocks climb a wall of worry.”

The current market advance looks and feels like the Dot.com advance in 1999. How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives. This is why long-term returns tend to take care of themselves by focusing on “risk controls” in the short term and avoiding subsequent major draw-downs.

I received many emails and questions on “why” we are adding the U.S. Treasury bond to our portfolios. The question is understandable, given its dire performance in 2022, where bonds had the biggest drawdown since 1786.

However, there is, as they say, “more to the story than meets the eye.”

A previous survey from BNY Mellon shows that very few people understand the bond market and how it works.

“A BNY Mellon Investment Management national survey on fixed-income investing was stunning: A measly 8% of Americans were able to accurately define fixed-income investments.“

Such is not surprising since the financial media focuses only on the “sexier” side of the business – equities.

However, bonds are necessary from the investment perspective and the economic view. As we have discussed previously, low-interest rates are a function of an overly indebted economy. If rates rise too much, bad things have historically happened.

“The chart below is the interest service ratio on total consumer debt. (The graph is exceptionally optimistic as it assumes all consumer debt benchmarks to the 10-year treasury rate.)  While the media proclaims consumers are in great shape because interest service is low, it only takes small increases in rates to trigger a ‘recession’ or ‘crisis’ event.”

Of course, as noted, interest rates reflect economic growth. As economic growth slows and disinflationary pressures present themselves, rates will ultimately track economic growth lower.

A Long History Of Rates & Economic Growth

The chart below shows a VERY long view of interest rates in the U.S. since 1854.

As noted, interest rates are a function of the general economic growth and inflation trend. More robust growth and inflation rates allow higher borrowing costs to be charged within the economy. Such is why bonds can’t be overvalued. To wit:

“Unlike stocks, bonds have a finite value. At maturity, the principal gets returned to the lender along with the final interest payment. Therefore, bond buyers know the price they pay today for the return they will get tomorrow. As opposed to an equity buyer taking on investment risk, a bond buyer is loaning money to another entity for a specific period. Therefore, the interest rate takes into account several risks:”

• Default risk
• Rate risk
• Inflation risk
• Opportunity risk
• Economic growth risk

“Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer will not pay a price that yields a negative return in the future. (This assumes a holding period until maturity. One might purchase a negative yield on a trading basis if expectations are benchmark rates will decline further.) “

Therefore, it was unsurprising that the recent inflation surge preceded higher interest rates. However, that inflation push was artificial from massive monetary interventions. As monetary inputs fade, disinflation will push yields lower.

Disinflation from the contraction of liquidity will coincide with slower economic growth and, as noted above, lower interest rates.

Buy Bonds For Capital Appreciation & Protection

Understanding the dynamics between inflation, economic, and interest rates is a critical backdrop to understanding why now is likely the opportunity to increase bond exposure in portfolios for both income and capital appreciation. Most people view bonds as an income-only investment. With yields low, why own bonds? However, there is another aspect to bonds; capital appreciation.

There is an inverse relationship between bond prices and interest rates. When interest rates are low and rising, bond prices fall. However, when they are high and falling, bond prices rise.

In our portfolio management process, we buy bonds for three reasons:

1. Capital appreciation – the same reason we buy equities
2. Total return – interest income plus capital appreciation
3. Risk reduction – lower volatility assets to offset higher volatility assets (equities.)

If you consider bonds as an “asset class,” the analysis changes from an income strategy to a capital appreciation opportunity.

Using a monthly chart, treasury bonds are at a critical oversold juncture. Historically, when bonds were this oversold such coincided with a financial event or recession. Such is not surprising given, as noted above, the impact of higher rates on a highly leveraged economy.

Since interest rates are the inverse of bond prices, we can look at this long-term chart of rates to determine when Treasury bonds are overbought or oversold.

• In 2018, rates slid lower as the realization that Fed rate hikes would negatively impact economic growth and financial stability.
• As 2019 progressed, the yield curve inverted, pushing rates lower as investors sought safety.
• In March 2020, as the pandemic raged, the demand for safety caused rates to plunge to record lows.
• In 2021, rates surged as stimulus-induced inflation surged.

Historically, bonds are the beneficiary of a “risk-off” rotation during market downturns. Such not only provides a return but reduces overall portfolio volatility.

Conclusion

The hope is that the Fed will again start dropping interest rates. However, as we have noted previously, the only reason for the Fed to cut rates would be to offset the risk of an economic recession or a financially related event. Should such occur, the “risk off” rotation would cause a drop in rates toward the pandemic-era lows. Such a decline would imply an increase in bond prices of approximately 50%.

In other words, the most hated asset class of 2022 may outperform stocks by a large margin if a recession occurs.

So, yes, we are opportunistically buying bonds for our portfolio.

Chipmaker Nvidia (NVDA), one of the biggest beneficiaries of AI technologies, soared Thursday as its earnings and revenues beat expectations. However, what drove NVDA higher by over 25% was not its quarterly results, which incidentally showed negative earnings and revenue growth, but its outlook. NVDA’s management stunned investors by forecasting $11 billion in revenue for Q2, well above the prior $7.18 Billion forecast. Such a sharp increase over a short period is nearly unprecedented. Wall Street analysts quickly raised their price targets for NVDA, as shown in the Tweet of the Day below. Many other AI-related stocks are following NVDA’s lead higher.

With Thursday’s price surge, NVDA gained over $220 billion in market cap. To put that in context, an AI competitor of theirs, AMD, has a market cap of $174 billion. Further, 473 S&P 500 stocks have a market cap below $220 billion. NVDA will benefit greatly from AI. The question, however, for investors is whether the valuations for NVDA and some other AI companies are too high. To wit, at its current price-to-sales ratio of 39x, NVDA will have to own the entirety of the GPU chip space in ten years, the stock price can’t change, and it will still be costly at 13x price to sales. NVDA’s P/E and P/S dwarf other technology market cap giants like Apple, Microsoft, Google, and Meta.

What To Watch Today

Earnings

Economy

How Long Can A 5-Stock Rally Last

The heat map below shows the year-to-date performance of the stocks that comprise the S&P 500. It isn’t difficult to understand why the market has been doing so well this year, despite concerns about recession, Fed rate hikes, and inflation.

The chart below shows the YTD performance of the top-5 stocks versus the S&P 500, Mid- and Small capitalization indices as well.

Of course, The question that arises is how long a very narrow rally can last. Given that the current “A.I.” rally reminds us much of the “Dot.com” bubble in the late 90s, we can see a similar performance skew. Assuming the 1998 “Long-Term Capital Management” debacle was the 2022 correction, the current “AI” chase could last between 18 and 24 months. Such would put us well into 2024 before valuation trouble potentially arises.

Of course, this time is not like last time, and analogs rarely track closely. However, the one truth is that the current 5-stock rally can last much longer than logic suggests. But, it will eventually end.

Don’t forget to take profits.

Another Black Eye For Uncle Sam’s Credit Rating

Fitch Ratings placed the United States credit rating on “rating watch negative.” A ratings watch action often precedes the downgrading of a company or nation’s credit rating. Currently, Fitch rates the US as AAA. They attribute the watch to a few factors. At the top are political partisanship and the possibility of a delay in interest or principal payments. Longer term, the implications of the current political climate also concern Fitch. To wit:

The brinkmanship over the debt ceiling, failure of the U.S. authorities to meaningfully tackle medium-term fiscal challenges that will lead to rising budget deficits and a growing debt burden signal downside risks to U.S. creditworthiness.

On August 5, 2011, S&P downgraded the US from AAA to AA+. The ten-year UST note closed the day before the downgrade at 2.46%. A week later, it fell to 2.23%. The ten-year closed 2011 at 1.87%. The downgrade had no negative consequences for the Treasury bond market. Over the last 12 years since the downgrade, the amount of federal debt has doubled. More concerning, the ratio of debt to GDP has grown from 90% to over 120%. The trend is problematic, as Fitch notes.

Confidence in the Fed Chairman

The graph below, courtesy of the Visual Capitalist, shows that confidence in the Fed Chairman currently resides at a 23-year low. During the pandemic’s peak, when the Fed was aggressively pumping the economy and financial markets with liquidity, confidence rose to the highest level since the Alan Greenspan era. Since the consequences of Powell’s policy, high inflation, and interest rates are weighing significantly on confidence.

Turkey Follows Saudi Arabia in Promoting Dollars

A week ago, in our Commentary entitled Saudi Arabia Says Phooey to Dedollarization, we wrote the following:

Saudi Arabia has been vocal about replacing the dollar as the world’s reserve currency. Yet their demand and use of dollars, as witnessed by the recent dollar debt issuance, say they want or need dollars. Further enlightening, Saudi Arabia pegs their currency to the dollar and has for over 70 years.

Saudi Arabia is not the only country speaking out of both sides of their mouth regarding de-dollarization. Another country recently engaged in de-dollarization talks, Turkey, has been asking its banks to buy US dollar bonds. Per Bloomberg, the purpose is to “keep its borrowing costs stable and fend off a spike in its credit default swaps.” Like Saudi Arabia, Turkey must rely on the dollar for economic stability. As noted in the commentary, there is no large-scale viable alternative to replace the dollar. While de-dollarization is a nice talking point for some countries and may gain its leaders’ popularity, the reality is the dollar’s role as the world’s reserve currency will not change in the foreseeable future.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Current estimates predict the U.S. Treasury will raise between $600 and $700 billion once Congress increases the debt cap. Currently, the Treasury is drawing down its “checking account,” i.e., its Treasury General Account (TGA), as it can only replace maturing debt, not add new debt. The net result is that they are spending more than they are borrowing. Consequently, they are adding, not draining, liquidity from the financial system. Liquidity is nebulous and impossible to calculate to a tee. It’s even harder to compute how liquidity directly affects markets and how traders’ psychology about perceived liquidity affects markets. That said, it is an important determinant of market direction and worth exploring how the coming barrage of Treasury debt will affect liquidity.

There are three significant components of liquidity. They are the Fed’s balance sheet, reverse repos transacted with the Fed, and the TGA. The Fed currently does $95 billion monthly of QT to drain liquidity. The reverse repo program has remained remarkably constant, not draining or adding liquidity. The drawdown of the TGA added over $500 billion of liquidity since January, mainly offsetting QT. Further, recent Fed bank lending programs also offset QT. The net result, as shown below, is liquidity increased this year. The coming Treasury debt issuance will become a substantial liquidity drain once the cap is increased, as shown below.

What To Watch Today

Earnings

Economy

The following is an abbreviated excerpt from this coming weekend’s “Bull Bear Report.” (Click the banner below to subscribe for free email delivery.)

Could The Economy Avoid A Recession?

If you read or watch the media, the debate over a recession continues to rage. In one camp are those that are due to debt increases, surging interest rates, and a reversal of stimulus that a “hard recession” is inevitable. Others, especially those on Wall Street hoping for higher equity prices, suggest that “no recession” is likely and why earnings will begin to rise again. Then there is the possibility of a “soft recession,” where the economy does slow but does lead to a sharp increase in unemployment or a dramatic decline in equity prices.

Let me state that I do NOT know the answer. We can only evaluate the data as it comes in and manage portfolios according to the risks we are willing to accept.

However, with that said, some evidence supports the “soft recession” scenario. A recent precedent for such an economic outcome was in 2011. Interestingly, during that period, the world faced a manufacturing shutdown in Japan due to an undersea earthquake creating a tsunami that flooded Japan and sparked a nuclear meltdown. At the same time, the U.S. was entrenched in a debt ceiling debate, a downgrade of the U.S. debt rating, and threats of default. Given the combination of events, and the dependence on Japanese suppliers, the economy’s manufacturing sector contracted, convincing many of an impending recession.

However, as shown, that recession never happened.

The reason was that the service sector of the U.S. economy remained strong enough to keep the economy afloat until the debt ceiling issue was resolved and Japan returned online. Unlike in the past, where manufacturing was a large component of economic activity, today, services comprise nearly 80% of each dollar spent.

This isn’t the first time we have seen the manufacturing side of the economy contract, but services remained robust enough to keep the overall economy out of recession. As shown, when the economy’s manufacturing side contracts while services remain expanding, the economy had a “soft recession.” The 1998, 2011, and 2015 periods are the most recent examples.

Of course, there are some important differences between today and 2011. In 2011, Inflation was low, the Fed funds rate was zero, and Ben Bernanke was providing additional accommodative monetary conditions through “Operation Twist” Today, inflation is running at 5%, the Fed funds rate is 5%, and the Fed is removing accommodative monetary conditions through “Quantitative Tightening.”

Read the rest of the analysis this weekend.

Trucking Continues to Point to a Recession

Last week JB Hunt Transportation Services (JBHT) warned that the freight trucking sector was slowing down. JBHT’s President said: “Simply stated, we’re in a freight recession.” UPS echoed their sentiment on Tuesday.– April 27 Commentary

The quote above led our Commentary a month ago. The American Trucking Association (ATA) is now echoing those concerns. Per ATA’s chief economist Bob Costello-

While the broader economy continues to surprise and thus far stave off an expected recession, the freight economy is starkly different. The goods-portion of the economy is soft and as a result, even contract truck freight is now falling, albeit not nearly as much as the spot market. The tonnage index hit the lowest level since September 2021 in April and has now fallen on a year-over-year basis for two straight months.

Freight and shipping have always been excellent leading indicators of economic activity. Hence, will the warnings above again prove prescient, or will strength in the services industries offset said weakness?

Another Instance of Steep Valuations

Equity valuations are high. As investors, we can digest that in different ways. For instance, some investors will say yes, they are high but can go higher. The dot com bubble proves that is undoubtedly true. Others may say that high valuations portend lower returns over time. Such is also true, but timing a valuation normalization can be trying. Lastly, some investors will claim that most valuation measures do not account for future earnings growth. There is one method that does and is worth exploring.

The S&P 500’s fwd P/E/G ratio is the forward P/E ratio divided by expected earnings growth. At its current level, the ratio dwarfs 2000 levels and is nearing mid-2020 levels. Liz Young, Head of Investment Strategies at Sofi, explains:

After that peak, earnings and growth expectations surged due to stimulus and reopening, bringing this ratio down. Not sure we can expect the same now…stocks look expensive by this metric.

The Long-Term Case for Energy Stocks

In a recent SimpleVisor Five for Friday article, in which we scanned for five stocks based on a theme, we highlighted the energy sector. In particular, we wrote:

As the push for a green-energy transition gains popularity, producers of traditional fossil fuels have a disincentive to invest in production growth. Coupled with recently surging profits and attractive money-market rates spurred by the Fed’s fight against inflation, major energy companies are building sizable cash piles…. This week’s screen attempts to find large energy companies with a high potential for returning capital to investors through share buybacks.

One of the essential factors in the scan was the ratio of price to free cash flow, also known as free cash flow yield. Free cash flow measures how much cash a company has after paying all of its expenses and capital expenditures. Rising profits and slowing capital expenditures leave the energy industry with an extremely high cash flow yield. Some of this extra cash flow will be returned to shareholders via buybacks or dividends.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Most people think the nation’s money supply is the sole cause of inflation. They fail to realize inflation has two equal dance partners. The money supply and the velocity of the money supply dance hand in hand to determine the rate of inflation.

The money supply is shrinking for the first time since at least 1960. Yet, despite the most significant decline in the money supply in sixty years, inflation remains sticky. How can that be?

Given the importance of monetary velocity and its relationship with money supply, let’s better understand velocity and ponder how it may change in the coming months.

The strong correlation between bond yields, inflation, and monetary policy gives us more reason to understand and predict velocity.

Key Takeaways

• The Fed seriously erred in 2021, focusing too much on supply and not enough on demand.
• What is Monetary Velocity?
• The Fed can slow velocity, but it requires job losses and or eroding consumer confidence.
• Forecasting the money supply and velocity leads to a complete inflation forecast.
• Lacy Hunt of Hoisington Investment Management guides where velocity may be headed and what it means for bonds.

The Fed’s Big Error in 2021

In Mid-April 2021, the BLS reported that monthly CPI was +0.66%. That equates to a nearly 8% annualized rate or four times the Fed’s 2% target. Two weeks after that April CPI report, the Fed stated:

With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.

There was nary a concern at the Fed or on Wall Street that the recent uptick in inflation was a problem. Believing it was “transitory,” the Fed kept interest rates at zero and continued increasing their bond holdings by $120 bn a month (QE). Such dovish monetary policy would continue through the year, as shown below, despite the highest inflation in forty years.

The word “transitory” was relentlessly spoken by Powell and other Fed members to describe an expected short burst higher in prices.

