The number of publicly listed U.S. companies has significantly decreased, from 7,300 to 4,300 in the last 30 years. At the same time, the number of private companies has risen fivefold. Per a Bloomberg article entitled The Stock Market Is Becoming A Dumping Ground, Jamie Dimon attributes the decline in the number of public companies to “increasingly burdensome regulation, intensifying public scrutiny and a growing obsession with short-term financial results.” Not only is it more challenging to operate a publically traded company for the reasons Dimon lists, but private capital has become a much more significant funding source. The graph below, courtesy of Moonfare, shows that the total market cap of public companies has risen marginally on a global basis. Compare that to the significant growth of private equity firms.

The ongoing shift from public to private should raise concern for individual investors. Most individuals can not invest in private equity funds due to SEC wealth requirements. Additionally, most 401k retirement plans don’t offer private equity options. This leaves a large percentage of individuals limited to investing in public companies. If newer companies with outsized growth prospects are more incentivized to stay private versus going public, individual investors, by default, are stuck with slower-growth companies. Per the Bloomberg article mentioned above:

Look at the Russell 2000 Index, probably the best-known tracker of small public companies. In 1995, the index’s profitability, as measured by return on equity, was 7.8%. It has trended lower ever since, and this year, Wall Street analysts expect an ROE closer to 2.4%. The same trend is apparent when looking at other measures of profitability, including return on capital or assets.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

Yesterday, we touched on some interesting commentary from Sentiment Trader on the surge in Gold prices. In the meantime, stocks have finally given in to some selling pressure over the last couple of days as the market retreated to retest support at the previous market highs. The more important development was the triggering of the short-term “sell signal,” which suggests that we could continue to see pressure on the markets heading into the election.

However, it is worth noting that the selloff so far has been mild and was running in front of today’s employment report that will likely confirm the Federal Reserve’s next move. If the employment number is very strong, it may disappoint market participants who are hoping for an additional 50-bps rate cut in November. However, a too weak number could concern investors about the potential for sharper economic contraction. Like Goldilocks, the number must be weak enough to support a 50-bps rate cut but not too weak to raise recession fears.

While the short-term market outlook is mixed, the longer-term trend remains bullish, as shown by our SimpleVisor Weekly Money Flow indicator. That indicator remains on a solid buy signal and does not indicate bearish market risk over the next few weeks. As shown, the last buy signal was triggered in mid-January 2023, and despite some bumps along the way, has kept portfolios allocated toward equity risk.

The next week will likely determine the markets next direction, so continue to manage risk accordingly.

ISM Services Jump

The ISM services sector survey jumped this past month to 54.9, indicating robust economic activity. At 54.9, ISM services are at the highest level since February 2023. Price paid also increased, rising to 59.4 from 57.3 last week. The only fly in the ointment was the employment index, which fell into contractionary territory at 48.1. As you may recall, the ISM manufacturing employment figure dropped to 43.9 from 46. Could the economy be accelerating while job growth slows? Such an instance would certainly be uncommon, but we have seen far stranger things over the past four years.

Oil Prices Surge On Israeli Threats

Only a few days ago, oil prices were breaking down as OPEC leading countries showed signs of disagreement and the global economy appeared to weaken. Oil prices reversed course over the last few days as Iran struck back at Israel with a barrage of rockets. Now, the concern is what Israeli retaliation will look like. It appears, based on comments from President Biden, attacks on Iran’s energy infrastructure are being discussed.

Iran is the world’s seventh-largest oil producer and the third-largest OPEC producer. If they had to shut down production, Saudi Arabia and other countries would not likely be able to make up Iran’s missing supply. Furthermore, if Israel were to target Iranian oil production, would Iran strike out against Saudi and Kuwaiti oil production facilities? Given oil prices are “only” up less than 10% over the past few days, the market seems to be discounting a widespread attack on Iranian oil and escalation to other countries. However, caution is warranted as market opinions can change on a dime.

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As the November 2024 election draws near, the election outcome will profoundly affect the financial markets. Whether Donald Trump or Kamala Harris wins the presidency, each administration will bring distinct policies creating investment opportunities and potential risks for investors. With a divisive political landscape, it is crucial to understand how these potential outcomes can shape the stock market and your portfolio strategy.

Let’s break down the key sectors that stand to gain from a Trump or Harris presidency and explore the risks investors should be aware of heading into this election outcome.

Investment Opportunities in a Trump Presidency

Energy & Fossil Fuels

If Trump wins, that election outcome will likely favor the traditional energy sector, with policies designed to roll back regulations from the current Administration that have restricted oil and gas exploration. During Trump’s previous term, he aggressively pursued pro-energy policies, resulting in a boom for fossil fuel companies like ExxonMobil (XOM) and Chevron (CVX). As shown in the chart below from the U.S. Energy Information Administration, crude oil exports surged from 1 million barrels per day in 2017 to 3.5 million in 2020. During a second term, Trump’s emphasis on deregulation and energy independence could lead to a similar boost.

Investors should look for growth opportunities in large oil producers and service companies like Diamondback Energy (FANG), which directly benefit from increased production.

Defense and Aerospace

Defense spending is another area that would benefit from a Trump election outcome. Trump has been a strong proponent of increasing military spending to modernize and strengthen national security. Such policies historically benefited defense contractors such as Lockheed Martin (LMT) and Raytheon Technologies (RTX). These companies will likely see further government contracts and funding for military expansion, making them attractive investments. Given that defense spending increases in Democratic and Republican administrations, such will likely be the case again. Lastly, defense stocks are also typically defensive in uncertain market environments and are generally very stable dividend payers.

Financials and Banking

A Trump election outcome is also expected to favor the financial sector through further deregulation. Trump has already demonstrated a willingness to roll back restrictions imposed by Dodd-Frank, making it easier for financial institutions to operate with less oversight. This would benefit large banks such as JPMorgan Chase (JPM) and Goldman Sachs (GS). However, larger regional banks like Truist Financial (TFC) and PNC Bank (PNC), which have struggled amid higher interest rates during the previous administration, would also benefit.

A stronger economy, reduced regulatory restrictions, and lower interest rates from the Federal Reserve would create higher profitability, reduced compliance costs, and less collateral impairment. Additionally, as discussed in “Tax Cuts And TCJA,” Trump’s policies may favor continued corporate tax cuts, boosting bank earnings and shareholder returns.

Investment Opportunities in a Harris Presidency

While Kamala is not the incumbent, she represents a likely continuation of the current administration’s policies.

Clean Energy and Sustainability

If Kamala Harris wins the election, it will likely create a tailwind for the clean energy sector. Following the Inflation Reduction Act, which allocated more than $800 billion to climate change-related projects, Harris will likely promote policies to increase investment in renewable energy sources. Companies involved in solar, wind, and energy storage, such as NextEra Energy (NEE), First Solar (FSLR), and Tesla (TSLA), would stand to benefit. However, it is notable that more than 100 solar-related companies have filed for bankruptcy in 2024, so investors must remain prudent about individual company fundamentals. Investors could consider clean energy ETFs, such as ICLN (iShares Global Clean Energy ETF), to gain exposure to a broad range of companies that could benefit from government subsidies, tax incentives, and infrastructure projects focused on sustainability.

Healthcare and Pharmaceuticals

Harris’s healthcare agenda is expected to focus on expanding access to healthcare, strengthening the Affordable Care Act, and implementing policies to reduce prescription drug prices. This could benefit both large pharmaceutical companies like Pfizer (PFE) and Johnson & Johnson (JNJ), as well as healthcare providers and insurers like UnitedHealth Group (UNH).

Additionally, with an increased focus on public health, biotech companies involved in innovative medical research and vaccine development could also experience growth. Investors should watch stocks related to healthcare services and medical device innovation.

