The Fed offers banks and money market funds reverse repurchase agreements (RRP) to drain excess liquidity in the money markets, allowing them to manage the Fed Funds rate. RRP are collateralized overnight loans made by banks and money market funds to the Fed. In March 2021, RRP balances surged due to the excessive liquidity caused by fiscal and monetary stimulus. Had the program not existed, Fed Funds and Treasury Bill demand would have pushed yields well below what the Fed desired. The graph below shows the increase (green) in RRP balances alongside the RRP rate (blue) and one-month Treasury bill yields (red).

The box below highlights that one-month treasury bill yields are now more attractive than RRP. Therefore, RRP balances are declining, signifying that excess liquidity is fading. Money market funds are removing funds from RRP to buy higher-yielding Treasury bills. So far, the decline of RRP is healthy. However, RRP balances may fall to near zero. When that occurs, the Treasury must replace that liquidity from other sources. Coupled with ongoing QT, which also drains liquidity, the removal of excess liquidity from the money markets may increase liquidity stresses for banks and, therefore, the markets.

What To Watch Today

Earnings

Economy

• No notable economic releases

Market Trading Update

Last week, the market struggled to advance early in the week. On Thursday and Friday, markets climbed to set new closing highs for the year, as shown. However, the combination of overbought conditions and excess bullish sentiment limited gains from weaker-than-expected economic reports that should keep the Federal Reserve at bay next week. It is worth remembering, however, that we are still lower nearly two years later. Most investors have spent the last 15 months making up previous losses, and it is possible that markets may struggle next year as well.

As noted by YahooFinance on Thursday:

“Historically, volatility tends to contract at the end of December, paving the way for predictable year-end gains. But this year, November’s gangbuster returns may have brought forward an early Christmas for investors. ‌Stocks have had three principle catalysts over the last two years — inflation, jobs, and the Federal Reserve — and all three are on the docket over the next week. Whether bullish or bearish, markets could get quite interesting in what is normally a sleepy time of year.”

The jobs report yesterday was weak across the board, which will likely keep the Federal Reserve on hold for now, and next week is the inflation report and the last FOMC meeting for the year. With volatility at extremely low levels, as shown, a hot CPI report or a “hawkish message” from the Fed could cause stocks to stumble.

The message remains that risk is prevalent at the moment. However, the question is whether the “Santa Claus” rally was pulled forward.

While bullishness certainly prevails at the moment, along with a strong momentum in the market, this is a great time to set aside the narratives and return our focus to the basic portfolio management rules.

Rules For “Santa Rally”

If you are long equities in the current market, rebalancing risk is easy.

1. Tighten up stop-loss levels to current support levels for each position.
2. Hedge portfolios against major market declines.
3. Take profits in positions that have been big winners
4. Sell laggards and losers
5. Raise cash and rebalance portfolios to target weightings.

Notice, nothing in there says “sell everything and go to cash.”

Remember, our job as investors is pretty simple – protect our investment capital from short-term destruction so we can play the long-term investment game. Here are our thoughts on this.

• Capital preservation is always the primary objective. If you lose your capital, you are out of the game.
• Seek a rate of return sufficient to keep pace with the inflation rate. Don’t focus on beating the market.
• Keep expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4%)
• Higher rates of return require an exponential increase in the underlying risk profile. This tends to never work out well.
• You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.
• Portfolios are time-frame specific. If you have a 5-year retirement horizon but build a portfolio with a 20-year time horizon (taking on more risk), the results will likely be disastrous.

As discussed on Tuesday, there is a wide range of potential outcomes, based on valuations, in 2024. No one knows with any certainty what next year will hold. However, by focusing on risk controls and the technical underpinnings, we can safely navigate the waters to safety.

We are certainly anxiously anticipating the arrival of “Santa Claus.” However, we remain keenly aware of the lessons taught to us in 2018 and 2020 that nothing is guaranteed

The Week Ahead

This will be an important week for economic data and the Fed. We suspect the Fed will maintain its hawkish tone in their FOMC minutes and Powell’s press conference on Wednesday. While no one expects the Fed to raise rates, expectations vary as to how the Fed may address the recent easing of financial conditions. If they become more hawkish, stocks and bonds may suffer. That said, recent speeches by Powell and other Fed members lead us to believe they will reiterate what they have said over the last few weeks.

The key data points to follow are CPI on Tuesday, PPI on Wednesday, and Retail Sales on Thursday. CPI is expected to rise 0.1% from 0.0% last month. Core CPI is expected to stay at 4.0% on a year-over-year basis. Retail sales will incorporate some of the post-Thanksgiving holiday sales.

The BLS Employment Report

The BLS employment report came in a little better than expected. The economy added 199k jobs in November. Expectations were for a gain of 185k. However, after the ADP and JOLTs reports, many were expecting something worse. The unemployment rate, which had been ticking higher over the previous six months, fell 0.2% to 3.7%. Wages and hours worked also were 0.1% higher than expected. From the Fed’s perspective, this is probably welcome news. It shows the economy remains healthy and may simply be normalizing instead of slipping into a recession. Seasonal adjustments are large in November and December, so we may find out down the road that the report was stronger or weaker than what was reported.

The graph below, courtesy of MacroMicro, shows the employment diffusion index dropped to 57.8% in November. Such is the lowest level in three years. The index measures the percentage of industries reporting job growth. A decline below 50% would raise recession concerns.

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The “American Dream” is dead.

It would certainly seem to be the case if you believe surveys like Gallup that showed nearly 50% of the younger generation favor socialism over capitalism. To wit:

“Since 2010, young adults’ positive ratings of socialism have hovered near 50%, while the rate has been consistently near 34% for Gen Xers and near 30% for baby boomers/traditionalists.”

Or, a more recent WSJ poll conducted by the NORC at the University of Chicago found that only 36% of Americans still believe in the “American Dream.”

But such a dire sentiment should be surprising given the increasing disparity between socio-economic classes. The recent struggles with the pandemic-era driven shutdown, then rising inflation, and spiraling housing costs are certainly reasons that many would believe the “American Dream” is dead.

However, the pessimism about capitalism in the U.S. has been brewing since the “Financial Crisis.” Its early forms started with “Occupy Wall Street” following the subprime crisis and continued growing as political divisions deepened. The rise of civil unrest has deeper roots, as noted by Pew Research in 2017:

“The U.S. economy is in much better shape now than it was in the aftermath of the Great Recession…But by some measures, the country faces serious economic challenges: A steady hollowing of the middle class and income inequality reached its highest point since 1928.”

If you look at the faces of those pushing back, they are of every race, religion, and creed. Their commonality is they are the demographic most impacted by job losses, income destruction, financial disparity, and debt. That inequality gained enormous traction following the Federal Reserve’s repeated bailouts of the financial system. Today, the top 10% of income earners own roughly 88% of financial assets.

More notably, total household net worth has only marginally increased for the bottom 50% of Americans since the turn of the century.

As the “rich” got richer, the masses noticed their economic prospects failed to improve. It should be of no surprise that those most disenfranchised eventually started to push back, demanding more support from the Government.

However, what the media proclaims to be the “American Dream” and what is in “reality” are two very different things.

What The American Dream Is And Isn’t

The media disparages the “American Dream” based on the ability to buy a home, minimum wages, or healthcare costs.

This is entirely wrong.

The “American Dream” is the idea that the Government should protect each person’s opportunity to pursue their vision of happiness. It is the dream of opportunity, the dream of freedom, and the dream of liberty.

That dream was penned in the Declaration Of Independence:

“We hold these truths to be self- evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”

The founders of this nation NEVER penned that American citizens had the RIGHT to a house, free health care, or government welfare.

As Kimberly Amadeo previously penned:

“The Founding Fathers put into law the revolutionary idea that each person’s desire to pursue happiness was not just self-indulgence. It was a part of what drives ambition and creativity. By legally protecting these values, the Founding Fathers set up a society that was very attractive for those aspiring to a better life.”

Or, as James Truslow Adams quoted in his book “Epic Of America:”

“The American Dream is that dream of a land in which life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement. The American Dream is NOT a dream of motor cars and high wages merely, but a dream of social order in which each man and each woman shall be able to attain to the fullest stature of which they are innately capable, and be recognized by others for what they are, regardless of the fortuitous circumstances of birth or position.”

So, precisely what is the “American dream?”

It’s Up To You

The “American dream” is about the opportunity to achieve a result, not the result itself. Many of the younger generation today feel as if the ability to achieve success is out of reach. According to a 2020 YouGov poll:

“A poll of more than 14,000 people finds that just over half (54%) of US adults think the American Dream is attainable for them. About 3-in-10 (28%) believe it’s unattainable for them personally, while 9 percent reject the idea of the American Dream entirely.”

The American dream was never about being granted a high salary, given an opportunity, or gifted wealth.

However, we were given the “freedom” to start with nothing and, by sheer “will,” create success. For example:

• Jan Koum, CEO and Founder Of WhatsApp, once lived on food stamps.
• Kenny Troutt, the founder of Excel Communications, paid his way through college selling life insurance.
• Howard Schultz grew up in a housing complex for the poor.
• Investor Ken Langone’s parents worked as plumbers and cafeteria workers.
• Oprah Winfrey was born into poverty.
• Billionaire Shahid Kahn washed dishes for $1.20 an hour.
• Kirk Kerkorian dropped out of school in the 8th grade to be a boxer.
• John Paul DeJoria, the founder of Paul Mitchell, once lived in a foster home and out of his car.
• Do Won Chang, founder of Forever 21, worked as a janitor and a gas station attendant when he first moved to America.
• Ralph Lauren was a clerk at Brooks Brothers.
• Francois Pinault quit high school in 1974 after being bullied because he was so poor. 

There are millions more like them. The only difference between them and those complaining about the “American Dream” is they had the drive to work, the willingness to sacrifice, and the courage to reach for it.

Capitalism Is Not Perfect

One thing is for sure. Capitalism is not perfect.

“Capitalism is an imperfect economic system, because differential performance in the pursuit of economic success, as well as luck, results in there being (a) some people who are less successful as well as some who are more and (b) a few who are glaringly successful.’

Obviously, I’m someone who has profited from capitalism, so my views could be dismissed as hopelessly biased.

However, I’m 100% convinced that the capitalist system has produced the most aggregate gains for our society, exceptional overall progress, and a better life for most.  For me, the best assessment of capitalism is the one Winston Churchill applied to democracy:

No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except all those other forms that have been tried from time to time.

In the same way, I’m convinced that capitalism is the worst economic system; except for all the rest.” – Howard Marks

Due to 50 years of debt, deficits, and ongoing interventions in the financial system, there is a visible gap between the “rich” and everyone else. However, that is not a failure of “capitalism;” it is the byproduct of “corporatism.”

Capitalism is the only system that will allow you to achieve unbridled success.

Yes, the Government can pay for anything you want. We tried that in 2020. The result was a massive spike in inflation, ultimately putting those receiving the benefits in a worse financial condition.

The other problem with “free money” is that requires those who are succeeding to pay for it.

Think about it.

Do you want to work hard, sacrifice, and take on an exceeding amount of risk to achieve success, only to pay for those who don’t?

Such is why socialism always fails.

“The greater good can only be achieved by making the good greater.” – Daniel LaCalle

10-Steps To Achieve Your “American Dream.”

Let me clarify the issue for you.

“The ‘American Dream’ isn’t going into debt to buy a home. The ‘American Dream’ is the ability for ANY person, regardless of race, religion, or means, to achieve success, and in many cases great success, through hard work, dedication, determination, and sacrifice.“

In other words, anyone can succeed through hard work, dedication, determination, and sacrifice.

I know. It sounds hard. And it is.

Those who achieve success aren’t whiners and don’t blame others for their failings. 

They DO SOMETHING about it. 

The difference between success and failure is the “will to keep going.”

Therefore:

1. Be accountable for your current situation. Blaming others only keeps you from taking steps to fix it.
2. Your life depends on it, literally. If you don’t take control of your life, it will take control of you. 
3. Control your circumstances. Put yourself in a position to control what happens around you. 
4. You have to REALLY want it. If you aren’t committed, you are going to fail.
5. Be bold. No one will take you seriously unless you take yourself seriously first.
6. Find a guide. In business, find a mentor to guide you through the wilderness. 
7. Are you a “renter” or an “owner?” “Renters” can walk away without consequence. “Owners” have too much at stake to lose. Be willing to commit to everything. If you have no choice BUT to succeed…you will.
8. Be willing to work. Success is not a weekday 9-5 job. It is a 24-7 adventure that will consume your life. If you aren’t willing to “do the time,” don’t start. 
9. You probably need to get rid of your current friends. If you want to know where you will be in 5 years, look at who you surround yourself with today. Successful people surround themselves with successful people. 
10. Get off of social media. If you want to succeed, get out into the real world and find the opportunities overlooked by others.

The “American Dream” isn’t dead, at least not yet.

But you must decide to take the first step.

JP Morgan CEO Jamie Dimon testified to Congress on Wednesday in a routine meeting about the banking industry. In the process, the topic of Bitcoin and other cryptocurrencies came up. Despite having significant investments in blockchain, Dimon had some choice words for Bitcoin and other cryptocurrencies. In particular, the following quote is making headlines: “If I was the government, I’d close it down.” These are not the first anti-crypto comments he has made. Per CNBC: In previous statements, Dimon has called bitcoin “a hyped-up fraud,” a comment he later walked back. He had also likened it to a “pet rock.”

Bitcoin has been on a tear recently, rising about 65% since mid-October. Gold has risen markedly since then, and yields have come down significantly. It was at that time the Fed alluded that a pause was probable, as the recent tightening of financial conditions was doing their job for them. Bitcoin is the most volatile of the aforementioned asset classes so it makes sense it would rally the most. The graph below shows the drawdowns in Bitcoin can be huge but the ensuing rally, as we are seeing, can be very profitable.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

Yesterday, the market regained some of its losses from Wednesday but did not resolve the big “outside reversal” day. The last time we had a similar outside reversal was back in July when the market set its highs for the year. Like then, the market was topping with a MACD “sell signal” in place, and the market rallied for two days AFTER the outside reversal day.

Today is the all-important employment report, which, if weak, could fuel a surge in the market to a new high for the year. A stronger number could elicit a sell-off as traders reassess their hopes of Fed rate cuts early next year. Also, share “buybacks” end today, which will remove an important support from the market near-term. With the market still overbought and deviated above its moving average, the downside risk still outweighs the current upside. However, with the CPI report on Tuesday and the next FOMC announcement on Wednesday, there is little chance of knowing what happens next. Continue to manage risk until we get through next week.

Watch Out- Personal Interest Expenses Are Rising Quickly

The graph below cautions that consumers may be on the verge of reducing their credit usage. With that, personal consumption, representing about 70% of GDP, would slow.

In 2020, personal income rose despite mass layoffs. This was due to the numerous government stimulus/relief packages. At the same time, interest rates were plummeting, allowing individuals to refinance debt at lower interest rates. The result, as shown, is that interest expenses as a percentage of income fell to the lowest level in over 60 years. In 2022, interest rates started rising, and interest expenses followed. From January 2020 to current, interest expenses have increased 109%, while incomes only rose 9%.

Currently, the ratio of interest expense to income is well above pre-pandemic levels and approaching similar ratios that existed before the recessions of 2000 and 2008. Not only does the graph warn that consumers may have to cut back on credit-related spending and possibly consume less to pay off some debt, but it also shows how the lag effect takes time to fully impact consumers and, ultimately, the economy.

Credit Markets Price In A Goldilocks Scenario

As we wrote in the opening, Bitcoin, gold, and yields may be telling us that Fed rate increases are over and cuts are on the horizon. Rate increases, as shown below, have preceded every recession since at least 1950. As we highlight, there are only two instances in which the Fed increased rates, and a recession didn’t shortly follow.

The credit markets seem to think the recent hikes may be like those two prior recession “false alarms.” The second graph shows that the BBB-rate corporate credit spread, or the extra yield versus a risk-free Treasury bond, is falling. If credit investors were concerned about a recession, they would demand a higher yield premium. In other words, the spread would be rising. Simply, the corporate bond market thinks a Goldilocks scenario lies ahead.

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The ADP jobs report came in at 103k versus the expected 130k. The ADP also revised the jobs count from October to 106k from 113k. Over the last three months, the average gain has been just under 100k. Unlike the BLS, which surveys companies about their employment activity, ADP uses actual payroll data, including more than 25 million private sector employees. Its methods avoid double counting employees with multiple jobs and estimates, which are often provided to the BLS for their surveys. While the BLS is much more closely followed, ADP is more likely to give us a more accurate state of the jobs market.

100k ADP new jobs a month is still decent but below the 138.4k pre-pandemic average and half of the average for 2023. Within the report, a couple of indicators show that the key drivers of job growth and wages are quickly normalizing. First, ADP’s chief economist notes: “Restaurants and hotels were the biggest job creators during the post-pandemic recovery.” “But that boost is behind us.” The leisure and hospitality industry lost 7,000 jobs in Thursday’s report. The Fed has been very concerned that higher wage growth feeds inflation. To that end, ADP says the rate of pay increases for “job-stayers” and “job-changers” is the lowest in over two years.

If Friday’s BLS report shows similar labor conditions, the Fed is done raising rates, barring an unexpected jump in inflation.

What To Watch Today

Earnings

Economy

Market Trading Update

While the market tried to start the day out on the upside, the selling pressure continued throughout the day, with the market ending near its lows. Importantly, the sell-off yesterday triggered the MACD “sell signal,” and the RSI index moved solidly into correction territory. While this does NOT mean that markets must decline precipitously, it does suggest that upside is outweighed by downside risks.

As we have noted over the last several days, the risk/reward has not been in the investor’s favor, so we have suggested completing tax loss selling and portfolio rebalancing at these more elevated levels. As noted, whatever pullback we do get over the next week or so, particularly as stock buybacks go into “blackout” on Friday, will likely be limited. Use any pullback to add exposure as needed for now.

The next big driver for both bonds and stocks will be Friday’s employment report.

