Monthly Archives: June 2020

Small Cap Returns Point To Interest Rate Worries

As shown on the left, from 1979 until 2000, the correlation between small cap returns (Russell 2000) and the U.S. Treasury ten-year yield was often highly negatively correlated. As circled in the graph on the right, the U.S. experienced its highest yields in history during this period. Due to their high debt loads, small cap stocks are interest rate sensitive. Therefore, bouts of higher rates resulted in weaker returns during this period. Conversely, when yields were declining, small cap stocks performed well. By 2000, yields fell to more historic levels. From 2000-2019, the relationship between small caps and yields became positive. Small cap investors were keying in on economic factors without the onus of high interest rates. Higher yields, albeit low compared to the prior period, often accompanied more robust economic growth and better earnings for small caps.

With the recent inflation and higher rates, the negative correlation between yields and small cap returns is back. Do small cap stock investors worry that a redux of higher inflation is returning? Or, might they be concerned that small-cap stocks do not have the same pricing power as larger-cap stocks and, thus, are negatively affected by higher inflation? Regardless of why the correlation has flipped, the small cap index now serves as a proxy for inflation and yields. Might small cap stocks be a safe port in the storm if a recession hits, or might the correlation turn positive?

correlation of small cap stocks to yields rates

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Earlier this week, I discussed the interesting chart setup for longer-duration bonds. To wit:

“On another note, the 20-Year Duration Treasury Bond chart looks much more bullish. A massive cluster of resistance is just above current bond prices, which have built nice support along previous lows. As the economy continues to weaken, and if the Fed does cut rates in June, bond prices will rise. Once prices clear that cluster of support, there is very little resistance to a further decline in yields and a rise in prices.”

I suggested that the resistance challenge could take a few months before breaking higher, coinciding with the Fed cutting rates. However, bond prices have rallied this week, and prices cleared most of that moving average resistance. While the move is early, it is a bullish indication for bonds with prices improving. I would not be surprised to see bonds struggle with this near term technical resistance. However, if bonds can build support above these averages and turn them into support levels, the outlook becomes more bullish. Furthermore, with the MACD turning onto a buy signal, such should provide additional lift to bond prices over the next month.

Market Trading Update

A Relative Opportunity In Apple

Apple shares have been floundering since mid-December despite the broader market trending higher. The year to date, the S&P 500 has been up by about 10%, yet its second largest contributor, Apple, has been down by nearly 8%. The first graph below charts the price ratio of Apple to SPY. The orange dotted line represents the ratio’s 200-day moving average, and the green line is the percentage difference between the ratio and the moving average. The ratio is currently about 20% below the moving average and on par with prior troughs. The second graph shows the ratio’s return for the next 200 days after it was 10% or more below its moving average. The top graph shows that deviations such as today are good buying opportunities. However, there are periods, such as 2013, when patience was required before the ratio turned upward.

ratio of apply to spy
apple spy returns when the ratio is oversold

If The Fed Is Done Hiking Bonds Look Tempting

The graph below, courtesy of JP Morgan Asset Management, shows total bond returns each time the Fed ends a rate hiking cycle. Presuming the last hike was July 2023, recent bond returns are below average. Given the past few years’ inflation experience and its recent stickiness, investors may still worry that the Fed hasn’t hiked for the last time. However, if the rate hiking cycle is over, history shows that bonds offer tempting returns if inflation resumes its trend lower and the Fed starts cutting rates.

bond returns if fed is done hiking

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Financial Conditions Butt Heads With Borrowing Conditions

At last week’s FOMC meeting, Jerome Powell said, “We think financial conditions are weighing on the economy.”

His comments seem sensible, given the following:

  • The Fed is reducing its balance sheet (QT).
  • The Fed Funds rate is at its highest level in over 15 years.
  • Mortgage rates are about 7%, 3-4% above pre-pandemic levels.
  • Credit card interest rates are 20% or more.
  • Auto loans range between 7% and 10%
  • Consumer loan growth, excluding the pandemic, is down to levels last seen over ten years ago.
  • Outstanding Commercial & Industrial (C&I) loans are declining.

Powell’s statement indicates that financial conditions are tight. However, they are easy based on the Fed’s definition of financial conditions. If Powell doesn’t appreciate the difference between financial and borrowing conditions, we must assume most investors do not either.

chicago fed financial conditions

As we will explain, there is a big difference between financial and borrowing conditions. Equally worth considering is that the current combination of easy financial conditions and tight borrowing conditions makes monetary policy difficult for the Fed to balance.   

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What Are Financial Conditions?

The St. Louis Federal Reserve defines financial conditions as follows:

Measures of equity prices (also commonly referred to as stock prices), the strength of the U.S. dollar, market volatility, credit spreads, long-term interest rates, and other variables.”

Financial conditions tend to be easy when investors are optimistic and speculative. Let’s look at the four critical measures in the St. Louis Fed definition to understand why financial conditions are easy today.

Equity Prices: The S&P 500 is up 38% since 2023 and 10% through the first three months of 2024.

U.S. Dollar: The dollar index has been relatively flat since 2023 and the year to date.

Market Volatility: The VIX volatility index has been hovering between 12 and 15 this year. That is about one standard deviation below the average VIX reading of 19.32 over the last 35 years.

Credit Spreads: The BBB investment grade yield is only 1% above a comparable maturity Treasury. Such is the tightest spread since the 1990s.

Long-Term Interest Rates: Long-term interest rates have been significantly higher than average over the past few years and at levels last seen before the financial crisis in 2008. However, they are about 1% lower than their peak last year.

Equity prices, market volatility, and credit spreads point to very easy financial conditions, and we might also characterize their levels as speculative.

The dollar has had little effect on financial conditions as it has been relatively stable.

Long-term interest rates point to tighter financial conditions, albeit easing over the past six months.

The bottom line is that financial conditions are easy in large part because robust sentiment in the equity and credit markets more than offsets higher interest rates.

As shown below, our proprietary SimpleVisor Sentiment indicator is at its maximum level, and the CNN Fear & Greed Index is closing in on extreme greed.

simplevisor sentiment gauge
cnn fear and greed sentiment guide

What Are Borrowing Conditions?

Unlike financial conditions, borrowing conditions are far from easy. The two graphs below highlight the financial stress on consumer and corporate borrowers.

consumer loan interest rates

Credit card interest rates are over 20% and about 5% above the highest in the past 24 years. Mortgage and auto loan interest rates are up to levels not seen in at least fifteen years.

The following graph shows that 90-day commercial paper loans and yields on BBB-rated corporate bonds are at their highest levels since the financial crisis.

commercial paper and BBB rated interest rates

What Can And Can’t The Fed Manage?

The Fed plays a crucial role in directing financial and borrowing conditions. At times, like today, financial and borrowing conditions can be at odds with each other, which makes the Fed’s job of managing monetary policy more difficult.

The market’s perception of the Fed’s stance, hawkish or dovish, and more importantly, forecasts of how they may change policy can heavily impact market sentiment and financial conditions.

For instance, a strong correlation exists between QE and higher stock returns, lower volatility, and tighter credit spreads. The relationship occurs in part due to the psychology of investors. However, it’s also a function of the liquidity the Fed creates when conducting QE. For similar reasons, lower rates are thought to be beneficial for markets.

fed qe vs s&P 500

The Fed has a heavier hand in determining borrowing conditions. By managing its Fed Funds rate, the Fed sets the tone for long-term interest rates and significantly influences shorter-term rates. Further, QE and QT can add or subtract liquidity from the markets, directly affecting the supply and demand of liquidity available to all markets.

Powell’s Predicament

Financial conditions have eased considerably as investors priced out the odds of rate increases and have started pricing in rate cuts. The combination of lower interest rates and possibly less QT, coupled with robust economic growth, is the goldilocks scenario driving investors’ sentiment higher. This occurs despite extremely tight borrowing conditions and a hawkish monetary policy.

Currently, the Fed does not want financial conditions to ease further as the wealth effect of strong markets can have an inflationary impulse. They could hike rates or even talk of increasing rates to weigh on financial conditions. However, with tight borrowing conditions and the potential that the lag effect of prior rate hikes will ultimately cause a recession, they appear to be in no man’s land.   

As we share below, on a real basis, the Fed’s policy stance is the tightest it has been in fifteen years.  

fed real monetary policy graph
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Another Fed Predicament Coming Soon

Sentiment and liquidity drive markets in the short run. Both have supported higher stock prices and mania-like trading in AI stocks and cryptocurrencies.

However, that could be changing. As we note in Liquidity Problems, excess liquidity is rapidly draining from the financial system. The Fed knows the situation and may be called upon to deal with a liquidity shortfall. QT reductions and/or lower rates would ease liquidity concerns. But, doing so, especially if the economy stays robust and market sentiment is strong, would risk further easing of financial conditions, which in turn may keep inflation sticky at current levels. 