Technology and Innovation

Harris has consistently supported advancing technology and innovation, particularly in artificial intelligence (AI), cybersecurity, and 5G infrastructure. Companies like NVIDIA (NVDA), Microsoft (MSFT), and Alphabet (GOOGL) are well-positioned to benefit from increased government support for technological infrastructure and research. With a Harris election outcome, investors can expect further investments in tech sectors that improve digital access and data privacy protections. This may also boost demand for cybersecurity solutions, benefiting companies specializing in this area. For further analysis, read our report on the coming demand for electricity needed by artificial intelligence.

Conclusion: Risks and How to Mitigate Them

Regardless of who wins, the election outcome presents certain risks that investors must consider. Election years often bring increased volatility, and this cycle is no exception. Here are the key risks and strategies to manage them:

• Tax Policy Uncertainty: A Harris presidency could bring corporate tax hikes, which may negatively impact the profitability of tech and financial companies. In contrast, a Trump presidency may lower taxes but could lead to growing deficits and potential inflationary pressures. Investors should stay informed of potential tax changes and consider shifting some assets to tax-advantaged accounts or dividend-paying stocks to cushion against negative impacts.
• Interest Rate and Inflation Risks: Both administrations will face challenges managing inflation and interest rates. As the Federal Reserve cuts rates, there is a risk of a resurgence of inflation. Investors should consider diversifying into sectors less sensitive to rate changes and focus on fundamentals and dividend payout histories.
• Healthcare Sector Volatility: A Harris administration may introduce new healthcare regulations that could compress margins for some pharmaceutical companies. While expanded healthcare access could benefit healthcare service providers, introducing pricing controls could create downside risks for drug manufacturers. Investors should maintain a diversified exposure to the healthcare sector, balancing risk with potential gains from policy-driven expansion.

How to Protect Your Portfolio

• Diversification: Spreading investments across sectors that could perform well under either administration—like clean energy, defense, and healthcare—can help mitigate risks tied to the election outcome. Maintaining a balance between growth stocks and defensive sectors can help weather volatility.
• Dividend-Paying Stocks: Companies with strong dividend histories, like Procter & Gamble (PG) and Coca-Cola (KO), can provide income during market uncertainty and reduce portfolio volatility.
• Follow Your Risk Management Discipline: As we often discuss, a healthy regime of taking profits, rebalancing portfolios, moving up stop-loss levels, and increasing cash balances can help mitigate portfolio risk during periods of uncertainty.

I have no idea how the election will turn out in November. However, like every election outcome, investors will have opportunities and face risks. Whether it’s Trump’s pro-energy and defense stance or Harris’s focus on clean energy and healthcare, positioning your portfolio for the post-election market requires careful consideration. Staying diversified, preparing for volatility, and managing risks will be key to navigating whatever outcome lies ahead.

Disclosure: RIA Advisors has positions in most or all of the specific stocks and ETFs mentioned in this article for its clients. This discussion is not a recommendation to buy or sell anything, and RIA Advisors may or may not own some of these positions at the time of publication. In no way should any of the information in this informational blog be considered a recommendation, solicitation, or advertisement. This blog is for educational and informational purposes only; past performance does not guarantee future results.

Despite some fearmongering in the media, the longshoremen strike, shutting down 14 major East Coast ports, is unlikely to have severe economic repercussions or result in a 2021-2022-like jump in inflation. Estimates suggest the economy could lose between $4 to $8 billion of economic activity each week the strike continues. America’s latest GDP figure was $29 trillion annually. Assuming the $8 billion upper end of the forecast, each week the port strike lasts, GDP will decrease by .027%. Even if the port strike lasts an entire quarter, it will only shave a third of a percent from GDP. Keep in mind that, for the most part, economic activity is not lost due to the strike; it’s just delayed.

The other fear is that shipping delays and shortages could increase inflation. There is a growing likelihood that if the strike continues, the supply of some goods, especially food, autos, and electronics, will decline, which may cause temporary price increases. However, unlike what we witnessed a couple of years ago, the demand for goods is not grossly elevated, and all other supply chains fully function. Furthermore, as the Bloomberg graph below shows, the inventory-to-sales ratio of affected industries is the most elevated except for 2009 and 2020. With excess inventories to help offset reduced supply and normal levels of demand, the odds of the strike creating systematic inflation are small. That said, the prices of some goods, especially food items that spoil quickly, could temporarily increase.

It is also important to note that if the port strike does last a while, the Fed and markets will look at data sans the strike effects. They will consider it temporary, as they often do with severe storms that can economically cripple a region.

What To Watch Today

Earnings

Economy

Market Trading Update

In yesterday’s note, we discussed the surge in oil prices due to the Iran/Israel escalation. Regarding commodities, prices are not set by just economic supply/demand factors. Prices are set primarily by futures traders on the NYMEX, which makes prices quite detached from long-term means. I recently touched on this issue relating to Gold prices, but I thought this recent analysis for Sentiment Trader affirmed what my previous analysis suggested.

“Despite a jump on renewed geopolitical tensions, gold didn’t quite reach another record high on Tuesday. Even so, it remains oh-so-close and on the cusp of adding to its 37 new highs in the past year, similar to a stretch in early 2020. A rolling one-year total of 37 new 52-week highs is impressive. During the past 50 years, there haven’t been many streaks like this, most confined to the great bull runs of the late 1970s and early 2000s.”

“The overall suggestion for gold investors is that more gas should be in the tank before a substantial pullback. There are many trend-following systems to help determine when that exit signal might occur, but using a simple 50-day moving average proved to be an okay heads-up that the momentum had run its course.“

Soaring gold prices always unnerve equity investors, who think that “gold knows something,” which makes people nervous about their stocks. However, there isn’t much to that theory. In reality, gold prices are usually a reflection of increasing bullish sentiment. As shown, all sectors tend to perform well after a surge in gold prices, with energy outperforming the most.

As we discussed in the “Everything Market,” the recent surge in gold prices reflects increasing bullish sentiment and too much money chasing too few assets.

Sentiment Trader concludes:

“Sentiment has become extremely optimistic, which is troublesome because its returns have been poor after extremes like this. Even so, there are times when momentum rules all and can steamroll sentiment or any other factor. We seem to be in one of those moments.”

Trade accordingly.

Oil And Bonds

Our recent Commentary from September 27 discussed a rumored breakdown of OPEC. The rumor came as oil prices traded bearishly and sat on critical support. Over the last two days, oil prices have surged on escalating concerns regarding Israel and Iran. Both the trend lower and the recent price spike have implications for inflation and, therefore, bond yields.

Oil prices and inflation often have a strong correlation. Accordingly, when inflation runs higher than average, the change in oil prices can significantly impact bond yields. The first graph below, courtesy of Game of Trades, shows that during the recent period of heightened inflation awareness, sizeable declines in the price of crude oil aligned with decreases in bond yields. The second graph from Game of Trades shows that stocks do well when oil prices have fallen over the last year. This, too, makes sense as lower oil prices lead to lower inflation. Moreover, lower inflation leads to Fed rate cuts. Maybe the recent stock market rally is due to weaker oil prices and its impact on inflation and, ultimately, the Fed.  

If the Middle East conflict is relatively short-lived and the trend lower in oil prices resumes, stocks and bonds may continue to do well. However, investors should manage risk carefully if hostilities escalate and the Iranian oil supply is threatened.

The Crystal Ball Challenge

A crystal ball would be an excellent addition to our market analysis arsenal. Advanced knowledge of market, economic, political conditions, and other events would likely positively impact our performance. The impact, however, would be over the longer run, not in the returns immediately following the foreseen events. Trading on a short-term basis with no context can be hazardous to your wealth.