We suppose the Fed reasoned that the Pandemic-related supply chain issues would ease as the vaccine took hold. At the same time, they must have thought consumer spending from the barrage of fiscal stimulus would fade, and demand would quickly fall back toward normal levels. Therefore, normalizing supply and demand would bring prices back to pre-pandemic levels. 

The Fed was dead wrong!

Supply chain issues and inventory levels did normalize, but demand stayed strong. Demand remains strong despite the Fed hiking Fed Funds by 5% in little more than a year and reducing their Treasury and Mortgage holdings by $700 billion.

The Fed grossly failed to forecast monetary velocity.

What is Monetary Velocity?

Per the St. Louis Fed:

The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.

Most financial pundits assume it’s the money supply that drives inflation. However, velocity, measuring how often the money supply circulates through the economy, is equally important. As the graph below shows, the money supply is falling but being offset by increasing monetary velocity.

To grasp how the supply and velocity of money dictate prices, ask yourself how inflation would be impacted if the Fed printed a gazillion dollars tomorrow.

Is the answer the same if we instead asked, what if the Fed printed a gazillion dollars but immediately locked it up in a vault and sent it into outer space?

We can parse Fed speeches and transcripts and know they now acknowledge that velocity matters.

Slowing Velocity Requires Pain

The only way to slow velocity is to weaken the economy and reduce consumer confidence. Unfortunately, higher interest rates and QT are not helping this time. Often the most prominent factor causing consumer confidence and increasing one’s propensity to spend is a person’s employment situation.

A tight labor market, as we have, creates job security and higher wages and incentivizes workers to seek new jobs with better salaries. The graph below shows the number of job openings, and the Quits Rate soared after the pandemic but is finally moderating. Consumer confidence is falling as the labor market normalizes.

The Fed has significant control over the money supply via its balance sheet. They indirectly control consumer and corporate confidence and demand via interest rates and narratives.

For the first time in our memory, the Fed predicted a recession. The minutes from the March 22, 2023, Fed meeting stated:

“Given their assessment of the potential economic effects of the recent banking-sector developments, the staff’s projection at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years.”

For a complete understanding of the interplay between the money supply, velocity, economic activity, and inflation, we recommend reading our 2018 article Stoking the Embers of Inflation.

How Will Money Supply and Velocity Change Going Forward?

The money supply is relatively easy to forecast. The graph below shows that the change in the size of the Fed’s balance sheet has a statistically significant relationship with the money supply. The Fed expects QT to reduce the Fed’s balance sheet by $95 billion a month for the foreseeable future.

The other primary determinant is credit growth. With financial standards tightening and banks likely to lend less, along with QT, the money supply will likely continue to shrink.

And Velocity

Velocity is a function of the money supply and economic activity. To help better assess how it may change going forward, we summarize Hoisington Investment Management’s First Quarter Review. Click HERE for the entire article.  

Hoisington writes that velocity “is determined by the marginal revenue product of debt and the loan to deposit ratio (L/D).”

• The marginal revenue product of debt, or effectiveness of debt, will undoubtedly turn lower as over $20 trillion of U.S. debt matures in the next two years and must be reissued at higher interest rates. Having to allocate more capital toward interest payments from productive investment weakens productivity, a key driver of economic growth. For equity analysts, think of this figure as the return on capital.
• Loan growth will slow considerably in conjunction with weakening economic activity. While not mentioned in their report, the regional banking crisis further ensures that loan growth will slow.
• As a result of both points, velocity and, therefore, inflation should turn down. Also, given the Fed’s desire to firmly squash inflation, the Fed may have limitations in its ability to lower rates or use QE to combat weaker growth. Such will only provide more impetus for inflation to fall. 

Summary

Many economic indicators point to weakening economic growth. Further, with excess pandemic-related savings vanishing and credit card debt exploding, the means to spend and keep velocity elevated are eroding.

The labor force is showing some, albeit small, signs of weakening. In addition to the JOLTs graph we shared, initial jobless claims have recently risen above the 2019 pre-pandemic average. The latest University of Michigan consumer confidence, shown below, is declining after increasing over the last 12 months. 

The money supply will continue to decline. Consumer and business confidence is eroding, and loan growth is slowing rapidly. Consequently, monetary velocity will likely reverse in the coming quarters.

Unfortunately, we need the quarterly GDP data to calculate velocity, so while velocity may be declining in the real world, it could take six to eight months to see its decline.

If the money supply and velocity fall, inflation rates will decline. As a result, bonds and other interest rate-sensitive stocks and instruments will likely benefit. 

We leave you with the final sentence of Hoisington’s article:

Therefore, with the historical pattern of the financial, GDP, and price/labor cycles preceding on its well-documented path, this year’s decline in long-term Treasury bond yields is expected to continue.

In March and April, the price of gold rose by 15% as the debt cap was hit, and the banking crisis accelerated. Since early May, gold has given up a third of those gains. Recent volatility in gold prices corresponds inversely with the dollar and with the news surrounding debt cap negotiations. At first glance, such price behavior sounds perfectly normal. However, looking back over time, the price of gold is highly correlated to the level of real yields, and at other times, like today, it gyrates with markets, economic data, and political events. Understanding what is and isn’t driving gold prices is crucial for those trading or investing in gold. In Gold Investors are Betting on the Fed, we quantify how monetary policy greatly affects gold prices.

“gold prices are highly correlated with real yields when real yields are near or below zero. The correlation is negative, meaning that as real yields fall, gold prices rise.”

The correlation between gold and real yields is robust when the Fed pushes interest rates below their natural rate (below expected inflation), as they did through much of the post-Financial Crisis era. In such an environment, gold traders and investors can predominately take their cue from the Fed and inflation expectations. However, when the Fed is hawkish, gold prices are much more unpredictable. The graph below shows the strong correlation (r2 =.64) between gold prices and real yields when Fed administered an easy policy. Conversely, there is no relationship between prices and real yields when their policy is hawkish. Gold is currently untethered and may continue to be volatile as debt cap negotiations and fear-mongering continue.

What To Watch Today

Earnings

Economy

It’s Nvidia Earnings Day

As I discussed in Tuesday’s blog, “A.I., Narrow Markets, And The New TINA,” the darling stock of the A.I. movement is Nvidia (NVDA) which has been on a stellar run this year. The question is whether or not their earnings report today will be enough to justify a 29x price-to-sales ratio.

Nvidia has a long history of trading above and below high valuations, with its long-term average running at roughly 9x sales.

As I noted in that article:

“The problem with 29x price to sales is that between now and the end of 2033, Nvidia will need to grow sales by 1% every month for the next ten years, and the stock price can not change during that period. There are two problems with this. First, since 2002, Nivida has had a monthly sales growth of just 1.26%. It is far different to grow sales at that pace when sales are $2 billion versus $33 billion today. Secondly, even if Nvidia can maintain that pace of uninterrupted growth, which means Nvidia will own 100% of the GPU market, it would only reduce its valuation to a still expensive 9x sales.”

All eyes will be focused on today’s earnings report and, most importantly, the guidance they provide about the recovery of the semiconductor space and its footprint in the “Generative A.I.” space. We will likely see a sharp price movement in NVDA in one direction or the other. If it is higher, I would take profits as the good news is mostly priced in. However, a downside break will be an opportunity to pick up shares of a “momentum trade” at a better entry point.

Whatever the outcome, it will be interesting to watch.

PMI Surveys Argue Higher for Longer

The Fed got unwelcome news from the latest round of PMI surveys. The PMI manufacturing survey fell to 48.5, putting it in economic contractionary territory. At the same time, the services survey rose to 55.1, pointing to robust growth in the services industries. Manufacturers are retrenching, which will result in less production and layoffs. Less production will limit supply which can be inflationary. Manufacturing accounts for less than 10% of the workforce. Therefore, any layoffs in the sector will not be significant. The services sector, which appears to be doing well, will likely continue hiring people, adding to inflationary pressures. The sector should easily offset manufacturing job losses.

While only one survey and for one month, the data argue the Fed is now more likely to keep interest rates higher for longer.

Home Sales Beat Expectations, But Revisions Matter

The latest home sales data show why we must be skeptical of initial economic data. Most economic reports, which make the headlines and steer markets, can be faulty. For this reason, the NBER relies on revised economic data before making judgments about recessions.

The latest example is new home sales. New home sales grew 4.1% in April, well above the expected -2% decline and in line with last month’s 4% reading. At first blush, that sounds good. What most media outlets fail to tell you is the prior reading of 4% was reported as 9.6% last month.

The graph below from calculated risk shows that new home sales have ticked up over the last few months, likely due to lower mortgage rates. The Freddie Mac 30-year mortgage rate is still high at 6.39% but well off its 7.08% peak. While U.S. Treasury yields have ticked higher due to debt cap concerns, mortgage rates remain steady.

Bud Light Makes a Costly Marketing Decision

Two months ago, Bud Light placed a picture of Dylan Mulvaney, a transgender influencer, on its beer cans. Per the Wall Street Journal, the purpose was as follows:

Alissa Heinerscheid, the first woman in Bud Light’s four-decade history to run its marketing, had devised a strategy to combat the beer’s long-declining sales by appealing to a wider swath of customers, including more women and younger adults.

The graph below from the article shows some drinkers of Bud Light were not happy with the marketing campaign and, in many instances, have chosen to boycott Bud Light and instead buy Coors Light and Miller Lite. Per the Journal, InBev, the parent company of Bud Light, is returning to its more traditional marketing targets.

The company now plans for the first time to include Bud Light in the brewer’s long-running sponsorship of a veterans organization, wholesalers said. Bud Light is also leaning back into television commercials on themes like football and country music.

The second graph below shows that since Bud Light’s marketing campaign, InBev stock is down about 15%, while Molson Golden (TAP), which owns Coors and Miller, is up about 22%.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

The A.I. chase is making for a very narrow market. As Bob Farrell once quipped:

“Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”

Breadth is important. A rally on narrow breadth indicates limited participation, and the chances of failure are above average. The market cannot continue to rally with just a few large-caps (generals) leading the way. Small and mid-caps (troops) must also be on board to give the rally credibility. A rally that “lifts all boats” indicates far-reaching strength and increases the chances of further gains.

As Bob noted, the chart below shows the ARMS Index. This volume-based indicator, developed by Richard W. Arms in 1967, determines market strength and breadth by analyzing the relationship between advancing and declining issues and their respective volume. It is usually used as a short-term trading measure of market strength. However, when smoothing the index with a 34-week average, extremely low readings often coincide with near-term market peaks. Such is what we are seeing currently.

The rally this year has been extremely narrow. As quoted in last week’s article discussing the “A.I. Revolution:”

“The A.I. boom and hype is strong. So strong that without the A.I.-popular stocks, S&P500 would be down 2% this year. Not +8%.” – Societe Generale

We can show this anomaly more clearly by looking at the stocks in the S&P 500 as a “heat map” over the last three months. As you can see, the largest stocks in the index by market capitalization have been holding the index in positive territory.

Unfortunately, the stocks that investors are piling into are also, by far, the most expensive in terms of price-to-sales.

This, of course, elicits two questions.

• Why is this happening?
• What happens next?

The New T.I.N.A. Is Not The Old T.I.N.A.

What is TINA? TINA is an acronym for the phrase “There is no alternative.”

For investment managers, generating performance is necessary to limit “career risk.” If a manager underperforms their relative benchmark index for very long, they most likely won’t have a “career” in the investment management business. Currently, there are two drivers for the mega-capitalization stock chase. First, these stocks are highly liquid, and managers can quickly move money into and out without significant price movements. The second is the passive indexing effect. As investors move money back into the market, it unequally flows into the largest capitalization stocks in the index.

As shown, for each $1 invested in the S&P 500 index, $0.32 flows directly into the top 10 stocks. The remaining $0.68 is divided between the remaining 490 stocks. This “passive indexing effect” has changed the market dynamics over the last decade.

When looking at the year-to-date performance of those top 10 stocks, it is clear where the overall index’s performance is coming from.

As my colleague Doug Kass recently noted in his consistently excellent daily digest.

“Today, TINA can arguably be associated with a small group of large-cap tech stocks – Microsoft, Meta, Apple, Alphabet, Nvidia, and Amazon. To many, there is no alternative to these six stocks, and their leadership is as conspicuous as the last narrow market advance in history…that of The Nifty Fifty. 

The following chart underscores the remarkable year-to-date outperformance of the unweighted Nasdaq versus the equal-weighted Index. This NDX > NDXE spread is now +11% on the year, by far the widest spread over any 4.5 month period in the last 18 years.”

As Jefferies recently noted, the long technology is now both an extremely overcrowded and overbought trade.

“We have been banging on about the last few days, how the US Tech sector is working on a pretty convincing exhaustion setup. We obviously do not want to go on about the same thing over and over again, but in all fairness, it is the only convincing chart setup right now across pretty much all markets and all assets.

As it is usually with these type of exhaustion outlooks, there is no way to tell, if we get an imminent reaction, or the choppy trading continues. But what can be said with pretty strong confidence is, that upside right now from current levels will be hard to come by.‘

This massive overbought condition of the Technology sector relative to the rest of the market is easily seen in the SimpleVisor Relative Performance Analysis.

It is worth noting that such periods of outperformance were ultimately unsustainable. While such does NOT mean the market must experience a mean-reverting event, it does suggest that, at the minimum, there will be a rotation to other market sectors.

One thing is sure: the old T.I.N.A. of chasing stocks due to zero interest rates is not the new T.I.N.A. of performance chasing.

The A.I. Chase Can Last Longer Than You Think

As discussed in “The A.I. Revolution,” these speculative market phases can last up to a decade.

“These booms provided great opportunities as the innovations offered great investment opportunities to capitalize on the advances. Each phase led to stellar market returns that lasted a decade or more as investors chased emerging opportunities.

We are experiencing another of these speculative “booms” as “Generative AI” grips investors’ imaginations. The chart below compares the 1999 “Dot.com/Internet Revolution” in the Nasdaq composite versus the 2023 “Generative AI” revolution.

Of course, these speculative periods have recurred repeatedly over the last four decades as investors’ imaginations outpaced the underlying fundamental realities.

Previous investment bubbles like the “Dot.com” resulted in investors chasing a narrow group of stocks hoping for future revenues that failed to materialize. Today, investors are chasing mature companies expecting a massive surge in future revenues to justify exceedingly high starting valuations.

The A.I. Darling

A good example is Nvidia (N.V.D.A.) which is at the heart of the A.I. revolution. Nvidia currently trades at a price-to-sales ratio of 29x. Such is 300% higher than when Scott McNeely suggested investors were stupid to pay 10x sales for Sun Microsystems at the peak of the Dot.com bubble. (Read the entire quote here)

Nvidia has a long history of trading above and below high valuations, with its long-term average running at roughly 9x sales.

The problem with 29x price to sales is that between now and the end of 2033, Nvidia will need to grow sales by 1% every month for the next ten years, and the stock price can not change during that period. There are two problems with this. First, since 2002, Nivida has had a monthly sales growth of just 1.26%. It is far different to grow sales at that pace when sales are $2 billion versus $33 billion today. Secondly, even if Nvidia can maintain that pace of uninterrupted growth, which means Nvidia will own 100% of the GPU market, it would only reduce its valuation to a still expensive 9x sales.

In other words, at 29x sales, an investor must be willing to lock zero returns over the next decade on a fundamental basis. In this light, chasing A.I. stocks seems much less appealing.

While the fundamentals don’t support current investor expectations, the “mania” phase of a “melt-up” can last much longer than you think. However, as with every other bubble period in history, this, too, will end.

As investors, it is essential to participate in these market evolutions. However, it is equally important to remember to sell when expectations exceed fundamental realities.

In other words, in the famous words of legendary investor Bernard Baruch:

“I made my money by selling too soon.”

Do the headlines below sound familiar? They should because the same fears and political rhetoric as 2011 are surfacing as the nation faces yet another debt crisis stalemate. Congress has raised the debt cap 78 times since 1960, but many political and media pundits are concerned that this time is different.

• US Malaise, Debt Stalemate Shake Allies Globally
• Obama tells nation debt stalemate requires compromise now
• U.S. debt stalemate sinks stocks
• How worried should we be if the debt ceiling isn’t lifted?
• A Stock Market Plunge Will Resolve the Debt-Ceiling

It’s worth looking back at 2011 to assess how the major asset classes traded before, during, and after the debt crisis stalemate. The table below shows that stocks were the worst-performing asset class both leading up to the debt crisis stalemate and in the week following resolution. Ten-year U.S. Treasury yields fell before and after the crisis. Gold was also a big winner. Surprisingly, despite fiscal turmoil, the dollar also did well before and after raising the debt cap.