Summary

The Goldilocks economy, coupled with the end of the rate hiking cycle, has investors giddy, which eases financial conditions. Ironically, while some of the easiest financial conditions in the last ten years have existed, borrowing conditions remain very tight. 

The Fed must balance these two conditions, which is difficult as they can counteract each other. Threading the eye of this needle may prove problematic given that inflation remains too high and, more recently, is showing some signs of being sticky. 

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Tesla And EVs Fall Out Of Favor

Yesterday’s Commentary discussed the fall of EV maker Fisker. After posting the article, Fisker shares were suspended from trading on the NYSE. Tesla, the world’s largest producer of EVs, has fared much better than Fisker, but it, too, is having problems. For example, Tesla’s revenue growth was only 3.5% in the fourth quarter. Competition from all automakers is a big problem. In particular, Tesla cut production in China as the country ramps up EV production of its vehicles. Tesla just posted its lowest sales in China since 2022. Demand for EVs is another problem. As shown below, the share of EVs to total vehicle sales slipped last month and fell below its trend. Other automakers like Ford and GM are backing off EV production estimates as they foresee weaker demand. As we noted in Is Toyota the Next Tesla, demand for hybrid cars is sapping EV sales as well.

The other problem facing Tesla shareholders is high valuations. Tesla’s largest competitor, Toyota, trades with a forward P/E of 11.2 and P/S of 1.1. Compare that to Tesla, with a forward P/E of 46 and P/S of 6.2. Tesla shares are pricing in significant growth, while Toyota and other automakers’ valuations imply that auto industry growth will be well below the broader market averages. Keep in mind that Tesla’s valuations, while elevated, are much lower than in 2021 when the stock was double today’s price. EVs are more than a fad, but it’s hard to know if EVs will continue to grow their market share at the rate it has over the past five years. Additionally, competition from hybrids, other automakers, and, ultimately, newer technologies pose significant risks to Tesla. While its stock has fallen 25% this year, it may not be time to buy the dip.

ev share of all auto sales

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable economic releases

Market Trading Update

As we begin to close out the month of March, the S&P 500 will have posted 5-positive months in a row. Historically, such long stretches can occur but are often punctuated by either a month or two of declines or a bigger corrective phase. The monthly chart of the S&P shows that over the last 20 years, there have been 9 occasions where the market rallied 5 or more months in a row. While previous stretches did not always resolve into bigger corrective processes, there were at least a month or more of negative returns, which reduced the existing overbought conditions.

Market Trading Update

With the market trading well above the 2-year moving average and overbought on many levels, a corrective process will occur at some point. However, at the moment, there is little to undermine the bullish sentiment in the market. While we continue to suggest remaining long equity exposure currently, it will be important to maintain a nimble strategy to reduce exposures as and when needed.

The current advance is getting very long, and buyers are becoming exhausted. It is important to remember that the market is a pool of buyers and sellers. Currently, the price is increasing as buyers have to coax sellers into a higher-priced transaction. However, when sentiment shifts and the buyers want to sell, there will be few to take shares at current prices.

As the adage goes, “Sellers live higher. Buyers live lower.”

It is how markets work.

Apartment Loss-to-Lease Ratio Signals Lower Rent Inflation

CPI and other inflation data greatly influence how the Fed manages monetary policy. Rent and imputed rents account for 40% of CPI. Therefore, whatever happens with rental prices greatly affects the Fed, which is also a significant factor driving investor sentiment and, ultimately, markets. Yesterday’s Commentary shared data showing that the number of apartments that came onto the market in 2023 and those coming in 2024 will dwarf the annual amounts built over the last 30 years. On its own, that extra supply should weigh on rental prices.

The graph below shows the loss-to-lease ratio, courtesy of RealPage Analytics, pointing to another factor that should keep rental prices lower. The following is from Jay Parsons:

We measure this through what the industry calls “loss-to-lease” — the premium for a new lease asking rent versus what current renters actually pay today (the in-place rent). A high loss-to-lease number means that current renters are paying a lot less than a new renter walking in the front door. That means they’re likely to see larger renewal increases. A low loss-to-lease number means that current renters are already paying close to today’s market prices for new renters. That means they’re likely to see a small (if any) increase on renewal. As of Jan 2024, loss-to-lease came in at 3.0%. That is a 3-year low. And as renewals continue to inch up (modestly) while new leases are expected to be fairly flat, that’ll narrow the gap more.

Remember that landlords prefer to keep a renter in place to avoid having an empty apartment earning no rent. Accordingly, most rent renewal price increases will likely be much less than in the last few years.

apartment loss to lease ratio rents

Baltimore Harbor Shuts Down

The collapse of the Francis Scott Key Bridge means that the Baltimore Port will be unusable for a while. The harbor is ranked the 17th largest in the U.S. based on total tonnage. However, it has led the nation’s ports in the import and export of new cars and trucks. The port also accounts for a lot of employment. Per the Maryland Daily Record:

A 2018 report detailed the economic impact of the port on the surrounding region. The report found that 37,300 jobs in Maryland are generated by port activity — 15,330 of which were direct jobs generated by cargo and vessel activities; 16,780 of which were “induced jobs,” supported by the local purchases of goods and services; and an estimated 5,190 indirect jobs.

The question for investors is what might the macroeconomic impact be, especially on prices. As Bloomberg notes,

“The worst thing that can happen for the Fed, the worst thing that can happen for the economy, are these kinds of supply side shocks because what they do is they reduce the productive capacity of the US economy boost inflation at the same time.”

The impact on the economy and inflation is yet to be known. Much of it depends on how long it takes to remove the debris and make the shipping lane viable. In the meantime, the ports of Newark, New Jersey, and Hampton Roads, Virginia, should be able to help accommodate the incoming and outgoing vessels. Employment related to the Baltimore port should be affected, but hopefully, it’s temporary.

We do not anticipate this will meaningfully affect the national economy or prices. However, our view may change as new information is released.

port of baltimore harbor

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Apartment Supply Will Surge This Year

Over the last few weeks, we have shared information about the troubles facing the commercial real estate (CRE) market and the regional banks that made CRE loans (CRE Pain & CRE Loans). The problem for CRE investors and lenders stems from overbuilding over the last ten years and high vacancy rates due to the work-from-home movement. Apartment buildings have fared much better.

The graph below from RealPage shows the supply of apartment units is quickly rising. In 2023, the number of new apartment units rose by 493k, the highest amount since the mid-1980s. This year, the new supply of apartments could be about 50% higher than last year’s and at 50-year highs. Is the apartment building industry risking a surplus of apartment buildings like CRE? The National Multifamily Housing Council (NMHC) says no. According to the council, “The U.S. needs to build 4.3 million units by 2035 to meet the demand for rental housing.

The apartment supply coming onto the market will help alleviate the shortage of housing, but if the NMHC is correct, the supply of apartment units should still be well short of demand. A shorter-term risk to that optimistic outlook could occur if mortgage rates fall sharply. Such would unfreeze the housing market. Homeowners trapped in houses unwilling to swap their current low mortgage for a much higher one could add a significant supply of houses to the market. Accordingly, apartment renters may buy homes instead of renting due to lower mortgage rates. Also of interest is that when the new apartment supply hits the market, it could even out the supply/demand mismatch in the short term and further stabilize rent prices, a key component of CPI.

new apartment supply

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

We started adding energy exposure to our portfolio at the beginning of the year. At the time, we got a lot of pushback as oil prices languished and demand seemed to fall. However, oil prices have steadily risen within a well-defined trend channel, just like the overall market, as capital is chasing virtually every asset class. While the increase in oil prices is not as aggressive as the S&P 500, the increase is beginning to approach more overbought levels.

We currently remain in our energy positions and have made some profits along the way. However, we suspect that when the overall market finally cracks and selling pressure emerges, we will likely see commodity prices decline as well.

Oil prices update

On another note, the 20-Year Duration Treasury Bond chart looks much more bullish. A massive cluster of resistance is just above current bond prices, which have built nice support along previous lows. As the economy continues to weaken, and if the Fed does cut rates in June, bond prices will rise. Once prices clear that cluster of support, there is very little resistance to a further decline in yields and a rise in prices. The resistance challenge will likely last a few more months, but by the end of 2024, bonds could provide a decent overall return.