Furthermore, assumptions of a specific result due to particular news are often faulty. As the old saying goes- buy the rumor, sell the news!

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Following the Fed’s somewhat aggressive 50 bps rate cut two weeks ago, the stock and Fed Funds futures markets started to get ahead of themselves. Accordingly, market participants expected the aggressive pace of easing to continue through the remainder of 2024. At one point the Fed Funds futures market was implying the Fed could cut rates by 100 bps in total by year end. On Monday, Powell reset market expectations, pulling up on the reins on the market’s aggressive expectations.

In a speech on Monday afternoon, Powell reminded investors that the Fed’s economic and interest rate projections, aka dot plots, released in mid-September, are still valid. In those projections, 18 of 19 members projected 50 bps of total rate cuts for the remainder of 2024. Instead of letting the market push the Fed into cutting by more than they wanted, Powell reset expectations with a more hawkish tone than he used at the last Fed meeting. In particular, as we quote below, he says the risks are two-sided. Such implies that there are still inflationary forces that can potentially limit the amount of easing. By resetting market expectations, Powell indirectly makes this week’s labor data all the more important. Therefore, if Friday’s BLS data is strong, the market could actually undercut the Fed and price in less than 50 bps of rate cuts through year-end.

Looking forward, if the economy evolves broadly as expected, policy will move over time toward a more neutral stance. But we are not on any preset course. The risks are two-sided, and we will continue to make our decisions meeting by meeting. As we consider additional policy adjustments, we will carefully assess incoming data, the evolving outlook, and the balance of risks. Overall, the economy is in solid shape; we intend to use our tools to keep it there. – Jerome Powell 9/30/24

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday’s commentary discussed the market breadth indicators that send both a bullish and bearish warning. Rising breadth is bullish as it signals healthy market participation. However, it is also bearish that when breadth measures are very elevated, it typically denotes that “buyers” are “all in.” When market breadth, regarding the percentage of stocks trading above respective moving averages, is high, any negative headline can spark a wave of selling. Such is what we saw yesterday as news of more saber-rattling between Iran and Israel put markets on edge.

Critically, we had previously discussed the deeply oversold conditions of the oil market and that something would occur that could spark a reversal of oil prices, forcing short-sellers to cover. The Israel/Iran news fit that bill, and oil posted sharp gains yesterday, pulling energy stocks up with them. From a technical view, both the MACD and RSI indicators are forming higher lows along with the price of oil. There is overhead resistance at the 200-DMA around $73/bbl, but a break above that level will cause a short-squeeze, moving oil prices to $77.

We are maintaining our long oil positions and will look for additional confirmation to add to those holdings.

Trade accordingly.

JOLTs Remains Weak Under The Hood And ISM Confirms

The headline JOLTs job openings number remains relatively strong at 8 million. That figure was up by about 300k jobs. However, under the hood, the data continues to point to growing weakness. As we share below, the new hires and quits rates continue to decline and, in both cases, are well below pre-pandemic levels. The last time the hires level was at current levels the unemployment rate stood around 8%. The way to best characterize the report is a low churn labor market. No one is hiring, firing, or quitting.

ISM Manufacturing was slightly weaker at 47.2, remaining below 50 and therefore pointing to a continued contraction of the manufacturing industry. Also closely followed within the survey are prices and employment. Prices were much cooler than expected, coming at 48.3 below estimates of 53.3 and last month’s 54.0. The employment gauge was also lower than expected at 43.9 versus the consensus estimate of 46.0. The ISM services survey on Thursday will be more telling as the services sectors represent about three-quarters of the economy.

The “Everything Market” Could Last A While Longer

When it comes to what is driving the “everything rally,” everyone has their thesis. The “stock jockeys” suggest that easier monetary accommodation by the Fed and improving earnings are the key drivers for equities. As noted above, the “gold bugs” are seduced by burgeoning government spending and expectations of a dollar decline to loft gold prices higher. Every asset class has its “reason” for going higher, but the real reason may be much simpler. This post will focus on stocks and gold as they garner the most headlines and have the most fervent of “true believers.”

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On September 18, 2024, the headlines read the Fed cut the Fed Funds rate by 50 basis points. At first blush, one would think that a trader with a crystal ball a couple of days before the Fed action would buy bonds and lick their chops over the money they would soon make. In this case, the crystal ball was a curse.

Bond yields rose following the rate cut despite what many investment professionals perceive to be a bullish event. If you scour the media, you will find rationales for the sell-off. Such includes the Fed stoking inflation or China’s massive stimulus package. In our opinion, it’s much more straightforward; it all comes down to context.

We were inspired to write this by a message asking us in disbelief if we had ever seen such an adverse bond market reaction to a rate cut.

To help answer the question, we share an article entitled When A Crystal Ball Isn’t Enough To Make You Rich by Victor Haghani and James White, along with their Crystal Ball Challenge. The article and challenge help us appreciate that context is often more valuable than a crystal ball.  

Technicals Provide Context

On September 18, when the Fed cut interest rates by 50bps, ten-year note yields rose slightly from the opening yield of 3.68% to close the day at 3.69%. Five days later, the yield rose another .12% to 3.81%.

A crystal ball enlightening a trader about the rate cut headlines would have been costly. However, a trader with the crystal ball and proper context may have been more successful. In trading, context describes market conditions and recent trends. On a short-term basis, excellent context can be gleaned from technical analysis.

To contextualize the Fed rate cuts, investors had been expecting a rate cut at the September meeting for months. Furthermore, in the days leading up to the announcement, the odds of a 50bps rate cut increased markedly. The critical context was the 1% decline in ten-year note yields since April, and, equally importantly, bond prices were extremely overbought on a technical basis.

This potential for a bearish reaction to what should have been positive news from the Fed was not lost on us. On September 17, the day before the meeting, we wrote the following summary on bonds in our Daily Commentary:

Yesterday, we discussed the market’s strong rally from the recent lows. However, the bond market has rallied just as strongly ahead of this week’s highly anticipated Federal Reserve meeting and the expected rate cut. As shown, Treasury bonds (as represented by TLT) are quite deviated from the 50-DMA and overbought on multiple levels. While we remain bullish on bonds in the longer term, particularly as the economy slows, the current overbought conditions and “exuberance” into the bond trade over the last few months is a bit overdone.

With the Fed meeting this week, the current setup suggests that even if the Fed cuts rates as expected, this could be a “buy the rumor, sell the news” setup for bonds. Of course, as is always the case, overbought conditions can remain overbought longer than most imagine, so trade accordingly.

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With that example of how context was more valuable than a crystal ball, we let you discover the value of a crystal ball without any context.

The Crystal Ball Challenge

The article noted in the introduction is based on information the authors gleaned by subjecting over 118 young adults schooled in finance to the Crystal Ball Challenge.

Before summarizing the article, click on the crystal ball below. Take the challenge and see what value, if any, a crystal ball with tomorrow’s headlines is in predicting short-term price changes. (LINK)

Review: When A Crystal Ball Isn’t Enough To Make You Rich

Per the whitepaper:

Was Taleb correct in his conjecture that “If you give an investor the next day’s news 24 hours in advance, he would go bust in less than a year”? While our experiment didn’t test his statement precisely – we only gave players 15 days of front pages, players were risking just $100 in the game, etc. – by and large we think Taleb is right.

The 118 young finance professionals posted a meager positive return. Their results were not statistically different than flipping a coin. They attribute the poor results to two factors.

The first was not correctly guessing how stocks and bonds would perform with knowledge of the headlines 36 hours in advance.

Second, the authors claim the players didn’t properly size their bets. We also presume that some traders made trades on headlines that did not affect the markets. In those cases, it was a 50/50 proposition.