This time the reaction is quite different. The S&P 500 is up 2% over the last month, while ten-year yields have risen by about 0.25%, and gold is off by 1.50%. Like in 2011, the dollar is rising before the potential crisis. We caveat the data below as there are a lot of macroeconomic, monetary, and fiscal policy differences between 2011. Further, the political dissension in the country is worse, and the fiscal imbalances are much larger.

What To Watch Today

Economy

Earnings

Has Tech Been The Debt Ceiling Debacle Hedge?

Over the last few weeks, the F.O.M.O. chase in Technology stocks has baffled the more bearish prognosticators. However, an overlooked reason for investors piling into Technology stocks may be the “debt ceiling” crisis. Technology stocks, by their very nature, are long-duration assets. As such, a disinflationary environment, which will precede lower interest rates, benefits cyclical growth stocks. While technology stocks were performing well earlier in the year, it has been interesting to see the ramp in the big technology-driven stocks in the market as the debt-ceiling rhetoric of a “potential default” heated up.

As the mainstream headlines noted, the risk of failing to raise the “debt ceiling” would potentially be a technical default of interest payments. Such an event would theoretically be disinflationary, triggering an economic recession and leading to lower rates. Such would explain why the defensive and economically-sensitive stocks have been performing so poorly while only a handful of highly liquid stocks that would benefit from such an environment have risen.

While this is likely an oversimplified explanation if technology stocks have been a hedge against a debt-ceiling crisis, a resolution that leads to a debt-limit increase should lead to a reversal of that hedge. Such is because when the debt ceiling is lifted, the Treasury will need to issue a lot of debt to refund current borrowings, leading to a short-term spike in interest rates and setting the backdrop for a reversal from disinflationary to inflationary assets short-term.

It’s just a thought.

Kashkari Warns that 6% Fed Funds May Be Needed

The following headline welcomed traders early Monday morning:

FED’S KASHKARI: IT MAY BE THAT WE HAVE TO GO NORTH OF 6%, BUT IT’S NOT CLEAR.

Might he be taking advice from our article, Speak Loudly Because You Carry A Small Stick? We summarize the article as follows:

Given the lag effect of prior rate hikes and the massive leverage embedded in the economy, we advise Jerome Powell to speak very loudly but take limited further action regarding rate hikes.

Minneapolis Fed President Neel Kashkari is one of the more hawkish Fed members. The recent FOMO-like Nasdaq environment is likely pushing him to use rhetoric to scare markets. The Fed has long believed that the stock market plays an important role in consumer confidence, which drives consumption and economic activity. Given that the Fed is trying to slow the economy, Kashkari may be using fear and speaking loudly to help accomplish its task.

The Bull-Bear Market Tug of War

On Monday, we published Monetary Support Suggests Bear Market is Possibly Over. The article starts by highlighting the growing debt-to-GDP ratio and the recent sharp increase in interest rates. It then helps answer the following quote from @MichaelAArouet :

“What are the odds that the fastest tightening cycle combined with highest debt/GDP level will end up in a soft landing?”

Yes, concerns for a recession are high, especially given the sharp increase in interest rates and the debt imbalance. But, as the article notes, “Federal spending ramps up” and “Monetary support is still high.” Might the decline in 2022 have already priced in weaker economic growth, and “it is possible the recent rally in stocks, a leading indicator, combined with the ongoing monetary supports, suggests we may start to see some improvement in the economic data.”

The article ends as follows:

I am not suggesting the markets, and the economy, won’t potentially struggle in the months ahead. However, we could avoid a deep economic due to the still massive amounts of monetary support in the system.

These competing forces will make investing more difficult until those monetary excesses reverse.

Don’t Wait on NBER to Call a Recession

The NBER is the official arbiter of recessions. The problem, as the Piper Sandler table below shows, is that they are, on average, about seven months too late in determining when a recession starts and over a year late in determining when a recession ends. While it can be problematic for investors relying on the NBER, they should be aware the NBER waits for revised economic data. Further, they heavily rely on a higher unemployment rate as a key recession determinant. The labor markets tend to be lagging economic indicators as layoffs do not typically occur until a recession is underway.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Last week, the S&P 500 volatility index (VIX) fell below 16 for the first time since November 2021. The VIX index uses options prices to imply how much future volatility the market expects. Typically, in upward-trending markets, the VIX trends below 20. Conversely, in bearish markets or shorter drawdowns, it lingers in the 20s but can peak above 50. Lower volatility, like the current reading of 16, implies the market is very comfortable with potential risks.

The graph below charts the S&P 500 and the VIX. We use two colors to highlight when the VIX is over 16 (orange) and under 16 (green). The VIX tends to reside under 16 during the beginning and middle stages of the rallies. Toward the latter stage, when valuations rise, and risks become more pronounced, volatility often perks up. Since 1990, the VIX has been below 16 a little more than a third of the time. Of these instances, the average daily gain has been 0.11%. Conversely, when the VIX is greater than 16, the average daily loss was -.013%. Bottom line: a VIX below 16 is bullish.

What To Watch Today

Economy

• No notable economic releases

Earnings

Bullish Buy Signals Are In

After 45 days of sideways action, the market broke decisively higher last week. While narrow in scope, that breakout allows the market to move higher. As I noted in Friday morning’s Daily Market Commentary:

“Following more good news from retailers, which further confirmed no imminent recession, stocks broke above the trading range that has contained markets since February. That breakout sparked massive short covering and a rush to buy into the technology sector index, with the mega-caps again leading the way, as we discussed in yesterday’s morning note.“

On Friday, the market pulled back and held the breakout level with the first test of the previous resistance. If that level holds next week, the market will have a new support level to build off of.

More importantly, as shown below, the MACD and the MoneyFlow “buy signals” confirmed that breakout. Such suggests that the most likely move for the market is higher for now.

The only “negative” to the market action is that the buy signals are triggering at fairly high levels from a historical basis, which will likely contain the upside of whatever rally the market provides. As noted in the chart above, the next target for the market near term is 4300. Any dips between the current market level and the rising trend line from the October lows, or the 50-DMA, should be used to increase equity exposure accordingly.

For now, there is absolutely no reason to be negative on the market as the bulls are clearly in control.

The Week Ahead

Heading into the Memorial Day weekend, there will be limited economic data and few earnings reports. Several housing numbers will be released this week, including pending home sales, building permits, and new home sales. On Friday, the Fed’s preferred inflation gauge, Core PCE, is expected to post a 0.3% monthly gain.

Like last week, many Fed members will share their views. Generally, they have been hawkish and in the “higher for longer” camp. Currently, the market assigns a 20% chance the Fed will increase rates at the mid-June meeting. The minutes from the Fed’s May meeting are due out on Wednesday. If the recent FOMO-like trading in the equity markets is of concern, they may mention it in the minutes. Other than that, the market is not expecting fireworks from the FOMC minutes.

Tech Valuations

Much has been made about this year’s +26% run in the Nasdaq (QQQ). Yet, fewer are talking about the soaring valuations left in its wake. The FinViz heat maps below provide a few key valuation measures for each S&P 500 stock. A stock’s market cap determines the size of each block. Also, each stock is placed within its appropriate sector.

The first graph below shows that Forward P/Es are generally very high for the largest tech companies. However, GOOGL and META are still reasonable in the communications sector. The second chart shows that the price-to-sales ratios are very high for many tech, communications, and some sub-sectors within healthcare. Note that NVDA now has a price-to-sales ratio of 51 using last quarter’s data. Using the more reliable 12-month trailing sales, its ratio is lower but still a very hefty 29. Consider it stood at ten only seven months ago! Last is the PEG ratio, which is the P/E divided by growth. This is an excellent tool for normalizing valuations within sectors as growth rates differ. Again, large swaths of the chart are deep red, measuring high valuations.

Recession Odds Delayed, But Not Going Away

It’s hard to avoid a graph or statistic using time-tested correlations that aren’t forecasting a recession. Yet, despite the gloomy forecasts, the economy keeps humming along. To wit, the Atlanta Fed GDPNow pegs second quarter GDP growth at 2.9%, albeit the model only has one month of data. The graph below compares the percentage of economists predicting at least one negative quarter of growth today versus six months ago. In November 2022, over 50% of economists thought we would have a negative quarter in the first or second quarter of 2023. Now an even greater 65%, see a negative quarter in the third quarter.

Economists are more sure of a recession today versus six months ago but keep pushing the date it occurs to the future. In our opinion, they are rightfully concerned about higher interest rates and tightening financial standards but not putting enough emphasis on the continued strong demand from consumers. Such demand may slow, but unless the labor market weakens considerably, a soft landing, not a recession, becomes viable. That said, monetary policy and its lags will continue to be an increasing headwind toward growth.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

We led a recent article about de-dollarization with the following quote: “For those losing sleep that the Chinese yuan, bitcoin, or some other currency will commandeer the dollar’s throne as the world’s reserve currency, sleep tight. That day is not coming anytime soon.” Saudi Arabia reminds us why we believe that the much-heralded death of the dollar is not coming soon. Saudi Arabia just issued $6 billion of U.S. dollar-denominated bonds. That follows approximately $10 billion of dollar issuance earlier this year.

Saudi Arabia has been vocal about replacing the dollar as the world’s reserve currency. Yet their demand and use of dollars, as witnessed by the recent dollar debt issuance, say they want or need dollars. Further enlightening, Saudi Arabia pegs their currency to the dollar and has for over 70 years. The graph below shows the flat exchange rate between the Saudi Riyal and the U.S. dollar over the last 20 years. For a country that seems intent on getting rid of dollars, they are as attached to dollars as any country. Even more interesting, Saudi Arabia has the one export almost every country needs, oil. Of all countries, Saudi Arabia has the most leverage in dictating trade terms away from the dollar. Why are they talking loudly about de-dollarization but further tieing themselves to the dollar’s value? Simply, there is no viable large-scale alternative.

Actions speak louder than words!

What To Watch Today

Earnings

Economy

Breakout!

Yesterday, following more good news from retailers, which further confirmed no imminent recession, stocks broke above the trading range that has contained markets since February. That breakout sparked massive short covering and a rush to buy into the technology sector index, with the mega-caps again leading the way, as we discussed in yesterday’s morning note.

More importantly, that breakout was confirmed by a MACD “buy signal.” We will most likely get a confirming “money flow buy signal” by the end of today if the market trades higher.

The only “negative” to the market action is that the buy signals are triggering at fairly high levels from a historical basis, which will likely contain the upside of whatever rally the market provides. For now, there is absolutely no reason to be negative on the market as the bulls are clearly in control.

Tech Versus the Rest

The graph below charts the price ratio of the tech sector versus the S&P 500. The strong tech outperformance of the last few months has put the ratio back to its 2021 and 2000 peaks. Tech, especially the largest stocks within the tech indexes, are significantly overbought and may pull back versus the broader markets in the short run. Longer term, though, it has been bumping up against resistance and may be poised for a breakthrough.

Regional Fed Surveys Provide HOPE

We often talk about individual regional Fed manufacturing surveys, which tend to be good leading economic indicators. The graph below takes the individual survey analysis to a broader level. The three charts below show how the five most followed regional indexes tend to track each other well. The business conditions index, a culmination of the sub-indexes, is solidly negative and at levels associated with recessions. New orders, an excellent leading indicator, are also at recessionary levels. Employment, on the other hand, is still expanding, albeit slowly. The significance of new orders versus employment can be found in our article Janet Yellen Should Focus on HOPE. To wit:

Michael’s HOPE model consists of Housing, New Orders (ISM), Corporate Profits, and Employment.

His framework acknowledges that the most interest rate-sensitive sectors are first to feel the brunt of tightening monetary policy. These sectors often serve as leading economic indicators. As interest rates dampen economic activity in interest rate-sensitive sectors, other sectors and facets of the economy begin to feel the impact of higher rates. HOPE illustrates the various lags or the time it takes for rate hikes to affect economic activity fully.

Walmart

Walmart bucked the trend among retailers this week, boosting its profit guidance for the year and posting solid sales growth. As you recall, over the last two days, Target and Home Depot reported flat to slightly declining sales growth and reduced their forward earnings guidance based on weakening consumption trends. Walmart is a little different than Target and Home Depot, as food/groceries account for nearly 60% of their sales. Food inflation has been running hot, and passing on the higher costs to consumers has been relatively easy. It’s quite possible consumers are spending more on food, ergo have less to spend on other items, like those sold at Target and Home Depot.

Walmart’s same-store sales, not including new stores, rose 7.4%, and E-commerce sales surged by 27% for the year. While annual earnings beat expectations nicely ($1.47 vs. $1.32), they were lower than last year. The income statement below shows that interest expense rose by almost $200 million for the quarter but was partially offset by an increase in interest income. Companies with higher debt loads will see interest expenses grow in the coming quarters as their debt matures and must be reissued at higher interest rates. Conversely, companies with a lot of cash and low debt benefit from the current interest rate regime.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Could massive monetary support have softened the deep bear market many expected? It is an interesting question. Particularly given the Fed has hiked rates at one of the most aggressive paces in history. Combined with inverted yield curves, surging debt levels, and weak economic data, a recession and bear market seem assured.

I always shudder at the four most dangerous words in investing, “this time is different.“ However, could the massive amount of monetary support combined with trillions in Government spending change historical outcomes?

One of my favorite Twitter follows, @MichaelAArouet, recently posted a compelling question.

“What are the odds that the fastest tightening cycle combined with highest debt/GDP level will end up in a soft landing?”

Here is the chart to support his question.

What is clear is that since 1981, the Federal Government has been on a rampant spending spree. To Michael’s point, low-interest rates supported increasing debt levels, and previous rate hike cycles inevitably ended in recession. Such is logical given that rate increases divert economic spending to debt service.

Such is seen in the chart below, which shows that increased debt levels subsequently lower economic growth rates. (The chart uses data based on CBO projections for debt levels and the BEA projections for potential inflation-adjusted GDP.)

While politicians consistently focus on spending more money to help the citizenry, the outcomes have been far less favorable. As discussed in “Taking Risk Is No Longer Necessary,” since 1982, economic prosperity has shifted from the middle class to the top 10% of income earners.

This shift from the middle class, combined with the massive fiscal and monetary supports of 2020 and 2021, introduces an exciting dynamic concerning Michael’s question. One issue many may be overlooking is that despite higher rates, the economy, and by extension, the stock market, maybe more resilient than expected.

Monetary Support Is Still High

One aspect of monetary support that much of the mainstream media overlooks was the massive Inflation Reduction Act of $1.7 Trillion that was on top of the more than $5 Trillion in direct stimulus payments during the Pandemic era.

Beginning in 2000, the “money supply” as a percentage of GDP grew sharply, with each Administration ratcheting up debt to pay for politically driven agendas. However, in 2020, monetary support changed radically by sending checks directly to households. That resulted in both a “surge” in economic activity and inflation due to “reopening” from an artificially manufactured “shutdown.” 

As shown, M2, a measure of monetary liquidity, is still highly elevated as a percentage of GDP. This “pig in the python” still moves through the economic system. The massive deviation from previous growth trends will require an extended time frame for reversion. Such is why calls for a “recession” have been early, and the data continues to surprise economists.

Federal Spending Ramps Up

However, another overlooked aspect of monetary support could keep the economy from a more profound recessionary drag. In 2022 the Biden Administration was finally able to force through $1.7 Trillion in Federal spending in the Inflation Reduction Act. Those funds are getting spent in 2023 to start various projects, which will provide economic support in the near term, regardless of their success or failure.

In the first quarter of 2023, Federal spending increased by 3% on a quarter-over-quarter basis. Using that increase as a baseline, we can project federal spending through the end of the year, which will eclipse $7 Trillion at the current run rate. Of course, if the current Republican-controlled house can negotiate some spending cuts while raising the debt ceiling, that number will decline.

The point here is that while many economists and analysts are predicting a sharp slowdown and recession later this year, which is indeed possible, there is still a lot of liquidity supporting economic activity in the near term.

Is The Worst Behind Us?

As investors, we must ask whether the market suggests the worse is behind us. Since October, stocks have been in a decent rally, with the Nasdaq leading the charge in 2023. That rally is noteworthy because the stock market leads the economy by 6-9 months.

However, this is the dichotomy that investors currently face. We have repeatedly noted the various recessionary indicators such as inverted yield curves, the 6-month rate of change of the Leading Economic Index, and our Economic composite. These indicators have a flawless track record of predicting recessions over time. I have shown both the LEI rate-of-change and the Economic Composite below. As noted, the current index readings are at levels consistent with recessions since 1974.

Given that economic data is primarily lagging, it will be some time before we know whether the current readings coincided with a recessionary slowdown. However, as noted by the two horizontal lines, outside of the 2020 and 2008 recessions, current readings are near levels that previously denoted recessionary lows.