BOnd chart

FedEx Revenue Decline As Does Hiring In The Transportation Sector

Last week, FedEx stock rose about 10% despite missing sales and earnings expectations and cutting forward-looking guidance. Share buybacks, cost reductions, and improved margins drove the stock gains. Regardless of the market’s reaction, the FedEx earnings report points to a continued slowing of shipping revenue and, therefore, weakness in consumer spending. Also, from a macroeconomic point of view, FedEx will be laying off employees in different areas of the company. In January, UPS announced they would cut 12,000 jobs. The graph below shows that the number of employees in transportation and warehousing has been falling steadily since 2022. Further, it is breaking below the growth trend that existed in the years leading up to the pandemic.

all employmees transportation fedex

Fisker Shares Point To Bankruptcy

EV automaker Fisker (FSR) was a market favorite in 2021 as EVs were set to take over the world, and speculation over “meme stocks,” including Fisker, was off the charts. Fisker shares have plummeted since peaking at $32 a share in early 2021. It appears bankruptcy is the likely option for this once-promising EV maker. On Monday, the stock fell nearly 30% as talks for a potential cash infusion from a large automaker were reported to have failed. Fisker has paused car production as it seeks to shore up its cash balances. They also missed a $8.4 million interest on bonds that was supposed to be paid on March 15th. They do have a 30-day grace period to make the payment. Whether it occurs in the next few days or after the 30-day grace period, bankruptcy appears inevitable.

fisker fsr share price

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Technical Measures And Valuations. Does Any Of It Matter?

Technical measures and valuations all suggest the market is expensive, overbought, and exuberant. However, none of it seems to matter as investors pile into equities to chase risk assets higher. A recent BofA report shows that the increase in risk appetite has been the largest since March 2021.

Risk Appetite Index

Of course, as prices increase faster than underlying earnings growth, valuations also increase. However, as discussed in “Valuations Suggest Caution,” valuations are a better measure of psychology in the short term. To wit:

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

Consumer confidence vs valuations

When investors are exuberant and willing to overpay for future earnings growth, valuations increase. The increase in valuations, also known as “multiple expansion,” is a crucial support for bull markets. As shown, the increase in multiples coincides with rising markets. Of course, the opposite, known as “multiple contractions,” is also true. With a current Shiller CAPE valuation multiple of 34x earnings, such suggests that investor confidence is elevated.

Valuation Model

As noted, valuations are terrible market timing indicators and should not be used for such. While valuations provide the basis for calculating future returns, technical measures are more critical for managing near-term portfolio risk.

Technical Measures Are Getting Extreme

As noted, investors are again becoming exuberant over stock ownership. Such is vital to creating multiple expansions and fueling bull market advances. High valuations, bullish sentiment, and leverage are meaningless if the underlying equities are not owned. As discussed in Household Equity Allocations,” the current levels of household equity ownership have reverted to near-record levels. Historically, such exuberance has been the mark of more important market cycle peaks.

Household equity ownership vs SP500

While household equity ownership is critical to expanding the bull market, the technical measures provide an understanding of when excesses are reached. One measure we focus on is the deviation of price from long-term means. The reason is that markets are bound to long-term means over time. For a “mean” or “average” to exist, prices must trade above and below that price over time. Therefore, we can determine when deviations are approaching more extreme levels by viewing past deviations. Currently, the deviation of the market from its underlying 2-year average is one of the largest in history. Notably, there have certainly been more significant deviations in the past, suggesting the current deviation from the mean can grow further. However, such deviations have crucially been a precursor to an eventual mean-reverting event.

Technical Model

The following analysis uses quarter data and evaluates the market using valuation and technical measures. From a long-term perspective, the market is trading at more extreme levels. The quarterly Relative Strength (RSI) measure is above 70, the deviation is close to a historical record, and the market trades nearly 3 standard deviations above its quarterly mean. As noted, while these valuation and technical measures can undoubtedly become more extreme, the ingredients for an eventual mean reverting event are present.

Quarterly risk based market model

Of course, the inherent problem with long-term analysis is that while valuations and long-term technical measures are more extreme, they can remain that way for much longer than logic suggests. However, we can construct a valuation and technical measures model using the data above. As shown, the model triggered a “risk off” warning in early 2022 when high valuations collided with an extreme deviation of the market above the 24-month moving average. That signal was reversed in January 2023, as the market began to recover. While a new signal has not yet been triggered, the ingredients of valuations and deviations are present.

Fundamental and Technical Model
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The Ingredients Are Missing A Catalyst

The problem with long-term technical measures and valuations is that they move slowly. Therefore, the general assumption is that if high valuations do not lead to an immediate market correction, the measure is flawed.

In the short term, “valuations” have little relevance to what positions you should buy or sell. It is only momentum, the direction of the price, that matters. Managing money, either “professionally” or “individually,” is a complicated process over the long term. It seems exceedingly easy in the short term, particularly amid a speculative mania. However, as with every bull market, a strongly advancing market forgives investors’ many investing mistakes. The ensuing bear market reveals them in the most brutal and unforgiving of outcomes. 

There is a clear advantage to providing risk management to portfolios over time. The problem is that most individuals cannot manage their own money because of “short-termism.” As shown by shrinking holding periods.

Holding periods for investors

While “short-termism” currently dominates the investor mindset, the ingredients for a reversion exist. However, that does not mean one will happen tomorrow, next month, or even this year.

Think about it this way. If I gave you a bunch of ingredients such as nitrogen, glycerol, sand, and shell, you would probably stick them in the garbage and think nothing of it. They are innocuous ingredients and pose little real danger by themselves. However, you make dynamite using a process to combine and bind them. However, even dynamite is safe as long as it is stored properly. Only when dynamite comes into contact with the appropriate catalyst does it become a problem. 

“Mean reverting events,” bear markets, and financial crises result from a combined set of ingredients to which a catalyst ignites. Looking back through history, we find similar elements every time.

Like dynamite, the individual ingredients are relatively harmless but dangerous when combined.

Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”

Importantly, this particular formula remains supportive of higher asset prices in the short term. Of course, the more prices rise, the more optimistic investors become.

While the combination of ingredients is dangerous, they remain “inert” until exposed to the right catalyst.

What causes the next “liquidation cycle” is currently unknown. It is always an unexpected, exogenous event that triggers a “rush for the exits.”

Many believe that “bear markets” are now a relic of the past, given the massive support provided by Central Banks. Maybe that is the case. However, remembering that such beliefs were always present before more severe mean-reverting events is worth remembering.

To quote Irving Fisher in 1929, “Stocks are at a permanently high plateau.” 

CRE Pain is Just Getting Started

The vacancy rate of commercial real estate is higher today than at any point in the 2008 global financial crisis, per the Wall Street Journal. Yet, the CRE industry isn’t experiencing the pain one might expect to see with such high vacancy rates. CRE deals involving distressed sellers are still surprisingly low, at just 3.5% of all deals formed in the US in 2023. Per MSCI Real Assets, that number is closer to 2.7% with the most recent data.

Many CRE investors owe a few favors to lenders with good graces that have delayed the pain accompanying distressed sales. Rather than forcing fire sales, some lenders are working out deals to extend loans in hopes of a market recovery. In other cases, distressed debt investors are coming forward to lend funds, albeit with less advantageous terms. Still, CBRE predicts that CRE landlords face a refinancing gap of $72.7 billion through the end of 2025. While Jerome Powell has acknowledged the CRE pain faced by regional banks and the risk of contagion to GSIBs, he’s confident that the situation is manageable.

Lenders are also eager to kick the can down the road. They don’t want to force borrowers to sell buildings into a weak commercial real-estate market, which would lead to punishing losses. 

This might explain why debt maturities aren’t triggering the kind of distress that some property watchers expected. Of the $35.8 billion of office loans that came due in the commercial mortgage-backed securities market last year, only a quarter were paid off in full, according to data from real-estate analytics firm CRED iQ. Other loans were extended or sent to a special servicer—a third party that tries to find the best outcome for the debt, which may include modified payment terms or foreclosure.

CRE Pain is Still Subdued

What To Watch Today

Earnings

  • No notable earnings releases

Economy

Economic Calendar

Market Trading Update

Last week, we suggested we could see a further correction given some of the weaknesses that had been accruing. Such was the case until Wednesday’s FOMC meeting announcement. While the meeting was largely as expected, with no real change to outlook, the outcome was seen as largely “dovish” as Powell reaffirmed the Fed was still on track to cut rates three times this year.

“While The Fed kept its median dot at 3 cuts for 2024, beyond that the dots signal considerably less aggressive Fed rate-cutting. We also note that while the median 2024 dot remained the same, 8 Fed voters were for 50bps or less in Dec, now it’s 9. The Fed now expects one less rate-cut in 2025 and 2026… and the so-called ‘neutral’ rate has also been increased.Zerohedge

Fed Dot Plot

With financial conditions now as loose as they were before the Fed started hiking rates, the markets remain unmoved by slightly more hawkish rhetoric.

Financial Conditions

With that announcement, the market surged to an all-time high, reversing the recent momentum weakness. The market remains in a nearly perfect trend that only Bernie Madoff could have designed. As we have repeated, to the point of “ad nauseam,” over the last several weeks, the market remains confined to a very defined channel. The 20-DMA continues as key support where computer algorithms continue to “buy dips,” and sellers resurface at the channel’s top.

Market Trading Update

For now, this mind-numbingly narrow channel, with extremely low volatility and high complacency, remains. What will change that dynamic? I have no idea. As shown, volatility continues to plumb the “nether regions” as investor optimism surges.