Sizing is an important point the authors stress. Trade sizes should have been minimal, or trades should not have occurred when the trader had little confidence their guess was correct. Conversely, they should have had larger sizes when they had more confidence. 

Experience Matters

The article shares a tweet from the very experienced Lloyd Blankfein, ex-Chair of Goldman Sachs. While he tweets about the market action concerning CPI on one specific day, we bet he would agree that, generally, having news before everyone else may not be all it’s cracked up to be.

After testing the younger finance professionals, the authors wanted to see how experienced traders would do. They “invited five seasoned and successful macro traders” to take their test. Once again, they found that advanced knowledge of headlines was not incredibly valuable. The traders got 63% correct. However, they posted an average return of 130%.

These players all finished with gains. On average, they grew their starting wealth by 130%, with a median gain of 60%. All of the players were selective and highly variable in their trade-sizing. They did not bet at all on about 1/3 of the trading opportunities, but bet big on days when they presumably felt confident in the impact of the news on stock or bond prices.

Guessing is a fool’s errand when it comes to investing. However, investing with context and adequately sizing your trades/investments based on your confidence level is vital.

The study, in a roundabout way, shows that context matters. As we opined in the opening, technical analysis can provide significant context as to recent trends, the strength of said trends, and how momentum may change. Furthermore, volume and trade analysis can help us find market pain points and price levels where investors are more likely to buy or sell.

Macroeconomic analysis and appreciation for the liquidity situation of a market are also essential to help bolster your context. Along the same lines, given the importance of actual and perceived liquidity, a good appreciation for the Fed’s current mindset and their current and likely stance on monetary policy is critical.

With proper context, a headline in your crystal ball may prove much more valuable.

Summary

A crystal ball would be an excellent addition to our market analysis arsenal. Advanced knowledge of market, economic, political conditions, and other events would likely positively impact our performance. The impact, however, would be over the longer run, not in the returns immediately following the foreseen events. Trading on a short-term basis with no context can be hazardous to your wealth.

Furthermore, assumptions of a specific result due to particular news are often faulty. As the old saying goes- buy the rumor, sell the news!

Over the last month, China has injected its economy with an incredible amount of monetary and fiscal stimulus, which has resulted in extreme optimism in its stock market. As we share below, the Hang Seng Tech index and the broader China stock market CSI 300 index are up 30-40% over the last few weeks. The lower graphs show that the technical indicators of the two indexes are very oversold. As shown on the bottom left, the China CSI 300 index RSI is approaching a significant peak, which was also associated with extensive stimulus plans in the past. Prior instances have accompanied a boom-bust scenario for Chinese stocks.

China has the world’s second-largest GDP at $18 trillion. It dwarfs the next largest economies, Germany and Japan, around $4 trillion each. Accordingly, given their size, U.S. and global investors must appreciate the possibility that China’s massive liquidity will work its way into stock markets worldwide. Also, this round of stimulus aims to boost private consumption. China’s citizens consume much less per capita than U.S. citizens. The global economic effects could be substantial if they successfully boost personal consumption. However, we caution that China has many structural impediments to growth. As such, it’s far from certain that this time will differ from economic revival efforts in the past. Thus, this round of stimulus’s global economic and financial effects may be minimal.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we discussed the bullish “cup and handle” formation in the S&P 500, giving us a year-end target of roughly 6000. While the price action of the S&P 500 is bullish, we must consider some short-term concerns. The bulls have been discussing the rising “breadth” of the market, which is indeed bullish when breadth is low and recovering. Improving breadth provides the “buying” power to drive the market higher. However, much like relative strength and momentum indicators, most buyers have likely bought when breadth reaches very elevated levels, leading to a short-term correction or consolidation.

The number of stocks trading above their respective 50- and 200-DMAs is at historically high levels. While such elevated levels do NOT mean a correction is imminent, they do suggest that further upside, without some corrective action first, is likely limited.

We see the same with the number of stocks trading with “bullish buy signals.” As shown, when the percentage of stocks with “bullish buy signals” is elevated, combined with elevated Relative Strength readings and high levels of “breadth,” such has typically preceded short-term corrections and consolidations.

While we expect the market to trade higher into year-end, given the current momentum and bullish sentiment, a pullback to support would be unsurprising given the short-term overbought and bullish conditions. With the election in just a month and earnings season kicking off this week, we suggest some risk management until these conditions are resolved.

The You Are Here Moment

The following summary of Jim Colquitt’s latest commentary comes via Substack. To read his entire Weekly Chart Review, visit Jim at jimcolquitt@substack.com.

The first graph below charts the average investor allocation to equities and the 10-year return that followed. He writes:

The current quarterly value for the “Average Investors Allocation to Equities” chart above is 50.3%. This value has only been exceeded 5 other times in almost 75 years’ worth of quarterly data points.

His second graph shows the robust correlation between investor allocations and ensuing returns.

The “You are here!” value is typically not the starting point for extended bull markets.Instead, the linear regression scatterplot suggests that from this starting point, we should expect a -2.19% annualized return over the next 10 years for the S&P 500.

While Jim’s comments and graphs are concerning, timing is crucial. They do not account for the timing of peaks and troughs over the next ten years. For instance, stocks could rally for three more years yet perform poorly over the next seven and return -2.19% annually. Jim ends his message as follows:

Risk assets are still in rally mode and I don’t think you want to fade that before the election but be careful not to overstay your welcome once the election is behind us.

Emerging Markets Lead The Way

The following tables from SimpleVisor show that the emerging markets ETF (EEM) far outpaced the other stock factors last week. About a third of EEM’s holdings are Chinese stocks. The sectors and factors, in general, continue to show healthy market breadth, although the absolute scores are starting to get high, potentially portending a short-term pullback.

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We are currently in the “everything market.” It doesn’t matter what you have probably invested in; it is currently increasing in value. However, it isn’t likely for the reasons you think. A recent Marketwatch interview with the always bullish Jim Paulson got his reasoning for the rally.

“It is this cocktail of ‘full support’ at the front end of a bull market which commonly has created an ‘Everything Market’ during the early part of a new bull. That is, for a period, almost everything simultaneously rises – value, growth, small, large, defensive, and cyclical stocks – and usually by a lot.

Short rates are falling, bond yields have declined, money growth is rising, fiscal stimulus has again expanded, and disinflation is still evident; and because of this new and overwhelming support, expectations for a soft landing should grow while both consumer and business confidence improves.” – Jim Paulson

But that isn’t the reason.

On the other side of the bull/bear argument are “gold bugs” enjoying soaring gold prices because “debts and deficits” are finally eroding the U.S. economy. As Michael Hartnet of BofA recently stated:

“Long-run returns in commodities are rising after the worst decade since the 1930s, led by gold, which is a hedge against the 3Ds: debt, deficit, debasement.”

The evidence doesn’t support that view. Historically, when deficits as a percentage of GDP increase, gold does very well as concerns about U.S. economic health increase (as per Michael Hartnett of BofA.) However, gold performs poorly as economic growth resumes and the deficit declines. Such is logical, except that since 2020, gold has soared in price even as economic health remains robust and the deficit as a percentage of GDP continues to decline.

While stocks and gold have risen this year, bonds, commodities, real estate, and cryptocurrencies have also enjoyed gains.

In other words, whatever your “thesis” is for whatever asset you own, the price action currently supports that thesis. That does not mean your thesis is correct.

In an “everything rally,” rising asset prices cover investing mistakes.

Therefore, this analysis should elicit two important questions: 1) what drives the “everything rally,” and 2) when will it end?