If such is the case, it is possible the recent rally in stocks, a leading indicator, combined with the ongoing monetary supports, suggests we may start to see some improvement in the economic data. If such is the case, then on an inflation-adjusted basis, the corrective market drawdown did achieve historical norms for recessionary periods.

Furthermore, the correction process may be complete as it held critical support at the 200-week moving average. Such remains support for the market since the 2009 lows. Again, if we see some improvement in sentiment-driven and data-driven surveys, such will confirm the market is leading the economic progress.

Conclusion

There are many arguments against the current market rally, given the lag effect of the Fed’s most aggressive rate hiking campaign since the 1970s. Furthermore, those rate hikes, and much tighter bank lending standards, will eventually reduce consumer spending. Such was the point made in “NFIB Sends Recession Alert.” To wit.

“However, tighter bank lending standards have always been a strong “recession alert” signal as it correlates with changes in retail sales. (Retail sales comprise roughly 40% of PCE, which is 70% of the GDP calculation.)”

I am not suggesting the markets, and the economy, won’t potentially struggle in the months ahead. However, we could avoid a deep economic due to the still massive amounts of monetary support in the system.

These competing forces will make investing more difficult until those monetary excesses reverse.

One thing is for sure. The volatility we have seen in the markets over the last year will likely continue. Investors should expect lower rates of future returns. Of course, that will result from much less monetary support and lower economic growth rates resulting from increased debt levels.

But that is an article for next time.

Despite the Debt Cap circus and continual default threats, the dollar has bounced 2% over the last few weeks. Is the dollar finally gaining some footing after falling 15% since late 2022, or is it consolidating before another leg lower? The direction of the dollar is meaningful. First, a weaker dollar is inflationary as the cost of imported goods rises in dollar terms. Second, corporate earnings tend to be negatively affected by a weaker dollar as they repatriate profits at lower dollar levels, but their exports are more price competitive. Third, U.S. bonds become more attractive to foreign investors. Lastly, foreign borrowers of debt benefit from lower interest costs and principal payments as their currency strengthens versus the dollar. It is also worth noting many financial assets go through periods of strong correlation, positive or negative, with the dollar.

The graph below shows the steep 28% bounce in the dollar index from mid-2021 to late 2022. Since then, it has given up a third of its gains. The resulting pattern is what technicians call a pennant or continuation pattern. Per Investopedia, “a pennant is a type of continuation pattern formed when there is a large movement in a security, known as the flagpole, followed by a consolidation period with converging trend lines—the pennant—followed by a breakout movement in the same direction as the initial large movement, which represents the second half of the flagpole.” Will the pattern be bullish, resulting in another significant dollar bounce higher? Or, will the dollar’s bounce of 2021 and 2022 vanish as the Fed relents to a more neutral or even dovish stance going forward? The second graph shows the MACD has a bullish positive divergence.

What To Watch Today

Earnings

Economy

The New T.I.N.A. Is Not The Old T.I.N.A.

What is TINA? TINA is an acronym for the phrase “There is no alternative.”

For investment managers, generating performance is necessary to limit “career risk.” If a manager underperforms their relative benchmark index for very long, they most likely won’t have a “career” in the investment management business. Currently, there are two drivers for the mega-capitalization stock chase. First, these stocks are extremely liquid and easy to quickly move money into and out of without significant price movements. The second is the passive indexing effect. As investors move money back into the market, it unequally flows into the largest capitalization stocks in the index.

As shown, for each $1 invested in the S&P 500 index, $0.32 cents flow directly into the top 10 stocks. The remaining $0.68 cents is divided between the remaining 490 stocks. This “passive indexing effect” has changed the market dynamics over the last decade.

When looking at the year-to-date performance of those top 10 stocks, it is clear where the overall index’s performance is coming from.

As my colleague Doug Kass recently noted in his always excellent daily digest.

“Today, TINA can arguably be associated with a small group of large-cap tech stocks – Microsoft, Meta, Apple, Alphabet, Nvidia, and Amazon. To many, there is no alternative to these six stocks, and their leadership is as conspicuous as the last narrow market advance in history…that of The Nifty Fifty. 

The following chart underscores the remarkable year-to-date outperformance of the unweighted Nasdaq versus the equal-weighted Index. This NDX > NDXE spread is now +11% on the year, by far the widest spread over any 4.5 month period in the last 18 years.”

As Jefferies recently noted, the long technology is now both an extremely overcrowded and overbought trade.

“We have been banging on about the last few days, how the US Tech sector is working on a pretty convincing exhaustion setup. We obviously do not want to go on about the same thing over and over again, but in all fairness, it is the only convincing chart setup right now across pretty much all markets and all assets.

As it is usually with these type of exhaustion outlooks, there is no way to tell, if we get an imminent reaction, or the choppy trading continues. But what can be said with pretty strong confidence is, that upside right now from current levels will be hard to come by.‘

This massive overbought condition of the Technology sector relative to the rest of the market is easily seen in the SimpleVisor Relative Performance Analysis

It is worth noting that such periods of outperformance were ultimately unsustainable. While such does NOT mean the market must experience a mean-reverting event, it does suggest that, at the minimum, there will be a rotation to other market sectors.

One thing is certain: the old T.I.N.A. of chasing stocks due to zero interest rates is not the new T.I.N.A. of performance chasing.

Tom DeMark Says Nasdaq is Exhausted

MarketWatch published a summary of famed market technician Tom DeMark, in which he thinks the Nasdaq, this year’s market darling, is close to peaking. Per MarketWatch:

In an email to MarketWatch, DeMark, who has advised investing legends including Paul Tudor Jones, Leon Cooperman and Steven A. Cohen, says the Nasdaq 100 QQQ, has been in an extended uptrend, but now it’s likely approaching exhaustion.

DeMark’s analysis counts the number of days in which the market rises or falls after setting a three day low or high. Essentially the analysis looks to capture strong but unsustainable price trends. His analysis triggers a buy or sell signal when his count reaches 13. Per the article:

“This will be the first time this year Nasdaq 100 time and price trend exhaustion components should be in sync with one another. Once they align, a subsequent close less than both the closes 4 and 5 days prior should confirm the nascent downtrend,” says DeMark.

Based on the quote above, a close below 325 on QQQ would confirm a new downtrend based on DeMark’s model. However, he would like to see two more higher closes first.

Housing Starts

Per the U.S. Census Bureau, a housing start “occurs when excavation begins for the footings or foundation of a building.” Given that it takes at least six months to build a house and up to a couple of years for a multifamily building, housing starts data provide a good leading indicator on construction employment and spending on construction related materials. Given the importance of housing, it also is a key leading economic indicator. The graph below shows housing starts tend to fall before recessions start but trough in most cases during the latter half of a recession.

Yesterday’s the Census Bureau reported that housing starts were down 22% over the last year. Such was the 12th consecutive annual decline. While the longest streak since 2006-2009, the decline is thus far limited. Further, the peak level in April 2022 occurred at the 65 year average, not at an elevated level. Therefore one can make the case that overbuilding was not nearly as big a problem as some of the other pre-recessionary drawdowns. Therefore the decline will also be less signficant.

Target Gets Gloomy

Like Home Depot, Target reduced forward earnings guidance as they anticipate weakening consumer spending. Unlike Home Depot, their earnings last quarter beat expectations, and their profit margins improved slightly. While not warning of a recession, like Home Depot, they see ongoing weakness in consumer expenditures. Per Target’s CFO and Chief Growth Officer:

“We are confident that the economy and consumer will stabilize overtime and will once again benefit from growth in that (discretionary) portion.”

“The consumer is under pressure,” Chief Growth Officer Christina Hennington said on a call with reporters. “The consistent inflation, the running out of savings as well as just economic uncertainty in general is having an impact on their choices and they’re making tradeoffs.”

While earnings rose nicely above expectations, revenue matched expectations and only grew by 1% from a year ago. Comparable sales, which do not include new stores, were flat versus last year. Despite flat sales, Target boosted earnings as they reduced inventory by 16%, which resulted in fewer customer discounts. Normalizing freight costs also helped.

The bottom line is that Home Depot and Target are bracing for an economic slowdown and have witnessed flat to negative sales growth for a year.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

We have been vocal that long-term Treasury bonds are an excellent investment at current yield levels. However, timing the purchase of bonds will prove difficult as numerous headwinds may temporarily impede their path lower in yield.

Discussing the potential headwinds to our trade idea is an important disclosure, given how often we voice our bullish bond opinion.

First, though, we remind you once again why we like bonds.

Key Takeaways

• Economic and inflation trends will likely continue their pre-pandemic trends.
• Bond yields and inflation are closely correlated.
• As the Treasury’s x-date nears, more bond investors may sell.
• Post-debt cap resolution will be met with significant Treasury debt issuance.
• The Fed is not doing the Treasury any favors.

Our Bullish Case for Bonds

Economic and inflation trends of the last 30 years will continue. That is it! That is our simple and concise thesis for why bond yields will be markedly lower in the future.  

Pandemic-related fiscal and monetary stimulus generated above-trend economic growth and high inflation. Consequently, bond yields spiked to levels last seen 15 years ago, as shown below. They also broke the downward trend persisting for thirty-plus years.

Our thesis rests on the premise that the current yields, reflecting the past few years’ events, are an anomaly, not a new trend.

Bondholders invest to increase their future purchasing power. They can only achieve such a goal by earning a yield greater than inflation. Therefore, bond yields are a function of expected inflation, primarily a function of economic activity.

As economic activity gravitates downward toward its natural rate of 1.5% to 2.0%, inflation and bond yields will surely follow.

The graph below shows the strong correlation between economic growth and inflation.

The following graph shows that bond yields and inflation have trended lower for the last thirty years.

The current Ten-year U.S. Treasury yield, less the CPI and GDP trend lines, is significantly elevated from the prior trend, as shown below. If pre-pandemic inflation levels resume, the ability to earn a long-term yield of 1.50-2.00% greater than the likely ten-year future inflation rate will be a steal. The circle within the graph shows that achieving a positive real yield (yield less inflation), even if small, has been an anomaly, not the rule over the last fifteen years.

Headwind 1- Debt Cap Drama

As political tensions heat up and the date of potential default (x-date) nears, the media and politicians will amp up their scare tactics. To wit:

• The debt ceiling must be raised to avoid economic calamity- Janet Yellen
• The fight over the debt ceiling could sink the economy – NPR
• US debt ceiling impasse pushes government credit default swaps to record high – Reuters
• How a U.S. default crisis could devastate your finances – Forbes

Such harrowing statements cause consternation among bondholders. Some domestic investors may sell bonds and move to cash until the situation is resolved. Foreign bondholders, less familiar with the ritual debt cap shenanigans, may also seek shelter. While most of the volatility will occur in the shortest of maturities, longer bonds will also gyrate with the headlines.

The graph below, courtesy of Bianco Research, shows the tremendous volatility in one-month bond yields. Short-term investors flocked to one-month Treasury bills when the x-date was longer than a month. At the time, the one-month yield fell to as low as 3.25%, while similar two- and three-month bills were around 4.75%.

With the x-date now occurring before the one-month bill matures, the yield is 5.60%, .50% above the 5.10% it should reside at.

Headwind 2- Post Debt Cap Issuance

Per Yahoo Finance:

For the first seven months of the fiscal year, the budget deficit hit $924.5 billion, more than double the same period of 2022, according to budget figures released Wednesday by the Treasury Department. Weaker revenues — including diminished transfers from the Federal Reserve — and bigger outlays for interest on the public debt, education and Social Security are among factors that propelled the widening.

The graph and comments highlight the sizeable fiscal deficit. As the chart shows, the deficit for fiscal 2023, thus far, is running on par with 2020 and 2021. Both years saw massive covid-related stimuli. The nation is running an emergency-like deficit despite a strong economy and the end of the pandemic.

Since January, when the Treasury debt outstanding hit $31.4 trillion, the Treasury ceased adding additional debt. Instead, they have used their “checking account” held at the Fed to fund the nation. The formal name for the account is the Treasury General Account (TGA). The graph below shows the steady decline in the TGA. It is expected to hit zero by June 8, 2023.

Once Washington agrees to increase the debt cap, the Treasury will ramp up issuance to restock its “checking account” and fund the widening deficit. Such a bump in the supply of bonds may require higher yields to help the bonds find a home. That said, the market knows heavy supply is coming and is likely pricing in much of the issuance before the Treasury issues new debt. Given the seemingly insatiable demand for Treasury Bills, the issuance bump may affect longer-term debt more than shorter-term debt.

Headwind 3 – Higher for Longer, QT, and Fed Remittances

The Fed, via monetary policy, drives up the deficit through higher interest expenses and remits less money to the Treasury. Further, the Fed is reducing its holdings of bonds.

The graph below shows that the Treasury’s interest expense has risen over $300 billion or 50% in a little more than a year. It now rivals defense spending. Higher inflation and the Fed’s monetary policy are to blame.

The Fed typically remits its interest on its bond holdings to the Treasury. Per the Fed:

The Federal Reserve Act requires the Reserve Banks to remit excess earnings to the U.S. Treasury after providing for operating costs, payments of dividends, and any amount necessary to maintain a surplus.

In 2021 and 2022, the Fed sent $109 and $76 billion to the Treasury, respectively, which ultimately reduced the Treasury’s borrowing needs. This year, the Treasury should expect very little help from the Fed.

Lastly, the Fed is reducing its balance sheet via quantitative tightening (QT). Doing so will essentially put an additional $95 billion of Treasury and mortgage bonds into the market every month. The extra supply will sap demand for new issue U.S. Treasury bonds.

The graph below shows how much new issuance the Fed absorbed via QE and is now returning those bonds to the market via QT.

Summary

The headwinds to lower bond yields are significant but surmountable as demand for bonds is high, especially at today’s yields. Further, if one believes the economic and inflation trends of the past thirty-plus years return, current yields are well above their potential lows. Only three years ago, the ten-year Treasury yield was 0.50%!

It’s important to note that just because one invests in a long-term bond does not mean they hold it until maturity. We envision holding long-term bonds until yields revert to pre-pandemic levels. At that point, we may sell the bonds, monetize the yield change, and reinvest the funds into another asset class or even higher-yielding corporate bonds.

The International Energy Agency (IEA) has some bullish and bearish news for oil prices. In the short run, the IEA sees pressure on oil prices due to recession concerns. To wit: “Prices were pressured lower by muted industrial activity and higher interest rates, which, combined, have led to recessionary scenarios gaining traction.” For context, as we share below, energy prices rose sharply early into the recessions of 1990 and 2008 and fell just as quickly during the recession. Oil prices declined during the recessions of 2000 and 2020. While a recession is generally bearish for oil prices, the IEA believes “the current market pessimism, however, stands in stark contrast to the tighter market balances we anticipate in the second half of the year when demand is expected to eclipse supply by almost 2 million barrels per day.”

The IEA increased its forecast for crude oil demand from only a month ago by 200,000 barrels per day. Following the removal of covid restrictions, China’s economic recovery is surpassing demand expectations and is largely responsible for the IEA’s updated demand expectations. The IEA also notes that the recent OPEC cuts will reduce supply by 850,000 barrels daily through the year-end. Also for consideration, the U.S. has to buy back oil for its Strategic Petroleum Reserves (SPR). At the start of 2021, the SPR held 638 million barrels of oil. Today the SPR only holds 371 million barrels. Restocking the SPR will provide somewhat of a floor to oil prices.

What To Watch Today

Earnings

Economy

Market Trading Update

Another day of a very lopsided market. As shown below, most stocks were in the red yesterday, outside of a handful of stocks supporting the broader market indexes.

That bifurcation becomes more apparent when looking at performance over the last 3-months.

The market is very out of balance at the moment, and a rotation is likely. The only questions are “What will cause it,” and “When.”

The risk of chasing just a handful of stocks is quite apparent. But, at some point, the market will rotate for whatever reason allowing for a better entry point to add to the “Generative AI” stocks which will likely continue to lead the charge for some time. The other issue is that many quality companies continue to get beaten up and offer a store of value. However, in the short term, the lack of performance is disheartening.

This bifurcation in the market makes it challenging to manage money. The risk, of course, is that chasing the winners may well turn out to be a case of the “buy high, sell low” behavioral process at work. Caution, and a lot of patience, remain advised.