Consumer Credit Is Getting Difficult To Obtain

Accounting for about two-thirds of GDP, personal consumption is the most important economic factor to consider when assessing future growth potential. Given that, the means for consumers to consume are vital to follow. The first graph below, courtesy of Apollo, shows that consumer credit is now more difficult to obtain than at any point in the last ten years. Additionally, it is the most expensive. The second graph shows that personal savings spiked due to direct checks from the government in 2020 and 2021. Since then, consumers have been saving less. While dipping into savings fueled growth in the past, consumers now need to rebuild savings. Lastly is wage growth. As we share in the opening, ADP wage growth is now the slowest in two years. That said, it is still robust. Further weakness in wages, along with credit and savings trends, will weigh on personal consumption and GDP.

More On Consumer Credit

Consumer credit has been growing rapidly, but as the WSJ points out in their article, American Borrowers Are Getting Closer To Maxing Out, those trends may ending. Per the article:

A recent note published by the Federal Reserve Bank of Boston found that as of July, consumers with annual household incomes of less than $50,000 whose accounts were delinquent were on average utilizing 80 to 90 percent of their available credit. This leaves “those consumers with a very small amount of credit left on their accounts to cushion against a deterioration of their financial situation,” according to the paper. Across all cardholder income groups as of July, average utilization rates—the ratio of outstanding card account balance to the account’s credit limit—were above February 2020 levels.  

As evidence that consumers are starting to struggle with credit, consider that credit card charge-off and delinquency rates are now at seven-year highs.

The strong job market and rising wages will deflect some of the credit card woes noted in the article. However, credit delinquency and defaults will continue to rise if the labor market weakens. As a result, banks will offer more stringent terms on credit, including lower credit lines.

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The Economist published an article entitled Is It Cheaper To Rent Or Buy Property? It shows how the financial decision of buying versus renting has drastically changed due to the fiscal and monetary response to the pandemic. With massive stimulus came inflation and higher mortgage rates. Typically, higher mortgage rates result in lower home prices. However, like most things in the last few years, house prices defied normal behaviors. However, they have recently stabilized. Existing home sales are now at the same levels as in the spring of 2020, when many buyers and sellers were scared to leave their houses, let alone make important financial decisions, such as buying or selling a house. The result is a drastic change in the financials of renting versus buying a home.

In a rarity, renting is now cheaper than buying a home. Since January 2020, the Case-Shiller National Home Price Index is up 44%. Over the same period, the Zillow Observed Rent Index is up 31%. It is not just the increase in home prices making homeownership more expensive than renting. Higher mortgage rates are also a problem. Based on average home prices and the 4+% spike in mortgage rates, the mortgage payment on many homes has doubled. Not surprisingly, renting is now cheaper in many parts of the country. Per the Economist: “By our reckoning, house prices would have to tumble by one-third, average mortgage rates would have to fall to 3.2%, or rental costs would have to rise by at least 50%.“

What To Watch Today

Earnings

Economy

Market Trading Update

There is no real change from yesterday, as the market continues to trade flat over the last few days. Despite the one-day pop to the previous year’s highs, the market has gone nowhere since the last week of November. The good news is that buyers continue to remain present, keeping sellers at bay for now. The market remains overbought, and we are very close to triggering a MACD sell signal, which should signal weaker prices over the next week or so. Remain cautious for now and continue rebalancing risks accordingly.

2024 S&P 500 Estimates

Our latest article, Wall Street Analysts Are Optimistic For 2024, looks ahead to what we can expect in 2024. Based on a MarketWatch survey of nine of the largest Wall Street banks and brokers, the average estimate for a 2024 end-of-year S&P 500 target is 4836. Such entails a 6% gain. The article notes that the problem with the optimistic forecasts is that they are predicated on 20% earnings growth. To sustain such a higher-than-average earnings growth rate, the following factors must exist:

The problem with current forward estimates is that several factors must exist to sustain historically high earnings growth. Per the article:

The problem with current forward estimates is that several factors must exist to sustain historically high earnings growth.

1. Economic growth must remain more robust than the average 20-year growth rate.
2. Wage and labor growth must reverse to sustain historically elevated profit margins, and,
3. Both interest rates and inflation must reverse to very low levels.

While such is possible, the probabilities are low, as strong economic growth can not exist in a low inflation and interest-rate environment. More notably, if the Fed cuts rates, as most economists and analysts expect next year, such will be in response to a near-recessionary or recessionary environment. Such would not support current strong earnings estimates of $220.24 per share next year.

The article forecasts a 6.5% return in a “NO-recession scenario.” But it cautions: “However, should the economy slip into a mild recession, valuations would be expected to revert toward the longer-term median of 17x earnings. Such would imply a level of 3744 or roughly a 17% decline next year.” If the bulls are correct and earnings grow at 20%, the economy avoids a recession, and valuations are static, an 18.5% gain is possible. The range of outcomes is graphed below.

Food for thought: the average return under the three scenarios is about 6-7%. High-quality corporate bonds yield 5% or more, and risk-free Treasury bonds yield about 4.25%. The decision to buy equities versus bonds is much harder today than a few years ago when rates were near zero.

Preview of the BLS Employment Report

October JOLTS job openings fell sharply to 8.7mm versus estimates of 9.3mm. The prior month was revised lower from 9.53mm to 9.35mm. The quits rate stayed constant at 2.3%, which is where it stood on the eve of the pandemic. The hiring rate continues to decline. It is now at +0.2%, a level consistent with an unemployment rate of around 4.5%. While the data shows weakening, layoffs remain at 1%, below the 1.4% pre-pandemic average (2000-2019).

The mixed data certainly points to the continued normalization of the labor market. However, there is not enough in the JOLTS data to conclude anything more troubling.

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After hiking rates by 5.25% since March 2022, the Fed is in a wait-and-see period, commonly deemed a pause. Since the Fed started hiking rates, inflation has declined meaningfully but remains moderately above the Fed’s 2% target. The economy continues to thrive, fueled by a strong labor market.

Despite the good news, a dark cloud lingers on the horizon. The Fed’s primary fear is that the lag effect of prior rate hikes has yet to impact the economy fully. They desire a soft landing, implying little economic degradation. But a much stronger downturn can’t be ruled out in their minds or ours. Given the odd juxtaposition between strong economic growth and recession fears, a Fed pause is the most likely action.

The Fed Funds futures market agrees with our assessment. As we show below, it expects the Fed to pause through February. Starting in March 2024, the market implies increasing odds of the Fed cutting rates.

If the Fed is in the pausing stage of the cycle, the logical question is how long it might last. More importantly, how might stocks and bonds perform during the pause and eventually when the Fed cuts rates?

The equity market appears to be giddy at the prospect of rate cuts, but as we will discuss, equity investors should start contemplating risk reduction strategies. Bond investors are the ones that should be giddy!

Stock Investor Giddiness Explained

The November 3, 2023, BLS employment report underwhelmed expectations. However, the bad news was good news. The stock market roared as investors presumed a Fed pause was a done deal. Since then, it has continued rising nearly 6% in only a few weeks. Bonds followed. Over the same period, the U.S. Treasury ten-year note yield has fallen by .50%.

The weaker-than-expected CPI inflation report fueled the notion that the Fed was done.

WSJ reporter Nick Timiraos, the Fed’s media mouthpiece, leads credence to the Fed pause narrative. Shortly following the CPI report, Nick tweeted the following:

“The October payroll report and inflation report strongly suggest the Fed’s last rate rise was in July. The big debate at the next Fed meeting is shaping up to be over whether and how to modify the post-meeting statement to reflect the obvious: the central bank is on hold.“

Stock and bond investors are giddy at the prospect of slower growth and lower inflation. Such outcomes are not good for equity investments. Yet logic is trumped by the hope that the Fed’s next move may be to lower interest rates.

If this rate cycle is like almost all others in the last 100 years, a Fed pause will be followed by rate cuts.

How long of a pause should we expect before rate cuts?

How Long Will A Pause Last?

Nineteen weeks ago, on July 26, 2023, the Fed last hiked rates. The graph below, courtesy of ZeroHedge and Bloomberg reporter Simon White, shows five instances since 1970 when the Fed paused rate hikes for at least 18 weeks and resumed hiking. Only two of the cases were in the last 40 years.

In the accompanying article, Simon writes:

But when rates are already restrictive as they are today, it would be unprecedented. The longest the Fed has held rates after last hiking them, and then raising them again when rates are already restrictive – i.e., when the real Fed rate is greater than the neutral rate (using the Holston-Laubach-Williams estimate) – is 14 weeks, between August and November 1988.

No one can be 100% confident inflation will continue lower. As such, the Fed’s probability of raising rates again is not zero. However, the Fed seems more concerned that the lag effect of the prior 5.25% in rate hikes has yet to fully exert its weight on the economy. It is this dark cloud on the horizon that pressures them to pause.

The last three pause cycles since 2000 lasted 36 weeks on average. Thirty-six weeks from what may be the start of the recent pause puts us in March 2024. As we wrote in the opening, March 2024 is also the month when the Fed Funds futures market starts pricing in rate cuts.

Stocks And Bonds In Pause and Rate Cut Phases

How do stocks and bonds perform during the stages of monetary policy?

The graph below shows Fed Funds (black), the S&P 500 (orange), and 10-year U.S. Treasury bond yields from 1998 to the present. We highlight the rate hike, pause, and rate-cutting cycles with red, yellow, and green, respectively. For this article, we only consider the pause to be after the Fed increases rates.

Below, we isolate the three prior and the current partial cycles to appreciate what happens during the three cycles.

Marrying Historic Returns And Logic

Stocks often do well when the Fed is hiking rates and bond yields typically rise. This occurs because the economy is running above trend, and the Fed will raise rates for fear of inflation. Their aim during such periods is to slow growth back to trend.

The economy is fueled by debt. Accordingly, higher interest rates almost always result in below-trend growth and a recession.

The term “soft landing” is often used during rate hike cycles despite their frequent occurrences. The graph below shows that a rising Fed Funds rate preceded every recession since 1950. The circles show the only instances when Fed hikes did not result in an immediate recession.

Stock performance is mixed during the Fed’s pausing cycle after rate hikes. As shown above, stocks rose decently before the financial crisis and pandemic but fell before the dot-com bust. Bond yields fall during the pause as investors anticipate slower growth and less inflation. In all three prior periods, yields fell. Currently, yields have risen during the pause but are now trending lower.

Lastly, stocks tend to perform poorly during the rate cuts, and bond yields continue to fall. Such is unsurprising as the Fed typically raised rates too much, and a soft landing turned into a hard landing.

At the bottom of the graphic are the average returns for stocks and bonds for the four periods. As shown, stocks are the investment of choice during rate increases while bond yields rise. The pause period is tricky for stockholders. Bondholders should be comforted during both the pause and the rate-cutting period. Stock investors should consider risk reduction strategies as a rate cut will likely be the next Fed move.  

Summary

If history proves prescient and the Fed is genuinely pausing before a series of rate cuts, investors should consider how they might shift their exposures between stocks and bonds.

Within the equity markets, lower beta, more value-oriented stocks, and reduced equities allocations have tempered losses in past rate-cutting environments. On the other hand, bond yields may have already peaked around 5%. The current rate decline may be the tip of the iceberg if a recession is coming.

The risk to our forecast is that history doesn’t always repeat. Secondly, we have zero assurances the Fed has ended its rate hiking cycle. If the Fed raises rates again, the pause clock starts over, and stocks may do better than bonds.

Lastly, the Fed and government may panic as they did in 2020 and provide a bazooka to the equity markets via massive QE and zero interest rates. If so, any decline in equities may be short-lived. Conversely, longer-term bond yields could rise as investors now appreciate how such a massive fiscal and monetary reaction to weakness can generate inflation.

It’s that time of the year where Wall Street polishes up their crystal balls and pin targets on the S&P index for the upcoming year. As is often the case, while Wall Street is always optimistic, the forecasts prove pretty wrong.

For example, on December 7th, 2021, we wrote an article about the predictions for 2022.

“There is one thing about Goldman Sachs that is always consistent; they are ‘bullish.’ Of course, given that the market is positive more often than negative, it ‘pays’ to be bullish when your company sells products to hungry investors.

It is important to remember that Goldman Sachs was wrong when it was most important, particularly in 2000 and 2008.

However, in keeping with its traditional bullishness, Goldman’s chief equity strategist David Kostin forecasted the S&P 500 will climb by 9% to 5100 at year-end 2022. As he notes, such will “reflect a prospective total return of 10% including dividends.”

The problem, of course, is that the S&P 500 did NOT end the year at 5100.

Then, in 2022, Wall Street analysts suggested that 2023 would be a year of meager return of just 3.9% with a median price target of 4000.

Of course, reality turned out to be markedly different.

However, the guessing game is an annual tradition of Wall Street analysts and, as is always the case, to borrow a quote:

“(Market) Predictions Are Difficult…Especially When They Are About The Future” – Niels Bohr

Okay, I took a little poetic license, but the point is that while we try, predictions of the future are difficult at best and impossible at worst. If we could accurately predict the future, fortune tellers would win all the lotteries, psychics would be richer than Elon Musk, and portfolio managers would always beat the index.

However, all we can do is analyze what occurred previously, weed through the noise of the present, and discern the possible outcomes of the future. The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the unexpected and random events they inevitability occur.

We have seen plenty, from trade wars to Brexit, to Fed policy and a global pandemic in recent years. Yet, before those events caused a market downturn, Wall Street analysts were wildly bullish that wouldn’t happen.

So what about 2024? We have some early indications of Wall Street targets for the S&P 500 index, and, as is always the case, they are primarily optimistic for the coming year.

“The estimates from sell-side strategists put the average target for the S&P 500 at 4,836 for the end of 2024, implying an advance of merely 6.3% from Monday’s close, according to MarketWatch calculations of the data (see table below). That is below the average yearly return of around 8% for the large-cap index since 1957 and its year-to-date surge of 18.5% in 2023, according to Dow Jones Market Data.” – MorningStar

Will next year be another bull market year for stocks, or will the bear finally come out of hibernation? We don’t have a clue but can make educated guesses about ranges given current valuations.

Estimating The Outcomes

The problem with current forward estimates is that several factors must exist to sustain historically high earnings growth.

1. Economic growth must remain more robust than the average 20-year growth rate.
2. Wage and labor growth must reverse to sustain historically elevated profit margins, and,
3. Both interest rates and inflation must reverse to very low levels.

While such is possible, the probabilities are low, as strong economic growth can not exist in a low inflation and interest-rate environment. More notably, if the Fed cuts rates, as most economists and analysts expect next year, such will be in response to a near-recessionary or recessionary environment. Such would not support current strong earnings estimates of $220.24 per share next year. This represents roughly 20% from Q3-2023 levels, which is the most recently completed quarter.

Nonetheless, with that said, we can use the current forward estimates, as shown above, to estimate both a recession and non-recession price target for the S&P 500 as we head into 2024. These assumptions are based on valuation multiples within ranges of current market levels.

In the NO-recession scenario, the assumption is that valuations will fall slightly as earnings increase to 22x earnings over the next year. (22x earnings has been the average over the last few years.) The S&P 500 should theoretically trade at roughly 4845 by 2024 based on current estimates. Given the market is trading at approximately 4550 (at the time of this writing), such would imply a 6.5% increase from current levels.

However, should the economy slip into a mild recession, valuations would be expected to revert toward the longer-term median of 17x earnings. Such would imply a level of 3744 or roughly a 17% decline next year.

While an additional 17% decline from current levels seems hostile, such would align with typical recessionary bear markets.

Which would also coincide with Fed rate cuts to offset the deflationary risk to the economy.

However, we must consider one more scenario.

Maybe The Bulls Are Right

We would be remiss in not providing for a bullish outcome in 2024. However, we must consider several factors for that bullish outcome to take shape.

1. We assume the $220/share in year-end estimates remains valid.
2. That the economy avoids a recession even as inflation falls
3. The Federal Reserve pivots to a lower interest rate campaign.
4. Valuations remain static at 22x earnings.

In this scenario, the S&P 500 should rise from roughly 4550 to 5395 by the end of 2024. Such would imply an 18.5% gain for the year. Given the market is up approximately 19% in 2023, such a gain

The chart below combines the three potential outcomes to show the range of possible outcomes for 2024. Of course, you can do the analysis, make valuation assumptions, and derive your targets for next year. This is just a logic exercise to develop a range of possibilities and probabilities over the next 12 months.

Conclusion

Here is our concern with the bullish scenario. It entirely depends on a “no recession” outcome, and the Fed must reverse its monetary tightening. The issue with that view is that IF the economy does indeed have a soft landing, there is no reason for the Federal Reserve to reverse reducing its balance sheet or lower interest rates.

More importantly, the rise in asset prices eases financial conditions, which reduces the Fed’s ability to bring down inflation. Such would also presumably mean employment remains strong along with wage growth, elevating inflationary pressures.

While the bullish scenario is possible, that outcome faces many challenges in 2024, given the market already trades at fairly lofty valuations. Even in a “soft landing” environment, earnings should weaken, which makes current valuations at 22x earnings more challenging to sustain.

Our best guess is that reality lies somewhere in the middle. Yes, there is a bullish scenario where earnings decline and a monetary policy reversal leads investors to pay more for lower earnings. But that outcome has a limited lifespan as valuations matter to long-term returns.

As investors, we should hope for lower valuations and prices, which gives us the best potential for long-term returns. Unfortunately, we don’t want the pain of getting there.

Regardless of which scenario plays out in real-time, there is a reasonable risk of weaker returns over the next year than what we saw in 2023.

That is just the math.

Per the Tweet of the Day, our SimpleVisor relative analysis tool suddenly shows the real estate sector is the most overbought sector. For the better part of the year, real estate and many other sectors grossly lagged behind the technology and communications sectors. As we approach year end, the tide is turning. The graph below shows last week’s performance of each sector alongside its year-to-date performance. The real estate sector rose over 4% last week, cutting its year-to-date negative return in half. Basic materials, which had been down for the year pushed into the green with a +2.75% performance on the week. At the same time, the communications sector was down 2.5%, and technology barely eked out a gain. With year end nearing, what might be causing the stark differences in the relative performance of various sectors?