Whatever Your Thesis Is – It’s Probably Wrong

When it comes to what is driving the “everything rally,” everyone has their thesis. The “stock jockeys” suggest that easier monetary accommodation by the Fed and improving earnings are the key drivers for equities. As noted above, the “gold bugs” are seduced by burgeoning government spending and expectations of a dollar decline to loft gold prices higher. Every asset class has its “reason” for going higher, but the real reason may be much simpler. This post will focus on stocks and gold as they garner the most headlines and have the most fervent of “true believers.”

In every market and asset class, the price is determined by supply and demand. If there are more buyers than sellers, then prices rise, and vice-versa. While economic, geopolitical, or financial data points may temporarily affect and shift the balance between those wanting to buy or sell, in the end, the price is solely determined by asset flows.

Notably, the amount of money flowing into assets has been remarkable since 2014. Despite many “concerns,” 2024 is on track to be the second-strongest year of monetary inflows since 2021. That statistic is amazing when considering the government was flooding the system with trillions in monetary and fiscal stimulus then versus contracting it currently.

Unsurprisingly, as asset prices increase during the “everything market,” more money is pulled into those assets, forcing prices to rise as demand outstrips supply. As we noted previously, for “every buyer, there is a seller…at a specific price.” That “demand” for stocks, gold, real estate, cryptocurrencies, etc., comes from many sources.

1. Hedge funds
2. Private equity funds
3. Corporate share buyback programs
4. Passive indexes
5. Pension funds
6. Institutional funds
7. Mutual Funds
8. Retirement plans
9. Global investors
10. Retail investors

Most important is the supply of capital from Central Banks.

Of course, a massive accumulation of cash in money market funds will face declining yields as the Federal Reserve cuts interest rates.

As noted, whatever your “thesis” for owning an asset probably isn’t the actual reason. There are three primary reasons why asset prices are rising in the “everything market.”

1. Liquidity
2. Liquidity
3. Liquidity

In other words, in an “everything market,” there is too much money chasing too few assets.

As noted, “money flows” are the “demand side” of the equation. As previously discussed, the “supply side,” or the amount of “assets available,” continues to decline. Such explains why managers continue to “chase stocks” despite high valuations.

“The number of publicly traded companies continues to decline, as shown in the following chart from Apollo. This decline has many reasons, including mergers and acquisitions, bankruptcy, leveraged buyouts, and private equity. For example, Twitter (now X) was once a publicly traded company before Elon Musk acquired it and took it private. Unsurprisingly, with fewer publicly traded companies, there are fewer opportunities as market capital increases. Such is particularly the case for large institutions that must deploy large amounts of capital over short periods.”

The same is true for gold. While the demand for gold increases as prices rise, the supply of gold has declined since 2019.

As such, gold is no longer a “risk-off ” asset with a negative correlation to equities but is now a risk-on asset, just like equities. The 4-year correlation to the S&P 500 is near previous peaks, with subsequent performance.

Of course, these “everything markets” can last much longer than logic suggests. However, they do end. What causes “everything markets” to end is whatever exogenous, unexpected event turns off the flow of liquidity.

Technically Speaking

As noted, “everything markets” can last longer than logic dictates. However, they eventually end, and we don’t know what will cause it or when. Take a look at the two charts below.

In each chart, I have denoted periods where three factors occurred:

1. The market traded at 2-or more standard deviations above the 4-year moving average
2. Relative Strength was overbought on a long-term basis
3. The MACD was elevated and triggering a “sell signal.”

In both cases, these technical extremes marked short to long-term corrections and consolidations for stocks and gold. For the S&P 500 index, these periods also corresponded to more important headline events such as the “Crash of 1987,” the “Dot.com Crash,” and the “Financial Crisis.” Notably, like the S&P 500, the technical deviations for gold are also at levels that have denoted short to long-term corrective cycles.

As Paulsen noted in his interview, “everything markets” typically last only six months to a year. He expects this one to be in force at least for “the next several months.”

“Although the road ahead, even if some of my thinking proves correct, will still be interrupted by regular bouts of volatility, investors may want to consider staying bullish during the next several months, finally enjoying a mini restart to this bull market and perhaps witness what full support can do for your portfolio.”

We have no idea what will eventually cause a shift in liquidity as the Federal Reserve and global central banks move back into easing mode. (The monetary conditions index combines interest rates, the dollar, and inflation. It is inverted to correspond to rising asset prices.)

Critically, September was the biggest month of monetary easing since April 2020 amid the global pandemic crisis.

Notably, an eventual reversal could be caused by a “crisis event” or a reversal of monetary flows. The technical analysis tells us that it will occur and likely when the fewest investors expect it.

But that isn’t today.

Of course, this is always the case, so investors regularly “buy high and sell low.”

Remember Warren Buffett’s famous words when investing in an “everything market.”

“Investing is a lot like sex. It feels the best just before the end.”

Of course, maybe that is why Warren has been raising a lot of cash lately.

That’s it for today! If you want more insights like these, subscribe to our newsletter for regular updates on market trends and investing strategies.

The Fed got a welcome bit of news on Friday with the PCE price index. The Fed’s preferred measure of inflation fell to 2.2% on a year-over-year basis. That is the lowest reading since February 2021. The Fed’s 2% inflation target for PCE is now within reach by as early as year-end. However, the core PCE inflation measure, excluding food and energy, is 2.7%, so more work is needed on the inflation front. That said, the data was market-friendly as both the monthly PCE and Core indexes only rose by 0.1%, below the 0.2% market expectations. The monthly core PCE price index has been running at 1.5% annually over the last four months.

It’s too early for the Fed to declare their inflation mission accomplished. However, the recent PCE data and other inflation trends should give them comfort to keep reducing rates. Moreover, if the labor market continues to weaken, they could cut more aggressively than they or the market expect. As we share below, the market now assigns a 50% they cut by a total of 75bps by year-end. Furthermore, it assigns equal 25% odds that they cut by 100bps or 50bps.

What To Watch Today

Earnings

Economy

Market Trading Update

y, the market retested the breakout of the previous highs and held. Next week, if the market can hold these levels without breaking that support, the breakout will be confirmed, which should provide a bullish bias into the end of the month.”

Such remains the case this week. Notably, completing the “cup and handle” pattern suggests a potential further upside to 6000 by year-end. While that target may seem ambitious, it aligns with recent Wall Street upgrades.

“The pattern was first described by William J. O’Neil in his 1988 classic book on technical analysis, How to Make Money in Stocks. A cup and handle price pattern on a security’s price chart is a technical indicator that resembles a cup with a handle, where the cup is in the shape of a ‘u’ and the handle has a slight downward drift. The cup and handle pattern is considered a bullish signal, with the right-hand side of the pattern typically experiencing lower trading volume. The pattern’s formation may be as short as seven weeks or as long as 65 weeks.”

That pattern seems quite evident in the following chart of the S&P 500 index. With the breakout of the “cup and handle” formation in place, a further rally into year-end seems to be the logical next step. Such suggests that any near-term correction to relieve overbought conditions should remain confined to the bullish trend. In other words, investors should consider buying any near-term declines.

Just for reference, the last time we discussed a cup and handle formation was in December 2023, where we noted:

“That pattern seems quite evident in the following weekly chart of the S&P 500 index. With the breakout of the “cup and handle” formation in place, an attempt at all-time highs seems to be the logical next step. Any subsequent correction to relieve overbought conditions should maintain the bullish trend line from the March 2020 lows.”

While I received some pushback at the time, the market has rallied and set numerous new all-time highs this year.

The pattern is bullish, but it does not mean the market is guaranteed to rise. As is always the case, manage risk accordingly.

The Week Ahead

The market’s attention will shift from inflation to the labor market. JOLTs on Monday, ADP on Wednesday, and the BLS employment report on Friday will heavily impact the Fed’s next rate decision. Current expectations are for the addition of 142k jobs, with the unemployment rate staying stable at 4.2%. Also on the docket is the ISM manufacturing and services surveys. These will help us further assess executives’ sentiment on the labor market, as well as their overall confidence and views on price trends.