Market Trading Update 2

However, as is always the case, at some point, this will reverse itself. What triggers it is unknown, but a good warning sign will be a violation of the 20-DMA. As noted, we suspect such a violation will trip the algorithms into “sell” mode and increase downside price pressures. The problem for investors is that this bullish trend has already lasted much longer than expected and could continue. Therefore, we must maintain our current positioning and remain vigilant for a break of the trend channel to take more aggressive risk reduction actions.

As they say at amusement parks, “Make sure your seat belts are fastened securely and enjoy the ride.”

The Week Ahead

Following last week’s FOMC meeting, the focus will now be on the PCE price index this Friday. Inflation is falling but remains above the Federal Reserve’s target. After a sticky February CPI number, PCE will be even more important as it’s the Fed’s preferred measure of inflation. The consensus expectation is for the PCE price index to rise to 0.4% MoM in February, up from 0.3% MoM in January. Also to be released on Friday is the Personal Income and Expenditures data for February. Personal income is slated to grow 0.4% MoM, retreating from 1% growth in January. Meanwhile, personal spending is expected to rise 0.4% MoM following a 0.2% increase in January. Thus, the expectation is zero real growth in personal income and expenditures in February.

Other notable economic data this week include February Durable Goods Orders on Tuesday and the final estimate of fourth-quarter GDP growth on Thursday. Durable Goods Orders have been volatile over the past few years. The consensus anticipates 1% growth in February after falling 6.1% in January. Excluding Transportation, the consensus is for 0.4% growth in February following a decrease of 0.3% in January.

Market Forces Contribute to State Migration Losing Sparkle

Higher home prices and inflation are eating into the savings of those looking to leave states like New York for Texas. The pandemic sparked a plunge into remote work culture, which presented those in high-cost-of-living states a sort of arbitrage opportunity. Per Bloomberg, those making $250k in New York in 2019 could have saved as much as $135k by moving from New York to Dallas.  

Now, the benefits are waning as market forces take effect. Like any arbitrage opportunity, the net benefit will shrink until exploitation no longer makes sense, given the costs. As shown below, possible savings have fallen by nearly a quarter since 2019 as the markets adjust to supply/demand dynamics.

New Yorkers who left for sunny Miami in 2023 saved almost 30% less than they would have if they moved in 2019. Meanwhile, those who left Manhattan for Dallas or Austin saved about 20% to 25% less if they moved last year compared to 2019.

And while Manhattan is still the most expensive place to live in the US, higher inflation rates in Miami, Dallas, and Austin means costs in those popular destinations are catching up to New York, said Jaclyn DeJohn, the managing editor of economic analysis at SmartAsset.

State Migration is Losing Sparkle

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Retirement Crisis Faces Government And Corporate Pensions

It is long past the time that we face the fact that Social Security” is facing a retirement crisis. In June 2022, we touched on this issue, discussing the stark realities confronting Social Security.

“The program’s payouts have exceeded revenue since 2010, but the recent past is nowhere near as grim as the future. According to the latest annual report by Social Security’s trustees, the gap between promised benefits and future payroll tax revenue has reached a staggering $59.8 trillion. That gap is $6.8 trillion larger than it was just one year earlier. The biggest driver of that move wasn’t Covid-19, but rather a lowering of expected fertility over the coming decades.” – Stark Realities

Note the last sentence.

When President Roosevelt first enacted social security in 1935, the intention was to serve as a safety net for older adults. However, at that time, life expectancy was roughly 60 years. Therefore, the expectation was that participants would not be drawing on social security for very long on an actuarial basis. Furthermore, according to the Social Security Administration, roughly 42 workers contributed to the funding pool for each welfare recipient in 1940.

Of course, given that politicians like to use government coffers to buy votes, additional amendments were added to Social Security to expand participation in the program. This included adding domestic labor in 1950 and widows and orphans in 1956. They lowered the retirement age to 62 in 1961 and increased benefits in 1972. Then politicians added more beneficiaries, from disabled people to immigrants, farmers, railroad workers, firefighters, ministers, federal, state, and local government employees, etc.

While politicians and voters continued adding more beneficiaries to the welfare program, workers steadily declined. Today, there are barely 2-workers for each beneficiary. As noted by the Peter G. Peterson Foundation:

Social Security has been a cornerstone of economic security for almost 90 years, but the program is on unsound footing. Social Security’s combined trust funds are projected to be depleted by 2035 — just 13 years from now. A major contributor to the unsustainability of the current Social Security program is that the number of workers contributing to the program is growing more slowly than the number of beneficiaries receiving monthly payments. In 1960, there were 5.1 workers per beneficiary; that ratio has dropped to 2.8 today.”

Ratio of workers to SSI Beneficiaries

As we will discuss, the collision of demographics and math is coming to the welfare system.

A Massive Shortfall

The new Financial Report of the United States Government (February 2024) estimates that the financial position of Social Security and Medicare are underfunded by roughly $175 Trillion. Treasury Secretary Janet Yellin signed the report, but the chart below details the problem.

Four layers of massive debt and liabilities

The obvious problem is that the welfare system’s liabilities massively outweigh taxpayers’ ability to fund it. To put this into context, as of Q4-2023, the GDP of the United States was just $22.6 trillion. In that same period, total federal revenues were roughly $4.8 trillion. In other words, if we applied 100% of all federal revenues to Social Security and Medicare, it would take 36.5 years to fill the gap. Of course, that is assuming that nothing changes.

However, therein lies the actuarial problem.

All pension plans, whether corporate or governmental, rely on certain assumptions to plan for future obligations. Corporate pensions, for example, rely on certain portfolio return assumptions to fund planned employee retirements. Most pension plans assume that portfolios will return 7% a year. However, a vast difference exists between “average returns” and “compound returns” as shown.

Difference between compound and actual returns

Social Security, Medicare, and corporate pension plans face a retirement crisis. A shortfall arises if contributions and returns don’t meet expectations or demand increases on the plans.

For example, given real-world return assumptions, pension funds SHOULD lower their return estimates to roughly 3-4% to potentially meet future obligations and maintain some solvency. However, they can’t make such reforms because “plan participants” won’t let them. Why? Because:

  1. It would require a 30-40% increase in contributions by plan participants they can not afford.
  2. Given many plan participants will retire LONG before 2060, there isn’t enough time to solve the issues and;
  3. Any bear market will further impede the pension plan’s ability to meet future obligations without cutting future benefits.

Social Security and Medicare face the same intractable problem. While there is ample warning from the Trustees that there are funding shortfalls to the plans, politicians refuse to make the needed changes and instead keep adding more participants to the rolls.

However, all current actuarial forecasts depend on a steady and predictable pace of age and retirement. But that is not what is currently happening.

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A Retirement Crisis In The Making

The single biggest threat that faces all pension plans is demographics. That single issue can not be fixed as it takes roughly 25 years to grow a taxpayer. So, even if we passed laws today that required all women of birthing age to have a minimum of 4 children over the next 5 years, we would not see any impact for nearly 30 years. However, the problem is running in reverse as fertility rates continue to decline.

Interestingly, researchers from the Center For Sexual Health at Indiana University put forth some hypotheses behind the decline in sexual activity:

  • Less alcohol consumption (not spending time in bars/restaurants)
  • More time on social media and playing video games
  • Lower wages lead to lower rates of romantic relationships
  • Non-heterosexual identities

The apparent problem with less sex and non-heterosexual identities is fewer births.

Fertility rate of women

No matter how you calculate the numbers, the problem remains the same. Too many obligations and a demographic crisis. As noted by official OECD estimates, the aging of the population relative to the working-age population has already crossed the “point of no return.”

Working age vs Elderly Population

To compound that situation, there has been a surge in retirees significantly higher than estimates. As noted above, actuarial tables depend on an expected rate of retirees drawing from the system. If that number exceeds those estimates, a funding shortfall increases to provide the required benefits.

Sharp uptick in retirements

The decline in economic prosperity discussed previously is caused by excessive debt and declining income growth due to productivity increases. Furthermore, the shift from manufacturing to a service-based society will continue to lead to reduced taxable incomes.

This employment problem is critical.

By 2025, each married couple will pay Social Security retirement benefits for one retiree and their own family’s expenses. Therefore, taxes must rise, and other government services must be cut.

Back in 1966, each employee shouldered $555 of social benefits. Today, each employee has to support more than $18,000 in benefits. The trend is unsustainable unless wages or employment increases dramatically, and based on current trends, such seems unlikely.

The entire social support framework faces an inevitable conclusion where wishful thinking will not change that outcome. The question is whether elected leaders will make needed changes now or later when they are forced upon us.

For now, we continue to “Whistle past the graveyard” of a retirement crisis.