Typically in December, as institutions prepare for year end, mutual funds distribute capital gains, interest income, and dividends. Doing so often requires selling in those sectors and stocks with the biggest gains. Additionally, some institutions like to window dress their portfolios going into year end. Many institutions only report their holdings monthly or quarterly. Therefore, they may buy or sell stocks based on what they want their investors to think they held throughout the last month or quarter. Most often, markets are pressured in early to mid-December as mutual funds weigh on markets. However, once those trades are finished, the infamous Santa Rally often appears.

What To Watch Today

Earnings

Economy

Market Trading Update

After testing this year’s high on Friday, the markets pulled back some on Monday. However, even with the market down, there was buying both mid-day and into the close, showing support from buyers. One noteworthy change over the last week or so is the lag in performance by the “Magnificent 7” and the rotation into some of the more beaten-down sectors of the market, like Healthcare. This is likely due to mutual fund reblanancing for year-end distributions as those sectors with the biggest runup this year are sold down to weight and the laggards are brought up to weight. This is likely NOT a change in attitude but a short-term situation that will likely resolve itself over the next few days.

With the “stock buyback” window closing this week, one support for the bull rally over the last month is being removed. With the markets very overbought and close to a sell signal, continue to take profits, rebalance risks, and look for a better opportunity to increase exposures.

Growth Versus Value In Small Caps

We have often opined on the outperformance of large-cap growth stocks and the underperformance of value and smaller-cap stocks this year. The graph below looks inside the small-cap Russell 3000 index to show that the chase for growth over value isn’t limited to large-cap stocks. The Russell 3000 growth index is beating the value index by over 30% this year! However, as shown in the bottom bar chart, in 2022, small-cap value beat growth by about 25%.

Gold Shines Then Falters On Sunday

If you woke up Monday morning and saw gold futures down $25, you may not have thought much of it. Given its recent $200 surge, a rest from its recent pace seems reasonable. However, Monday’s price action is more ominous for those who were watching gold when the futures market opened Sunday at 6 pm ET. As shown below, gold rose over $50 within the first few hours of trading. Once peaking at $2150, it started falling precipitously. The first graph below shows gold prices put in quite a bearish candle. Such a candle with a long wick, following a strong trend higher or lower, can signal a reversal. The second graph better details the price action since Sunday night.

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10-year U.S. Treasury note yields have fallen by nearly 0.75% since late October. Fundamentally supporting the steep decline in yields is weaker than expected CPI and PCE inflation data. Further, the last BLS employment report shows a slowing of job growth. Additionally, and maybe most importantly, the Fed seems content that the recent tightening of financial conditions will do their job for them. On Friday, Powell further confirmed the Fed may be done hiking as he said the “risks are now balanced.” The market projects a Fed rate cut that could come early this spring. With that fundamental backdrop, let’s assess the technical situation. The following paragraph focuses on the recent yield increase and what that might portend. Further in this Commentary, we provide more technical and fundamental information to better gauge where 10-year yields may go.

The graph below shows 10-year yields troughed below 0.50% and have since risen to 5.00%. The pattern of higher yields provides critical technical levels if yields are now headed lower. The most critical line is the red resistance line, which may become support for yields. The green linear trend line and black parabolic curve are very close to the red line. Both have supported yields in the past. If the three support lines are broken, odds favor a decent yield decline. If so, the blue Fibonacci retracement lines may be the next target. Assuming 5% was the peak, the first Fibonacci retracement is 3.22%. In the short term, bond prices are overbought. Technical indicators like the MACD and RSI, coupled with the support lines, argue yields may rise in the coming weeks, but the longer run looks promising for bondholders.

What To Watch Today

Economy

• No notable economic releases today

Earnings

Market Trading Update

The rally continued this past week, and we are approaching the 100% retracement of the July highs. Such changes the dynamics of a pullback to the previous resistance levels of 78.6%, 61.8%, and 50% retracements. With the 50-DMA coinciding with the last 50% retracement level, we expect the maximum drawdown of any correction to hold that level going into year-end.

While it seems as if “nothing will stop the market,” such was the same sentiment we discussed in July in “Trading An Unstoppable Bull Market.” To wit:

“We must remember that market advances can only go so far before an eventual correction occurs. My best guess is that if the markets are to reach all-time highs this year, we will likely have a correction to reset some of the more extreme overbought conditions.”

Of course, that correction came the next month.

Notably, we noted in July that our gauge of individual and professional investors’ “positioning” is getting overly bullish, which also corresponds to the collapse in the volatility index. From a contrarian position, the higher the allocation to equities, the more likely the market is closer to a correction. 

As shown, we are once again at similar levels.

Despite this bull market run once again seems to be “unstoppable,” it won’t be. We still expect a short-term correction or consolidation to provide a better entry point to increase equity positioning. Trade accordingly.

The Week Ahead

The Fed will be on media blackout with respect to the coming meeting on December 13th. As such, employment data will take the stage this week. JOLTs on Tuesday, ADP and jobless claims on Thursday, and the BLS report on Friday will further inform us of the state of employment. Following last week’s lower-than-expected 150k increase in jobs, the market expects the economy added 160k jobs. Data for November can be tricky due to seasonal adjustments related to Thanksgiving and the beginning of the holiday sales season. Often, jobs data for November and December are well above or below expectations but revised in the future to levels closer to what was expected at the time.

More Technicals On 10 Year Yields

As we note in the opening, the MACD and RSI warn of oversold yields. The graph in the opening is of yields, so oversold relates to declining yields. The first graph below, courtesy of SimpleVisor, is the price of the ETF IEF, which holds 7 to 10 year UST notes. The line below the price graph is the SV Moneyflow Indicator. This is our proprietary stochastic model. The indicator is at high levels and getting ready to cross. Such is confirmed in the MACD and Stochastic graphs below our indicator. Given the sharp decline in yields and the corresponding increase in bond prices, a decline in prices or a period of consolidation to work off overbought signals would be healthy. However, the risk for bears is that the next round of employment and inflation data will underwhelm expectations and push yields below the key support we note in the opening.

The second graph helps ascertain if the 5% 10 year yield was the peak yield for this cycle. Often, investors capitulate at market peaks and troughs, and such events occur with significant volume. The graph charts TLT along with its trading cost volume. Instead of using the number of shares, which is common, our volume indicator multiplies the number of shares traded and the price. This produces a dollar volume, making volume comparable across all price ranges. It shows that the dollar volume occurring at 5% yields was the largest in 20 years. The last time TLT saw anything close to the same volume was the capitulation event, which happened when yields troughed and TLT peaked.

Fundamental Outlook For Bonds

Lastly, we take a look at the big picture. The graph below shows a clear downward yield trend since the early 80s. Even without drawing lines, we can see that the trend has broken. From a technical perspective, that is concerning. However, even if the long-term trend has broken, which we doubt, it’s entirely possible a retracement of rates much lower to form a double bottom or a higher low is likely.

The reason we doubt the trend ended is fundamentals. The growth of government debt weighs negatively on future economic growth. The massive stimulus worked. It lit a fire under the economy, and prices shot higher. Broken supply lines also fueled inflation. However, the enormous amount of government borrowing used to pay for the stimulus will detract from growth and be disinflationary or deflationary in the future.

Bonds tend to track inflation and inflation expectations closely. The second graph shows the strong correlation between the two. As such, inflation holds the key to where long-term bond yields are going. But in the short run, technicals and market narratives can cause brief divergences between the two.

As we have said before, unless this time is different, expect the thirty-year trend of lower yields to continue.

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When President Biden took office, investors assumed clean energy would be a top priority. Therefore, clean energy stocks should do very well. The narrative made sense. As shown below, clean energy stocks were up over 20% in the first few months of Biden’s term. Those gains, however, didn’t last. Since then, clean energy stocks are about 50% lower. In our Commentary – Is The Lithium Crash A Buying Opportunity?, we discuss the free-falling price of lithium and the stock price of the world’s largest lithium producer, Albermarle. The message is that narratives, right or wrong, can push stock prices well above their fair values at times. Clean energy will be a solid growth industry, and some stocks will benefit greatly. However, as we learned with many tech stocks in 2000, the market often gets well ahead of itself. Such is the case with green energy.

Microsoft (MSFT) provides a lesson about an outstanding company with a stock price getting ahead of itself. On the eve of the dot-com bust, MSFT had risen ten fold since 1995 and had P/E and P/S ratios of 84 and 55, respectively. Meeting such valuations would entail massive growth. Once the market cracked, MSFT fell by two-thirds. It took 13 years to retain prior highs. In the late 90’s the promise of the internet pushed MSFT shares beyond what should have been reasonably expected at that time. MSFT lived up to the hype. Today it trades at 10x the 1999 peak. Investors were eventually paid handsomely, but short to medium term traders enamored with the narrative and ignorant of fundamentals, there was a hefty to price to pay. Such may hold for clean energy. Many clean energy stocks may be precious, but their valuations rose too fast.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

The market spent most of yesterday waffling in negative territory, but a very late-day buying spree in the last half hour sent the S&P 500 into positive territory to close out the month. But what a month it was, with the S&P 500 rallying nearly 9% for the month. It is worth noting that since mid-month, the volume behind the rally has weakened as the markets became more severely overbought.

For now, there is little to be concerned with. Starting today and proceeding over the next three weeks, mutual fund distributions (along with hedge funds, etc.) will make annual distributions, which could provide some selling pressure. Use pullbacks to near-term support to add equity exposure as needed.

Several Fed speakers are out today, which could put pressure on the bond market, so it will be worth listening to what they have to say with the next FOMC meeting fast approaching.

PCE and Jobless Claims

More positive inflation news came out yesterday. The PCE price index was flat versus expectations of a +0.1% increase and the prior print of +0.4%. The core monthly index was +0.2%, also a tenth of a percent below expectations. The year-over-year core PCE is still higher than the Fed prefers at 3.5%, but it’s moving in the right direction.

Initial jobless claims rose by 9k to 218k. Such is still a historically low number and well within the recent range. However, as we have recently been commenting on, continuing jobless claims are rising rapidly. The graph below, courtesy of Bloomberg, shows continuing claims are now at two-year highs. There are not a lot of job layoffs, but those who are being laid off are finding it more difficult to find a new job. Continuing jobless claims is often a good leading indicator of jobless claims. Thus far, jobless claims show no indication of weakness in the labor market. However, that may change in the coming months.

“Prices Are Still Too High”

BIDEN: “WE STILL HAVE MORE WORK TO DO, PRICES ARE STILL TOO HIGH.”

The headline above hit yesterday morning. It is important to take some time to digest what President Biden likely means versus what he appears to say. Biden’s quote implies that prices are still elevated and need to decline, presumably to pre-pandemic levels. In economic terms, Biden wants deflation. What we think he really means, and what the Fed openly desires, is for prices to continue to increase but only at a 2% a year pace.

The graph below helps appreciate the difference between the two outcomes. The blue line and the black dotted line is the CPI index and its trend. The orange line grows the index at an annualized 2% rate. The orange line is what Biden means and the Fed aims for. What Biden implies is the purple line. For the CPI index to get back to the pre-pandemic trend in a year we would need to experience 7% deflation. Such a level of deflation hasn’t been seen since the great depression and if its up to the Fed or President, that will not occur on their watch.

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I previously discussed a slate of recessionary indicators with high correlations to recessionary onsets. However, as we head into 2024, many Wall Street economists predict a “soft landing” or “no recession” outcome for the economy. Are these recessionary indicators with near-flawless track records wrong this time? Will it be a soft landing in the economy or something worse?

We must start our recessionary indicator review with the “Godfather” of them all – “Yield Curve Inversions.”

Bonds are essential for their predictive qualities, so analysts pay enormous attention to U.S. government bonds, specifically the difference in their interest rates. As such, there is a high correlation between the yield curve’s slope and where the economy, stock, and bond markets generally head longer term. Such is because everything from volatile oil prices, trade tensions, political uncertainty, the dollar’s strength, credit risk, earnings strength, etc., reflects in the bond market and, ultimately, the yield curve.

Regarding yield curve inversions, the media always assumes this time is different because a recession didn’t occur immediately upon the inversion. There are two problems with this way of thinking.

1. The National Bureau Of Economic Research (NBER) is the official recession dating arbiter. They wait for data revisions by the Bureau of Economic Analysis (BEA) before announcing a recession’s official start. Therefore, the NBER is always 6-12 months late, dating the recession.
2. It is not the inversion of the yield curve that denotes the recession. The inversion is the “warning sign,” whereas the un-inversion marks the start of the recession, which the NBER will recognize later.

As discussed in “BTFD Or STFR,” if you wait for the official announcement by the NBER to confirm a recession, it will be too late. To wit:

“Each of those dots is the peak of the market PRIOR to the onset of a recession. In 9 of 10 instances, the S&P 500 peaked and turned lower prior to the recognition of a recession.“

Here is the analysis in table form. It is worth noting that the market’s lead to the economic recession has shrunk markedly since 1980. As such, given the rally in the market this year, it is not surprising a recession has not been recognized as of yet.

Which Yield Curve Matters

Which yield curve matters mostly depends on whom you ask.

DoubleLine Capital’s Jeffrey Gundlach watches the 2-year vs. 5-year spreads. Michael Darda, the chief economist at MKM Partners, says it’s the 10-year and the 1-year spread. Others say the 3-month and 10-year yields matter most. The most-watched is the 10-year versus the 2-year spread.

While most mainstream economists focus on a specific yield curve, we track ten different economically important spreads from short-term consumption to long-term investments. Most yield spreads we monitor, shown below, are inverted, which is historically the best recessionary indicator. However, technically, the UN-inversion of the yield curve is the recessionary indicator.

Notably, when numerous yield spreads turn negative, the media will discount the risk of a recession and suggest the yield curve is wrong this time. However, the bond market is already discounting weaker economic growth, earnings risk, elevated valuations, and a reversal of monetary support. As such, a recession followed when 50% or more of the tracked yield curves became inverted. Every time. (Read this for a complete history.)

But it isn’t just the yield curve as a recessionary indicator that we are watching.

Are Leading Indicators Wrong?

We wrote “Economic Cycles Will Recover” in July after a significant drop in many leading economic indicators. To wit:

“As with market cycles, the economy cycles as well. There is little argument that the current economic data is fragile, whether you look at the Leading Economic Index (LEI) or the Institute Of Supply Management (ISM) measures. As with the market cycle, long periods of slowing economic activity will eventually bottom and turn higher. The Economic Composite Index, comprised of 100 hard and soft economic data points, clearly shows the economic cycles. I have overlaid the composite index with the 6-month rate of change of the LEI index, which has a very high correlation to economic expansions and contractions.”

As shown, the data has bottomed since July and has started to improve. Notably, these economic measures are at levels that previously marked the bottoms of economic contractions outside financial crises or economic shutdown events. As noted in July, the improvement in economic activity seen in Q3 and Q4 was expected. That improvement also supports the earnings cycle we have seen as of late.

While there are reasons to remain suspect of an upturn in the current economic and market cycles, it is difficult to discount the historical evidence completely. Yes, the Federal Reserve has hiked rates aggressively, which weighs on economic activity by reducing personal consumption. However, the government continues to increase spending levels sharply, i.e., the Inflation Reduction Act and the CHIPs Act, which support economic activity.

We see that same support to economic activity in the monetary supply (M2) as a percentage of the economy. While those monetary and fiscal supports are reversing following the “pandemic-related” spending spree, both are reversing.

Eventually, the support provided by those massive infusions into the economy will fade. The hope is that the economy will return to normal functioning by then. The only issue is that we have no historical precedent to base those hopes on.

Soft Landing Or Recession?

The question of a “soft landing” or an outright “recession” is difficult to answer. It is certainly possible that all of the tell-tale signs of economic recession may be wrong this time. There is another possibility. Given the massive increase in activity due to a shuttered economy and massive fiscal stimulus, the reversion may take longer than expected. Both scenarios support the rising optimism of Wall Street economists in the near term. However, such also brings to mind Bob Farrell’s Rule #9:

“When all experts agree something else tends to happen.”

As noted previously, we would already be in a recession if we had entered this current period at previous growth rates below 4%. The difference is the contraction began from a peak in nominal GDP of nearly 12%. As noted above, a bounce in activity is not surprising after a significant contraction in the economic data. The question is whether that bounce is sustainable. Unfortunately, we won’t know the answer for quite some time.

We know that Federal Reserve actions regarding hiking rates have about a 6-quarter lead over changes to economic growth. Given the last Fed rate hike was in Q2 of this year, such would suggest a further slowing in economic activity into the end of 2024.

Investor Implications

As noted above, the massive surge in monetary stimulus (as a percentage of GDP) remains highly elevated, which gives the illusion the economy is more robust than it likely is. As the lag effect of monetary tightening continues to weigh on consumption, the reversion to economic strength may surprise most economists.

For investors, the implications of reversing monetary stimulus on prices are not bullish. As shown, the contraction in liquidity, measured by subtracting GDP from M2, correlates to changes in asset prices. Given that there is significantly more reversion in monetary stimulus to come, this suggests that lower asset prices will likely follow. However, the markets have recently been betting that a reversal of liquidity is coming. Given the inflationary implications of providing monetary accommodation, i.e., rate cuts and quantitative easing, it seems unlikely the Federal Reserve will act before the onset of a recession. If that assumption is correct, investors may set themselves up for disappointment.

As we update our recessionary indicators, there is still no clear visibility regarding the certainty of a recession. Yes, this “time could be different.” The problem is that, historically, such has not been the case.

Therefore, given this uncertainty, we must continue to weigh the possibility that Wall Street economists are correct in their more optimistic predictions. However, we must remain open to the probabilities that still lie with the indicators.

No one knows what the future holds with any degree of certainty. Therefore, we must remain nimble in our investment approach and trade the market for what it is rather than what we wish it to be.

Warren Buffett’s partner, Charlie Munger, passed away on Tuesday at the ripe age of 99. Charlie Munger and Warren Buffett founded Berkshire Hathaway in 1975. In the nearly fifty years of value investing, the simple genius of both founders has made them billionaires and many Berkshire investors millionaires. Berkshire Hathaway has a market cap of nearly $800 billion, ranking it as the 9th largest public company in America by market cap. While Buffet is often in the media and tends to get most of the credit for Berkshire’s success, Charlie Munger is equally smart and responsible for what they built.