Real Retail Sales

April retail sales grew by 0.4%, below expectations for a 0.7% gain. However, excluding vehicles and gas, retail sales beat expectations growing 0.6%. While the April data looks good, the trend is not as optimistic. As shown below, retail sales are only up 0.5% over the last year, courtesy of Charlie Bilello. Such is the lowest annual growth rate in three years. The data, however, is skewed by inflation, which makes it worse than it appears. Once adjusted for inflation, retail sales have fallen 4.2% over the last year and have gone nowhere over the past two and a half years. Don’t mistake higher prices for increased activity!

Bond Shorts

The graph below from The Market Ear should provide guarded optimism for bondholders. Among those labeled speculators, which includes CTAs and hedge funds, the combined net short of 2, 5, and 10-year U.S. Treasury futures are now at the most extreme level in history. These investors can undoubtedly get more short and further pressure bond prices, but at some point, such a large position could make for an explosive rally if they have to cover en masse. CTAs are believed to be very long equities against large short bond positions. Consequently, a short covering event in bonds may coincide with equity weakness.

Home Depot Update

We led yesterday’s Commentary by stating how, over the course of this week, Home Depot’s, Walmart’s, and Target’s earnings reports will guide us on the health of personal consumption. Home Depot led off with a weak earnings report by falling short on earnings and revenue. More concerning, they lowered future guidance. They now see comparable store sales down by 2 to 5% versus flat. As a result, Home Depot expects EPS to decline by 7 to 13% versus the mid-single digits. It’s also worth noting that their interest expense rose by 27.4% compared to last year. Net earnings fell 8.5% year over year. About 2% or $100 million was due to higher interest rates.

Per the earnings report:

Impact on first-quarter sales from lumber deflation and weather, further softening of demand relative to our expectations, and continued uncertainty regarding consumer demand.

Our take: when inflation was running high, they could pass on inflation easily and boost margins which helped to grow earnings. Consequently, normalizing prices for many of the products they sell takes away such profits. Further demand is weakening for housing supplies. Home Depot’s comment about slowing consumer demand is difficult to decipher. Consumers spent well more than average on their homes during the pandemic. Is the consumer pulling back for economic reasons or because they are now allocating money to other goods and services? Target, Walmart, and in a month, Amazon will help answer the question.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Home Depot, Target, and Walmart announce their earnings today, tomorrow, and Thursday, respectively. Given their size and retail presence, their earnings releases will shed more light on the consumer’s health and inflation. Their revenues should be resilient over the last three months as the labor markets remained strong and credit usage was high. However, margins may shrink for all three companies as we are increasingly hearing from retailers that it’s becoming more difficult to pass on inflation to consumers. Their forward outlooks and any changes they make to their guidance will be more telling than last quarter’s results.

Analysts expect Home Depot will see a slight decline in revenues versus last year but a larger 6% decline in EPS. Consequently, Home Depot’s margins are shrinking as it struggles to pass higher costs to its clients. Higher mortgage rates and much fewer mortgage refinancings also weigh on Home Depot’s sales and earnings. Walmart’s revenue and earnings will likely be better than Target’s as Walmart has a more significant food/grocery business. Investors will likely key on their inventory levels. As you may recall, the two retailers struggled with high inventories a year ago, and their stocks got hit hard, as shown below. It is presumed they are both in a much better position today. Shares of Home Depot and Target have remained relatively flat since their earnings reports a year ago. Walmart, after getting dinged for inventory control problems, has trended higher.

What To Watch Today

Earnings

Economy

Market Trading Update

Another day of going nowhere. For the last 45 days, the market has made no decisive movement in one direction or another. With prices becoming more compressed, a breakout will occur which should give us a tradeable move. The only question is whether it will be higher or lower.

With retail sales on deck and Home Depot (HD) disappointing this morning, we will likely get a good glimpse at whether the economy is stabilizing. Such will be meaningful to the question of whether earnings have troughed or not. The downside remains limited to a 5-10% correction, but the upside is also limited. Continue holding an overweight position in cash until the market tells us what it wants to do next.

Market Caps Around the World

In recent Commentaries, we have noted that the largest U.S. stocks have been primarily responsible for this year’s gains. Hence, most other stocks, as we discuss in the next section, are lagging quite a bit. To better appreciate the market power of the largest U.S. stocks, it’s worth comparing them to the size of stock markets worldwide.

The graph below shows the ten largest stock markets as a percentage of total global stock markets. We added the four most extensive U.S. stocks to appreciate their size. All four of those stocks rank in the top ten globally. Apple’s market cap is larger than all but the total size of the U.S. and Japanese stock markets! Data is courtesy of Dimensional Funds.

A Reversion is Coming

In our Commentary, A Tale of Three Markets, we wrote the following to describe the growing performance divergence between the Nasdaq and the rest of the market:

The Nasdaq 100 (QQQ), in which these stocks carry the most weight is bullish. It keeps setting higher highs, its 50dma is above its 200dma, and both moving averages trend upwards. The S&P 500 (SPY) is moderately bullish, with its moving averages trending up but failing to hit higher highs. Lastly, the equal-weighted S&P 500 (RSP) is providing bearish indications. It’s been setting a series of lower highs. More concerning, its downward trending 50dma will potentially cross below the 200dma in what technicians call a death cross.

We thought it might be helpful to elaborate on the topic as the divergence between mega-cap stocks and most other stocks grows. Therefore, the first graph below is from our proprietary SimpleVisor relative analysis (Ideas – Relative Analysis Pairs). As it shows, RSP, representing an equal-weighted S&P 500, is grossly oversold versus QQQ. Their performance, which tends to be well correlated, is diverging. The second graph shows that RSP has been lagging (blue), and the price ratio of RSP to QQQ has been trading poorly. Note the correlation below the charts was recently negative. Such is not a regular occurrence. Lastly, the graph from the Daily Shot shows that futures speculators are buying QQQ futures while aggressively selling S&P 500 futures.

These divergences will reverse, but when? If 1998-1999 is a good example, the separation between the Nasdaq and other markets may have quite a few months to go.

New York’s Fed Empire State Survey Struggles

Last month the New York Fed’s Empire State Manufacturing Survey was much better than expected. At the same time, most of the other regional Fed Manufacturing surveys continued to show weakness. This month’s Empire survey shows a sharp reversal, joining the other surveys. Most regional and national manufacturing surveys are at or near levels typically associated with a recession. Below is a quick summary from the report:

Business activity fell sharply in New York State, according to firms responding to the May 2023 Empire State Manufacturing Survey. The headline general business conditions index dropped forty-three points to -31.8. New orders and shipments plunged after rising significantly last month. Delivery times shortened somewhat, and inventories contracted. Both employment and hours worked edged lower for a fourth consecutive month. Prices increased at about the same pace as last month. Capital spending plans turned sluggish. Looking ahead, businesses continued to expect little improvement in conditions over the next six months.

Capital spending turned more than “sluggish,” as the report mentions. The second graph below, courtesy of Sophia, shows that intentions to embark on capital spending, a good barometer of future economic activity, fell sharply and to concerning levels.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

The artificial intelligence, or “AI,” revolution is upon us. The financial media and headlines are abuzz with stories of generative “AI” and the subsequent “industrial revolution.”

Not surprisingly, attention has turned to AI with the launch of ChatGPT. The benefits are already apparent with the incorporation of AI into search engines. Even TikTok videos on ” making a million” using AI suggest why stocks associated with AI surged in recent months.

The Industrial Revolution is often considered a continuous event from the 1800s to the present. However, it is better understood as a series of paradigm shifts. The first, which began in the late 18th century, was propelled by mechanization and steam power. Mass production, electricity, and the assembly line fostered the second, which ran through the early 20th century. The third, which began post-WWII, introduced giant leaps in space exploration, computers, automation, and information technologies.

The fourth paradigm shift is occurring now. That revolution encompasses the advent of exponential technologies, from artificial intelligence and intelligent machines to robotics, blockchain, and virtual reality. Those technologies have already impacted how we live for over a decade.

These booms provided great opportunities as the innovations offered great investment opportunities to capitalize on the advances. Each phase led to stellar market returns that lasted a decade or more as investors chased emerging opportunities. (We will come back to those blue-shaded areas momentarily.)

We are experiencing another of these speculative “booms” as “Generative AI” grips investors’ imaginations. The chart below compares the 1999 “Dot.com/Internet Revolution” in the Nasdaq composite versus the 2023 “Generative AI” revolution.

If that analogy holds, it suggests the opportunity to capitalize on the impact of “AI” from an investment perspective remains.

But what about those blue-shaded boxes?

Those Blue Shaded Boxes

While the allure of “AI” certainly has investors salivating at the potential return profile, the valuation problem remains. As shown, despite the technological advances made from space exploration, the internet, or even “AI,” over-valuation can lead to long periods of stagnation.

Throughout history, low valuations preceded the best investment return periods. Such is because low valuations allowed for multiple expansions as investors could “pay up” for expected earnings growth. For example, in 1994, investors could buy Microsoft (MSFT) shares at a Price-to-Sales ratio of roughly three. As the internet boomed and more computers were needed to attach to the internet, sales for Microsoft accelerated. Today, shares of Microsoft are trading at more than 11 times Price-to-Sales. The expectations are that AI will fuel another massive boom in revenue.

However, therein lies the problem with valuations. At 11x price-to-sales, there is little margin for error. A good reminder of the importance of valuations was the comment made by Scott McNeely. Scott was the CEO of Sun Microsystems at the peak of the Dot.com revolution in 1999.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. It assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are?”

This is an important point. At a Price-to-Sales ratio of two, a company needs to grow sales by roughly 20% annually. That growth rate will only maintain a normalized price appreciation required to maintain that ratio. At 11 times, the sales growth rate needed to maintain that valuation is astronomical.

But it isn’t just Microsoft. The table below lists the S&P 500 companies trading at five times sales or higher. I have highlighted a few of the more visible companies discussed in the mainstream media.

Yes, many of these companies will benefit from adopting “AI.” However, it is hard to justify, even under optimistic assumptions, that revenue growth will support the multiples paid today.

Even ChatGPT suggested the same.

“Paying more than five times the price to sales for an investment may pose several potential problems for investors, including overvaluation risk, unstable earnings, market saturation, competitive pressure, and industry-specific factors. As such, investors must conduct thorough due diligence and consider various financial and non-financial factors before making any investment decisions.”

Or, as Warren Buffett once quipped:

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

Been Here Before

“Maybe this time is different. Those words, supposedly the most dangerous to utter in the investing realm, came to mind amid the frenzied pops in the highly anticipated initial public offerings recently.” – Randall Forsyth, “Shades of 1999.”

For anyone who has lived through two “real” bear markets, the imagery of people trying to “trade” their way to riches is familiar. The recent surge in anything “AI” related is not new.

The companies that advanced regardless of actual revenue, earnings, or valuations were on the cutting edge of the internet revolution. As such, many thought “trees could grow to the sky.” Endless possibilities existed of how the internet would change our lives, the workplace, and futures. While the internet did indeed change our world, the reality of valuations and earnings growth eventually “mean reverted.”

It is crucial to remember that while valuations are essential to the eventual outcome of speculative market phases, it is a terrible market timing indicator. Price measures the current “psychology” of the “herd” and is the most precise representation of the behavioral dynamics of the living organism we call “the market.”

We are currently in a speculative phase regarding “AI” and its impact on the world as we know it. Unsurprisingly, searches for “AI” have exploded as retail investors chase performance.

And the breadth of the winners versus the losers in the market is extremely weak.

“The AI boom and hype is strong. So strong that without the AI-popular stocks, S&P500 would be down 2% this year. Not +8%.” – Societe Generale

The difference this time is that we are not starting from a place of low valuations. As noted above, current valuations are expensive across the entire market and astronomical in stocks like Microsoft, Nvidia, Adobe, and Apple.

While we are in the boom phase of the “AI” market, valuations suggest that the ride will eventually end. Chasing markets is the purest form of speculation. It is simply a bet on prices going higher rather than determining if the price being paid for those assets is selling at a discount to fair value.

A lot of money will be made in “AI” before this phase ends. But as with all market phases in the past, the end of the era was simply a function of the realization that “valuations matter.”

Regional bank woes have thus far been a function of interest rate risk, not credit risk. By this, we mean the banks made loans or bought debt assets with low-interest rates. As rates increased, the value of said loans declined. When deposits left these banks, the assets had to be sold, resulting in losses. With interest rates remaining high and depositors continuing to move money from banks to money market funds, interest rate risk remains a threat. As if that wasn’t enough risk for some banks, some will soon have to deal with the possibility of credit losses due to a record-high office vacancy rate.

The graph below shows that banks hold about 60% of commercial real estate (CRE), i.e., office space. Of that, smaller banks hold over two-thirds. The U.S. metro office space vacancy rate is now 18.7%, a new high. It has also been reported that rent is unpaid on approximately one-fifth of office space. With over $400 billion of CRE debt maturing between now through 2025, regional banks are increasingly at risk they will have to realize credit losses. A possible recession coupled with the work-from-home movement and increasing office vacancies could spell trouble for some banks.

What To Watch Today

Earnings

• No notable releases today.

Economy

Market Trading Update

This week, both the CPI (consumer price index) and PPI (producer price index) showed inflation continues to decline as year-over-year comparisons become much easier. With the bulk of the high inflation rates caused by the shutdown behind us, inflation will continue to trend lower back to the long-term 2% target, which will align with lower economic growth rates in the future.

What was most notable was the massive collapse in the spread between CPI and PPI. That collapse has both bullish and bearish implications. From a bullish perspective, sharp declines in the spread have historically correlated to market lows, as expectations are that lower inflation will boost consumer spending. (Increasing spreads typically correlate with higher asset prices.)

The bearish side of the collapse is that it suggests that companies’ net profit margins will likely remain under pressure as the ability to pass on higher costs will become more challenging.

We have not fully resolved the inflation issue yet, so the market’s upside will likely remain unchanged. Of course, such aligns with our comments from last week’s newsletter. To wit:

The market remains on a “sell signal” and again tested and held critical support at the 50-DMA and the downtrend support line from the April highs. The consistent test and holding of support remain bullish overall, and unless or until that is broken, the more bearish concerns are secondary.

With our sell signals still intact, we remain cautious for now. We noted last week that the “upside may be somewhat limited,” which was the case. However, we are now approaching more oversold levels with technically strong support. If we see an improvement in the price action, we suggest increasing exposure again accordingly. However, for now, that is not the case.”

Last week, such was the case as the market again struggled within a relatively tight trading range. Despite many bearish headlines, from more potential bank failures to weaker economic data, the market continues to trade bullishly. With moving averages sloping higher and downtrend support levels holding, we continue to grind away our current sell signal. It is important to remember that a market can correct excesses in two ways. The first is by declining in price. The second is by consolidating sideways.

So far, the correction has come as a consolidation, with the market continuing to cling to support at the 20-DMA. The rising trend line from the October lows is apparent as buyers step in on dips.

The Week Ahead

This will be a relatively quiet week, with Q1 earnings reports mainly behind us and inflation and unemployment data for April reported. The week’s big economic data point is retail sales on Wednesday. The market currently expects retail sales to increase by 0.6%. As discussed in the next section, it will be interesting to see if eroding consumer confidence reduces consumption.

Also of note this week, Chairman Powell will be speaking on Friday. Investors will want to see if his view from the last FOMC press conference has changed. If so, is he more dovish or hawkish?

Sentiment Erodes as Inflation Worries Heat Back Up

The University of Michigan Consumer Sentiment Survey fell sharply to 57.7 from 63.5. The likely culprit is a decent pickup in longer-term inflation expectations, not the regional banking crisis captured in last month’s survey. One-year inflation expectations were constant at 4.5%, but 5-10 year expectations jumped from 2.9% to 3.2%. The first graph below shows that current and expected conditions fell this month. The second graph puts the data in context. As Charlie Bilello shows, the current poor sentiment level is on par with the financial crisis but lower than 7 of the last 11 recessions. The findings should correlate with a decent decline in consumer spending. However, the sentiment index has been muddling at pessimistic levels, and we haven’t seen a material decrease in consumption yet.

On numerous occasions, Jerome Powell has referenced this survey as important to help the Fed assess inflation expectations. The Fed believes expectations tend to predict inflation. As such, the Fed Funds market may increase the odds of a hike rate hike in June. Currently, the market implies a 12% chance of a hike.

The second lesson is that the public’s expectations about future inflation can play an important role in setting the path of inflation over time. – Jerome Powell August 2022

Trading With Mixed Views

Technical studies on the S&P 500 are generally bullish, as we have regularly shared in the market trading update section of the commentary. That said, many reliable indicators are pointing to a recession. The discrepancy in potential outcomes is paralyzing for many investors. Our recent piece, Risk and Return Imaging, provides advice. The article uses statistics to help investors appreciate the risk and reward possibilities in various market environments.