Monday is quarter-end. We may see volatile price action related to quarter-end window dressing on Monday and the following couple of days. As we saw last week, a slew of Fed members will speak. The speeches on Friday, following the BLS report, could be the most interesting.

Tax Cuts- An Examination Of The 2017 TCJA Impact

Corporate tax rate reductions in the United States have delivered tangible economic benefits, including increased capital investment, job creation, wage growth, and enhanced global competitiveness. The Tax Cuts and Jobs Act of 2017 is a key example of how reducing corporate tax rates can stimulate economic activity. Companies like Apple, Walmart, and Pfizer have used their tax savings to reinvest in the U.S. economy, create jobs, raise wages, and bolster their global standing.

While the long-term effects of corporate tax cuts continue to be debated, there is no denying that, when implemented strategically, they can positively impact the broader economy. Furthermore, following the TCJA, tax receipts increased even though tax rates declined. Such is expected if the economy benefits from tax cuts. However, as noted above, those benefits were cut short by the onset of the pandemic and confounded by the massive interventions following.

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An analysis of Presidential Candidate Trump’s policy proposals recently suggests that tax cuts will increase the deficit. While the raw analysis is correct, as it subtracts the potential for reduced tax collections from the tariff revenue, it ignores the impact on economic growth.

There is much rhetoric about the impact of tax cuts, mostly centering around “only benefitting the rich.” While it may seem that “the rich” are the ones who benefit, there are two important points to consider. First, “the rich” already pay most of the taxes. The Tax Foundation shows that the top 10% of income earners paid 59.1% of taxes. The top 25% of income earners comprised nearly 70% of all tax revenue, with the top 50% paying 97% of all taxes.

Of course, such begs the question of those claiming the “rich should pay their fair share” what that fair share is.

Secondly, due to the complexities of the current tax code, there is a significant difference between the “statutory” tax rate and what corporations pay (the effective rate). In 2018, the effective corporate tax rate was reduced to 21%, yet at the time, the actual tax rate paid was around 14%. Today, despite no change to the statutory rate, the effective tax rate has risen to almost 17%.

Notably, changes to the statutory rate are far more symbolic than actual. However, employers experience a strong psychological impact when tax rates are changed. Increases in tax rates often lead to companies’ defensive posturing to offset the impact of higher taxes. Decreases in tax rates, while there may be very little impact on the effective rate, tend to provide economic benefits.

3-Examples The Economic Benefit Of Corporate Tax Cuts

Corporate tax rate reductions have long been a cornerstone of economic policy discussions in the United States. Proponents argue that reducing corporate taxes can stimulate investment, create jobs, and enhance the country’s global competitiveness. Critics often claim that such tax cuts primarily benefit large corporations and wealthy shareholders, with limited trickle-down effects on the broader economy. There is certainly truth in that statement. As we argued previously, corporate tax cuts often find their way into enriching corporate executives

However, this article explores the three key economic benefits of corporate tax rate reductions supported by real-world examples. Let’s begin with one of the most significant benefits: a boost to capital investment. With lower tax burdens, companies retain more profits, which can be reinvested into expanding operations, developing new technologies, and conducting research and development (R&D). These investments improve productivity, drive innovation and foster long-term economic growth.

Example 1: The Tax Cuts and Jobs Act of 2017

A prominent example of the relationship between corporate tax reductions and increased investment is the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA slashed the U.S. federal corporate tax rate from 35% to 21%, creating a more favorable environment for business investment. In the aftermath, several major corporations announced significant capital investments in the U.S. economy. Following those tax cuts, capital expenditures grew until 2019 as the economy started worrying about the pandemic and the shutdown.

A good example was Apple, which committed to investing $350 billion in the U.S. over five years, with a portion of the investment attributed to the savings from the tax cuts. This included plans for a new campus, data centers, and technology infrastructure to further drive innovation in artificial intelligence and 5G technology.

Additionally, the TCJA spurred investment across various sectors, particularly in manufacturing and energy, where companies used their tax savings to modernize facilities, adopt new technologies, and expand production capacity. However, the onset of the pandemic and subsequent massive monetary interventions have obscured the longer-term effects of the tax cuts.

2. Job Creation and Wage Growth

Corporate tax cuts can also lead to job creation and wage growth. When companies reinvest their tax savings into business expansion, they often need to hire more workers to support the growth. Additionally, businesses may pass some of their tax savings to employees through higher wages, bonuses, or enhanced benefits. Again, that happened in the short run, particularly in small and mid-sized businesses. However, as noted, the pandemic-related crisis confounded the longer-term effects.

Example 2: Walmart’s Wage Increases and Bonuses

Following the TCJA’s enactment, Walmart, the largest private employer in the U.S., announced it would raise its starting wage to $11 per hour and provide bonuses of up to $1,000 to more than a million employees. While Walmart’s decision was partially driven by a competitive labor market, the company explicitly credited the tax cuts as a factor in its ability to increase wages and offer bonuses.

Walmart’s actions underscore the potential for corporate tax reductions to positively impact employees. By lowering tax liabilities, companies have greater flexibility to reward their workforce through wage increases, bonuses, or improved benefits. As discussed in “Labor Market Impact.” increased wages stimulate consumer spending, a critical driver of economic growth.

Beyond individual companies, studies have shown that reductions in corporate tax rates can have a broader positive impact on wages. According to the National Bureau of Economic Research, a one percentage point reduction in corporate tax rates can lead to a 0.5% wage increase over the long term. This is especially true in industries where businesses are highly profitable and can pass on some of their tax savings to employees. Although the effects are often more gradual, corporate tax cuts can support wage growth across various sectors.

3. Enhanced U.S. Competitiveness in a Global Economy

In the era of globalization, corporate tax rates play a crucial role in determining a nation’s ability to attract and retain businesses. High corporate tax rates can make a country less competitive compared to others with lower tax rates, potentially driving businesses to relocate operations abroad. By reducing corporate tax rates, the U.S. can enhance its attractiveness to domestic and foreign corporations, encouraging investment and job creation within its borders.

Example 3: Repatriation of Foreign Profits After the TCJA

The Tax Cuts and Jobs Act included provisions encouraging U.S. companies to repatriate overseas profits. Before the TCJA, U.S. corporations faced high taxes on foreign earnings, which led many companies to keep profits offshore rather than bringing them back to the U.S. The TCJA’s shift to a territorial tax system and a one-time tax on repatriated profits led to a significant influx of capital returning to the U.S.

According to the U.S. Bureau of Economic Analysis, U.S. companies repatriated more than $664 billion in foreign profits in the year following the tax reform. That capital repatriation significantly boosted the U.S. economy, with many companies using the funds to pay down debt and invest in domestic operations. They also used the capital to boost stock buybacks and issue dividends. Again, as noted, while there may have been longer-term benefits, the pandemic-related crisis cut them short.

Notably, the TCJA made the U.S. a more attractive destination for business investment by aligning the corporate tax rate more closely with other developed nations. This has been particularly important in industries such as technology and pharmaceuticals, where companies weigh corporate tax rates heavily when deciding where to base their operations. For example, Pfizer, one of the largest pharmaceutical companies in the world, explicitly mentioned the positive effects of the U.S. tax reform on its global competitiveness and financial strategy.

Conclusion

Corporate tax rate reductions in the United States have delivered tangible economic benefits, including increased capital investment, job creation, wage growth, and enhanced global competitiveness. The Tax Cuts and Jobs Act of 2017 is a key example of how reducing corporate tax rates can stimulate economic activity. Companies like Apple, Walmart, and Pfizer have used their tax savings to reinvest in the U.S. economy, create jobs, raise wages, and bolster their global standing.