Berkshire investors and others will be watching closely to see who his successor may be. Warren Buffett is 93 years old. Consequently, the successor may have a dominant role at Berkshire for years to come. In his 99 years, Charlie Munger has become known to be one of the greatest investors ever. Further, he has been quite open about what has led to his wild success. In a section below, we share just a small bit of the knowledge and wisdom that made him the legend he is.

What To Watch Today

Earnings

Economy

Market Trading Update

Another day of market sloppiness as get ready to close out the month today. The market started off strong yesterday morning but faded into the afternoon, even as bond yields fell below 4.3%. Speaking of bonds, the recent move has gotten ahead of itself, so if you are trading bonds, this would be an ideal time to take some profits and look for a yield reversal for the next buy. I suspect that between now and the Fed meeting in December, we will get either some economic news or comments from the Fed that reinforce their inflationary concerns. Such would reverse the recent selloff in bonds, providing a better entry point to increase exposure heading into 2024.

From a technical perspective, bonds have cleared the important 50 and 100-DMA, with a bullish cross of the 20-DMA above the 50-DMA. If bonds can hold the current level, the next major target will be the 200-DMA. As noted, expect a pullback with the MACD and RSI levels reaching more overbought short-term levels. Any correction that holds the 20-DMA will be a bullish setup for another rally to ensue. There is a lot of overhead resistance between 100 and 110 on the iShares 20+ Year Treasury Bond ETF chart below. However, a move above those levels will be great for bondholders but most likely will occur consistent with the onset of a recession.

Munger’s Wisdom

There are hundreds of quotes attributable to Charlie Munger. While he often spoke about his investments and the fundamental and market traits he seeks in companies when investing, he also shared a lot of wisdom on life. Accordingly, we share just a tiny handful of his quotes. If you want more, Google Charlie Munger, and you will be overwhelmed with the amount of accessible knowledge he has shared in his lifetime.

• There is no better teacher than history in determining the future… There are answers worth billions of dollars in a history book.
• There are three ways to go broke: ‘liquor, ladies, and leverage’
• In my whole life, I have known no wise people who didn’t read all the time – none, zero.
• A great business at a fair price is superior to a fair business at a great price
• I think that every time you see the word EBITDA, you should substitute the words “bullshit earnings“
• All intelligent investing is value investing, acquiring more than you are paying for
• Mimicking the herd invites regression to the mean
• You must force yourself to consider opposing arguments. Especially when they challenge your best-loved ideas
• You need patience, discipline, and agility to take losses and adversity without going crazy
• Most people are too fretful, they worry too much. Success means being very patient, but aggressive when it’s time
• Live within your income and save so that you can invest.

Government Spending Drives GDP

Third quarter GDP was revised higher by 0.3% to 5.2%. Such is the strongest quarterly growth in almost two years. Making the revision interesting is that personal consumption, which accounts for two-thirds of GDP on average, was revised 0.4% lower to +3.6%. However, making up for the revision is government spending, which grew at 5.5%. Within that, defense spending surged 8.2%. While the Fed may not like such strong economic growth, the data is old. Recent economic data point to much slower growth. For example, the Atlanta Fed GDPNOW forecasts 2.1% growth for Q4. The Fed should like the revision to the core price component. It now stands at +2.3%. Consequently, as graphed below, it is near the Fed’s 2% target and in the pre-pandemic range.

Real GDI was reported at +1.5%, well below +5.2% for GDP. The third graph below shows this is the widest gap in at least 50 years. We discussed this divergence after the second quarter GDP report. It has widened further in the latest quarter. As we wrote in GDI or GDP:

We are concerned that significant differences between GDP and GDI tend to occur before recessions

We followed up in Economic Data Points Diverge as follows:

Therefore, given that GDI measures the income side of the equation (derived from production), it is logical that GDI should track pretty closely to GDP over time. Furthermore, it should be logical that deviations between production and consumption should indicate a shift in the economic underpinnings.

Therefore, robust economic activity will continue and show up in GDI in the coming quarters. Conversely, as is typical, GDI tends to lead the way and signals weak economic growth ahead.

Our take: the bulls will say, “What recession?” while the realists will point out that GDP is a lagging indicator.

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The existing home sales market has been at a standstill. Buyers are turning away due to 7%+ mortgage rates and high prices. At the same, selling a house is equally difficult. Sellers do not want to get rid of low-rate mortgages and assume a much higher mortgage on a new purchase. Supply problems in the existing home market have aided sales of new homes. Homebuilders have enticed buyers via reduced mortgage rates. DH Horton claims about 60% of their closings use “rate buy downs.” Further, they have resorted to reducing prices via “introducing smaller product footprints, and de-amenitizing some of the homes a bit.” Based on recent NAHB (National Association of Homebuilders) data, new home sales are trending lower.

NAHB’s latest New Residential Sales Report shows that new home prices and sales are falling while inventory is rising. The graph below from Wolfstreet.com shows NAHB median new home prices are down nearly 20% from 2022 peaks, albeit still decently above pre-pandemic levels. While smaller houses and “de-amenitizing” result in lower prices, the rising inventory of new homes may further pressure new home prices. Per Wolfstreet- “Inventory for sale of new houses at all stages of construction rose to 449,000 houses in October, which translated into 8.8 months supply at the current rate of sales – more than ample inventory and supply, and homebuilders are motivated to make deals to move this inventory.”

New and existing home sales greatly affect economic activity and significantly contribute to CPI inflation data. If recent trends continue, we should expect much lower inflation and weak economic activity. See our Tweet of the Day for David Rosenberg’s view on the NAHB median sales price index and sticky inflation.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, the market jumped higher out of the gate and looked set to try to push the recent highs. However, it failed at about mid-day and closed the day mostly unchanged. This action is not surprising given the current overbought nature of the market. As shown below, the accumulation/distribution line is starting to roll over as volume continues to contract since the beginning of the rally this month. This action suggests that the current consolidation/corrective action will continue until these signals reverse. However, given the current weakness, any pickup in selling pressure will be able to drag the market lower in the short term. Continue to trade cautiously for now. While there is no reason to be overly bearish at the moment, maintaining a little dry powder may prove opportunistic later in December.

The S&P 7 Are Reaching Peak Valuations

The predominant investment theme of 2023 was the gross outperformance of 7 S&P 500 stocks. 7 of the largest S&P 500 stocks have thus far accounted for nearly 100% of the year’s gains. Can the dominance of such a small handful of market leaders continue? The answer is absolutely, but for how long? At some point, likely coinciding with a bear market, the valuations of the 7 stocks will cause doubt in investors’ heads, as such instances have in the past.

For a historical perspective on two other periods when a small number of stocks led markets higher, we share the graphic below from Apollo and the Kobeissi Letter. The table compares P/E valuations of the S&P 7 to the leaders of the late 90s tech bubble and the Nifty-Fifty blue chips stocks in the 1960s and 70s. The average P/E of the S&P 7 is over two times that of the S&P 500 and comparable to the prior instances in the table.

Once the Tech bubble popped, the market leaders fell precipitously, much more than the broader markets. It took many years, as shown below, for the four stocks and many other high-flying stocks to regain their prior highs.

• Intel: 18 years
• Cisco: 22 years
• Dell: Went private in 2013. At that time, it was down -75% from 12/31/99
• Microsoft: 13 years

Per Wikipedia, the popping of the Nifty Fifty bubble saw similar underperformance of the leaders:

The long bear market of the 1970s which began with the 1973–74 stock market crash and lasted until 1982 caused valuations of the nifty fifty to fall to low levels along with the rest of the market, with most of these stocks under-performing the broader market averages.

Passive investing may keep the S&P 7 stocks in favor for a while longer, but ultimately, high valuations are challenging to sustain, especially in bear markets.

Fed President Waller Prefers To Pause

This week, we are paying close attention to Fed speeches to see if the recent decline in yields and an uptick in stock prices concern them that easier financial conditions may force the Fed to hike rates. Based on comments of Fed Governor Chris Waller, it appears a hike is not likely.

“I’m increasingly confident that policy is currently well positioned to slow the economy & get inflation back to 2%. I’m encouraged by what we’ve learned in the past few weeks — something appears to be giving & it’s the pace of the economy”

“Policy is well positioned” alludes that current rates are doing their job of slowing the economy and reducing inflation. Waller, nor any Fed member will say the Fed is done, but his language certainly makes a case that chances are high we have seen the last rate hike of the cycle. As investors, we should address how long a pause may last before the Fed cuts rates. Importantly, how stocks and bonds have done during prior rate pausing and cutting cycles. We will have more on the topic and historical data in a coming article.

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“For me context is the key – from that comes the understanding of everything.” -Abstract Artist Kenneth Noland. That holds true for us as well! Proper context is required to appreciate better if market narratives accurately describe the truth.

For example, in Moody’s recent decision to put the United States government on credit watch negative, the context driving their decision is not necessarily run-away deficit spending, as most investors believe. They made their decision within the context of high-interest rates.   

In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or increase revenues, Moody’s expects that the US’ fiscal deficits will remain very large, significantly weakening debt affordability.

Make no mistake, large fiscal deficits and accompanying Treasury debt issuance are a problem. However, the downgrade is directly attributable to the level of interest rates. The concern will vanish quickly, regardless of debt issuance patterns, if interest rates fall appreciably.

At zero percent interest rates, Uncle Sam, or for that matter, you and I, can borrow trillions upon trillions of dollars and not have to worry about making good on the interest payments.

Let’s provide context and facts to assess better if the latest bond market bear narrative claiming that higher yields are a direct function of massive Treasury debt issuance holds water.

Surging Government Interest Rate Expense

Our article, The Government Can’t Afford Higher for Longer, discusses how higher interest rates are and will potentially affect federal interest expenses. To wit:

Total federal interest expenses should rise by approximately $226 billion over the next twelve months to over $1.15 trillion. For context, from the second quarter of 2010 to the end of 2021, when interest rates were near zero, the interest expense rose by $240 billion in aggregate. More stunningly, the interest expense has increased more in the last three years than in the fifty years prior.

Let’s reread the last line- “More stunningly, the interest expense has increased more in the last three years than in the fifty years prior.”

Since 2020, the federal debt has risen by $9 trillion. In the fifty years prior, federal debt grew by approximately $24 trillion. $9 trillion is significant and fiscally imprudent. However, the primary culprit behind the sharp upturn in the nation’s interest expense is interest rates, not debt issuance.

The graph below shows that the weighted average interest rate on all government debt has increased by about 1% over the last three years. If interest rates had not risen, today’s interest expense would be a little over $600 billion, not $1 trillion as it is. In that scenario, it would only be up by about $50 billion from the eve of the pandemic.

The Bear Narrative Du Jour

A popular bond bear market narrative claims exceptional debt issuance is behind the soaring bond yields. Many bond bears believe that even if inflation falls back to the Fed’s 2% goal, interest rates will stay high due to current levels of debt issuance.  

In 2020, the government’s debt outstanding grew by $5 trillion, including a whopping $3.25 trillion in the second quarter alone. In 2020, the average ten-year UST yield was 0.92%. During the second quarter, when the market was digesting years’ worth of issuance in three months, the average yield was 0.69%.  

Apparently, tremendous debt issuance was not problematic in the bond markets then. Might the level of yields and the ensuing interest expense matter a lot more than the amount of debt issuance? 

Japan adds credence to that thought. It has a debt-to-GDP ratio of more than double that of the U.S., yet even with inflation rising, it has interest rates of 1% and lower.

Massive Debt Issuance Put Into Context

We searched Twitter for “massive Treasury issuance,” and the quotes below, all from the last six months, are just the tip of the iceberg.

The following graph shows quarterly and annual Treasury debt issuance. The bulge in 2020 and 2021 is prominent. But is the massive debt issuance we are currently experiencing that different from pre-pandemic periods?

Again, proper context is needed to answer our question. Since 2020, the economy has grown by about $5.5 trillion, about 25%. Over that period, the government’s tax receipts have increased by 33%.  

The graph below shows the longer-term increase in the federal debt-to-GDP ratio and the surge occurring during 2020. However, look at the recent trend, which we blow up in the second graph. It seems that “massive” debt issuance is not problematic in the context of the size of the economy and the tax base.

The Real Problem

As Moody’s notes, the problem is not a deficit or a debt issuance problem. It’s an interest rate problem. Regardless of logic, markets often trade on false narratives for short periods. So, let’s assume the narrative of massive debt issuance continues to weigh on the bond market. What might the Treasury or Fed do to lower rates?

The first thing to consider is that each day interest rates are high, the interest expense will keep rising. Treasury debt with low interest rates matures and is refunded with higher interest-rate debt. As such, higher interest rates feed the narrative, increase the pressure on the bond markets, and boost funding needs.   

The Fed can sway long-term rates lower with Operation Twist. Such allows them to continue to do QT, but all the while selling short-term bond holdings and buying long-term bonds. While not likely in the near term, they can also buy bonds (QE). The risk is that doing so would be perceived as inflationary and might cause investors to push yields higher.

The Treasury is already trying to limit its long-term debt issuance. As we wrote in the November 2, 2023 Daily Commentary:

The Treasury is favoring shorter-term debt as it likely wants to avoid locking in current yields for long periods. Consequently, less than 10% of the debt increase will come from the 10-30 year sectors. Long-term Treasury note and bond investors should like the Treasury’s stance.

Additionally, the Fed and Treasury can change bank regulatory and capital rules to make it more advantageous for banks and other financial institutions to hold Treasury debt versus other assets.

Summary

Fiscal imprudence is a big problem, and we are not making light of it. We have written volumes on how unproductive government spending ultimately weakens our economy and reduces citizens’ wealth.

However, as bond investors, we need to understand what drives bond yields and what doesn’t. Having debunked the “massive debt” narrative, we end with a reminder of what drives bond yields.

The graphs below, from our article Bond Market Noise Hides Tremendous Opportunity, show the near-perfect correlation between Treasury yields versus inflation and inflation expectations.

 We end this article with a quote from the article:

The noise in the bond market is thunderous these days as inflation is still well above norms, deficits remain high, and the Fed continues to promise higher rates for longer. Noise creates differences between the yield on bonds and their true fair value.

Noise is hard to ignore, but it can create tremendous opportunities!

With the holiday season in full swing, look out your window. You will see FedEx and UPS trucks, and those from the U.S. Postal Service and Amazon. Believe it or not, Amazon is the truck you may most frequently see. Per the WSJ, Amazon “has grabbed the crown of biggest delivery business in the U.S., surpassing both UPS and FedEx in parcel volumes.” In 2020, Amazon delivered more than FedEx, and it just surpassed FedEx in 2022. Amazon went from being a giant FedEx and UPS customer to their biggest competitor in just ten years. The U.S. Postal Service is still the largest deliverer by volume, as they handle packages for all three deliverers as well as their commercial and individual customers.

The graph below from the WSJ shows that parcel delivery growth has flatlined at UPS and FedEx while it has grown rapidly at Amazon. Amazon uses a creative strategy to expand its services. For about five years, they have been employing contractors to help meet their customers’ needs. They now elicit the help of over 200,000 contractor drivers. The strategy allows them to expand their network, reach more customers, and keep revenue in-house. Revenue at UPS and FedEx has grown 5x and 9x, respectively, since 1993. However, both companies are witnessing declining revenue over the last year. In the past 30 years, they only experienced falling revenue during the recession of 2008/09. Amazon is a problem for UPS and FedEx.

What To Watch Today

Earnings

Economy

Market Trading Update

The market ended a little lower yesterday in mixed trading all day. Such is unsurprising, given the massive run since the beginning of November. With the market extremely overbought, we have previously pointed out the risk of a pullback in the first few weeks of December before the traditional year-end “Santa Rally.” The chart below shows potential retracement levels for such a correction, providing logical entry points to increase equity exposure in portfolios if needed.

A 23.6% retracement would coincide with the 20-DMA, which is rising strongly and should provide initial support at that level. A failure at that minor support would then retrace the “gap up” in the index from early November. The 38.2% and 50% retracement levels are key support and will coincide with the 50-DMA. While a deeper correction to the 200-DMA, encompassing a 61.8% retracement, is possible, it is unlikely, given the market’s current momentum. However, if such does occur, it would likely coincide with the onset of either a much more “hawkish” Federal Reserve and/or substantially weaker economic data surfacing. For now, the 23.6% to 38.2% rectracements seem the most logical before a year-end rally. Trade accordingly.

Ten Fed Speakers This Week- Pay Attention

This week, ten Fed members and likely more will speak on the state of the economy, inflation, and monetary policy. If you recall, two weeks before the last FOMC meeting, several Fed members let it be known that higher interest rates were weighing on the economy. Consequently, they alluded that a pause of rate hikes was likely. Simply, the market was doing their work for them. The messages were clearly coordinated.

Over the last few weeks, financial conditions have eased quite a bit. As we wrote in Looser Financial Condition Are A Problem For The Fed:

What Powell stated was overlooked by the market last week.Powell clarifies that recent interest rate increases, a stronger dollar, and weaker stock prices could keep them from hiking rates. However, he qualifies the statement by emphasizing they want to see the persistence of said market conditions. What they do not desire, as shown above, is a reversal to looser financial conditions. In other words, the Fed does NOT want to see stock prices and bond yields “fluctuating back and forth.“

With the next Fed meeting on December 13, this will be the last week for Fed members to speak before their self-imposed media blackout next week. As such, keep a close ear on their discussions of financial conditions. Will they back off the seemingly dovish sentiment and present a unified hawkish outlook on rates? If they are concerned, expect similar messaging this week. Of most importance will be Powell’s speech on Friday.

The odds of a rate hike at the December 13th meeting are currently a hair above zero percent. They increase for the January 31st meeting but only to 6.9%. After that, the odds grow for a rate cut. This week, we will monitor the target rate probabilities to see if Fed speakers are affecting Fed Fund rate expectations.

50 of 51 States (Including DC) Are Reporting Higher Unemployment

Danielle DiMartino Booth shares an interesting statistic with potentially significant ramifications for payrolls. Including Washington D.C., 50 states reported their unemployment rose last month. Such has occurred nine other times since 1976. The data below overwhelmingly show that after 50 states report increasing unemployment rates, the subsequent one, two, and three months have always seen a shrinkage in the BLS payrolls report. With October passing the 50 state/D.C. threshold, will next week’s employment report show a decline in payrolls? If so, it would be quite a shock to the markets. The current estimate for the October BLS report due next Friday is a gain of 125k jobs.