QE Light May Allow the Fed to Help the Treasury

With inflation remaining sticky well above the Fed’s 2% target and the economy showing few signs of weakness, the Fed will find it difficult to cut rates meaningfully. Furthermore, ending QT and re-starting QE is much less likely in this environment. The problem with the Fed’s anti-inflationary stance is that it forces the government to pay higher interest expenses, further increasing deficits and debt issuance. A new version of QE, let’s call it QE Light, might be the solution. Our latest article, QE By A Different Name, dives into a QE Light rumor floating around the street.

QE Light could allow the Fed to support the Treasury while maintaining a hawkish bias.  To do so, the bank regulators could remove all capital and leverage requirements on Treasury holdings for the largest banks. Next, they could employ a new version of the BTFP program, which they recently retired. Per the article:

In a new scheme, bank regulators could eliminate the need for GSIBs to hold capital against Treasury securities while the Fed reenacts some version of BTFP. Under such a regime, the banks could buy Treasury notes and fund them via the BTFP. If the borrowing rate is less than the bond yield, they make money and, therefore, should be very willing to participate, as there is potentially no downside.

Federal Budget Situation and Debt

What To Watch Today

Earnings

  • No notable earnings releases

Economy

Economic Calendar

Market Trading Update

The most perfect trading trend continues uninterrupted.

Despite some previous deterioration in momentum, that was reversed quickly on Wednesday and Thursday following the FOMC announcement. Perceived as dovish, stocks got a strong bid from the 20-DMA and rallied to the top of the market’s ongoing “perfect trend.” As I noted yesterday morning on Twitter,

“If you can goal seek a market move…this is what it would look like. Trips to the bottom of the channel at the 20-DMA continue to get bought. Tops get sold. The algos remain in control for now.”

While the market has moved back onto a buy signal, it is back to overbought on both an RSI and MACD basis. There is no reason to be overly cautious as the bullish trend continues. The upside likely remains limited without a bigger correction first. However, we won’t need to worry about that until the 20-DMA is violated. That should trigger more selling as the computer algos switch from “buying dips” to “selling rips.”

Market Trading Update

Flash PMIs Signal We’re in Good Shape

The S&P Global Flash PMIs for March indicate that the first quarter is ending on a positive note. The Services PMI fell to 51.7, slightly missing estimates but still sitting comfortably in expansionary territory. Meanwhile, the Manufacturing PMI rose to 52.5, its highest level in nearly two years, blowing past estimates of 51.7. The employment component of the indices was the highest yet in 2024. Perhaps the one drawback is the Prices component, which signaled that inflationary pressures picked up in March. Per the report:

The rate of input cost inflation quickened to a six-month high amid faster increases across both monitored sectors. Service providers indicated that higher operating expenses generally reflected increasing wages, while rising oil and gasoline costs were often mentioned by manufacturers. In turn, companies in the US raised their own selling prices at a faster pace. In fact, the rate of inflation was the sharpest in just under a year and stronger than the series average. Respective rates of output price inflation accelerated sharply across both manufacturing and services, quickening to 13- and eight-month highs as companies passed through higher input costs to their customers.

Flash PMI Prices Index

Swiss National Bank Surprises with a Rate Cut

The Swiss National Bank became the first developed market central bank to cut rates in this inflationary cycle. In the decision for the 25bps cut, the Swiss cited the country’s relatively low inflation after an effective fight over the past few years. In fact, the economy is experiencing significantly lower inflation than other developed market economies, as shown in the first chart below, courtesy of Zero Hedge. The action is supported by a significant revision lower to the Swiss National Bank’s inflation forecasts, as shown in the second chart below from Bloomberg. The Swiss Franc fell sharply against the USD and EUR following the news, depreciating 1.2% and 1%, respectively.

While the SNB was the first to cut rates, it doesn’t necessarily mean other developed economies will soon follow suit. The Fed and ECB are the key players to watch, and once they begin cutting rates, a broader trend could emerge. As we wrote yesterday, recent Fed projections assume we will see three rate cuts in 2024. However, a resilient economy and sticky inflation have the potential to derail those expectations. If so, QE Light could be the next trick up the Fed’s sleeve.

Swiss Inflation Is Way Lower Than Elsewhere
Swiss National Bank Inflation Forecasts

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Fed Dot Plot Projections Point To Stronger Growth And Rate Cuts

The last release of the Fed’s quarterly Summary of Economic Projections, aka dot plots, was in December. At the time, the median 2024 GDP projection of the 19 Fed members was a relatively slow 1.4% growth. Further, they expected PCE prices to decline to 2.4% by year-end. Both estimates were slightly lower than their September projections. Economic growth has been stronger than expected through the beginning of 2024, and inflation is sticky. The December dot plots projected that the Fed would cut rates 3x in 2024 (2 more than expected in September). No members thought they would raise rates. The markets were bullish on the forecasts. They interpreted them as the Fed would stay on hold until the spring and then cut rates as many as 6-7 times. Investors have since backed off their rate-cut estimates. Before yesterday’s FOMC meeting, investors aligned with the December dot plot Fed Funds expectation.

The new dot plots point to a more upbeat Fed than a few months ago. They raised their GDP forecast from 1.4% to 2.1%, and core PCE inflation rose 0.2% to 2.6%. Most importantly, the median Fed estimate still calls for three rate cuts in 2024 and three more in 2025. However, two of the nineteen members surveyed are predicting no cuts this year. One of them doesn’t foresee cuts in 2025, either.

The Fed minutes are virtually unchanged. Powell anticipates reducing the monthly amount of QT “fairly soon.” During the press conference, Powell affirmed that they are confident that lower market rents will show up in CPI prices and, as we have written, will lower inflation. Despite recent sticky inflation, they still think the overall story of inflation moving down to 2% “on a bumpy road” is still valid.


What To Watch Today

Earnings

Economy

Market Trading Update

Might The BOJ Rate Hike Signal A US Recession?

Yesterday’s Commentary touched on the historic rate increase by the BOJ and how it could impact global financial markets. To wit:

The BOJ policy shift has implications for global markets. For starters, Japan is one of the world’s largest exporters of capital. Low and negative interest rates have incentivized individuals, corporations, and pension funds to convert their yen to other currencies and buy much higher-yielding assets in other countries. Secondly, the so-called yen carry trade allows non-Japanese investors to borrow in yen, convert the yen to other currencies, and invest in other countries. This trade, estimated at $20 trillion, bolsters asset prices in the United States and around the world.

The following graph provides an interesting twist linking prior BOJ rate hikes with U.S. recessions. As the chart from BCA Research shows, the BOJ has hiked rates three times in the last 35 years before yesterday’s rate increase. Each rate hike was followed by a recession, regardless of how much or little they increased rates. The 2020 pandemic-related recession is the only outlier.

boj japan monetary policy and recessions

The Lag Effect Of Higher Interest Rates Is Hitting Households

The following Bloomberg graph provides evidence that the rising interest rate cost to debtors offsets the benefits of higher interest rates for savers. Households’ total annual interest expense on their mortgages, credit cards, and other forms of debt has risen by nearly $420 billion since the Fed started hiking rates in 2022. Over the same two-year period, interest income was only $280 billion. As we wrote about in Bougie Broke, consumers are slowly running out of the means to keep up with above-average consumption. Further, any weakness in the labor markets would further weigh on personal consumption. Keep in mind that personal consumption represents about two-thirds of GDP.

household higher interest rates lag effect

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The BOJ Ends Historic Run Of Negative Rates

The Bank of Japan (BOJ) has finally ended its eight-year run of negative interest rates. On Tuesday morning, the BOJ boosted their overnight rate from -.10% to a range of 0% to 0.10%. Furthermore, the BOJ discontinued its Yield Curve Control (YCC) operations and stopped purchasing equity and corporate bond ETFs and REITs. However, their QE program will continue, although they are not explicitly targeting longer-term maturities via YCC. Longer-term Japanese yields are slightly lower on the news.

The BOJ policy shift has implications for global markets. For starters, Japan is one of the world’s largest exporters of capital. Low and negative interest rates have incentivized individuals, corporations, and pension funds to convert their yen to other currencies and buy much higher-yielding assets in other countries. Secondly, the so-called yen carry trade allows non-Japanese investors to borrow in yen, convert the yen to other currencies, and invest in other countries. This trade, estimated at $20 trillion, bolsters asset prices in the United States and around the world. Unless the BOJ continues to raise rates or the yen rallies versus the dollar, we are not concerned that capital flows from Japan will reverse. However, it is a risk worth watching.

boj policy rate

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

In yesterday’s commentary, I posted a chart of the S&P 500 showing several technical indicators suggesting a short-term correction may be near. I received a few questions about the S&P chart overlay on an indicator called a “ZigZag.” I will explain what it is and why I like it.