One of the environments we studied was bull versus bear markets. We used a simple rule to define bull and bear markets, thus allowing us to quantify risk and return. If the daily S&P 500 was above its 200-day moving average (dma) we deemed it bullish and vice versa when below the 200dma. The first graph below shows how favorable daily returns occur more often in bull markets than bear markets. Conversely, bear markets have fatter tails. This means the instances of outsized gains or losses are larger than in a bull market. Most telling, the average annualized return in bull markets is 25.45%. In bear markets, the return is -22.29%. Volatility is almost twice as high in bear markets compared to bull markets. The second table shares more statistics.

This leaves us with advice. Own the market above the 200dma and trade with caution below it. The rule is most tricky when the market is near the 200 dma as it is today.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Three well-followed market indexes provide investors with three different tales. These tales are a function of the narrow market breadth in which a small handful of the largest stocks lead the way higher. The Nasdaq 100 (QQQ), in which these stocks carry the most weight is bullish. It keeps setting higher highs, its 50dma is above its 200dma, and both moving averages trend upwards. The S&P 500 (SPY) is moderately bullish, with its moving averages trending up but failing to hit higher highs. Lastly, the equal-weighted S&P 500 (RSP) is providing bearish indications. It’s been setting a series of lower highs. More concerning, its downward trending 50dma will potentially cross below the 200dma in what technicians call a death cross.

Which tale is the best indicator of what will come? If the market can maintain its bullish bias and a broader array of stocks participate in the upside, RSP should break the downward trend and possibly avoid the death cross. In that scenario, SPY will break above the flat resistance line, which will also be bullish. Conversely, the top ten or so stocks responsible for nearly 100% of this year’s S&P 500 gains could reverse lower. If most stocks in the indexes follow them lower, it would be bearish for all three indexes.

What To Watch Today

Earnings

• No notable earnings releases today

Economy

Market Trading Update

With inflation data coming “in line” with expectations, such has not provided any support for the “bullish view” of an imminent “rate cut.” While the inflation data did cool a bit, it remains elevated, suggesting that while the Fed will likely “pause” on further rate hikes to allow the “lag effect” to catch up with the economy, there is no incentive for the Fed to cut rates anytime soon. As such, stocks remain range bound for now.

For investors, however, there is no reason to be overly negative in the near term. The market continues to build on a bullish trend, all major moving averages are now sloping higher, and the compression of the trading range will eventually end. A breakout above 4200 will be a strong bullish signal for a further advance. A break below 4100 will suggest a return of tougher price action. Until the market declares itself in one direction or the other we are stuck in a holding pattern with higher levels of cash and fixed income for now.

Good and Bad News

The graph below shows the stunning surge and decline in the New York Fed’s global supply chain pressure index. The index popped higher as Covid shut down ports and kept many supply chain workers home. Coupled with strong demand due to massive stimulus, inflation took off. Since then, the supply side has normalized, but demand remains strong, accounting for the slowly declining inflation rate. That is the good news.

The bad news is that the index below is approaching levels last seen during the financial crisis. This may indicate that economic growth will falter in the coming quarters as demand for shipped goods is declining. The bottom graph shows the year-over-year decline is unlike anything we have seen in over 25 years. However, like much economic data, the anomaly is the statistical result of the surge higher in 2020 and 2021.

PPI and Jobless Claims

PPI came in below expectations at +0.2%. The core PPI, stripping out food and energy, was also +0.2%. Year over year, PPI is now down to 2.3%. The graph below shows that PPI and Core PPI are not sticky, like CPI. More importantly, they are getting pretty close to pre-pandemic levels. PPI tends to lead CPI. As such, yesterday’s data should comfort the Fed that they have hiked rates enough.

Jobless claims continue to tick higher. They rose to 264k, up from 242k last week and the 182k low last September. Jobless claims are also starting to increase moderately above the pre-pandemic rate. From 2018 through 2019, jobless claims averaged 218k. Continuing claims also continue to rise slowly. Neither indicator is concerning, but they both show discernable trends higher. These indicators will be closely watched as they tend to lead the broader employment data.

Bond Yields Are Stuck

We led with a discussion of how the three equity indexes, RSP, SPY, and QQQ, are sending three distinct tales. We continue by telling the tale of the bond market. As shown below, long-term Treasury bonds (TLT) have been in a tight channel for over two months. They have consistently held support at 102. At the same time, upward progress keeps getting halted around 108.

This tight range may hold until the debt cap is resolved. However, a resolution to the channel may have to wait until the market is clearer on the Fed’s future policy path. The Fed just transitioned to what is widely believed to be a natural policy. Shifting to a more dovish tack or back to a hawkish path may likely determine the direction in which TLT breaks out of the channel.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

What if I told you that future returns could approach zero? Such seems hard to believe, considering young investors piling back into the markets since the beginning of the year. As I discussed previously, this behavior follows the clubbing many received in 2022.

“A recent Wall Street Journal article discussed how retail traders that made millions during the pandemic trading the market are now mostly wiped out.“

A quick search of headlines from the end of 2022 confirms that much of the retail spirit was broken.

• Retail Traders Throw In The Towel – Sept 2022
• The Era Of The Meme Trade Is Over – Oct 2022
• Are Retail Investors Done? Biggest Liquidation Since 2020 As Retail Is Now ‘Selling The Rally’ – Oct 2022
• Retail Traders Lose $350 Billion In Brutal Year – Dec 2022

At the end of 2022, it seemed pretty clear that retail investors were done as they ‘hit the bid” to liquidate stocks at a record pace.

However, that was 2022. Since January, retail investors returned with a vengeance to chase stocks in 2023, pouring $1.5 billion daily into U.S. markets, the highest ever recorded.

This chase for equity risk since the beginning of the year was built on the premise of a “Fed pivot” and a “no recession” scenario. In this scenario, economic growth continues as inflation falls and the Federal Reserve returns to a rate-cutting cycle. However, as discussed in “No Landing Scenario At Odds With Fed,” that view has a fatal flaw.

“What would cause the Fed to cut rates?

• If the market advance continues and the economy avoids recession, the Fed does not need to reduce rates.
• More importantly, there is also no reason for the Fed to stop reducing liquidity (QT) via its balance sheet.
• Also, a “no-landing” scenario gives Congress no reason to provide fiscal support providing no boost to the money supply.

In other words, if the hope of zero interest rates and a return to QE is whetting retail investor appetites, then the “no landing” scenario is problematic.

Such is also why future returns may approach zero.

Why Future Returns May Approach Zero

The speculation of outsized returns by retail investors is unsurprising, given that most have never seen an actual bear market. Many retail investors today didn’t make their first investments until after the financial crisis and, since then, have only seen liquidity-fueled markets supported by zero interest rates. As discussed in “Long-Term Returns Are Unsustainable.”

“The chart below shows the average annual inflation-adjusted total returns (dividends included) since 1928. I used the total return data from Aswath Damodaran, a Stern School of Business professor at New York University. The chart shows that from 1928 to 2021, the market returned 8.48% after inflation. However, notice that after the financial crisis in 2008, returns jumped by an average of four percentage points for the various periods.

After more than a decade, many investors have become complacent in expecting elevated rates of return from the financial markets. However, can those expectations continue to get met in the future?”

Of course, those excess returns were driven by the massive floods of liquidity from the Government and the Federal Reserve, including trillions in corporate share buybacks and zero interest rates. Since 2009, there has been more than $43 Trillion in various liquidity supports. To put that into perspective, the inputs exceed underlying economic growth by more than 10-fold.

However, after a decade, many investors became complacent in expecting elevated rates of return from the financial markets. In other words, the abnormally high returns created by massive doses of liquidity became seemingly ordinary. As such, it is unsurprising that investors developed many rationalizations to justify overpaying for assets.

Commitment To Growth

The problem is that replicating those returns becomes highly improbable unless the Federal Reserve and Government commit to ongoing fiscal and monetary interventions. The chart below of annualized growth of stocks, GDP, and earnings show the outsized anomaly of 2021.

Since 1947, earnings per share have grown at 7.72%, while the economy has expanded by 6.35% annually. That close relationship in growth rates is logical, given the significant role that consumer spending has in the GDP equation.

The market disconnect from underlying economic activity over the last decade was due almost solely to successive monetary interventions leading investors to believe “this time is different.” The chart below shows the cumulative total of those interventions that provided the illusion of organic economic growth.

Over the next decade, the ability to replicate $10 of interventions for each $1 of economic seems much less probable. Of course, one must also consider the drag on future returns from the excessive debt accumulated since the financial crisis.

That debt’s sustainability depends on low-interest rates, which can only exist in a low-growth, low-inflation environment. Low inflation and a slow-growth economy do not support excess return rates.

It is hard to fathom how forward return rates will not be disappointing compared to the last decade. However, those excess returns were the result of a monetary illusion. The consequence of dispelling that illusion will be challenging for investors.

Will this mean investors make NO money over the decade? No. It means that returns will likely be substantially lower than investors have witnessed over the last decade.

But then again, getting average returns may be “feel” very disappointing to many.

At 4%, Cash Is King

Another problem weighing against potential future returns is the return on holding cash. For the first time since 2009, the alternative to taking risks in the stock market is just “saving money.” Obviously, “safety” comes at the cost of the return, but at 4% or more, savers now have an alternative to investing. However, this works against the Fed’s goal of increasing the wealth effect in the financial markets.

Following the financial crisis, Ben Bernanke dropped the Fed funds rate to zero and flooded the system with liquidity through “quantitative easing.” As he noted in 2010, those actions would boost asset prices, lifting consumer confidence and creating economic growth. By dropping rates to zero, “risk-free” rates also dropped toward zero, leaving investors little choice to obtain a return on their cash.

Today, that narrative has changed with current “risk-free” yields above 4%. In other words, it is possible to “save” your way to retirement. The chart below shows the savings rate on short-term deposits versus the equity-risk premium of the market.

One of the problems with the “cash hoard” in 2023 is there is no incentive to reverse savings into “risk assets” unless the Fed drops rates and reintroduces “quantitative easing.” However, as discussed in “Banking Crisis Is How It Starts,” if the Fed reverses to accommodative policies, it is because “something broke.” 

Such won’t be the time to take on more risk, but less.

When you start considering the implications of a market plagued by high valuations, slow growth, and the potential for less liquidity, it is easy to make a case for lower future returns.

While that does not mean returns will be zero every year, at the end of the decade, we may look back and ask what was the point of “investing” to begin with.

The April CPI inflation headline number, most followed by the media, provided a pleasant downward inflation surprise. The year-over-year inflation number was 4.9%, .1% lower than expectations. This is the first time annual inflation has been below 5% in two years. The monthly change was +.4%, in line with expectations. We call it a “surprise” because many Wall Street banks and dealers thought the inflation numbers would be higher than expected. While the headline was a surprise, the core inflation data, most followed by the Fed, continues to show stickiness in prices falling. Core CPI, excluding food and energy, fell by .1% to 5.5%, as expected.

Given the high inflation rates a year ago and their outsized effect on annual data, we prefer to focus on the recent trend. Accordingly, in this environment, we use the running three-month annualized data. The graph below shows the downward surprise was limited to the headline inflation data. Three-month annualized core inflation, while certainly lower than its 9% peak in June 2021, remains stubborn. However, inflation surprises may be just around the corner. About a third of the inflation data is based on imputed rents. The Zillow Rent Index (ZROI) was up 4.62% year over year and 2.81% on a three-month annualized basis. ZROI peaked in January 2022 at 16%. The CPI rent measure is still at its peak and will inevitably follow ZROI lower in the coming months.

Bottom line: Inflation is falling by not at the rate the Fed would like it to. That said, they may be pleasantly surprised in a few months if the BLS measure of rents declines as expected.

What To Watch Today

Earnings

Economy

Market Trading Update

As noted in yesterday’s update, the CPI report was a “nothing burger” coming in as expected with the headline up 0.4%, which is 4.8% annualized inflation. While the market struggled with the data and sold off in the first half of the day, a late-day rally returned the market towards the day’s highs and above the 20-DMA once again. Even with the rally, the market remains range bound but continues to flirt with the top of a narrowing consolidation pattern. At some point, the market will make a decisive break out of this pattern, giving us the best opportunity to position ourselves for the next leg of the market’s move. Unfortunately, we don’t know with certainty whether that will be higher or lower.

As such, we continue to suggest remaining cautious. We will likely have our answer to “what’s next” sooner than later.

One-Month T-Bills Hit Record High Yield Awaiting The Debt Cap

As the graph below from Bianco Research shows, the year on a one-month Treasury bill hit 5.43%. Such is a record high since the Treasury began issuing one-month bills over 20 years ago. If you recall, a few weeks ago, we discussed how the one-month yield was plummeting while two and three-month bills stayed the same. At that time, the one-month yield at times was more than 1% below the three-month bill. Today it’s about 25bps above.

The culprit is the coming debt cap negotiations. The concern for one-month bill investors is not a default but a delayed payment. Given the short duration of a one-month bill, a multi-day delay can have a decent effect on the annualized yield.

Lending Standards Lead Employment

In Monday’s Commentary, we noted:

Meanwhile, demand for commercial and industrial loans weakened considerably. The survey reported the broadest share of banks with weaker loan demand since 2009.

The graph below shows lending standards for commercial and industrial (C&I) loans (blue) have tightened considerably. It also shows that in the last three recessions, excluding 2020, the annual change in employment fell and troughed about 3-4 quarters later. There was no lag in 2020 as the pandemic had an immediate economic impact. Based solely on this data, we should expect the unemployment rate to increase.

When Druckenmiller Speaks, People Listen

Famed investor Stanley Druckenmiller presented at the Sohn Investment Conference on Tuesday and provided plenty of advice. Druckenmiller made a name for himself as one of George Soros’s top portfolio managers and ultimate successor.

Druckenmiller is bearish on the near-term outlook and sees a hard landing. He thinks that NBER will ultimately find a recession started this quarter. That says he does see opportunities once the economy bottoms. To wit- “A hard landing will offer unbelievable opportunities.“

…when you have free money, people do stupid things. When you have free money for 11 years, people do really stupid things. So there’s stuff under the hood, it’s starting to emerge. Obviously the regional banks recently, we had Bed Bath and Beyond.

But I would assume there’s a lot more bodies coming.

Just make sure to preserve your capital until they present themselves.

Druckenmiller likes copper due to what he thinks will be explosive EV growth. That said, he is waiting on buying it as he fears a recession will hurt demand and allow him to buy it at lower prices. He does like gold and silver, although he says, “They historically have not done well in hard landings.“

He also thinks AI “could be every bit as impactful as the internet literally going forward.” However, like copper, he seems to be waiting for a hard landing to make a bigger bet in the industry. Currently, he owns Microsoft and Nvidia.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Today’s Commentary focuses on passive investment strategies and how they are making difficult decisions for value investors. Passive investors tend to “buy the market.” By this, we mean they often focus on the largest passive ETFs. Some may buy the well-known index ETFs and call it a day. Other passive investors shift between stock factors like value or growth ETFs or funds focused on the market cap, for example. Within these categories, distortions have evolved as the funds and strategies grow in size. For example, value ETFs tend to favor stocks often considered “value” stocks but do not necessarily have value-like valuations. Often the stocks meet Wall Street’s self-serving classifications but not what a responsible investor would categorize as value.

As popular ETFs grow, the stocks they prefer in their respective categories grow even more prominent and further inflate their valuations. But, it leaves those left behind with cheaper valuations and much more potential. The graph below, courtesy of the Financial Times, is dated but shows the steady progression of passively managed funds versus actively managed. The FT also notes that the ten largest ETFs and mutual funds own 66% of fund assets. As a result, value-based judgments of a small number of funds play an outsized role in partially determining winners and losers.

As value investors, we must often decide whether we buy the stock that has been outperforming despite lofty valuations or the cheap stock with tons of potential but not much in the way of recent performance. The sections below continue with more of how passive funds are skewing the market for value stocks and making life difficult for investors.

What To Watch Today

Earnings

Economics

Market Trading Update

Today is the always much anticipated CPI report which will presumably “tell the tale” of the Fed’s next move. The Fed may have to hike rates again if the number is too hot. To cool, and maybe, as the bulls hope, the Fed will begin cutting rates sooner than later. The reality is that today’s report won’t mean a lot in the grand scheme of things. The Fed is likely on pause for now unless inflation is screaming higher, which the input data suggests it won’t be, and there is no reason for them to cut rates with the market and economy functioning on all cylinders.

The reality is that the market remains range bound for now and on a “sell signal,” limiting the current upside. One thing to note is the volatility index continues to drop. I suspect at some point, we may see a pop higher in volatility, coinciding with a sell-off in the market back to the 4000 level. Such will likely present a decent entry point to add some exposures.