The second table below shows the most recent unemployment figures by state. If you are having trouble reading it, click HERE to view it.

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Is a stock market correction coming before the Santa Claus rally at the end of the year?

It is a fascinating turn in sentiment, given that investors were convinced of the bear market’s return just a month ago. Now, investors are “making their list and checking it twice.” Given the 10% advance over the past month, it isn’t surprising, as hope rises that the Fed will return to more accommodative policies next year. Earnings remain very “nice,” and the market views the economic risks as primarily priced in.

There are indeed “naughty” economic indicators, but the market seems convinced it will all be transient. Furthermore, companies seem to be able to pass costs along to consumers, at least for now. The hopes are high that profit margins will remain strong and earnings will eventually catch up to valuations.

Investors’ “wish lists” are hung by the chimney with care, hopeful the “Santa Claus rally” will soon be there. While they remain “snug in their beds, the historical data dances in the heads.” The chart below from EquityClock.com shows the annual S&P 500 index “seasonality.” 

There is little to worry about, and a significant stock market correction is unlikely.

However, notice that dip at the beginning of December.

Mutual Fund Distributions Come First

Before “Santa Claus” makes his anticipated visit to “Broad and Wall,” mutual funds must distribute their capital gain, dividends, and interest income for the year. These distributions start in late November, but a large number of distributions occur in the first two weeks of December. Again, notice that dip in the seasonality chart above.

Those distributions are why I get many emails from individuals every year confused by a sharp decline in their mutual funds. To wit:

“Lance, I don’t understand what happened to my fund. Yesterday, the fund was trading at $10.54 per share, and today it is at $9.78. There is no news to account for decline.“

There is nothing wrong with the mutual fund. They made their annual distribution. In this case, it was capital gains and dividend income.

When the distribution occurs, the fund price is immediately impacted. However, you will receive additional fund shares or a cash deposit in a day or so. That difference depends on how you have elected to take your distributions. Your portfolio value will decline by the distribution amount on that date. But your value will return to normal when that distribution is received and credited.

There is no need to panic.

However, there is potentially a negative impact on the market as those distributions are made. Such is particularly true when volumes are light and markets are overbought. As shown, the volume has declined during the advance from the summer stock market correction. Furthermore, the market is now overbought and deviated from the 50-DMA.

The problem is that “for every seller, there must be a buyer.” The chart below shows where volume exists at various price levels.

Buyers appear closer to the 50-DMA when mutual funds start making distributions. I am not saying the market will correct to that level. It is where the most volume occurred previously and is the most likely support area.

As the Wall Street axiom goes: “Sellers live higher. Buyers live lower.”

A Lump Of Coal

The one thing the market does well is doing precisely the opposite of what you would expect.

However, there is a strong likelihood that with the market short-term overbought, deviating from the 50-DMA, and volume declining, any additional selling pressure from mutual fund distributions could pressure prices short-term. As shown, a correction generally occurs whenever most indicators are as overbought as they are currently. That does NOT mean the bull market is over. It only means that before the market can move higher, it needs a healthy reset to bring buyers back into the market.

Does that mean the market can not move higher first? No. However, if you feel pressure to chase the market higher into 2024, a pullback would provide a much better opportunity to increase exposure on a risk/reward basis.

While there are no guarantees, a stock market correction in the first few weeks of December increases the odds that “Santa does visit Broad and Wall.” 

However, beyond that, in 2024, I don’t have a clue. Wall Street analysts are optimistic that the economy will avoid a recession, earnings will expand to support current valuations, and the Federal Reserve will start cutting rates. Anything is possible, but I am a bit more sanguine on outcomes when looking at the market on a longer-term basis, with economic risk to earnings.

But we will delve into that more with the turn of the calendar. That is when we will better understand what to expect as portfolio managers return from their winter slumber.

A Stocking Stuffer

Since we have our “stockings hung by the chimney with care,” we can stuff them with a few essential investment guidelines to navigate as we head into year-end.

• Investing is not a competition. There are no prizes for winning but severe penalties for losing.
• Emotions have no place in investing. You are generally better off doing the opposite of what you “feel” you should be doing.
• The ONLY investments that you can “buy and hold” are those that provide an income stream with a return of principal function.
• Market valuations (except at extremes) are inferior market timing devices.
• Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short-term trading. Knowing what type of investor you are determines the basis of your strategy.
• “Market timing” is impossible– managing risk exposure is logical and possible.
• Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.
• There is no value in daily media commentary– turn off the television and save yourself the mental capital.
• Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities. The winner is the one who knows when to “fold” and when to go “all in.”
• No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one temporarily out of favor.

While anxiously anticipating the arrival of the “Santa Claus Rally,” we must remember the lesson taught in 2018.

Nothing is guaranteed.

But that is why we pay attention to risk and manage our portfolios for the probabilities versus the possibilities.

From 2021 through 2022, the price of lithium carbonate, a key component of EV batteries, soared 14-fold. At the time, Tesla and other car markers were paying dearly to secure the limited supplies of available lithium and future production. Since then, as the Trading Economics graph below shows, the price of lithium, quoted in Chinese Yuan per ton, has given up much of those gains. In 2021 and 2022, the popular narrative was that EVs will largely displace internal combustion engines over the next ten to twenty years. If true, the current lithium supply is woefully short of what is needed. However, production is ramping up quickly as higher prices incentivize exploration.

Per Mining.Com, “Supply is coming on stream faster than you can say ‘boo.’ Demand remains strong, but prices have been unsustainable for some time now.” While there is a significant supply of lithium coming online in the next few years, which is weighing on prices today, many experts still believe lithium supplies will not be large enough to sate demand. Per Reuters: “Albemarle (ALB), the world’s largest lithium producer, is growing rapidly across the Americas, Asia and Australia. Still, it expects global lithium demand to exceed supply by 500,000 metric tons in 2030. Various consultancies and other producers have slightly different projections, but all warn of a looming shortage.” We evaluate ALB below to assess what it may offer long term investors.

What To Watch Today

Earnings

Economy

Market Trading Update

Last week, we noted that:

“Market rallies are common heading into year-end, and this rally is no different. However, we are now reaching more extreme levels of typical reflexive rallies, and a consolidation or correction to support should be expected.

We are currently wrestling with the 78.6% retracement level, which is also resistance from the September highs. Given the more overbought conditions, it is not surprising the market has had trouble advancing over the last several days. Given we are entering a holiday-shortened week, trading volume will be light, and volatility will likely pick up. If the market does correct soon, supports will be the previous 61.8% and 50% retracement levels, respectively. “

That rally continued this past week, and we are currently approaching the 100% retracement of the July highs. Such changes the dynamics of a pullback to the previous resistance levels of 78.6%, 61.8%, and 50% retracements. With the 50-DMA coinciding with the previous 50% retracement level, we would expect the maximum drawdown of any correction to hold that level going into year-end.

As we will discuss in more detail on Tuesday, the normal seasonal trends of the market suggest that a pullback in early December should be expected. (Notice the early December dip in the chart below.)

“Before “Santa Claus” makes his anticipated visit to “Broad and Wall,” mutual funds must distribute their capital gain, dividends, and interest income for the year. These distributions start in late November, but a large number of distributions occur in the first two weeks of December. Again, notice that dip in the seasonality chart above.”

While the setup for a year-end rally remains intact, such does not preclude a short-term “dip” to reduce the market’s more extreme overbought and deviated conditions currently. Such will provide a much better entry point to increase equity risk accordingly.

The Week Ahead

As the Fed readies for its coming December 13th FOMC meeting, we will hear many Fed speakers opining on policy. Of most importance will be Jerome Powell on Friday. Thursday, PCE price indexes will help the Fed better assess inflation. Economists expect the PCE price index to decline to +0.2% from +0.4% last month. The BLS labor report will not be released this Friday despite being the month’s first Friday. It is scheduled for next Friday.

Albermarle- Technical Summary

If demand for EVs continues at the current pace and the supply of lithium is insufficient to meet demand, the price of lithium will rise, benefiting those companies producing it. North Carolina-based Albermarle (ALB) is the world’s largest producer of lithium and has the largest market cap of all public lithium producers. Given its potential, let’s review ALB.

As shown below, ALB shares have tracked the recent rise and fall of lithium prices. The weekly chart shows a sloppy head and shoulders pattern above the dotted red neckline. Having now broken its neckline, technically, the stock could fall further to around 100. The share price recently broke below the green line, which marked the prior high in 2017 and provided support in early 2021. From a technical point of view, the blue line connecting three major lows should provide strong support. However, getting to said level entails a 50% decline. The MACD and RSI, below the price graph, are extremely oversold. A short-term bounce is likely, but ALB may not necessarily have reached its ultimate low in the current cycle.

Albermarle- Fundamental Summary

Despite the short-term bearish technical backdrop, the fundamental story is more promising. As shown below, ALB’s key valuation ratios are close to 30-year lows. This is essentially a function of its recent explosive revenue and income growth with little stock price appreciation. Since the first quarter of 2021, revenue has increased 3x, and EBITDA by 4x. Over the same period, the stock shot higher by similar magnitudes but has since given it all back and then some.

At current valuations, ALB is well situated to attain much higher price levels if the demand for EVs continues to climb and lithium supplies, over the long run, are insufficient to meet demand. Conversely, there are recent warnings from automakers that demand for EVs is waning. At the same time, there are several new mining operations bolstering supply. While the EV industry’s growth is up for debate, and the lithium supply will grow, current valuations provide investors with a healthy margin for error.

To summarize, the bet made by ALB bulls and bears is on the future of EVs. Currently, EVs comprise about 15% of new car sales. Future expectations vary wildly. By 2030, the IEA expects EVs to account for about 35% of sales, as shown in the second graph below. Others think the number could be significantly higher. Beyond the supply and demand for lithium and the market saturation of EVs, ALB also has to maintain its market-leading position and adequately invest in new production, all while managing profit margins. For those with a long-term investment horizon and a positive outlook for EV growth, ALB offers good value.

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Might the future of retirement saving plans for corporate employees be changing? Starting next year, IBM will no longer match their employee’s contributions to their 401k plans. Instead, they will contribute 5% to the employee’s retirement benefit account (RBA). During the first three years of the RBA program, IBM will pay its beneficiaries a 6% return. From 2027 to 2033, they will guarantee a return equal to the 10-year UST yield with a floor of 3%. After 2033, the program employees’ RBA balances will earn the yield on the 10-year UST.

From an employee’s perspective, the change will likely reduce their savings as stocks tend to outperform bond yields over the long run. Further, employees can’t borrow against it as they can a 401k. From IBM’s perspective, they appear to be using the new program as a cheap funding source. Instead of giving money to employees via matching contributions, IBM is funding a pension and paying them interest. Simply, IBM is borrowing from its employees. As shown below, on average, IBM ten-year notes yield 1.00% more than the 10-year UST yield. After 2027, when the RBA rate floats with Treasury yields, IBM will essentially borrow from their employees at interest rates almost a full percent below where they currently borrow. Today’s high-interest rates may hide the program’s flaws, but employees will pay the price if rates regress to pre-pandemic levels.

The RIA Advisors and SimpleVisors team wishes you and yours a happy Thanksgiving!

What To Watch Today

Earnings

• No earnings reports today due to the Thanksgiving holiday.

Economy

• No economic reports today due to the Thanksgiving holiday.

Market Trading Update

With the market closed for the Thanksgiving holiday and only half of a trading day on Friday, there is little risk of stocks not finishing the week on a positive note. For that reason, our next Daily Market Commentary will be on Monday.

As shown below, the market trades two standard deviations above the 50-DMA and is overbought on many levels. Notably, the MACD “buy signal” is getting very elevated. Every time that indicator normally reaches such levels, a short-term correction or consolidation ensues. This does NOT mean the market, because of momentum, can not get even more overbought over the next week. However, it DOES suggest a pullback to the 50-DMA will likely occur BEFORE we get the traditional year-end “Santa Rally.”

Likewise, bonds are also getting very overbought on the same metrics but not yet as egregious.

If you are trading these positions, this is a good opportunity to temporarily take profits and wait for a correction to add back into these positions. Whatever triggers a correction in stocks will also trigger a correction in bonds, given their high correlation this year. Most likely, comments from the Federal Reserve about needing to remain vigilant on inflation will likely do the trick as they try to push out current expectations of near-term rate cuts.

In the meantime, have a VERY happy, safe, and, of course, filling Thanksgiving holiday.

More On Employment

Our recent article, Employment Is Sending Signals, explores several charts to determine better if the recent weaker employment data is a recession warning or just a normalization to pre-pandemic levels. We end the article as follows:

The labor market is undoubtedly deteriorating and sending signals that have been historically valuable warnings that a recession is coming. However, the massive fiscal stimulus and odd behavioral changes occurring since 2020 should make us consider this time may be different.

In the article, we share a model that uses a one-year moving average and recent changes in the unemployment rate. The model has a strong record of predicting recessions. John Hussman’s latest article follows in our footsteps but adds six more labor market data points to generate a more robust recession signal. As shown below, six of his seven indicators are flashing recession warnings. John summarizes the information as follows:

I’ll emphasize again that I don’t believe we have enough evidence to expect a recession with high confidence, but it should be clear that the data are increasingly leaning away from, not toward, the idea of a “soft landing.”

Nvidia (NVDA) Earnings Snapshot

Nvidia (NVDA) just beat earnings expectations across the board. They beat the revenue estimate by 12% and EBIT by nearly 20%. NVDA’s management also guided earnings and revenue expectations higher than expected for the coming quarter. Revenue continues to grow at stellar rates. Per the report, they are up to 56.4% on a three-year cumulative annualized basis (CAGR), higher than 51.7% and 32.7% from the prior two quarters. The bottom line is that explosive growth continues.

There was a wrinkle in the report, which should provide investors with some caution. Despite raising expectations for sales, a key component of revenue is China. NVDA expects a steep decline in fourth-quarter sales to China due to the administration’s new export controls on tech companies to regulate sales of important technology to China. Accordingly, the company is developing three new compliant chips for China. Assuming they are successful, the new chips will hopefully resuscitate sales to China.

As shown below, NVDA shares traded slightly lower on the earnings report. However, given that the stock is up about 20% in the last few weeks, the sell-off is not unexpected, even on good news.

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The Fed’s tone markedly changed in the weeks preceding the November 1 FOMC meeting. Many Fed speakers offered that higher interest rates will tighten financial conditions, allowing them to take a break from rate increases. The messaging was solidified at the November 1 FOMC meeting. To wit, the following statement from Jerome Powell.

In this case, the tighter financial conditions we’re seeing from higher long-term rates but also from other sources like the stronger dollar and lower equity prices could matter for future rate decisions, as long as two conditions are satisfied. The first is that the tighter conditions would need to be persistent and that is something that remains to be seen. But that’s critical, things are fluctuating back and forth, that’s not what we’re looking for. With financial conditions, we’re looking for persistent changes that are material. The second thing is that the longer-term rates that have moved up, they can’t simply be a reflection of expected policy moves from us that we would then, that if we didn’t follow through on them, then the rates would come back down.

Powell clarifies that recent interest rate increases, a stronger dollar, and weaker stock prices could keep them from hiking rates. He qualifies the statement by emphasizing they want to see the persistence of said market conditions. They do not want to see stock prices and bond yields “fluctuating back and forth.“

Since the Fed meeting, stocks have risen about 10%, ten-year note yields are nearly .50% lower, and the dollar index has fallen 3%. Needless to say, tighter financial conditions, as the Fed defines, have not been persistent. Will easier financial conditions force the Fed to revert to its more hawkish tone and try to persuade higher interest rates and lower stock prices?

What To Watch Today

Earnings

Economy

Market Trading Update

As noted in Monday’s commentary, while the market could certainly pull back to the lower of the “Bollinger bands,” corrections will likely remain confined to the 50-dma. As such, we will want to use those opportunities to trade portfolios into higher levels of equity exposure. With the market more overbought and extended currently, we want to remain cautious about committing our cash reverses to the broad market more aggressively.

Yesterday, the market pulled back a smidge but did little to reduce the current overbought conditions. As shown in our MoneyFlow analysis, all of our current “buy” indicators remain and are stretched. A pullback will occur at some point, just as it did last December before the Santa Claus Rally ensued. Given the more extended and overbought conditions, we continue to suggest rebalancing portfolio risk as needed, but caution against getting to underexposed given the current bullish bias to the market.

Existing Home Sales Continue To Fall

Existing home sales fell -4.1% in October to a seasonally adjusted annual rate of 3.79 million. That’s the lowest reading in over ten years, as shown below. For perspective, consider the current 3.79 million home sales are lower than during the first months of the pandemic. The data is for homes that settled in October when mortgage rates peaked near 8%. The next few existing home sales reports will help the Fed ascertain if the recent decline in rates is boosting the housing market.

Fickle Consumers And Lower Inflation Weigh On Retail Sales

On Tuesday, Kohls, Best Buy, and Lowes posted weaker-than-expected sales. The companies make it clear that consumers have become more financially constrained. Consequently, equity analysts are starting to downgrade holiday sales forecasts. In their press releases and investor calls, the three companies mention deal-driven fickle consumers. High inflation and increased debt levels are certainly causing consumers to reduce spending. Over the last couple of months, the overriding message from these retailers and others alludes that consumers are not as in good financial health as in prior quarters. Best Buy is “prepared for a customer who is very deal focused with promotions and deals for all budgets…” Lowes opened 5% lower as comparable sales fell 7.4% “due to a decline in DIY discretionary spending…”

Retailer sales are a function of the financial condition of consumers and, often overlooked, inflation. In particular, sales figures over the last two years were significantly boosted due to higher prices. As such, comparisons to prior quarters’ sales become difficult.

The graphic below from The Transcript shows that three of the largest retailers appear confident that high inflation is in the past. Will price changes normalize or keep falling? If the latter, as Walmart warns, sales at retailers may continue to decline. Further, if retailers sense deflation, they are likely to keep inventories low. The consequence will be weaker sales for the manufacturers of goods.