“The ZigZag indicator is not an indicator per se, but rather a means to filter out smaller price movements. A ZigZag set at 10 would ignore all price movements less than 10%; only price movements greater than 10% would be shown. Filtering out smaller movements gives investors the ability to see the forest instead of just trees. It is important to remember that the ZigZag feature has no predictive power because it draws lines based on hindsight. Any predictive power will come from applications such as Elliott Wave, price pattern analysis, or indicators. However, the ZigZag can be used with a retracements feature to identify Fibonacci retracements and projections.” – Stockcharts.com

As noted, the “ZigZag” indicator smooths out daily volatility and helps to reduce emotional biases that can interfere with portfolio management over time. In the chart below, I have set the ZigZag to filter out all price movements of less than 10% and removed the index. Notably, the lows in ZigZag were in June and October of 2022, which preceded decent market rallies. It also turned in late July last year as the market topped and bottomed in October. The indicator appears to have topped this past week. It will take about a week to confirm if the current “ZigZag” indication is denoting the start of a bigger correction process. Given the prevalence of deterioration in other leading technical indicators, we suspect that may be the case.

Market Trading Update

MicroStrategy Insiders Are Selling

Last Friday’s Commentary gave readers a worrying analysis of MicroStrategy (MSTR). MSTR is a technology company with no growth in its sales or earnings over the last ten years. Its share price surged despite the lack of fundamental justification for owning the stock. The reason for the investor optimism is that MSTR has been accumulating bitcoin. With the recent pop in bitcoin prices, it makes sense that the value of MSTR would follow. However, as noted, “We constructed the table below to show how MicroStrategy investors are paying a 43% premium to own Bitcoin.”

Given the massive premium to buy bitcoin and the ease of purchasing bitcoin via the new ETFs, MSTR’s price was at significant risk. Two days after writing the article, it appears investors are waking up. Since peaking at 1815 last week, its stock is down 25%. The excessive premium versus bitcoin was warning enough in our minds, but maybe the fact that insiders consistently sell shares should be another strong deterrent to owning the stock. The table below, courtesy of SimpleVisor, shows that Michael Saylor, who has been very outspoken about Bitcoin, has sold over $5 million worth of stock over the last few weeks. On February 27th, its CEO, Phong Le, sold over $8 million worth of shares.  

microstrategy insider sell mstr
microstrategy mstr graph

Warren And Sanders Warn The Fed

As we ponder what the Fed may or may not do or say today, we must consider the political pressure on the Fed. Earlier this week, Senators Elizabeth Warren and Bernie Sanders urged Fed Chairman Jerome Powell to lower interest rates. In a letter to Chairman Powell, they said they want a “a clear and rapid timetable for reducing interest rates, ideally beginning at the May FOMC meeting.” A similar sentiment from both sides of the aisle was given to Chairman Powell during his testimony to Congress two weeks ago. Given the coming election, such an argument for a rapid timetable seems politically motivated. However, Fed Funds are about 2% above the rate of inflation. Such is the tightest monetary policy in about 15 years and is weighing on smaller businesses.

real monetary policy is tight fed

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QE By A Different Name Is Still QE

The Fed added Quantitative Easing (QE) to its monetary policy toolbox in 2008. At the time, the financial system was imploding. Fed Chair Ben Bernanke bought $1.5 trillion U.S. Treasury and mortgage-backed securities to staunch a financial disaster. The drastic action was sold to the public as a one-time, emergency operation to stabilize the banking system and economy. Since the initial round of QE, there have been four additional rounds, culminating with the mind-boggling $5 trillion operation in 2020 and 2021.

history of QE

QE is no longer a tool for handling a crisis. It has morphed into a policy to ensure the government can fund itself. However, as we are learning today, QE has its faults. For example, it’s not an appropriate policy in times of high inflation like we have.

That doesn’t mean the Fed can’t provide liquidity to help the Treasury fund the government’s deficits. They just need to be more creative. To that end, rumors are floating around that a new variation of QE will help bridge potential liquidity shortfalls.

The Sad Fiscal Situation

The Federal government now pays over $1 trillion in interest expenses annually. Before they spend a dime on the military, social welfare, or the tens of thousands of other expenditures, one-third of the government’s tax revenue pays for the interest on the $34 trillion in debt, representing deficits of years and decades past.

There are many ways to address deficits and overwhelming debt, such as spending cuts or higher taxes. While logical approaches, politicians favor more debt. Let’s face it: winning an election on the promise of spending cuts and tax increases is hard. It’s even harder to keep your seat in Congress if you try to enact such changes.   

More recently, the Federal Reserve has been forced to help fund today’s deficits and those of years past. We can debate the merits of such irresponsible behavior all day, but for investors, it’s much more critical to assess how the Fed and Treasury might keep the debt scheme going when QE is not an option.

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Borrowing For Deficits

Before spreading rumors about a new variation of QE, let’s review the problem. The graph below shows the widening gap between federal spending and tax receipts. Literally, the gap between the two lines amounts to the cumulative Federal deficit. Instead of plotting deficit data, we prefer outstanding total federal debt as it better represents the cumulative onus of deficits.

treasury deficits expenditures and tax revenues debts

The graph below shows the Treasury debt has grown annually for the last 57 years by about 1.5% more than the interest expense. Such may not seem like a lot, but 57 years of compounding makes a big difference.  

Declining interest rates for the last 40+ years are to thank for the differential. The green line shows the effective interest rate has steadily dropped until recently. Even with the current instance of higher interest rates, the effective interest rate is only 3.00%.

treasury debt

Fiscal Dominance

The Fed has been increasingly pressed to help the U.S. Treasury maintain the ability to fund its debt at reasonable interest rates. In addition to presiding over lower-than-normal interest rates for the last 30 years, QE helps the cause. By removing Treasury and mortgage-backed securities from the market, the market can more easily absorb new Treasury issuance.

Fiscal dominance, as we are experiencing, occurs when monetary policy helps the Treasury fund its debts. Per The CATO Institute:

Fiscal dominance occurs when central banks use their monetary powers to support the prices of government securities and to peg interest rates at low levels to reduce the costs of servicing sovereign debt.

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2019 Revisited

In 2019, before the massive pandemic-related deficits, government spending ramped up over the prior few years due to higher spending and tax cuts. In September 2019, the repo markets strained under the pressure of the growing Treasury demands. The banks had plenty of securities but no cash to lend. For more information on the incident and the importance of liquidity in maintaining financial stability, please read our article, Liquidity Problems.

When a bank, broker, or investor can’t borrow money despite being willing to post U.S. Treasury collateral, that is a clear sign that the banking system lacks liquidity. That is exactly what happened in 2019.

The Fed came to the rescue, offering QE and lowering interest rates.

Shortly later, in March 2020, government spending blossomed with the pandemic, and the Fed was quick to help. As we shared earlier, the Fed, via QE, removed over $5 trillion of assets from the financial markets. That amount was on par with the surge of government debt.

The Fed is mandated to manage policy to achieve maximum employment and stable prices. Mandated or not, recent experiences demonstrate the Fed has become the de facto lender to the Treasury, albeit indirectly.

The Fed Is In Handcuffs

While Jerome Powell and the Fed might like to help the government meet their exorbitant funding needs with lower interest rates and QE, they are shackled. Higher inflation resulting from the pandemic and fiscal and monetary policies force them to reduce their balance sheet and keep rates abnormally high.

Unfortunately, as we wrote in Liquidity Problems, the issuance of Treasury debt rapidly drains excess liquidity from the system.

While the Fed hesitates to cut rates or do QE, they may have another trick up their sleeve.

Spreading Rumors

The following is based on rumors from numerous sources about what the Fed and banking regulators may do to alleviate funding pressures and liquidity shortfalls. 

Banks have regulatory limits on the amount of leverage they can employ. The amount is set by the type and riskiness of assets they hold. For instance, U.S. Treasuries can be leveraged more than a loan to small businesses. A dollar of a bank deposit may allow a bank to buy $5 of a Treasury note but only lend $3 to a riskier borrower.

The regulatory structure currently recognizes eight Global Systematically Important Banks (GSIB). They are as follows:  Bank of America, The Bank of New York, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, and Wells Fargo & Company.

Rumor has it that the regulators could eliminate leverage requirements for the GSIBs. Doing so would infinitely expand their capacity to own Treasury securities. That may sound like a perfect solution, but there are two problems: the banks must be able to fund the Treasury assets and avoid losing money on them.  

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BTFP To The Rescue Again

A year ago, the Fed created the Bank Term Funding Program (BTFP) to bail out banks with underwater securities. The program allowed banks to pledge underwater Treasury assets to the Fed. In exchange, the Fed would loan them money equal to the bond’s par value, even though the bonds were trading at discounts to par.

Remember, since 2008, banks no longer have to book gains or losses on assets unless they are impaired or sold.

In a new scheme, bank regulators could eliminate the need for GSIBs to hold capital against Treasury securities while the Fed reenacts some version of BTFP. Under such a regime, the banks could buy Treasury notes and fund them via the BTFP. If the borrowing rate is less than the bond yield, they make money and, therefore, should be very willing to participate, as there is potentially no downside.

The Fed still uses its balance sheet in this scheme, but it could sell it to the public as a non-inflationary action, as it did in March 2023 when the BTFP was introduced.