The market has been rotating as late between inflation and disinflation trades which is expected. However, in the end, it will likely be the disinflation trades that continue to shine this year. Look to rotate allocations accordingly.

Main Street Value (CLX and CVS)

We lead with a question to appreciate better the value proposition and the problematic decisions investors must make.

Main Street USA has two identical-looking stores next to each other for sale. As a potential store owner, you want to buy a business with the most potential. The purchasing price of the stores is based on their sales. Both stores made $1,000,000 in sales last year. Store A sells for $2.8mm, and store B is $270k. So what do you get in store A worth 10x the price of B? While store A has an operating margin of slightly more than 2x store B, it has only been growing its sales and earnings at about one-fifth of the rate of store B. Most importantly, assuming recent growth rates continue, store A should return the initial $2.8mm investment in 23 years. It will only take store B six years.

Which would you buy?

We presume you chose store B. However, store B is not always the right answer in the stock market. The correct choice is not necessarily the stock that produces the most cash flow per dollar of investment. Instead, it is the stock whose price will rise the most. The data for store A in the example is Clorox (CLX), and store B is CVS. The table shows that despite much more growth over the last ten years, CVS trades at low valuation ratios. CLX, with marginal growth, trades at growth-like valuations.

Regarding our question, do you buy the value stock with high or low valuations? The second graph shows the market has favored CLX and is not focusing on valuations. However, given its limited growth and high valuations, Clorox’s potential for future gains is marginal. Conversely, CVS has significant potential to increase its valuations and, therefore, stock price.

AT&T (T) – Another Lesson in Value

AT&T (T) is a more mature company with a flatter revenue and earnings growth trajectory similar to CLX. However, unlike CLX, T trades at a price to sales of 1.03, price to earnings of 6.73, and price to cash flow of 7.29. T is very cheap. T has an operating profit margin almost double CLX and four times CVS’s. Further, T incentivizes shareholders with a 6.48% dividend yield compared to 2.8% and 3.5% for CLX and CVS, respectively.

T not only has a high dividend and low valuations but is changing to promote more growth and reduce expenses. They recently began streamlining operations by spinning off Warner Media, DirectTV, and AT&T TV. The expectation is that the exit from the very competitive media industry will increase profitability in the near term. Also, T is in the process of upgrading from copper broadband cables to its fiber network. The upfront cost is expensive and drains earnings, but fiber will increase speed, increase customer satisfaction, and lower future maintenance costs.

Even with the changes to their business, T will not grow at CVS rates. Further, they have approximately $138 billion in debt. Higher interest rates are a threat given their debt level, but the company only has $7 billion in maturing debt this year. T is a cash cow providing investors with a lofty dividend yield backed by a 10.8% cash flow yield. For reference, CLX has a cash flow yield of 5%.

As shown below, T stock is down nearly 50% over the last five years. While the chart is likely scaring off investors, the company can reward patient investors with a significant dividend yield and, in time, price appreciation as its efforts to reduce costs and increase profitability pay off.

What’s an Investor to do?

Microsoft just announced they expect to grow 15-18% over the coming years. Compare that to Clorox, which will be lucky to grow at a few percent. Now consider CLX has a higher P/E ratio than MSFT.

In the April 26 Commentary, we looked at another value star, McDonald’s, which offers little earnings, sales growth, and high valuations. To wit:

Despite falling revenue and no earnings growth, the stock has risen nearly 4x since 2014. Buying back about 25% of its shares since 2014 explains some of the price gains. A more significant chunk of the gains can be attributed to valuation expansion. In other words, despite no growth, investors have been willing to pay more for the same dollar of earnings. Since 2014 MCD’s P/E has risen from 17 to 29. Its price to sales (P/S) is 9.3, three times its level in 2014. A price to sales of such a high level is often associated with high-growth potential companies, not low to no-growth firms.

Do we buy the high flyers and hope they can continue to defy valuation gravity? Or do we buy the beaten-down stocks offering investors a lot of potential? In the long run, it’s highly likely true value stocks like T and CVS will beat out non-value value stocks like CLX and MCD. But the distortion we note may continue to grow as passive strategies slowly take market share from active strategies.

We are value-oriented investors. But, in today’s climate, we must play the passive game and hold value stocks with high valuations. At the same time, we can mix in some stocks with deeply discounted valuations with a much more favorable risk/reward ratio.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

Today an investor can earn a 4%+ return with zero risk. For the last 15 years, such would be called a pipe dream. Today it’s reality. Consequently, investors face a risk-free rate not far from historical equity returns. This setup presents investors with options with which they are mainly unfamiliar.

With the Fed purposely trying to slow economic growth and a banking crisis in full swing, do the heightened risks argue investors should gladly accept the current bond yields and reduce equity exposure?

To help you appreciate the question, we get wonky with statistics. This article visualizes risk and return profiles in different market environments and monetary policy stances. The goal is to show how changes in market tone and or the Fed’s rate policy alter the expected risk and returns profile of equities.

Key Takeaways

• Statistics allow us to quantify and compare risk and return probabilities for assets.
• Fat tails increase the odds of more risk and return than one might expect.
• We share distribution curves for bull versus bear markets, QE versus QT, and changes in the Fed Funds rate.

Statistics 101- Bell Curves

Before we visualize risk and return profiles in different environments, it’s worth brushing up on statistics.

A normal data distribution has perfectly symmetrical returns. For example, if there are six days with a 2.456% gain over four years, there are also six with a 2.456% loss. A perfect bell curve distribution does not occur with stock returns and is a rarity in almost every data set. Regardless, the closer a collection of historical returns resembles a normal distribution, the more confidently we can quantify risk and return expectations.

S&P 500 Return Distribution

Below are daily S&P 500 returns since 1970. While the curve looks like the one above, it is far from a perfect distribution.

The area graph above shows the percentage of instances where the range of returns on the x-axis occurred. For example, the most common instance, accounting for 14% of the trading days, is a slight gain between zero and 0.25%. Note the x-axis is in .25% increments except beyond +/-3%, at which point we group occurrences into more extensive ranges.  

We summarize the graph in the table below.   

The graph is far from a normal distribution. For example, a three-standard deviation (sigma) move includes gains of 3.30% or more and losses of 3.24% or worse. Three sigma events happened 183 times or 1.4% of the time. In a normal distribution, such outlier events should occur once every 2.85 years or 19 times in the 53-year history we present. The actual occurrence was 10x as frequent. More stunning, there were 36 five standard deviation events. There should only be one every 13,843 years! The bottom line is that the risk of greater-than-expected gains or losses is much more than expected in a perfectly distributed bell-shaped curve.

Fat Tails

Statisticians refer to this phenomenon as fat tails and measure it with kurtosis. The larger the kurtosis, the fatter the tails, i.e., the greater the risks. Conversely, a negative kurtosis indicates the data is more centered around the mean with less risk than a normal curve would suggest.

Skew is another stat describing the shape of the curve. Skew measures how symmetrical a curve is. The data is considered fairly symmetrical if the skew is between -0.5 and +0.5. Beyond those bounds, the skewness increases.

The critical consideration is that most risk models assume a normal-shaped curve. Therefore, the more skew and kurtosis, the more we underestimate the odds of unwelcome outcomes.  

Bull vs. Bear Market Returns

With a basic understanding of distribution curves and statistics to help appreciate them, we visualize returns in various market environments.

We start with a comparison of bull and bear markets since 1970. For this analysis, we consider the S&P 500 in a bull market when its price is above its 200-day moving average (dma) and in a bear market when below the 200-dma. 

The graph below compares bull and bear market histograms. Bear markets have a much flatter-shaped curve with fatter tails. Fat tails in bear markets result from large and more frequent positive and negative returns. As shown in the table, the kurtosis of bear markets is 10.75, indicating fatter tails. The bull market distribution has a kurtosis and skew near zero. The bull market return distribution is much more normal than the bear market distribution.

The tables below further highlight the differences. Annualized volatility is almost twice as high in a bear market than in a bull market. As they say, bull markets take the steps up, while bear markets take the elevator down.  

Active QE vs. QT

Next, we compare periods where the Fed actively adds to its balance sheet (QE) versus those when they actively reduce its balance sheet (QT). The data is from 2008 to the current.

Periods in which the Fed was doing QT are slightly skewed to the left versus periods of QE. It is important to realize that QE often began when stocks were declining. Therefore, QE tends to include bullish and bearish trends.

The data tables below do not provide much insight. The periods of QE and QT have a similar distribution of returns. However, returns tend to be significantly better during QE. Further, the percentage of positive daily returns during QE is slightly higher than in bull markets. QE is unequivocally bullish, but QT may not be as bearish as many believe.

We caveat the results as the QT periods are limited to 2018, half of 2019, and the second half of 2022.

Change in Fed Funds

The graph above and the tables below point to weak returns, relatively high kurtosis, and highly negatively skewed returns when the Fed raises interest rates. However, volatility tends to run low during these periods. The Fed often raises rates at the end of periods of above-average growth and into the beginning of recessions.

Periods when the Fed reduces rates tend to lead to better returns, albeit with heightened volatility.

Summary

A risk-free 4% return seems like a good option if a recession ensues and the market follows 2022’s path lower. As we demonstrated, volatility increases while returns falter in bear markets.

However, the analysis was less clear about how the current Fed policy stance regarding QT and higher rates statistically affects returns. As we uncovered, the problem with our research is that periods of QT and higher rates spanned bullish and bearish trends.

Based on this analysis, the market trend may be the most crucial factor for considering risk and return. When the market trades above its 200-day moving average, the average daily returns are much greater than the average since 1970, and volatility is much lower.

Conversely, bear markets produce horrible returns, higher volatility, and a more abnormal distribution of returns.

Extra: 200-dma

Given the importance of the 200-dma, we present the graphs below. The first short-term graph shows the S&P 500, its 200-dma, and the slope of the dma. Slope quantifies the rate and direction in which the 200-dma is headed. The most bullish trend occurs when the S&P 500 is above its 200-dma, and the slope is positive and rising.

The graph below provides guidance on where the S&P 500 sits versus its 200dma.

The Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) confirmed a widely expected tightening of bank lending standards in the first quarter. The share of banks with tighter standards on loans to medium and large businesses rose to 46% from 44.8% in the fourth quarter of 2022. Given the regional bank fallout in late March, the tightening of lending standards could have been worse. Meanwhile, demand for commercial and industrial loans weakened considerably. The survey reported the broadest share of banks with weaker loan demand since 2009.

The chart below shows the historical relationship between the SLOOS and high-yield credit spreads. Despite the rapid rise in interest rates and tightening lending standards, credit spreads remain relatively muted. In other words, banks adjust to heightened risk in loan portfolios, while bond investors still don’t show a sense of urgency. What gives?

What To Watch Today

Earnings

Economy

Market Trading Update

As I discussed in yesterday’s “Before The Bell,” the market has remained range bound since the beginning of February. This is despite the Fed hiking rates, bank crisis, etc. As shown, the sell signal remains intact, and as we stated previously, such suggests that the upside is limited. However, it does NOT mean the market has to sell off dramatically. Such has been the case that has frustrated the bears expecting a decline and the bulls trying to make money.

Eventually, this range will resolve itself with either a break to the upside or downside and the only problem is that we do not know which it will be. Plenty of valid arguments exist for both an economic recovery and a recession. Such makes it very difficult to manage money from a risk perspective in the short term. In such situations, it is often better to be patient and let the market tell us what to do next.

NVDA’s Massive Edge

Nvidia has been one of the greatest beneficiaries of the Artificial Intelligence hype this year. The stock’s share price has increased 100% YTD, doubling the return of its closest competitor, AMD. So, given the market-wide excitement about AI and inevitable competition down the road, why has the stock offered such a stark outperformance? For one, it’s the leading provider of advanced GPU chipsets, the backbone of machine-learning models. Given this is a highly technical space with tighter standards than most industries, having a first-mover advantage is highly valuable. Beyond this, NVDA is cementing another competitive advantage: switching costs. According to Bernstein semiconductor analyst Stacy Ragson on Bloomberg’s OddLots Podcast:

Now, what Nvidia has done on top of this, not only with having the hardware, is they’ve also built a really massive software ecosystem around all of this. Their software is called Cuda. Think about it as kind of like the software, the programming environment. Like the parallel programming environment for these GPUs. And they’ve layered on all kinds of other libraries and STKs and everything on top of that, that actually makes this relatively easy to use and to deploy and to deliver.

And so they’ve built up not just the hardware, but also the software around this. And it’s given them a really, really sort of like massive gap versus a lot of the other competitors that are now trying to get into this market as well.

For companies who have spent tens of millions building data centers with NVDA’s chips and learning to operate within the Cuda environment, they now have significant switching costs. This gives NVDA pricing power down the road, leading to higher operating margins than its competitors. While NVDA’s outperformance this year may seem outrageous, its competitive advantage in this new frontier is just as outrageous- and it might even justify the lofty valuation.

Market Breadth Like This May Spell Trouble

As we wrote last Monday, the market has rallied this year on bad breadth. The chart below illustrates the divergence. The Vanguard Mega Cap Growth ETF (MGK) is up nearly 22% this year, the broader index is up only 8.3%, and an equal-weighted index is up just 1.5%. In other words, a handful of stocks have driven most of the gains. BTIG analyst Jonathan Krinsky looked at the historical record and noted that similar breadth tends to appear near market peaks:

Krinsky found that, going back to 1990, there have been 29 instances where the S&P 500 has traded above its 200-DMA for at least 34 sessions.

Market breadth has only been weaker during two of those occasions, Krinsky found. By now, 69% of S&P 500 constituents have typically moved above their 200-DMAs, according to Krinsky.

What might this mean for stocks? Krinsky found some evidence to support his view that stocks are likely headed lower. For example, four of the six periods where breadth was the weakest occurred near market peaks, including in December 1999, July and September 2000, and October 2007.

Amazon Takes Aim at Delivery Costs

Amazon (AMZN) is looking for more ways to cut costs as it shifts to tighter operating standards following a massive expansion. The company has previously announced several rounds of layoffs this year. This time, it aims to reduce delivery costs by offering customers compensation to use pickup points instead of home delivery. Per Investing.com,

“Amazon over the last few days has emailed an unknown number of Prime subscribers offering them $10 to retrieve an order of $25 or more at company pickup points at locations such as Whole Foods, Amazon Fresh or Kohl’s (NYSE:KSS) stores.”

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

The COT (Commitment Of Traders) data, which is exceptionally important, is the sole source of the actual holdings of the three critical commodity-trading groups, namely:

• Commercial Traders: this group consists of traders that use futures contracts for hedging purposes. Their positions exceed the reporting levels of the CFTC. These traders are usually involved with producing and processing the underlying commodity.
• Non-Commercial Traders: this group consists of traders that don’t use futures contracts for hedging and whose positions exceed the CFTC reporting levels. They are typically large traders such as clearinghouses, futures commission merchants, foreign brokers, etc.
• Small Traders: the positions of these traders do not exceed the CFTC reporting levels, and as the name implies, these are usually small traders.

The data we are interested in is the second group of Non-Commercial Traders (NCTs.)

NCTs are the group that speculates on where they believe the market will head. While you would expect these individuals to be “smarter” than retail investors, we find they are just as subject to “human fallacy” and “herd mentality” as everyone else.

What we know is that markets move based on sentiment and positioning. This makes sense considering that prices are affected by the actions of both buyers and sellers at any given time. Most importantly, when prices, or positioning, becomes too “one-sided,” a reversion always occurs. As Bob Farrell’s Rule #9 states:

“When all experts agree, something else is bound to happen.” 

So, how are traders positioning themselves currently? 

Let’s look at NCT’s current net positioning (long contracts minus short contracts) to gauge excessive bullishness or bearishness. 

All “Experts” Are Short The Stock Market

As noted above, all “experts” seem to think the market is ripe for another downturn and bear market. As such, they have shorted the S&P 500 index in anticipation of a potential correction in the months ahead. The interesting thing about such negative positioning is that it tends to be a contrarian indicator. As Sam Stovall once stated:

“If everyone is bearish, who is left to buy?”

Currently, the net short positioning by NCTs in the COT data is at levels not seen since either 2007 or 2011. The difference between the two periods is notable.

There are a couple of reasons why NCTs are shorting the market so extremely. The first is that they are betting on a further decline in the market. Such is possible given they were late shorting the market in 2022, and the recent rally from the October lows provides a better entry point. The second reason is they are hedging long positions in portfolios against a decline.

Given the still negative sentiment in the overall market, hedging portfolios is a logical choice. The difference between outcomes is dependent on whether the market is in a bullish or bearish cycle.