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As I wrote this blog, the S&P 500 index is up roughly 17% year-to-date. Most likely, your portfolio isn’t. This is a common frustration among many investors in the market this year in particular. As discussed previously, the S&P 500 index performance is a bit deceiving. The majority of the gain in the market this year has come from essentially seven stocks with the largest concentration in the index in terms of market capitalization.

The surge in those stocks has skewed the performance of the broad market index. The performance of the bottom 493 stocks remains markedly different.

As shown, the market capitalization of the top seven stocks is so large that it skews the performance of the index overall. We can see this visually by comparing the performance of the market and equal-weighted S&P 500 indices.

This market bifurcation may not change in 2024 if Goldman Sachs is correct in their estimates.

“Consensus expects the Magnificent 7 will continue to deliver faster growth than the rest of the index. Analyst estimates show the mega-cap tech companies growing sales at a CAGR of 11% through 2025 compared with just 3% for the rest of the S&P 500. The net margins of the Magnificent 7 are twice the margins of the rest of the index, and consensus expects this gap will persist through 2025.

From a valuation perspective, the Magnificent 7 trade at a large P/E premium vs. the rest of the market, but relative valuations stand in line with recent averages after accounting for expected growth. The Magnificent 7 trades at a P/E of 29x, 1.7x the 17x P/E multiple of the median S&P 500 stock. This ratio ranks in the 91st percentile since 2012. However, on an earnings-weighted basis, the Magnificent 7 long-term expected EPS growth is 8 pp faster than the median S&P 500 stock (+17% vs. +9%).”

Why am I telling you this? Well, when the end of the year comes, and you look at your performance relative to the S&P 500 index, you will likely be disappointed.

However, that is precisely what Wall Street wants you to do.

Wall Street Wants You To Compare

Comparison is the root cause of more unhappiness than anything else. Perhaps it is inevitable that human beings, as social animals, have an urge to compare themselves with one another. Maybe it is because we are all terminally insecure in some cosmic sense.

Let me give you an example I discussed with Adam Taggart at Thoughtful Money last week.

Assume your boss gave you a new Mercedes as a yearly bonus. You would be thrilled until you learned everyone in the office got two. Now, you are upset because you got less than everyone else on a “relative” basis. However, are you deprived on an absolute basis of getting a Mercedes?

Comparison-created unhappiness and insecurity are pervasive. Social media is full of images of people showing off their lavish lifestyles, giving you something to compare to. No wonder social media users are terminally unhappy.

The flaw of human nature is that whatever we have is enough until we see someone else who has more.

Comparison in financial markets can lead to awful decisions. For example, investors have trouble being patient and letting whatever process they have work for them.

For example, you should be pleased if you made 12% on your investments but only needed 6%. However, you feel disappointed when you find out everyone else made 14%. But why? Does it make any difference?

Here is an ugly truth. Comparison-related unhappiness is for Wall Street’s benefit.

The financial services industry is predicated on upsetting people so that they will move money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks, products, and style boxes is nothing more than the creation of more things to COMPARE with. The end result is investors remain in a perpetual state of outrage.

The lesson we want to drive home here is the danger of following Wall Street’s advice of beating some arbitrary index from one year to the next. What most investors are taught to do is to measure portfolio performance over a twelve-month period. However, that is absolutely the worst thing you can do. It is the same as being on a diet and weighing yourself every day. 

If you could see the whole future before you, making an investment decision knowing your eventual outcome would be effortless. However, we don’t have that luxury. Instead, Wall Street suggests that if your fund manager lags in one year, you should move your money elsewhere. This forces you to chase performance, creating fees and commissions for Wall Street.

We chase performance because we all suffer from the 7^th deadly sin – Greed. 

Most of us want all of the rewards without regard for the consequences. However, instead, we should learn to “love what is enough.“

In a year like 2023, where primarily seven companies drove the S&P 500 index, many individuals, thinking they “missed out,” will want to change their strategy for next year.

As is often the case, such will likely be a mistake.

Goldman Sachs May Be Disappointed

The table below from Callan Investments is an excellent example of the risk investors take by chasing last year’s best-performing sector. If you pick any asset class, you will see they are rarely the top performer for long. A good example in 2023 was that “cash” won, and the S&P 500 index was down 18%. If you had chased last year’s best-performing asset class, you would have woefully underperformed the S&P 500 index in 2023.

While Goldman expects the S&P 500 index to have another winning year, as we noted in “Trojan Horses,” analysts are often wrong, and by a large degree.

“This is why we call it ‘Millennial Earnings Season.’ Wall Street continuously lowers estimates as the reporting period approaches so ‘everyone gets a trophy.’” 

The chart below shows the changes in Q4 earnings estimates from February 2022, when analysts provided their first estimates.

But while Goldman is very optimistic about earnings growth in 2024, the rest of the analysts community has already started cutting their previous estimates for next year.

Given still elevated interest rates, tighter lending standards, and slowing wage growth, there is more than a substantial risk of slower economic growth next year. While such would lower inflation, it will also reduce earnings growth, suggesting 2024 could be a lower return year for the S&P 500 index.

Conclusion

When you sit down at the end of the year to analyze your performance, I suggest not looking at just 2023 as your benchmark. Investing aims to achieve a rate of return over a long period to reach your financial goals. Therefore, look at the average rate of return you have achieved over the last 5-years and compare that to your goal. This will give you a better sense of how you are doing and reduce the potential for emotional mistakes.

For example, over the last 5-years, the S&P 500 equal-weighted index has returned on a nominal basis 43.21% versus 57.05% for the market-cap weighted equivalent. However, during that period, the returns from the equal-weighted index came with lower volatility, allowing you to stay invested during more troubling times. More importantly, if you need a 6% rate of return to reach your retirement goal, even though the equal-weighted index underperformed in 2023, the 8.6% average return still has you ahead of your objectives.

Financial Resource Corporation summed it up best; 

“For those who are not satisfied with simply beating the average over any given period, consider this: if an investor can consistently achieve slightly better than average returns each year over a 10-15 year period, then cumulatively over the full period they are likely to do better than roughly 80% or more of their peers. They may never have discovered a fund that ranked #1 over a subsequent one or three-year period. That ‘failure,’ however, is more than offset by their having avoided options that dramatically underperformed.

For those that are looking to find a new method of discerning the top ten funds for the next year, this study will prove frustrating. There are no magic short-cut solutions, and we urge our readers to abandon the illusive and ultimately counterproductive search for them.

For those who are willing to restrain their short-term passions, embrace the virtue of being only slightly better than average, and wait for the benefits of this approach to compound into something much better.”

If you want to be a better investor, do what most investors don’t:

• Look for stable returns – not the highest returns.
• Invest for a reasonable annual return to help you reach your investment goal.
• Don’t compare yourself to some anomalous index.
• Save, Save, Save!
• Manage your money – after all – it is your money.

It’s not as complicated as you think.

The squeeze is on in the orange juice futures market. The price of orange juice tends to be stable, typically hovering between $100-$150 per 15,000 pounds of frozen orange juice concentrate, as shown below. On occasion, the price spikes to $200 or higher during the winter months as irregular cold snaps harm the crops. Over the past two years, orange juice prices have seen an irregularly consistent increase that is not letting up as prior short-term price spurts have. With orange juice futures trading at three times their average of the last 15+ years, let’s dive in and see why orange juice prices are surging.

First, Florida, the largest orange grower in the U.S., Brazil, and Mexico have all been hit with a disease called citrus greening that is reducing crops. It is not expected to ease the supply problem anytime soon. Per Reuters: “Ibiapaba Netto, executive director at CitrusBR, the association representing Brazilian juice producers, said that a reversal of the current tight supply situation would take time, and is not certain to happen.” The second reason is the weather. Hurricanes hitting Florida over the last few years have reduced orange juice crops. Lastly, the population shift from the northeast and west coast to Florida creates a need for more housing. To help meet rising demand, construction firms are buying land from orange juice farmers.

What To Watch Today

Earnings

Economy

Market Trading Update

“We must remember that market advances can only go so far before an eventual correction occurs. My best guess is that if the markets are to reach all-time highs this year, we will likely have a correction to reset some of the more extreme overbought conditions, as shown below. Any pullback to the 50-DMA is likely a good entry point to increase exposure on a better risk/reward basis.” – Trading An Unstoppable Bull Market

That was written on July 29th as the market continued to march higher, seemingly with nothing to stop it. Then, the market declined by 10% over the next three months. Once again, we seem to be witnessing an “unstoppable bull market,” which is pushing more overbought extremes, yet nothing seems able to stop it.

Currently, we are in a “bull market” advance. As such, we want to maintain our exposure to equity risk. However, this does not mean we should ignore what the market tells us and let the ebbs and flows wash over us. Eventually, another “ebb” will come, and we will want to reduce risk accordingly. However, that is not today.

“In a bull market, you can be either long or neutral. In a bear market, you can only be neutral or short.” – Dennis Gartman

While the market could certainly pull back to the lower of the “Bollinger bands,” corrections will likely remain confined to the 50-dma. As such, we will want to use those opportunities to trade portfolios into higher levels of equity exposure. With the market more overbought and extended currently, we want to remain cautious about committing our cash reverses to the broad market more aggressively.

“Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival.” – Gerald Loeb

With both technical and sentiment readings suggesting the short-term market risks are elevated, it is likely wise that investors use the current speculative frenzy to rebalance portfolio risks accordingly.

1. Tighten up stop-loss levels to current support levels for each position.
2. Hedge portfolios against more significant market declines.
3. Take profits in positions that have been big winners.
4. Sell laggards and losers (Tax Loss Harvesting)
5. Raise cash and rebalance portfolios to target weightings.

For now, the bullish trend continues but is getting very overbought. While we have increased our equity exposure over the last month, we remain underweight overall. We will rebalance our weightings to target levels when the market gives us the opportunity.

Stocks And Bond Correlation

The graph below, courtesy of Jim Bianco, helps explain why stock prices and bond yields have been moving in opposite directions recently. Our economy is heavily driven by debt. Therefore, the cost of debt, i.e., interest rates, plays a prominent role in the usage of debt, which again is an important driver of economic activity. With interest rates at 10+ year highs, interest expenses are weighing on corporate bottom lines, and high-cost debt makes investing for future profits more costly. Ergo, stock prices, predicated on future cash flows, are taking notice of the bond market. As Bianco’s graph shows, stocks barely eke out gains when yields are rising. Conversely, the S&P 500 returns on average 14.5% when yields are low or falling. As shown in the second graph, yields have been declining a large majority of the time since 1980.

The Conference Board’s LEI Warns of Recession

The latest leading economic indicators (LEI) report from the Conference Board warns of a coming recession. The LEI fell by 0.8% in October to 103.9. That follows a 0.7% decline in September. The Board uses a 3-D rule to determine whether to warn of a recession. Per their rule:

The 3D’s rule provides signals of impending recessions 1) when the diffusion index falls below the threshold of 50 (denoted by the black dotted line in the chart), and simultaneously 2) when the decline in the index over the most recent six months falls below the threshold of -4.4 percent. The red dotted line is drawn at the threshold value (measured by the median, -4.4 percent) on the months when both criteria are met simultaneously. Thus, the red dots signal a recession.

The table below also from the report shows that most components of their index contributed negatively toward the latest reading.

“Among the leading indicators, deteriorating consumers’ expectations for business conditions, lower ISM® Index of New Orders, falling equities, and tighter credit conditions drove the index’s most recent decline. After a pause in September, the LEI resumed signaling recession in the near term. The Conference Board expects elevated inflation, high interest rates, and contracting consumer spending—due to depleting pandemic saving and mandatory student loan repayments—to tip the US economy into a very short recession. We forecast that real GDP will expand by just 0.8 percent in 2024.”

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According to a recent article by the American Farm Bureau (AFB), Thanksgiving dinner will be cheaper this year than last year. That said, prices for the turkey and traditional Thanksgiving dinner side dishes are still up over 20% from pre-pandemic levels. The turkey accounts for 45% of the price of the dinner at an average cost of $27.35. That’s down 5.6% from last year. Last year, turkey prices were elevated as the supply was reduced due to the avian flu. Not all goods fell in price. Per the report, pumpkin pie mix and dinner rolls are higher by 3.8% and 3.0%, respectively. However, whipping cream is down over 20%, and fresh cranberries are down 18%. Prices vary by region. Per the report, Thanksgiving dinner in the northeast is the highest in the country at $64.38. The Midwest and the South have the lowest costs, with both around $59.00.

From a bigger picture, the cost of Thanksgiving dinner tells us a lot about the insidious nature of the recent spate of high inflation. The Fed aims to get the annual inflation rate back to 2%. If the inflation rate dips moderately below the Fed’s target, the odds start to greatly favor the Fed will do everything in its power to generate more inflation. Therefore, while prices have stopped rising at near double-digit rates, it is extremely unlikely we will revisit the general price levels of 2019.

What To Watch Today

Earnings

Economy

• No economic releases of consequence

Market Trading Update

Last week, we discussed the decline in interest rates as recession fears resurfaced. As we noted then:

“The market pullback on Thursday was well-needed after the longest ‘win streak’ for stocks since 2021. After regaining the 200-DMA, the market surged through the 20- and 50-DMA. As we have discussed, pullbacks to support will be buying opportunities. Such was the case on Friday, as the test of the 50-DMA brought buyers into the market and rallied stocks sharply.”

Market rallies are common heading into year-end, and this rally is no different. However, we are now reaching more extreme levels of typical reflexive rallies, and a consolidation or correction to support should be expected. As we noted previously:

“We pushed through the 50% retracement level, which is also the 50-DMA. As noted above, that clears the way for a rally higher with a more bullish tone. That now sets the next targets at the 61.8% and 78.6% levels, then this year’s highs.”

We are currently wrestling with the 78.6% retracement level, which is also resistance from the September highs. Given the more overbought conditions, it is not surprising the market has had trouble advancing over the last several days. Given we are entering a holiday-shortened week, trading volume will be light, and volatility will likely pick up. If the market does provide a correction next week, supports will be the previous 61.8% and 50% retracement levels, respectively.

Continue following the basic investment rules and take advantage of tax loss selling as needed.

1. Tighten up stop-loss levels to current support levels for each position.
2. Hedge portfolios against more significant market declines.
3. Take profits in positions that have been big winners.
4. Sell laggards and losers.
5. Raise cash and rebalance portfolios to target weightings.

From a portfolio management perspective, we have to trade the market we have rather than the one we think should be. This can make the challenge of battling emotions difficult from week to week. However, the rally we expected has arrived, providing a better risk/reward opportunity to rebalance equity exposure.

The Week Ahead

Other than the FOMC minutes from their prior meeting on Tuesday, this will be a quiet week on the news front. As discussed in yesterday’s Commentary, jobless and continued jobless claims will likely become more followed. They are robust leading indicators of the labor market. After a plethora of Fed speakers last week, we expect a limited number of Fed speeches this week.

The stock market is closed for Thanksgiving and will close at 1 pm ET on Friday.

Fed’s Esther George Worries About The Lag Effect

In a recent interview with MNI, Kansas City Fed President Esther George discusses the lag effect and how it plays into her thinking on Fed policy. Her views help us appreciate the difficulty the Fed faces in fighting inflation with higher rates versus the effect higher rates have on the banking sector. She harkens back to 2005-2008.

The last tightening cycle going back to 2005, we didn’t see much going on for a couple of years until that caught up and really hit the economy hard. It’s one of the reasons I’ve tolerated this idea that lags could still be working their way through.

As she notes, it took three years from the first rate hike for the cumulative effect of 5% in interest hikes to crush the banking sector. While she might want to raise rates more today, she fears the lag effect can snowball quickly as it did in 2008. She warns:

I think banks are only one shock away from having some problems.

The graph below shows the Fed hiked rates steadily for two years. It then paused for an entire year. The 2008 financial crisis didn’t become evident to the Fed until March 2008. Currently, the Fed has raised rates for about a year and a half, also by about 5%. As the Fed contemplates pausing or raising rates further, George worries about what may lie on the other side of their actions.

Walmart Warns of Deflation

The quote below from Walmart CEO Doug McMillion discusses the prospect of a period of deflation at Walmart. Other retailers have mentioned less inflation, but Walmart is the first to mention falling prices.

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Democrats should start worrying about the level of debt and the increasing deficit. I previously discussed this issue when President Obama held the White House, when Marshall Auerback, via the Nation, wrote:

“Delivering on big progressive ideas like Medicare for All and the Green New Deal will never happen until Democrats get over their fear of red ink.”

While that article was a long and winding mess of convoluted ideas, the following excerpt was vital.

“In an environment increasingly characterized by slowing global economic growth, businesses are understandably hesitant to invest in a way that creates high-quality, high-paying jobs for the bulk of the domestic workforce. The much-vaunted Trump corporate ‘tax reform’ may have been sold to the American public on that basis, but corporations have largely used their tax cut bonanza to engage in share buybacks, which fatten executive compensation but have done nothing for the rest of us. At the same time, private households still face constraints on their consumption because of stagnant wages, rising health care costs, declining job security, poorer employment benefits, and rising debt levels.

Instead of solving these problems, the reliance on extraordinary monetary policy from the Federal Reserve via programs such as quantitative easing has exacerbated them. In contrast to properly targeted fiscal spending, the Federal Reserve’s misguided monetary policies have fueled additional financial speculation and asset inflation in stock markets and real estate, which has made housing even less affordable for the average American.”

While there is truth in that statement, and it is the same issue I have railed against previously in this blog, Mr. Auerback’s solution was seemingly simple.

“Democrats should embrace the ‘extremist’ spirit of Goldwater and eschew fiscal timidity (which, in any case, is based on faulty economics). After all, Republicans do it when it suits their legislative agenda. Likewise, Democrats should go big with deficits—as long as they are used for the transformative programs that progressives have long talked about and now have the chance to deliver.”

As I noted then, such a solution was essentially the adoption of Modern Monetary Theory (MMT), which, as discussed previously, is the assumption debt and deficits “don’t matter” as long as there is no inflation.

“Modern Monetary Theory is a macroeconomic theory that contends that a country that operates with a sovereign currency has a degree of freedom in their fiscal and monetary policy, which means government spending is never revenue constrained, but rather only limited by inflation.” – Kevin Muir

However, fast forward to the present, we tried MMT; the Democrats went big with debts and deficits and funded social programs, and the result was a massive spike in inflation and no actual increase in broad economic prosperity.