While the long-term effects of corporate tax cuts continue to be debated, there is no denying that, when implemented strategically, they can positively impact the broader economy. Furthermore, following the TCJA, tax receipts increased even though tax rates declined. Such is expected if the economy benefits from tax cuts. However, as noted above, those benefits were cut short by the onset of the pandemic and confounded by the massive interventions following.

As the U.S. continues to navigate global economic challenges, corporate tax policy will remain important for encouraging business investment, job creation, and sustained economic growth.

Tax policies of the next administration will play a key role in the economy and markets going forward.

Sources:

1. Apple Announces $350 Billion Contribution to U.S. Economy After Tax Cuts: CNBC
2. Walmart Raises Wages Following U.S. Corporate Tax Cut: USA Today
3. U.S. Companies Repatriate $664 Billion After TCJA: U.S. Bureau of Economic Analysis

Bloomberg cites economist Richard Koo, who claims China is in a balance sheet recession. A balance sheet recession, as defined by Koo, is as follows:

He defines a balance-sheet recession as a situation in which households and businesses divert more of their income toward paying down debt, rather than consuming or investing. Koo argues that was a key reason for Japan’s descent into deflation, and for the slow US and European recoveries from the 2008 financial crisis.

While the article focuses on China’s balance sheet recession, U.S. investors should pay attention. Like China, the U.S. government and the Fed have reacted forcefully to avoid balance sheet recessions. To do so, they spur borrowing via lower interest rates and bailouts, worsening the debt load yet keeping interest expenses manageable. Additionally, the government has been recklessly spending to prop up the economy, bolstering private sector incomes and balance sheets.

While the ever-growing debt accumulation has fostered economic growth, it brings on financial instability as balance sheets are not allowed to return to equilibrium. In turn, the more potential instability, the more desperate actions are taken by the government and the Fed to stabilize the economy. As highlighted by Goldman Sachs ‘ table below, China is embarking on massive monetary and fiscal stimulus spending. Can they come to the rescue again, or are they following Japan’s “lost decades” where stimulus, no matter how much, can’t counteract excessive debt? More importantly, is the U.S. following China?

What To Watch Today

Earnings

• No notable earnings reports today

Economy

Market Trading Update

Yesterday, we discussed the short-term bullish “cup and handle” technical formation, which suggests higher prices in the near term. While the case remains today, there is a reason to question the potential magnitude of those gains as we approach year-end. As I discussed yesterday morning, the WEEKLY chart of the S&P 500 index has two concerning technical issues worth watching.

As shown, a building negative divergence exists in both currently overbought relative strength and momentum measures. From a weekly perspective, this is slow-moving data, so the market may seem to “defy gravity” for a while longer. However, we last saw a similar negative divergence heading into 2022. Then, like today, the bullish sentiment was very elevated, the “everything chase” was underway, and there seemed to be nothing to stop stocks from going higher…until they didn’t.

While I am not suggesting a similar outcome as 2022, previous negative divergences have seen markets at least consolidate gains for an extended period, if not correct, to some degree. While the bullish bias currently exists, it is becoming increasingly evident that most of the gains for the current rally have likely been made. Continue to manage risk accordingly.

Initial Jobless Claims

Despite the concerning graphs we shared yesterday regarding weakness in the labor market, initial jobless claims continue to signal that all is well. Last week’s initial jobless claims slipped to +218K, slightly below the +223K expected, and last week’s +222K. Jobless claims are now at the lowest level in nearly six months.

Economists often warn that jobless claims above 250k and rising are concerning. We haven’t seen 250k new claims in over a year. However, it’s important to note that jobless claims may be a faulty indicator. In Commentary from January 2024, we wrote the following:

Bloomberg estimates that the average wage coverage gap is bigger than ever at $1,400. Simply, unemployment claims payouts have not kept up with inflation. On the contrary, gig/part-time jobs have. Therefore, laid-off workers are better off working for Uber and other flexible gig economy jobs. Michael Green of Simplify Asset Management sums this up well. “Effectively, we’ve created private market unemployment insurance with gig economy work where the hassle/compensation of obtaining traditional unemployment insurance is simply not worth it. This is consistent with rising unemployment rates for college grads and suggests that policy is missing yet another important signal.” To his point, low-paying part-time jobs replace jobless claims but make the labor market look healthier than it is.

Dissaray At OPEC

A reader brought the following tweet from @ed_fin to our attention yesterday. Ed clipped a Russian news article that states that Saudi Arabia is not complying with OPEC target price agreements. It argues that Saudi Arabia, OPEC’s de facto leader, should be cutting oil production more aggressively. The author further states that the OPEC+ deal no longer exists. Therefore, if this is true, and that is very debatable, OPEC may have trouble reigning in production against the backdrop of weakening demand. Such could cause the oil price to push oil to $60 or below. The graph below shows that crude oil prices recently bearishly broke out of a wedge pattern. The horizontal support line is critical for oil prices to hold. If it trades below the line, the author may prove correct.

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At last week’s FOMC meeting, Jerome Powell clearly stated that recent signs of labor market weakness were an important factor in cutting rates. Therefore, assuming inflation continues to decline, the strength or weakness of the labor market will likely determine how much more they cut the Fed Funds rate. The well-followed BLS, ADP, Jobless Claims, and JOLTs labor market data are essential to the Fed’s decision-making. Outside of those reports, there is a slew of other data that, while not as prominent, can provide more timely clues about the labor market. Today, we present two such lesser-followed labor market indicators.

The graph on the left comes from Tuesday’s Consumer Confidence report. According to the Conference Board, it measures “the percentage of respondents who say jobs ‘are plentiful’ compared to the percentage of respondents who say jobs ‘are hard to get.’” As shown, the index has peaked months before each recession and rebounds shortly after it is over. Furthermore, the index tends to either be increasing or decreasing. It rarely stays static. Post 1990, the recessions coincided with a ratio of zero or below. The ratio is declining and approaching zero.

The graphs on the right are from Tuesday’s Richmond Fed manufacturing and service sector surveys. Both show that employment in the district is weakening. Manufacturing conditions are now on par with the worst of the pandemic. The service sector is not as bad but below zero, connotating a labor force contraction. This is just one of many regional Fed surveys with similar sentiments regarding employment.

A recession is not imminent, but a growing amount of labor data points to weakness. Next week’s three employment reports and the national ISM surveys will either confirm the charts below or present a more optimistic view.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we touched on Wall Street’s rush to upgrade year-end price targets based on hopefully increasing economic growth rates. With markets breaking out to all-time highs, the rush to allocate to equities has been quite bullish. Technically, as discussed in yesterday’s Before The Bell video, the market has formed a “Cup and Handle” formation. This is historically a very bullish pattern that leads to higher highs. As discussed in that video, the breakout of that bullish formation technically supports Wall Street’s price target of 6000-6300 by year-end. Using the recent August lows to break above the July highs suggests a Fibonacci extension to 5986.

Of course, such a rally might not occur for plenty of reasons. The upcoming election, earnings season, and a continued weakening in consumer confidence and economic data remain. However, as is always the case, the markets can and often do, remain illogical longer than you can remain solvent.

We continue to remain equity-biased as bullish sentiment exists. However, we suggest paying attention to risk heading into November and looking for a better entry point for a potential year-end rally.

MBA Mortgage Index Is Surging, Sort Of

The MBA mortgage index rose to its highest level since July 2022 as mortgage rates fell to 6.13%. The index measures both home buying applications and refinancings. The first graph shows the MBA mortgage index surging, which is welcome news for the stagnating residential real estate market. However, the second graph puts the first graph in proper context. Despite being at a two-year, it is still at the lowest level in over 20 years.