During the 2008 “Financial Crisis,” a true bear market, the COT net short position remained as market prices declined. This occurred as traders took short positions to speculate on the additional downside as the bear market unfolded.

However, since 2009, large net short positioning has denoted market bottoms. Each of the periods where the COT net short positioning became more extreme, such provided the “fuel” for the ongoing advance as traders were forced to cover their short-positioning as markets rose.

We must answer whether we are in a bullish or bearish trend. As I noted in “Rolling Recessions,” despite the correction in 2022, we remain clearly defined to a rising bull market trend.

“Since 2015, the market has traded in a well-defined bullish trend. Any breakout above or below that channel was quickly resolved. Notably, the market remains well above its 2019 peak. This is why the Fed continues to tighten policy as the “wealth effect” remains well entrenched, supporting inflationary concerns.

In late 2020, the market surged above the bullish trend channel as massive fiscal and monetary interventions fueled enormous speculation.”

The debate, however, is whether the correction from the previous market peak has been completed after successfully retesting and holding the bottom of the long-term trend channel. A look at a weekly chart, and the subsequent confirming buy signals, suggests such may be the case. When the market trades above the 40-week moving average, such tends to remain the case for an extended period. Notably, when the market is more than 10% above its 40-week moving average, that denoted market excesses that eventually reverse.

With the market now trading above the 40-week moving average, despite the bearish headlines and concerns of a recession, such generally suggests a more extended period of higher prices. If such is the case, that massive net short position could fuel an increased advance in the market in the months ahead.

All “Experts” Are Short Treasury Bonds

Interestingly, the COT data also shows that NCTs are heavily net short the 10-year Treasury Bond. This heavy negative positioning against the 10-year Treasury is one of the reasons we suggest that the “Bull Market In Bonds Is Set To Return.”

“People don’t buy houses or cars. They buy payments. Payments are a function of interest rates, and when interest rates rise, loan activity falls as payments rise above affordability. In an economy where 70% of Americans have little savings, higher payments significantly impact family budgets. Such is a critical point. Higher interest rates create ‘demand destruction.‘

While buying bonds today may still have some “pain” in them, we are likely closer to a significant buying opportunity than not. More importantly, if we are correct, the coming bull market in bonds will likely outperform stocks and inflation-related trades over the next 12-months. Such an outcome would not be the first time that happened. Of course, buying bonds when no one else wants them is a tough thing to do.”

The net short positioning on bonds is now at the highest since late 2018 amid the market meltdown over the Fed hiking interest rates. While yields today are marginally higher, the drop in yields will likely be significant when that short position reverses.

The chart below strips out all positioning except when the net short positioning exceeds 100,000 contracts. Not surprisingly, since 2000, each such condition was at, or near, a peak in interest rates. Notably, there was only one other period in our data where the net short positioning was so extreme. That period was in early 2018 as the Fed was hiking rates. Within 12 months, the Fed cut rates back to zero and was starting a massive repurchase operation to support the banks and hedgefund liquidity issues.

Of course, the obvious question is whether bears can simultaneously be wrong on stocks and bonds.

The Bears May Get Frustrated

Is it possible that the bears on both major markets (stocks and bonds) could become frustrated? History suggests such could be the case as stocks and bonds rally as the massive net short positions in the COT data are unwound.

The chart below is the monthly “real,” inflation-adjusted return of the S&P 500 index compared to interest rates. The data is from Dr. Robert Shiller, and I noted corresponding peaks and troughs in prices and rates.

The data is a bit cluttered when looking at it in this manner. However, even an untrained eye can pick up that spikes in interest rates led to unfavorable outcomes for stocks. To understand the relationship between stock and bond returns over time, I took the data from the chart and created the table below of 47 periods over the last 123 years.

What jumps is the high degree of non-correlation between 1900 and 2000. As one would expect, if rates fell, stock prices rose in most instances. However, the opposite also was true. The chart below shows each of the 47 periods graphically.

The historical non-correlation changed in 2000, and rate movements and stock prices became correlated. The Federal Reserve is the only change that explains this immediate switch from non-correlation to correlation.

Importantly, since the turn of the century, both stock and bond markets have been correlated. Given the extreme net short positioning in the COT data, the bears on both sides may be wrong. Such is why it is crucial to ignore the media headlines, and one-sided commentaries, in favor of the data.

As I concluded in our recent missive on “Conviction,” it isn’t “being wrong” that is the biggest risk to your money. It’s “staying wrong,” that is.

Is this time different? Possibly.

But this is why we continue to focus on the data rather than the hyperbole.

Friday’s employment report revealed that Nonfarm Payrolls rose 253,000 last month, crushing expectations of a 185,000 increase. Meanwhile, the unemployment rate fell to 3.4%— its lowest since 1969, and average hourly earnings rose 0.5%, their fastest pace in a year.

Before Friday’s report, Fed Funds futures priced in a 60% chance of a rate cut at the July FOMC meeting. Those odds fell sharply to settle near 35% following further evidence of a resilient labor market. While the employment report lowers the chance of rate cuts coming sooner than later, it’s not enough to increase the likelihood of further rate hikes. Given the Fed’s growing emphasis on incoming data to drive decision-making, expectations priced into the Fed Funds futures market may see higher volatility going forward.

What To Watch Today

Economy

Earnings

Market Trading Update

With the majority of S&P 500 earnings behind us, the focus will turn to economic data, which has remained weak as of late outside employment numbers. Nonetheless, we are likely near a trough in economic activity and should start seeing improvement as we approach the end of the summer.

The reductions we made a couple of weeks ago helped shield portfolios from last week’s correction, which was both needed and expected. While technical signals often don’t make sense, more often than not, they are picking up on the “herd mentality” of the market. When an event happens, we immediately look for headlines to blame for the sell-off or advance, but the market is usually ahead of whatever the trigger turned out to be.

The market remains on a “sell signal” and again tested and held critical support at the 50-DMA and the downtrend support line from the April highs. The consistent test and holding of support remain bullish overall, and unless or until that is broken, the more bearish concerns are secondary.

The Week Ahead

This week will be quiet on the economic data front following last week’s FOMC rate decision and employment data. On Wednesday, we’ll receive an update on inflation with the April CPI data release. This release is highly anticipated given the Fed’s increasingly data-dependent attitude and Friday’s strong employment results. Market participants expect headline inflation to tick up to 0.4% MoM in April from 0.1% in March. However, expectations call for a decrease in Core Inflation to 0.3% MoM from its previous 0.4% MoM. Following the CPI data, April PPI data will drop on Thursday. The consensus is for an increase of 0.3% MoM after a negative surprise in March. Finally, we’ll receive the preliminary University of Michigan Consumer Sentiment and inflation expectations data for May on Friday.

Cyclicals are Shining This Earnings Season

More than 1,200 companies have reported 1^st quarter earnings through Friday. The chart below from Bespoke highlights that 70% of companies have topped earnings estimates. Cyclical sectors are outshining defensive sectors on average, with Materials, Industrials, and Consumer Discretionary beat rates all near 78%. Resilient employment keeps consumption intact despite inflation, translating to the highest beat rate for S&P 500 companies since Q4 2021.

Lofty Assumptions Meet Reality

The Financial Times published an interesting article by Drew Dickson outlining the gap between perception and reality within the Tesla story. Dickson discusses Tesla’s price cuts in the months leading up to the investor day in March. Were they a strategic bid for market share, or rather a defensive move amid increasing competition? Musk made it seem like a bid for market share. “Even small changes in the price have a very big effect on demand.” However, TSLA bulls were left scratching their heads when Q1 results were released on April 3^rd.

It turned out that Tesla couldn’t sell every car it made. Despite sequential price cuts of approximately 10-15 per cent, deliveries only grew by 6 per cent sequentially. In fact, Tesla actually overproduced in the quarter, growing inventories. An implied price elasticity of much less than 1.0 was evidence that price changes, whether big or small, had very little effect on demand.

On top of the lack of incremental demand from price reductions, gross margins fell by more than leadership had predicted.

Tesla failed to reduce costs through scale effects or lower input costs so first-quarter automotive gross margins (ex regulatory credits and leases) were 18.3 per cent, down from the 29.7 per cent generated a year before. A reminder that management had guided for “at least 20 per cent” just a month earlier.

Moreover, Tesla received Inflation Reduction Act (IRA) tax credits during the quarter. In a filing with the SEC, Tesla stated that a higher cost per unit during the first quarter was “partially offset by manufacturing credits earned as part of the IRA”. Management didn’t disclose a precise number but if, hypothetically, 17.5 per cent of costs was the “partial” offset then Tesla would receive a $269mn subsidy against production expenses. In this (theoretical but plausible) example, this means automotive gross margins ex all the funnies didn’t merely drop to 18.3 per cent, they may have plummeted to around 16.9 per cent. Tesla did not reveal anything about the IRA credits optically supporting margins on the conference call.

Decomposing the numbers, I estimate that the profit per vehicle likely dropped from circa $15,000 last year to just above $7,500. In other words, here was a price cut of approximately 12.5 per cent and profits almost halved.

Tweet of the Day

Please subscribe to the daily commentary to receive these updates every morning before the opening bell.

If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.

How does the minimum wage affect the Fed’s biggest fear? I touched on this subject previously as the Fed began its rate-hiking campaign. However, while the issue of the “millions of people” who aren’t paid a “living wage” for work makes headlines, the actual numbers are pretty underwhelming.

As of the end of 2021, there are 2 million workers at, or below, minimum wage. Crucially, this number includes those in the restaurant profession that are paid “wages” of $2/hour but also receive tips. Notably, the number and total percentage of ALL workers today at or below minimum wage are at the lowest levels since 1979.

Where Are They?

Unsurprisingly, you will find the majority of minimum wage earners in fast-food, transportation, and personal care occupations.

As the Bureau of Labor Statistics notes:

Minimum-wage workers tend to be young. Although workers under age 25 represented nearly one-fifth of hourly paid workers, they made up 44 percent of those paid the federal minimum wage or less.

The Federal Minimum wage is a political “hot potato” that garners attention but has little impact on the economy’s overall health.

“So what? People working at restaurants need to make a ‘living wage.'”

While it is an emotionally charged argument, the minimum wage is not meant to be a living standard.

Minimum wage jobs are starter positions to allow businesses to train, evaluate, and grow valuable employees.

• If the employee performs, wages increase along with additional duties.
• If not, they either remain where they are or get replaced.

Critically, minimum wage jobs were not meant to be permanent or “living wage.”

If an individual remains stuck at the minimum wage, it may have more to do with the worker than the employer. According to a recent survey of 1344 managers by ResumeBuilder.com, GenZ, the group most likely found working at minimum wage, is “the” most challenging generation to work with.

• 49% say it’s difficult to work with GenZ all or most of the time
• The top reasons they feel GenZ is difficult to work with are the lack of technological skills, effort, and motivation.
• 65% say they more commonly need to fire GenZers than employees of other generations
• 12% have fired a GenZer less than one week after their start date
• Being too easily offended is a top reason GenZers get fired.

Nonetheless, there is a misplaced outcry for hiking the minimum wage to $15 an hour, or in California’s case, $22. The problem, of course, is the economic impact on those receiving those pay increases.

As is always the case, there is “no free lunch.”

No Free Lunch

Okay, let’s hike the minimum wage to $15/hr. That doesn’t sound like that big of a deal.

However, assume the employee works full-time, earning $15/hour.

• $15/hr X 40 hours per week = $600/week
• $600/week x 4.3 weeks in a month = $2,580/month
• $2580/month x 12 months = $30,960/year.

Given that most are in the fast-food industry, what happens to the price of hamburgers when companies must pay $30,000 annually for “hamburger flippers?”

McDonald’s and Walmart can give you a clue.

“KeKe Mendez recorded herself driving to a McDonald’s drive-thru. When she approached the window, there wasn’t an employee in sight. Instead, she was met with an automated machine handling her order. The machine placed the bag down and pushed it on a conveyor belt to the window.“

After Walmart and Target announced higher minimum wages, layoffs occurred, and cashiers got replaced with self-checkout counters. Restaurants added surcharges to help cover the costs of higher wages, a “tax” on consumers, and chains like McDonald’s and Panera Bread replaced cashiers with apps and ordering kiosks.

Such should not be surprising as labor costs are the highest expense to any business. It’s not just the actual wages but also payroll taxes, benefits, paid vacation, healthcare, etc. Employees are not cheap; that cost must be covered by the goods or services sold. Therefore, if the consumer refuses to pay more, the costs must become offset elsewhere.

More importantly, just as we found out with sending stimulus payments to households, the service cost will increase once businesses realize more money is available. As noted by the Heritage Foundation, the impact of a $15 Federal minimum wage would increase childcare costs by $2000 to $6000 depending on the state.

In other words, there is “no free lunch,” as increasing the minimum wage will lead to an increase (inflation) in everything else, essentially wiping out the benefit of the wage increase.

However, there is more to hiking the minimum wage than just increased costs. It has the potential to exacerbate the Fed’s biggest fear.

The Wage Spiral

How can hiking the minimum wage foster a wage spiral?

Let’s look at an example parcel carrier job that currently pays $15/hour and has the following work requirements.

• Lifting boxes up to 150 lbs.
• Loading and unloading trucks in a warehouse that can be freezing or sweltering,
• Driving a large truck anywhere from 10-150 miles a day,
• Customer interaction,
• Route planning.

What would be the consequences of raising the minimum wage to $15/hour for this worker?

There are two possible outcomes.

1. Instead of lifting parcels of up to 150 lbs per day, they quit for a much easier job for the same pay; or
2. Demands a pay raise (which, if they don’t get the raise, they quit to take a much easier job.)

The parcel carrier service acquiesces and raises them to $20/hour. However, now the managers making $20/hour want a raise, and so forth. It is the same effect as throwing a rock into a pond. Yes, the rock (in this case, the number of minimum-wage workers) may be small, but the “ripple effect” to the pond’s edges becomes substantial.

As wages increase at the bottom, there is a trickle-up effect on all workers. Importantly, those accelerating wage costs ultimately must pass on to consumers, otherwise known as inflation. That cycle of rising wages and prices is the “wage-price spiral.” The Fed already got a taste of the problem with the influx of stimulus into the economy, which led to surging demand when employees were scarce.

Such is also why the Federal Reserve remains committed to keeping interest rates elevated to slow economic demand (which, in turn, will lower wages as unemployment increases) to reduce inflationary pressures.

The Consequences

The consequences of mandated minimum wage increases are problematic due to the impact such can have on overall wages, costs, and corporate responses. The Manhattan Institute previously concluded:

“By eliminating jobs and/or reducing employment growth, economists have long understood that adoption of a higher minimum wage can harm the very poor who are intended to be helped. Nonetheless, a political drumbeat of proposals—including from the White House—now calls for an increase in the $7.25 minimum wage to levels as high as $15 per hour.

But this groundbreaking paper by Douglas Holtz-Eakin, president of the American Action Forum and former director of the Congressional Budget Office, and Ben Gitis, director of labormarket policy at the American Action Forum, comes to a strikingly different conclusion: not only would overall employment growth be lower as a result of a higher minimum wage, but much of the increase in income that would result for those fortunate enough to have jobs would go to relatively higher-income households—not to those households in poverty in whose name the campaign for a higher minimum wage is being waged.”

Such is just common sense logic, but it also finds support from the CBO report.

• Reductions in employment would initially be concentrated at firms where higher prices quickly reduce sales. Over a longer period, however, more firms would replace low-wage workers with higher-wage workers, machines, and other substitutes.
• A higher minimum wage shifts income from higher-wage consumers and business owners to low-wage workers. Because low-wage workers tend to spend a larger fraction of their earnings, some firms see increased demand for their goods and services, which boosts the employment of low-wage workers and higher-wage workers alike.
• A decrease in low-wage workers reduces the productivity of machines, buildings, and other capital goods. Although some businesses use more capital goods if labor is more expensive, that reduced productivity discourages other businesses from constructing new buildings and buying new machines. That reduction in capital reduces low-wage workers’ productivity, which leads to further reductions in their employment.

The critical point here is that the unintended consequences of a minimum wage hike in a weak economic environment are not inconsequential. Given that businesses will fight to maintain profitability, hiking the minimum wage, given the subsequent “trickle-up” effect, will lead to further automation and the “off-shoring” of jobs to reduce rising employment costs. 

The Federal Reserve is keenly aware of the wage-price spiral and understands that increasing borrowing costs will eventually force wages to come down as the economy and inflation decline.

Unfortunately, those that just got the minimum wage increase may see their jobs soon replaced by a more cost-effective method.