So, what went wrong?

The Non-Solution

The problem with most Democratic spending ideas on social programs and welfare, like free healthcare or college, is the lack of a crucial ingredient. That ingredient is a “return on investment.” Dr. Woody Brock previously addressed this point in his book “American Gridlock;”

“Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.“

Let me be clear. There is no disagreement about the need for government spending. The debate is about the abuse and waste of it.

John Maynard Keynes’ was correct in his theory that for government “deficit” spending to be effective, the “payback” from investments made through debt must yield a higher rate of return than the debt used to fund it.

Currently, the U.S. is “Country A.” 

The problem with the more socialistic programs that Democrats continue to pursue with deficit spending is that it exacerbates the problem. The Center On Budget & Policy Priorities data can help visualize the issue.

As of the latest annual data, through the end of Q2-2023, the Government spent $6.3 Trillion, of which $5.3 Trillion went to mandatory expenses. In other words, it currently requires 113% of every $1 of revenue to pay for social welfare and interest on the debt. Everything else must come from debt issuance.

This is why debt issuance has surged since 2008 when Congress quit using the budgeting process to allow for rampant spending.

Of course, given the massive surge in spending, revenues cannot keep up the pace, leading to a rapid increase in debt issuance and a trending deficit.

However, while Democrats keep pushing for more socialistic programs, which garners votes in election cycles, they are now faced with a problem that may be their undoing.

Debt Diverts Productive Capital

Ben Ritz for the WSJ recently penned:

“Deficits are undermining the Biden economy. In the past year, the real federal budget deficit more than doubled, from $933 billion to $2 trillion. Democrats rightly argued that spending borrowed money was a critical economic support during the Covid pandemic. But the unemployment rate the over past year has been consistently lower than any point since the 1950s.

Economists, even those on the far left who subscribe to ‘modern monetary theory,’ agree that increasing deficits in a tight labor market fuels inflation. Voters’ frustrations with inflation and the interest-rate hikes implemented to bring it under control exceed their appreciation for low unemployment, fueling disapproval of President Biden’s economic record. Deficit reduction is more important than it has been at any other time in the 21st century.”

The problem with the analysis is that while the “unemployment rate” may be low, economic disparity is high. While the massive surge in pandemic-era spending boosted economic inflation, it also created an enormous rise in inflation, unsurprisingly. That inflation surge spurred the Fed to aggressively hike rates on the short end of the yield curve, while inflation and economic growth pushed long-term rates higher.

Subsequently, higher inflation and higher borrowing costs priced out wage increases with substantially higher living costs. Unsurprisingly, the net worth of the bottom 90% of Americans has failed to improve.

The problem for the Democrats is that continuing to push socialistic programs only makes the situation worse. Yes, more “free money” to individuals sounds excellent in theory, but prices ultimately increase more. The problem is exacerbated as non-productive debt erodes economic growth, and more debt diverts productive capital into interest payments.

“Annual interest payments are already at their highest level as a percentage of gross domestic product since the 1990s. By 2028 the government is projected to spend more than $1 trillion on interest payments each year—more than it spends on Medicaid or national defense. Worse, the U.S. may be entering a vicious circle whereby higher deficits increase debt and fuel inflation, which the Federal Reserve must combat by raising interest rates, causing debt-service costs to balloon further.” – Ben Ritz

While the Democrats continue to push for more social spending programs, we have potentially reached the point where that may be no longer feasible. I agree with Ben’s view that it may be time for both Democrats and Republicans to start taking steps to restore fiscal responsibility in Washington.

The average American family is no longer supportive of new progressive policies when they believe we can’t even pay for the promises already made.

Of course, if the economy slips into a recession before the 2024 election, we could see a political rout in Washington, D.C.

Michael Burry, who made a fortune shorting the subprime market in 2008, and was made popular in Michael Lewis’s book and movie The Big Short, is at it again. The quarterly SEC 13-F holdings report for Bury’s $1.7 billion hedge fund shows that he is short approximately $1.6 billion of the S&P 500 (SPY) and Nasdaq (QQQ). Given his track record, as glorified in The Big Short, the media headlines quickly shared his seemingly massive bearish $1.6 billion trades. We presume quite a few investors may be second-guessing their equity positioning. If you are in this camp, take a step back and let us explain what he did. –8/16/2023 Daily Commentary

In that Commentary, we postulated that Burry’s latest Big Short is not as big as the media let on. It turns out the Big Short was shorter than we knew. Since August, Burry added a significant number of stock index put options, sold many of his equity holdings, and added a sizeable bearish bet against semiconductors. The graph below shows the well-followed semiconductor ETF SMH just hit record highs, to Burry’s chagrin.

We just learned, via Burry’s SEC 13-D filings, that he closed his entire short positions on the S&P 500 and Nasdaq. According to the media, Burry’s latest Big Short suffered a 40% loss. If the media claims are true, the latest Big Short may be Burry’s last Big Short! More importantly, this serves as another example of why it can be dangerous to mindlessly follow the “smartest” or “most successful” investors.

What To Watch Today

Earnings

Economy

Market Trading Update

As we discussed last Friday, with the market’s rapid ascent since the beginning of November, we expected some consolidation in the market short-term to allow some of the more overbought conditions to reset. The last few days have seen the market struggle to make meaningful progress while spending part of the day in negative territory. If this bull market rally continues into year-end, we should expect to see a bit more corrective action potentially through the end of the month. As we have stated previously, there is nothing bearish about the current market setup, therefore, use these consolidations or corrections as opportunities to add to exposures at lower levels.

Walmart and Target: A Tale of Two Retailers

On Wednesday, Target shares rose over 15% as they reported better-than-expected earnings and sales. While the stock jumped on earnings, the company warned about its customers’ health. Per their CEO:

Shoppers aren’t buying much more than the necessities. They’re hungry for lower prices. And when they do make purchases, they’re postponing them – such as waiting until the temperature drops to buy a pair of jeans or a sweatshirt

A day later, their chief competitor, Walmart, beat earnings and sales estimates but were cautious on holiday spending. They did raise their EPS forecast, but it is slightly below Wall Street estimates. Like Target, they warned investors that their clients are “still tightening their belts.”

The news from both companies was very similar, but the market reaction was starkly different. To better appreciate why investors reacted as they did, consider the tremendous price gap between the two stocks that has occurred this year. Despite the significant moves over the last two days, Walmart leads Target by approximately 25% on the year.

Fed Funds Futures

With the recent weakness in employment, CPI, PPI, and retail sales reports, it’s worth seeing how the market perception of the Fed has changed. The lines in the graph below show where the Fed Funds futures market expects the monthly Fed Funds rate to be through next year. The bars highlight how much of Fed rate cuts are priced into the market.

As it shows, the market priced in an additional 15-20 bps of rate cuts over the past few weeks. It now expects Fed Funds to end 2024 at 4.47%, down from 4.65% on November 1. Such implies nearly four 25bps cuts between now and then.

Jobless Claims Creep Higher

Initial jobless claims data continue to rise slowly. The Department of Labor reported 231k claimants for initial jobless claims. That is up from 200k a month ago but well within the range of 2023. Our recession radar will increase if it approaches 300k. Of more concern are continued claims, measuring those who recently filed for claims and have been unable to find a new job. There are now 1.865 million in this camp, which has risen for eight consecutive weeks. Further, it is at the highest level going back to November 2021.

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Goldman Sachs released its 2024 forecast for the S&P 500 and the economy.

“We forecast the S&P 500 index will end 2024 at 4700, representing a 12-month price gain of 5% and a total return of 6% including dividends. Our baseline assumption during the next year is that the US economy continues to expand at a modest pace and avoids a recession, earnings rise by 5%, and the equity market’s valuation equals 18x, close to the current P/E level.”

While relatively optimistic on the economic front, it leaves investors with tough decisions. Goldman’s 6% total return forecast for the S&P 500 is slightly below historical average but not a bad return. However, there are safer alternatives that may be more tempting.

Currently, risk-free one-year Treasury bills yield 5.26%, and ten-year Treasury notes are 4.51%. Take some credit risk in the corporate bond markets, and one can earn higher returns. If Goldman proves correct, inflation is likely to stay at current levels or lower. Accordingly, bond yields are likely to fall or, in the worst case, remain around current levels. The table below compares potential returns for stocks and bonds. The gold box shows the performance returns that Goldman’s scenario would likely produce. If yields decline by 2%, it’s likely the economy will be in a recession, and Goldman’s stock forecast is likely too high. Conversely, if yields rise 1% or more, it’s also probable stocks underperform their forecast. Even if Goldman proves correct, less risky bond alternatives are worth considering.

What To Watch Today

Earnings

Economy

Market Trading Update

In the November 6th Daily Market Commentary, we presented projections for a Fibonacci retracement as the market approached the previous downtrend. To wit:

“We pushed through the 50% retracement level, which is also the 50-DMA. As noted above, that clears the way for a rally higher with a more bullish tone. That now sets the next targets at the 61.8% and 78.6% levels, then this year’s highs. While the highs are certainly possible, it is most likely a low-probability event.”

Since then, the market has pushed much higher than expected in such a short period. The market has completed a 78.6% retracement and has returned to a very overbought status. It is indeed possible that the markets will attempt a push to this year’s highs. However, such will likely not happen without a short-term correction or consolidation to reset the market for another push higher.

The market is very bullish, and short-term corrections should be used to add equity exposure as needed. As we noted in that previous commentary:

“The market is oversold, and the recent selling pressure across all assets is nearing exhaustion. If you are worried about what is happening overseas or with the Fed and the economy, use rallies to reduce risk at better price levels.”

1. Tighten up stop-loss levels to current support levels for each position.
2. Hedge portfolios against more significant market declines.
3. Take profits in positions that have been big winners.
4. Sell laggards and losers.
5. Raise cash and rebalance portfolios to target weightings.

With the markets now overbought versus oversold, this is an excellent time to clean up portfolios for a year-end advance.

Recession Or Normalization?

The labor market and its effect on inflation is paramount to Fed decision-making. Consequently, we just published Employment Is Sending Signals to help readers better assess the job market. It is well known that the unemployment rate is most often either rising or falling. It spends very little time stagnating. As such, trend changes in the unemployment rate are critical for forecasting a recession.

To help spot a new unemployment rate trend, we created a more conservative version of the Sahm rule and incorporated a moving average. To wit:

Our warning occurs if the unemployment rate crosses above its 12-month moving average and the unemployment rate has risen by .3% or more over the last six months.

We highlight these instances in yellow below. Since 1948, our tool signaled every recession with only a few false signals. Other than the false alarm in 1996, the other signals occurred slightly before a recession or in the aftermath of one.

Our model, shown below, just triggered a recession warning. However, given the abnormal amount of fiscal and monetary stimulus surrounding the pandemic, we must ask if the recent trend change is just the process of economic normalization or if a recession is coming shortly.

PPI and Retail Sales

Like CPI, PPI came in lower than expected. The monthly headline number was -0.5% versus a downwardly revised +0.4% from the previous month. It was decently below expectations for a 0.1% gain. You have to go back to the second month of the pandemic, in April 2020, to find a lower monthly print. Before that, -0.5% is the lowest monthly figure since 2014, as shown below. Core PPI, excluding food and energy, was 0.0% versus expectations of +0.2%.

Year over year, PPI prices are down to +1.3%, reversing the upward trend of the prior few months. Core year over year is +2.4%, .30% below expectations. You’d have to return to January 2021 for a lower read.

October retail sales came in at -0.1%, slightly better than the -0.2% expected, but this follows an upwardly revised +0.9% from the previous month. The control group, which feeds GDP, was in line with expectations at +0.2% and well off the upwardly revised +0.7% from last month.

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In February 2023, we wrote Janet Yellen Should Focus On HOPE. The article walks through Michael Kantrowitz’s HOPE model. HOPE, or Housing, New Orders (ISM), Corporate Profits, and Employment, provides a handy acronym to track parts of the economy that are interest rate sensitive and tend to be leading recession indicators.

As we wrote in the article:

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.

Over the last year, many H, O, and P measures indicate a recession is likely. E, employment, has been the lone holdout. However, there are recent signs employment trends are starting to change. Given rising unemployment may be the straw that breaks the back of the economic recovery, let’s look at some leading employment indicators to see what they indicate.

If a recession is on the horizon, these employment indicators should provide a warning. However, as you look at our graphs and read our commentary, consider that weakening labor statistics may reflect the normalization of labor conditions and not necessarily an imminent recession as they may have in the past.

Construction Employment

The H in HOPE is housing. Given the economic significance of new and used home sales and the construction of single and multifamily homes, we review the housing construction labor market and its prospects.

As is to be expected, with mortgage rates near 8%, housing activity has ground to a halt. The only sign of life is from new home sales. Homebuilders offer buyers mortgage rates 3% or so below current rates to sell homes. While successful, homebuilder sentiment is waning and is now at 7-month lows. The following comes from our September 20, 2023 Daily Commentary:

“Higher mortgage rates are resulting in a shortage of inventory of used homes and a surge in new homebuilding. Recent data shows a third of all homes for sale are new homes. That is almost three times the average ratio. While homebuilders have been taking advantage of the low inventory situation by offering home buyers reduced mortgage rates and other discounts, it appears they are starting to have concerns. The most recent NAHB builder confidence survey fell to 45. A reading below 50 means there are more homebuilders with negative sentiment than positive sentiment.”

The chart below from the University of Michigan Consumer Sentiment Survey shows that consumers think buying conditions are among the worst since 1960.

Housing starts, a good leading indicator for housing construction employment, peaked in April 2022 at 1,803 units. Since then, it has fallen by about 30% to 1,269 units. Multifamily (five or more units) starts topped simultaneously and has decreased by 54%. Residential construction employment has been unchanged since January. Still, it is likely to fall as construction on existing projects will soon finish, and there will be fewer new construction projects for the current laborers.

As shown below, construction employment trends with the number of housing units under construction. Currently, the number of units under construction and construction employment are at record highs. However, the number of permits and newly started projects is falling.

The black line shows the ratio of units under construction to permits (but not started). The ratio is rising as there are fewer newly permitted projects than current ones. As we saw in 1990 and 2008, that may bode poorly for construction employment.

Temporary Help Employees And Teens

Temporary workers and the youth are typically the most expendable employees. Further, they often have little allegiance to the company and are financially the cheapest to let go. Further, they usually work in the most economically sensitive sectors.

The graph below shows the number of temporary workers commonly declines as the unemployment rate rises. Temporary employment generally peaks before recessions and declines during them. It increases consistently during periods of growth.

The number of temporary workers has been falling since March 2022. In the prior thirty years, there were very few instances where the number of temporary workers declined in a growth cycle. Those that did occur were very short-lived. This instance stands out like a sore thumb and may likely be a precursor to a higher unemployment rate.

The following graph, courtesy of Florian Kronawitter’s article Will It Hold, shows that youth unemployment is rising rapidly, albeit the current level is still amongst the lowest since 1970.

Initial and Continuing Jobless Claims

The Department of Labor provides initial and continuing jobless claims data. Unlike the monthly Bureau of Labor Statistics (BLS) employment report based on corporate and individual surveys, claims data is based on actual state filings by newly unemployed people. Accordingly, the data is more reliable. Further, it is reported weekly, making it timelier.

Initial jobless claims are hovering at a historically low level. However, continuing claims, measuring how long people who previously filed jobless claims remain unemployed, reached their highest level of the past three months at 1.834 million. Continuing Claims have been rising since September 2022, but, like most data we share in this article, the number of continuing claims is low. The duration of the current increase is not typical in non-recessionary periods. The data implies jobs are becoming more challenging to find.  

Unemployment Rate

In April, the unemployment rate stood at 3.4%, the lowest in over fifty years. Since then, it has slowly turned higher, standing today at 3.9%. The unemployment rate always turns up as a recession gets underway. Therefore, we need to pay attention as there have been no instances since 1948 when the unemployment rate rose by half a percent, and the economy was not in a recession or entering one within months. 

To help us better track the unemployment rate, we combine the Sahm Rule and a chart one of our clients sent in.

In one of our recent daily Commentaries, we wrote the following about the Sahm Rule:

There is an economic rule of thumb called the Sahm Rule, which has a 100% track record predicting recessions. The rule’s premise states that if the three-month moving average of the unemployment rate increases by 0.5% above the 12-month unemployment low, a recession is not only likely but has probably started already. The Bloomberg graph below shows the current Sahm measure alert has not been triggered. Last Friday, the BLS reported the unemployment rate rose to 3.9% from a low of 3.4% in April. While the difference is +0.5%, the Sahm rule uses the three-month moving average, which is 3.83%. A reading of 4% or higher in the next month’s unemployment rate would trigger the alert, as would two consecutive months of 3.9%.

After the last unemployment report, one of our astute clients sent us a graph comparing the unemployment rate to its 12-month moving average. He discovers that when the unemployment rate rises above its moving average, it starts rising rapidly, and a recession ensues.

We combine his moving average calculation and a more precise version of the Sahm Rule. Our warning occurs if the unemployment rate crosses above its 12-month moving average and the unemployment rate has risen by .3% or more over the last six months.

We highlight these instances in yellow below. Since 1948, our tool signaled every recession with only a few false signals. Other than the false alarm in 1996, the other signals occurred slightly before a recession or in the aftermath of one.

Multiple Job Holders and Part Time Workers

The following two graphs highlight the financial health of individuals. During the early part of an economic growth cycle, the number of people needing multiple jobs declines as full-time jobs become more plentiful. As the cycle gets extended and the job market tightens, some people are forced to take on multiple jobs. Currently, the number of multiple job holders is at a record high. More telling, as a percentage of the total number of employees, it is the highest since the financial crisis.

The second graph shows the strong correlation between those working part-time for economic reasons and the unemployment rate. The number of part-time workers has steadily risen over the last year.

The BLS JOLTs Report

The BLS publishes a monthly report entitled the Job Openings and Labor Turnover Report, aka JOLTs. Two good leading indicators within this report help appreciate whether the labor market is expanding or contracting.

During economic expansion, job openings tend to increase as companies expand. Accordingly, because of increased hiring, companies find it harder to hire qualified employees.