Summary

The federal government’s escalating debt and interest expenses underscore the challenges posed by prolonged deficit spending. The problem has forced the Fed to help the Treasury meet its burgeoning needs. The situation becomes more evident with each passing day.

The recently closed BTFP program and rumors about leverage requirements provide insight into how the Fed might accomplish this tall task while maintaining its hawkish anti-inflationary policy stance.  

Quartz The Underappreciated Economic Lynchpin

In Spruce Pine, North Carolina, one small area supplies the world with high-purity quartz. Spruce Pine Quartz ranks among the world’s most important economic minerals. The following description is courtesy of a Wired article entitled- The Ultra pure, super-secret sand that makes your phone possible.

“Spruce Pine, it turns out, is the source of the purest natural quartz—a species of pristine sand—ever found on Earth. This ultra‑elite deposit of silicon dioxide particles plays a key role in manufacturing the silicon used to make computer chips. In fact, there’s an excellent chance the chip that makes your laptop or cell phone work was made using sand from this obscure Appalachian backwater….”

Conway’s Material World points to a concern regarding the importance of quartz from Spruce Pine: They claim that if terrorist sabotage of the mines occurred, “you could end the world’s production of semiconductors and solar panels within six months.” They note that the industry could adapt without the quartz, but finding a new process or alternative substance could result in a “grisly few years.” Given the importance of semiconductors, such a chip shortage would devastate the global economy.

quartz

What To Watch Today

Earnings

  • No notable earnings releases.

Economy

Economic Calendar

Market Trading Update

Yesterday, as has been the case for the last several months, the market rallied off the 20-DMA as the algos kicked in to buy the mega-capitalization stocks. With “On Balance” volume turning lower and the price-momentum oscillator (PMO) closing in on a “sell signal,” we may be approaching the corrective phase of this bullish advance. However, we have discussed that risk over the last several weeks, and the market has continued to climb slowly.

While this continues to be a “boy who cried wolf” scenario at the moment, it is important not to get lulled into a sense of complacency. As in the old fable, once the sheepherders stopped responding to the boy’s cries of danger, the wolves devoured the sheep. In the case of the markets, ignoring the warning signs in a market lulled into complacency is easy. However, as is always the case, when you stop paying attention to the warning signs, the “wolves” find their prey.

Market Trading Update

Equity Allocations Are At Cautionary Levels

The following analysis and graph are courtesy of Jim Colquitt via his Substack service. The blue line in his graph below shows the percentage of an average individual’s portfolio allocated to equities. For instance, currently, it is nearly 50%. In 2021, it peaked at its highest point since 1999. It then declined with the market from two standard deviations to one but remained historically high. Again, it is approaching two standard deviations as sentiment runs high in the equity market. So, what might this mean for future equity returns? Per Jim:

The yellow line in the chart shows the “10-Year Forward Annualized Price Return” of the S&P 500 Index. This tells us what the 10-year forward return was for the S&P 500 Index from the corresponding point on the blue line. This line maps to the right-hand scale of the chart and the values have been inverted to better show the relationship between the two metrics.”

His conclusion is not that we should expect negative returns annually for the next ten years. Instead:

It is important to remember that this does not suggest that the S&P 500 is going to return -1.19% each year for the next 10 years. Instead, it suggests that over the next 10 years, the annualized return over that entire 10-year period will be somewhere in the ballpark of -1.19%.This likely means that we will have a recession or two over that 10-year period which will be accompanied by outsized drawdowns followed by outsized rallies all of which culminating in a 10-year annualized return of somewhere in the neighborhood of -1.19%.

This chart serves as an important warning. However, and this is important, the indicator doesn’t warrant staying out of equities for the next ten years. It does warrant paying close attention to the risks you are taking and knowing where the exits are. It also argues that active management will likely be well rewarded over the next ten years versus a passive approach.

average investor allocation vs ten year returns

Got Energy?

As shown below, using our Relative Analysis tool, the energy sector (XLE) is now the most overbought sector compared to the S&P 500. For good stretches of the last six months, energy was among the most oversold sectors. Over the last month, energy has been the leading sector, up 5.19%. The following graph from Sentimentrader argues that the energy sector may continue to do well. It shows we are entering a seasonally bullish time for the sector.

relative analysis energy xle vs S&P 500
energy xle seasonality

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Blackout Of Buybacks Threatens Bullish Run

With the last half of March upon us, the blackout of stock buybacks threatens to reduce one of the liquidity sources supporting the bullish run this year. If you don’t understand the importance of corporate share buybacks and the blackout periods, here is a snippet of a 2023 article I previously wrote.

“The chart below via Pavilion Global Markets shows the impact stock buybacks have had on the market over the last decade. The decomposition of returns for the S&P 500 breaks down as follows:

  • 6.1% from multiple expansions (21% at Peak),
  • 57.3% from earnings (31.4% at Peak),
  • 9.1% from dividends (7.1% at Peak), and
  • 27% from share buybacks (40.5% at Peak)
Buyback contribution

Yes, buybacks are that important.

As John Authers pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

In other words, between the Federal Reserve injecting massive liquidity into the financial markets and corporations buying back their shares, there have been no other real buyers in the market. 

Given the increasing amount of corporate share buybacks, with 2024 expected to set a record, the importance of that activity has been a critical support for asset prices. As we noted in October 2023, near the bottom of the summer correction:

“Three primary drivers will likely drive markets from the middle of October through year-end. The first is earnings season, which kicks off in two weeks, negative short-term sentiment, and the corporate share buyback window reopens from blackout in November.”

Notably, since 2009, and accelerating starting in 2012, the percentage change in buybacks has far outstripped the increase in asset prices.

Share buybacks vs SP500

As we will discuss, it is more than just a casual correlation, and the upcoming blackout window may be more critical to the rally than many think.

A High Correlation

Unsurprisingly, the market rally that began in November correlated with a strong surge in corporate share repurchases. Interestingly, while the media touts the strong earnings growth shown in the recent reporting period, such would not have been the case without the surge in buybacks.

Share buybacks vs earnings

The result is not surprising given that the majority of earnings growth for the quarter came from the companies that are the most aggressive with share repurchases. However, given current valuation levels, it should make one question precisely what you are paying for.

Nonetheless, the buyback surge has supported the market surge since the October 2023 lows. We saw the same at the bottom of the market in October 2022. The chart shows the 4-week percentage change in share buybacks versus the S&P 500.

Share buybacks 4-week percent change versus the market.

The end of October tends to be the inflection point for the market, particularly over the last few years, because that is when the blackout period for share buybacks fully ends. While many argue that buybacks have little to do with market movements, a high correlation exists between the 4-week percentage change in buybacks versus the stock market. More importantly, since the act of share repurchases provides a buyer for those shares, the .85 correlation between the two suggests this is more than just a casual relationship.

Correlation of share repurchases 4-week percentage change to the S&P 500.

Investors Are Really Bullish

Currently, investors are very exuberant about the current investing environment. As discussed in “Market Top or Bubble?”, little seems to deter investor enthusiasm.

“The ongoing ‘can’t stop, won’t stop’ bullish trend remains firmly intact.

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

Sentiment vs the market.

At the same time, professional managers are also very bullish and are leveraging portfolios to chase returns. When professional investor allocations exceed 97%, such has historically been close to short-term market peaks.

Professional managers buy tops.

The risk to these more optimistic investors is that with the blackout period beginning, corporate demand, the largest buyers of equities, will drop by 35%. Therefore, given the correlation between buybacks and the market, a reversal of that corporate demand could lead to a market decline. Any decline will likely lead to a reversal of positioning by investors, further exacerbating that correction process.

While there is no guarantee of anything in the markets, it is likely a short-term risk worth paying attention to.

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The Fed Will Support Buybacks

While the blackout of share buybacks may lead to a short-term market correction, the Federal Reserve may provide additional support over the long term.

The Federal Reserve has been transparent and likely done with hiking interest rates for this cycle. Given the massive surge in the Fed funds rate, the economy has withstood that impact quite well. Of course, the reason was the enormous surge in fiscal support through deficit spending and a massive increase in the M2 money supply as a percentage of GDP.

m2 and the deficit as a percentage of the economy.

However, if the Federal Reserve lowers interest rates, it will reduce corporate borrowing costs, which has historically been a boon for share buybacks. Such is particularly the case for large corporations like Apple (AAPL), which can borrow several billion dollars at low rates and buy back outstanding shares. As shown, share buybacks rose sharply following the “Financial Crisis” but slowed during periods of higher rates. Corporations are now “front-running” the Federal Reserve in anticipation of increased monetary accommodation.

Buybacks vs the Fed funds rate

With corporate buybacks on track to set a new record this year, exceeding $1 Trillion, corporations will need lower rates to finance the purchases.

Goldman Sachs estimates of share repurchases.