The quit rate, measuring the number of people who recently quit their jobs to the total number of employees, helps us gauge how emboldened workers are about finding a new job. A higher quit rate occurs when individuals feel the labor market is sufficiently tight, whereas they can quit and easily find a better or higher-paying job.

The graph below shows the job openings rate is still well above pre-pandemic levels but has been trending lower for a year and a half. The quit rate is now back to pre-pandemic levels. Neither indicator points to a weak job market, but their trends indicate a deteriorating job market if they continue.

Summary

Economic deterioration or normalization? That question best defines the quandary the employment market presents us.

The labor market is undoubtedly deteriorating and sending signals that have been historically valuable warnings that a recession is coming. However, the massive fiscal stimulus and odd behavioral changes occurring since 2020 should make us consider this time may be different.

It’s tough to tell if the labor market is warning of a recession or just normalizing to a more sustainable level of employment.

Time will tell, and you now have some data to watch closely to help you answer our question.

All four broad CPI inflation measures were below expectations for the first time in a long while. Headline CPI for October was 0.00%, with year-over-year inflation at 3.2%. Core CPI was 0.2%, with year over year at 4.0%. All four were .10% below what was expected. The Tweet of the Day shares a chart showing that shelter prices, which rose 0.3%, remain an outsized driver of higher inflation. Given that October’s CPI was 0%, and shelter was +.3%, CPI excluding shelter declined last month. Due to recent price declines in rents and home prices, CPI shelter prices will, in time, fall to zero or even below, dragging CPI lower with it. So, the big question for stock and bond investors is what might the CPI report mean for the Fed’s policy posture.

The Fed whisperer, WSJ reporter Nick Timiraos, posted the following comments after the CPI report: “The October payroll report and inflation report strongly suggest the Fed’s last rate rise was in July. The big debate at the next Fed meeting is shaping up to be over whether and how to modify the postmeeting statement to reflect the obvious: the central bank is on hold.” Nick is likely correct, but the Fed will be careful not to get dovish. They risk sharp declines in interest rates and further increases in stocks. Such eases financial conditions and could potentially stoke inflation. Another consideration comes from the Apollo chart below. If the Fed’s last hike was in July, then historically, the Fed may only be 4-5 months from cutting rates. We caution the previous few years have been far from normal, so prior Fed behaviors may not hold up well.

What To Watch Today

Economics

Earnings

Market Trading Update

Wow. Following yesterday’s weaker-than-expected CPI report, the shorts were brutalized in a massive broad market surge higher, with growth stocks leading the charge. The realization that the Fed is now done hiking rates, led to market participants anticipating when rate cuts would occur. While this is premature, given only two recent reports showing weakness, the massive short market positioning in both stocks and bonds, combined with negative sentiment, was all that was needed for this rally since the beginning of the month.

As noted Tuesday morning:

“Yesterday, the market retested the breakout of the previous downtrend line resistance from the July highs. With the market turning that previous resistance into support, it further solidifies the bullish tone the market has taken since the beginning of July. Much like October of 2022, the bottom of that selloff was marked by the technical thrust higher beginning in November.”

With Tuesday’s surge higher, the break above the downtrend is now support for any short-term correction. As we have noted since the end of October, investors should look for opportunities to add exposure heading into December. The next best opportunity for a pullback to support will likely be in the first two weeks of December when mutual funds distribute their annual gains, dividends, and income. Such a pullback will set the market up for a year-end rally as portfolio managers “window dress” portfolios for year-end reporting.

The Technology Two

Yesterday’s Commentary shared SimpleVisor analysis highlighting the recent strong relative outperformance of the technology sector. In particular, the analysis focused on the well-followed technology ETF XLK. The analysis makes it appear that the whole technology sector was doing well, however, that is not necessarily true. The fact of the matter is that two stocks overwhelmingly drive XLK’s performance. The pie chart below shows that Apple and Microsoft make up nearly 50% of XLK. The next largest stock, NVDA, only comprises 4% of the ETF despite being nearly half the size of Apple and Microsoft. As goes Apple and Microsoft, go XLK!

China Trade Tensions Are Having An Impact

Trade tensions between the U.S. and China are starting to have an impact. As shown below, courtesy of BofA, China’s exports to the U.S. are down 18% from their peak. At the same time, their exports to the rest of the world are down 4%. Further evidence is shown in the second graph, courtesy of true insights. It shows that foreign direct investment into China is negative for the first time since at least 1998. Some of the disinvestment from China is a function of much higher interest rates in the U.S. versus China.

These two charts help partially explain why China’s economic growth, post-pandemic reopening, has been much weaker than experienced by the U.S. and most other developed economies.

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Are you an “investor” or a “speculator?” 

Over the last month, we have discussed the “false market narratives” that push investors to make portfolio mistakes. Such is why we previously discussed the “Investing Rules” needed to navigate volatile markets.

This past week, on the #RealInvestmentShow, we discussed the difference between being an investor, like Warren Buffett, and a speculator, which is both you and I.

In today’s market, the majority of investors are simply chasing performance. However, why would you NOT expect this to happen when financial advisers, the mainstream media, and Wall Street continually press the idea that investors “must beat” some random benchmark index from one year to the next?

But this defines the difference between being a “speculator” or an “investor?” 

Graham And Carret

If you were playing a hand of poker and were dealt a “pair of deuces,” would you push all your chips to the center of the table?

Of course not.

The reason is you intuitively understand the other factors “at play.” Even a cursory understanding of the game of poker suggests other players at the table are probably holding better hands, which will rapidly reduce your wealth.

More importantly, just like a game of poker, as individuals buying a few company shares, we have ZERO control over how that company manages its finances, makes decisions, or conducts its business. As such, we are “betting” on an unknowable future outcome with only a basic understanding of the risks involved.

Therefore, as individuals, we are “speculators” in the financial markets, and as such, we must focus on the management of the risks to allow us to “stay in the game long enough” to “win.”

“Philip Carret, who wrote The Art of Speculation (1930), believed “motive” was the test for determining the difference between investment and speculation. Carret connected the investor to the economics of the business and the speculator to price. ‘Speculation,’ wrote Carret, ‘may be defined as the purchase or sale of securities or commodities in expectation of profiting by fluctuations in their prices.’” – Robert Hagstrom, CFA

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.

Benjamin Graham and David Dodd attempted a precise definition of investing and speculation in their seminal work Security Analysis (1934).

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

There is also an essential passage in Graham’s The Intelligent Investor:

“The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against.”

Indeed, in today’s world of chasing markets from one year to the next, the meaning of being an investor has been lost. However, the following ten guidelines from legends of our time will hopefully get you back on track and turn you from being a speculator to a successful investor.

10-Investing Guidelines From Legendary Investors

1) Jeffrey Gundlach, DoubleLine

“The trick is to take risks and be paid for taking those risks, but to take a diversified basket of risks in a portfolio.”

This is a common theme that you will see throughout this post. Great investors focus on “risk management” because “risk” is not a function of how much money you will make but how much you will lose when you are wrong. As a speculator, you can only play if you have capital.

Be greedy when others are fearful and fearful when others are greedy. One of the best times to invest is when uncertainty and fear are the highest.

2) Ray Dalio, Bridgewater Associates

“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”

Nothing good or bad goes on forever. The mistake that investors repeatedly make is thinking, “This time is different.” The reality is that it will change despite whatever mainstream narrative is permeating headlines. The rule that never changes is that “what goes up must and will come down, and vice versa.”

Wall Street wants you to be fully invested “all the time” because that is how they generate fees. However, as an investor, it is crucially important to remember that “price is what you pay, and value is what you get.” 

Speculators don’t care about value. Investors do.

3) Seth Klarman, Baupost

“Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”

The most significant risk in investing is investor behavior driven by cognitive biases. “Greed and fear” dominate the investment cycle of investors, ultimately leading to “buying high and selling low.”

4) Jeremy Grantham, GMO

“You don’t get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.”

Successful investors avoid “risk” at all costs, even if it means underperforming in the short term. The reason is that while the media and Wall Street have you focused on chasing market returns in the short term, ultimately, the excess “risk” built into your portfolio will lead to abysmal long-term returns. Like Wyle E. Coyote, chasing financial markets will eventually lead you over the cliff’s edge.

5) Jesse Livermore, Speculator

“The speculator’s deadly enemies are: ignorance, greed, fear and hope. All the statute books in the world and all the rule books on all the Exchanges of the earth cannot eliminate these from the human animal….”

Allowing emotions to rule your investment strategy is, and always has been, a recipe for disaster. All great investors follow a strict discipline, process, and risk management diet. The emotional mistakes show up in the returns of individual portfolios over time. (Source: Dalbar)

6) Howard Marks, Oaktree Capital Management

“Rule No. 1: Most things will prove to be cyclical.

Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.”

As with Ray Dalio, realizing nothing lasts forever is critical to long-term investing. To “buy low,” one must first “sell high.” Understanding that all things are cyclical suggests that investments become more prone to declines after long price increases.

7) James Montier, GMO

“There is a simple, although not easy alternative [to forecasting]… Buy when an asset is cheap, and sell when an asset gets expensive…. Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance.”

“Cheap” is when an asset sells for less than its intrinsic value. “Cheap” is not a low price per share. When a stock has a very low price, it is usually priced there for a reason. However, a very high-priced stock CAN be cheap. Price per share is only part of the valuation determination, not the measure of value itself.

8) George Soros, Soros Capital Management

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

Regarding risk management, being right and making money is great when markets are rising. However, rising markets tend to mask investment risk that is quickly revealed during market declines. If you fail to manage the risk in your portfolio and give up all of your previous gains and then some, you lose the investment game.

9) Jason Zweig, Wall Street Journal

“Regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

The chart below shows the 3-year average of annual inflation-adjusted returns of the S&P 500 to 1900. The power of regression is seen. Historically, when returns exceeded 10%, it was not long before they fell to 10% below the long-term mean. Those reversions were devastating to investor’s capital.

10) Howard Marks, Oaktree Capital Management

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

The biggest driver of long-term investment returns is the minimization of psychological investment mistakes.

Baron Rothschild once said, “Buy when there is blood in the streets.” This means that when investors are “panic selling,” you want to be the one they sell to at deeply discounted prices. Howard Marks expressed the same sentiment: “The absolute best buying opportunities come when asset holders are forced to sell.”

Conclusion

As an investor, it is simply your job to step away from your “emotions” and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend significantly on how you answer that question and manage the inherent risk.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

As I stated at the beginning of this message, “Market Timing” is ineffective in managing your money. However, as you will note, every great investor throughout history has had one core philosophy in common: the management of the inherent risk of investing to conserve and preserve investment capital.

“If you run out of chips, you are out of the game.”

Moody’s, the last of the three major credit rating agencies to have an AAA rating on the United States government, put Uncle Sam on credit watch negative. The AAA rating is still intact. But, Moody’s warns investors and the Treasury Department that a rating downgrade to AA is probable unless serious budgetary steps are taken to limit debt issuance. However, and this is important, they add “in the context of higher interest rates” in their rationale. Will Moody’s remove their negative outlook if rates decline toward pre-pandemic levels? Might lower rates persuade S&P and Fitch to consider rating upgrades or put them on positive watch?

“In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or increase revenues, Moody’s expects that the US’ fiscal deficits will remain very large, significantly weakening debt affordability.” – Moody’s

Our thoughts: We believe Moody’s warning and downgrades from other rating agencies have a near-zero impact. A credit rating on an entity that can print its own money and presides over the world’s reserve currency is meaningless. In a way, the rating agencies acknowledge this. To explain, consider what the rating would be if the government were a private entity. As we wrote in Risk-Free Government Debt: “When Fitch calculates the credit rating for a company, it uses the debt service coverage ratio (DSCR), among other fundamental measures of debt, assets, and liquidity…. As shown, the government’s DSCR would land it firmly in junk bond territory between a B and CCC rating.“ The agencies currently rate USA debt on par with the most fiscally sound companies and sovereign nations.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, the market retested the breakout of the previous downtrend line resistance from the July highs. With the market turning that previous resistance into support, it further solidifies the bullish tone the market has taken since the beginning of July. Much like October of 2022, the bottom of that selloff was marked by the technical thrust higher beginning in November. While the current selloff was more protracted than that of 2022, the difference this time is the market is trading above the 200-DMA with only minor resistance at 4500. However, looking back at last year, the advance higher was not a straight line. We should expect some pockets of weakness along the way, particularly in mid-December. Continue to use weakness to add exposure to portfolios for now.

Technology Leads The Market Once Again

The first table below comes courtesy of SimpleVisor. The sector scores quantify how each sector measures against the S&P 500 on a technical basis. Red, as technology currently is, is extremely overbought, while green denotes oversold conditions. As shown, technology is grossly overbought, while all sectors are flat or negative versus the S&P 500. Such a stark difference between technology and just about everything else reminds us of the outperformance of the energy sector in 2022.

Next, the heat map below shows the performance of each of the S&P 500 stocks and their year-to-date gain. The size of each square is a function of each company’s market cap. Except for technology, Google, Meta, Amazon, and Tesla, you notice a majority of the market is having a bad year.

CPI This Morning

With markets eagerly following every last word from the Fed and the Fed nearly solely focused on inflation, today’s CPI could be a significant number for the markets. The table below shows what Wall Street forecasters expect the headline and core indexes to be. If the number exceeds estimates, stocks and bonds will likely sell off in unison. Conversely, a weaker-than-expected number, along with the recent slowing of the labor market, could easily cause the stock and bond markets to rally significantly.

Future Inflation Expectations & Bonds

The following table is worth considering. Inflation expectations of two major Wall Street firms are close to the Fed’s 2% objective. Given expectations are at or near 2%, it is surprising to see bonds yielding 4.75%-5.25%, based on the fact that interest rates hovered around inflation rates before the pandemic. The market is either betting that inflation will stay stubbornly high or that Treasury debt issuance will weigh heavily on the market. Regarding the second point, its worth noting the government’s debt-to-GDP ratio has actually declined since peaking in 2021.

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Our most recent article, CFNAI, The Most Important & Overlooked Economic Number, shares an important economic metric that many investors tend to ignore. Further, unlike the more popular economic data points, CFNAI is forward-looking. Speaking of economic statistics that are not well covered is the trucking industry. Trucking services account for nearly 6% of GDP; more importantly, trucks transport about 70% of domestic shipments. Per Statista, trucking contributed $369 billion to GDP, twice as much as air transport and multiples above all other forms of freight transportation services. As such, the health of the trucking industry is directly important for GDP calculations, but more importantly, demand for trucking informs us of the financial health of consumers and corporations. So, with that, let’s explore the health of the trucking industry.

Trucking employment is falling at a faster rate than the recessions of 2000 and 2008. This is not what we should expect in such a strong economy. The recent demise of Citizens Bank provides further evidence of trucking woes. The bank ties its failure to bad trucking loans. Yellow Corporation, founded 99 years ago with a 10% trucking services marketing share, failed earlier this year. Smaller companies are failing as well. Per Yahoo Finance, “rates on most lanes are at or below 2019 levels.” Lastly, as reported by FreightWaves, Convoy, a high-profile trucking brokerage, recently shut down for financial reasons. Other trucking services brokerages are also failing. The bottom line is that the state of trucking does not gibe with the most recent 4.9% GDP growth.

What To Watch Today

Earnings

Economy

• No notable economic releases

Market Trading Update

On Friday, the market recovered sharply following a couple of days of sloppy trading, with the market dismissing concerns about Jerome Powell’s hint at continued tight monetary policy. As noted through most this past week, the market is short-term overbought, but most likely, as we head into year-end, pullbacks will be shallow and brief, opportunities to add exposure. For now, money is continuing to pile into “momentum stocks” for the most part as a safe place to hide. As shown, there is little to suggest the rally that started at the beginning of November is in jeopardy.

On Friday, the market took out the upper downtrend line of the bearish channel from the July highs. If the market can hold above that previous resistance next week, our year-end target of 4500 becomes more viable. A retest of this year’s highs is certainly obtainable as well. However, it will most likely not be a straight advance higher. As we have suggested previously, we are using the rally to rebalance holdings in the portfolio, do some tax loss selling, and prepare portfolios for what we expect to be a challenging market in 2024.

The Week Ahead

CPI and PPI will be the most followed events of the week. Analysts expect CPI on Tuesday to be +0.3% monthly and fall to 3.3% annually. PPI is expected to rise by 0.1% versus 0.5% last month. The biggest driver of the CPI report will be shelter prices, accounting for over 30% of data. The pace at which CPI shelter prices catch up with declines in actual home and rental prices will help largely determine the path for CPI. Also of note, this week will be retail sales on Wednesday. After a robust 0.7% growth rate last month, expectations are for PPI to come in flat this month.

Bad 30-year Treasury Auction Or “Ransomware”?

Yesterday’s Commentary touched on the bad 30-year U.S. Treasury auction and the ransomware attack that prevented ICBC from bidding on the auction or providing much-needed liquidity to other Treasury bidders. Given the market reaction on Friday morning, there appears to be truth to the ransomware story. The blue circle shows the immediate drop in 30-year bond futures upon the release of the auction’s results. The black arrow highlights that the post-auction swoon had been recovered by the market’s opening on Friday morning.

As we noted, the bond market is short-term overbought, so weakness is unsurprising. However, the historically bad auction results should probably not be taken as a sign that demand for bonds is non-existent, as some market narratives allude.

Small-Cap Stocks Are Struggling Versus Large-Caps

The two graphs below paint a troubling story for small-cap stock investors. The first graph below from Jefferies shows that the market cap of small-cap stocks as a percentage of the total market has fallen to levels last seen in the 1950s. The rapidly growing popularity of passive investment styles means that larger-cap stocks tend to find favor over small-cap stocks. Small-cap stocks generally require more research and analysis. Assuming that investors continue to lean toward passive approaches, requiring little homework, and away from active styles increasingly, the trend should continue.

The second graph shows the price ratio of the Russell 2000 to the S&P 500. After significantly outperforming the S&P during the first decade of the 2000s, small-cap stocks have since given up those gains. The small-cap space has plenty of value, but many investors today are not value seekers. Small-cap stocks may again have their day in the sun when or if that changes.

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