Conclusion

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

Even if you are incredibly bullish on the markets, healthy bull markets must occasionally be corrected. Without such corrections, excesses are built, leading to more destructive outcomes.

What causes such a correction is always unknown. While the removal of buybacks temporarily may lead to a price reversal, those buybacks will return soon enough. And with $1 trillion in anticipated purchases, that is a lot of support for asset prices this year.

Does this mean the market will never face another “bear market?”

Of course not. There is a consequence for buying back shares at a premium. As Warren Buffet recently wrote:

“The math isn’t complicated: When the share count goes down, your interest in our many businesses increases. Every small bit helps if repurchases are made at value-accretive prices.

Just as surely, when a company overpays for repurchases, the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases.

Eventually, the detachment of the financial markets from underlying economic realities will be reverted.

However, that is not likely a problem we will face between now and year-end.

CRE Loans Threaten Regional Banks

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

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

goldman sachs cre loan data

What To Watch Today

Earnings

  • No notable earnings releases today

Economy

Economic Calendar

Market Trading Update

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

Market Trading Update

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

As we stated last week:

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

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

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

The Week Ahead

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

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

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

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

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

rsp vs spy perfromance

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Household Equity Allocations Suggests Caution

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

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

25% increase in 10-months.

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

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

Every bubble has two components:

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

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

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

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

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

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

An Economic Underpinning

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

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

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

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

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

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

Household equity ownership vs SP500

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

Household equity vs valuations

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

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

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

Household equity allocations vs 10-year forward returns

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

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

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

Global Equity risk

The only question is what eventually reverses that psychology.

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A Disappointment Of Hopes

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

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

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

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

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

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

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

Cumulative change in profits vs the market

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

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

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

MicroStrategy Investors Are Buying Bitcoin At A Massive Premium

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

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

microstrategy valuations

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

Market Trading Update

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

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

Magnificent 7

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

Market Capitalization of Momentum Stocks

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

Retail Sales and PPI

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

retail sales

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

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

More On Coming Liquidity Shortages

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

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

liquidity rrp treasury bills

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Sticky Inflation And Fed Policy In Context

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

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

fed funds vs cpi monetary policy and sticky inflation

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

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

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

Market Trading Update

Add Cocoa To The List Of “Mooning” Assets

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

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

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

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

cocoa nvidia and bitcoin

Nvidia Put Call Skew Shows Extreme Sentiment

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

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

nvda put call skew
nvda put call skew

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Blackrock Works For Blackrock Not You

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

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

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

blackrock bitcoin ishares etf

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

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

market trading update

CPI Remains Sticky

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

contribution to cpi

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

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

cpi inflation less shelter

The Labor Outlook Is Deteriorating

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

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

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


Tweet of the Day

deteriorating labor market

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Bougie Broke The Financial Reality Behind The Facade

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

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

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

The Wealth Divide Disclaimer

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

Bill Gates and I walk into the bar…

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

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

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

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

the wealth divide

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

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

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Revenge Spending

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

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

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

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

The Means To Consume 

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

Savings

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

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

personal savings

More on Insufficient Savings

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

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

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Debt

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

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

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

credit card debt

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

consumer loans credit cards and wages

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

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

Wage Growth

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

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

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It’s All About Employment

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

the unemployment rate

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

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

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

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

Summary

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

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

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

Digital Currency And Gold As Speculative Warnings

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

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

Dumb money index vs market

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

Net Smart Dumb Money vs Market

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

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

Investor Enthusiasm

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

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

Nvidia Price To Sales

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

Birds Of A Feather

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

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

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

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

“Standard Deviation” is defined as:

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

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

Standard Deviation Chart

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

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

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

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

NVDA chart vs Bollinger Bands

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

Gold vs Bollinger Bands

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

Bitcoin vs Bollinger Bands

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

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It’s All Relative

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

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

SP500 vs Gold

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

SP500 vs Bitcoin

Just for added measure, here is Bitcoin versus gold.

Gold vs Bitcoin

Not A Recommendation

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

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

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

Miners Fail To Keep Up With Gold And Bitcoin Rally

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

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

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

gold, bitcoin and their miners

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

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

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

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

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

“Standard Deviation” is defined as:

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

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

Standard Deviation Chart

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

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

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

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

NVDA chart vs Bollinger Bands

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

Gold vs Bollinger Bands

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

Bitcoin vs Bollinger Bands

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

Japan Exiting Negative Interest Rates Risks Carry Trade Unwind

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

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

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

Asking Vs. In-Place Rents

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

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

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

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

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

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

asking rents vs in place rents cpi fed

Tweet of the Day

us office vacancy rate

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Household Versus Headline- Which Employment Report Is Right?

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

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

household vs headline jobs surveys

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable economic reports

Market Trading Update

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

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

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

Market Trading Update

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

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

The Week Ahead

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

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

The Fed will go on a media blackout this week.

Expect More Underwhelming Economic Data

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

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

atlanta fed gdp now
citi economic surprise index

Tweet of the Day

S&P 500 up 25%

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Why Are Financial Conditions Easing?

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

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

financial conditions and borrowing conditions

What To Watch Today

Earnings

  • No notable earnings releases today

Economy

Economic Calendar

Market Trading Update

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

Bank reserves and the market

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

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

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

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

Market Tops are A process

Trade accordingly.

NYCB Is Given A Lifeline, But Not By Uncle Sam

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

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

nycb bank stock

More On The JOLTs Quit Rate

Yesterday’s Commentary stated:

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

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

quit rate and labor market
quit rate and employee compensation

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Presidential Elections And Market Corrections

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

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

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

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

Presidential Election Stock Market Cycle

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

Deviation of SP500 from 200-DMA

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

Deviation of market from 52-Week M/A

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

Will Policies Matter

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

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

GDP growth vs debt issuance

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

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

Average election year market performance.

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

Election year performance ex-2008 compared with YTD.

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

Election Year Performance bull and bear periods

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

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The Great Divide

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

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

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

Political Division in the US

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

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

Gridlock stock market performance

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

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

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

These risks are all undoubtedly possible.

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

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

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Portfolio Positioning For An Unknown Election Outcome

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

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

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

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

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

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

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

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

Bitcoin Declined 13% Intraday Again

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

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

bitcoin drawdowns

What To Watch Today

Earnings

Earnings calendar

Economy

Economic Calendar

Market Trading Update

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

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

Remain long but continue to manage portfolio risk accordingly.

Market Trading Update

Jerome Powell Testifies To Congress

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

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

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

fed fund futures probability analysis

JOLTs And ADP Point To A Moderating Labor Market

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

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

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

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

Tweet of the Day

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Paul Volcker Warns The Fed

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

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

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

paul volcker

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

Market Trading Update

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

Money Flow Weekly Index

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

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

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

target and walmart stock

ISM – Service Sector Showing Declining Inflationary Pressures

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

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

ism prices and cpi

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Liquidity Problems Are Closer Than You Think

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

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

Why The Fed Is So Important For Investors

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

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

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

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

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

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

What Does RRP Accomplish?

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

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

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

The Current Status Of RRP

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

fed RRP reverse repurchase program

Excess Liquidity Is Vanishing

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

However, excess liquidity is diminishing rapidly.

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

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

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Revisiting 2019

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

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

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

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

The graph below highlights when the Fed quickly reversed course.

fed funds, fed balance sheet, liquidity shortage of 2019

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

The Fed Is Prepping For Liquidity Problems

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

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

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

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

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

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

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

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

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

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

Further, she notes:

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

Summary

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

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

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

Valuation Metrics And Volatility Suggest Investor Caution

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

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

BofA Valuation Measures

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

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

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

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

Consumer confidence vs valuations

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

 I previously quoted Cliff Asness on this issue in particular:

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

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

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

Valuations and forward returns

Asness continues:

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

Which brings me to Warren Buffett.

Market Cap To GDP

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

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

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

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

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

Market Cap to GDP Ratio

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

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

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

Market Cap To GDP Ratio vs forward 10-year Returns

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

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

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F.O.M.O. Trumps Fundamentals

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

Notice, I said eventually.

As David Einhorn once stated:

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

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

Furthermore, as James Montier previously stated:

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

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

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

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

Regardless, there is a straightforward truth.

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

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

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

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

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

Nvidia Is Aiming For Apple and Microsoft

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

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

nvidia overtakes Aramco's market value

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

Weekly Performance of Market

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

Cup and Handle Formation

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

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

Survey Fatigue Can Mar Important Economic Data

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

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

survey response rates employment data

SMCI And The Russell Small Cap Index (IWM)

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

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

super micro computer SMCI

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Junk Bonds And Bitcoin Scream Wild Exuberance

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

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

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

junk bond spreads and bitcoin

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable reports are due today.

Market Trading Update

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

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

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

Market Trading Update

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

Sentiment Indicator Goldman Sachs

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

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

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

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

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

The Week Ahead

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

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

The Bank of England May Exit QE

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

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

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

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

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

fed assets QT and QE BOE

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