The index should continue to rise, assuming mortgage rates keep declining. However, because so many current homeowners have very low-rate mortgages, the benefits of lower mortgage rates will be slower to take hold than the market is used to. It may take mortgage rates of 5% or even lower to see the index rise above the pre-pandemic peak.

Agency REITs For A Bull Steepener

Like banks, most agency REITs borrow for shorter terms than the duration of their assets. Creating such a mismatch in a positively sloped yield curve can result in additional profits as borrowing costs are less than asset yields. 

If the bull steepener yield curve trend continues, agency REIT MBS should gain value. However, the duration of the MBS will shrink due to prepayments. New MBS replacements will have lower yields. However, funding costs should decline. There are many moving parts to consider. While the environment is conducive for profits, as we noted earlier, the performance of agency REITs comes down to hedging acumen.

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“The Fed will spur another round of inflation with rate cuts.” That line and similar sentiments have been plastered all over social media following the Fed’s aggressive 50 bps rate cut. Given the importance of inflation on asset returns, it is worth looking back at the last 40 years and appreciating the relationship between Fed Fund rate cuts and CPI. The graph below shows every instance in which the year-over-year Fed Funds rate was at least .50bps lower or more over the prior twelve months. It then plots them against the one-year change in CPI. CPI has fallen or remained relatively flat every time the Fed cut rates except for 2007 and 2008. From 2007 to mid-2008, the price of oil tripled to over $150 a barrel. Despite the surge in oil prices, all other prices were tame. To wit, CPI, excluding energy prices during that period, was declining slightly.

There is no evidence that rate cuts have caused inflation since 1985. The rebuttal to this argument recants the inflationary outbreaks of the 1970s and early 1980s. During this period, the inflation rate spiked three times, each higher than the prior instance. We have written a four-part article on the stark differences between then and now and why such a rekindling of inflation is not likely. (Links- ONE, TWO, THREE, and FOUR). We summed up the series as follows:

At its core, inflation is too much money chasing too few goods. That was the case in 2020 through 2022. This is not the case anymore.

The 2020s aren’t the 1970s by any stretch of the imagination!

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we touched on oil prices and Fed rate cuts. However, the market remains bullishly biased in the short term, with investor sentiment again reaching more exuberant levels. Technically, there is nothing wrong with the market currently. The S&P 500 broke out above its consolidation/correction pattern from August, with the Yen Carry Trade blowup now a distant and non-concerning memory. As is always the case, the market is forward-looking and is focused on improving economic and earnings estimates. As I noted on Twitter/X yesterday, Goldman Sachs has pushed their Q3 economic estimate to 3%.

Furthermore, analysts are pushing their year-end price targets even higher after predictions early this year came far short of reality. The hope is that earnings growth will reach 18% year over year by the end of 2025, supporting much higher price targets.

As the market continues to rack up one new all-time high after another, bullish sentiment builds, dragging more money into the equity chase. The MACD buy signal remains intact, and the markets are not overbought. Given the current deviation from the 50-DMA, further upside is likely limited, suggesting a slower grind higher as the moving average catches up. Such suggests that allocations remain weighted toward equity risk but watch for a pickup in volatility as we get closer to the election. November and December are setting up nicely for a sprint higher into the year-end close with Wall Street analysts now pegging 6000 as the target.

Job Concerns Are Weighing On Consumers

Consumer Confidence fell by the most in three years, as the ZeroHedge chart below shows. Additionally, the index is well below the recent range from the second half of 2021 to earlier this year. Per the Conference Board, the culprit for the sharp drop appears to be increasing concerns about the labor market. To wit:

“The deterioration across the Index’s main components likely reflected consumers concerns about the labor market and reactions to fewer hours, slower payroll increases, fewer job openings — even if the labor market remains quite healthy, with low unemployment, few layoffs and elevated wages,” Dana Peterson, chief economist at the Conference Board, said in a statement.

In a recent article titled Confidence Is The Underappreciated Economic Engine, we discussed confidence’s important role in the economy. We summed it up as follows:

As we led, it doesn’t take much of a change in confidence to tip an economy from running on all cylinders to a recession.

50bps Rate Cut and Outlook

Last week, the Federal Reserve made a significant move by cutting its overnight lending rate by 50 basis points. This marks the first rate cut since 2020, signaling the Fed is aggressively supporting the economy amid a backdrop of softening economic data. For investors, understanding how similar rate cuts have historically impacted markets and which sectors tend to benefit is key to navigating the months ahead.

In this post, we will explore the historical market performance following similar 50-basis-point rate cuts, highlight the best-performing sectors and market factors after such cuts, and outline three critical risks investors should be aware of heading into year-end.

READ MORE…

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In our recent two-part series on the yield curve (Part One  Part Two) we discussed the four predominant yield curve shifts and what they imply about economic activity and monetary policy. Additionally, given the current bullish steepening trend of the yield curve, we provided data on how prior bull steepening environments impacted various stock indexes, sectors, and factors. Missing from our analysis was a discussion of a specific type of REIT whose valuations are well correlated with the shape of the yield curve. If you are buying this bull steepener, agency REITs are worth your consideration.

What is an Agency Mortgage REIT?

REITs own, manage, or hold the debt on income-producing properties. REITs must pay out at least 90% of their taxable profits to shareholders annually. This unique legal structure makes investment analysis of REITs different than most companies. REIT investors must analyze how changing economic, financial market, and monetary policy conditions affect the interplay between their underlying assets and liabilities.

Within the REIT category are a subclass investors call agency REITs. These companies own mortgages on residential real estate. Furthermore, as connotated by the word “agency,” most of the mortgages are secured and guaranteed against default by government agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae. These securities are called Mortgage-Backed Securities (MBS). Because the U.S. government owns the agencies, MBS is essentially free of credit risk.

How Agency REITs Make Money

Agency REIT earnings primarily come from three sources: the spread between the assets and liabilities (mortgage yield and debt), hedging costs, and the amount of leverage employed. 

Hypothetically, let’s start a new agency REIT to help you appreciate how they operate.

• We solicit $1 billion from equity investors.
• A significant portion of the $1 billion is used to buy mortgage-backed securities (MBS).
• We then borrow $4 billion from a bank using the $1 billion of MBS as collateral.
• The proceeds from the $4 billion loan also purchase MBS.
• Our new REIT has about $5 billion of MBS against $1 billion of equity and $4 billion of debt.
• As a result, the REIT has 5x leverage.

Assuming our mortgages pay 6% and our debt costs 4%, we can make $140 million a year, equating to a 14% return for our equity holders. That handily surpasses the 6% return if leverage wasn’t employed.

The math is relatively simple. On the $1 billion of MBS funded with equity, the REIT will make 6% or $60 million. On the $4 billion of MBS funded with debt, the REIT will earn the 2% difference between the MBS and the debt, or $80 million. The total earnings of $140 million divided by the $1 billion equity stake equals 14%.

Unfortunately, managing an agency REIT is not nearly as simple as we illustrate.

The Complexities Of Agency REIT Portfolio Management

MBS are a unique type of bond. The mortgagors, homeowners, can partially or fully pay down their mortgages whenever they want. As a result of the unique prepay option, the duration of MBS varies significantly with mortgage rates. At the same time, the duration of a REIT’s liabilities are much more stable. Accordingly, the portfolio managers take on duration mismatch risk. 

The following chart shows the duration of a Fannie Mae MBS originated in 2021. The weighted average mortgage rates of the underlying loans in the MBS are 3.36%. When rates started rising rapidly in 2022, the mortgagors had no incentive to prepay their loans. As a result, the duration of this MBS rose by 2.50 years. Since then, the duration has fallen with mortgage rates, as the odds of prepayments have increased. A duration change of 2.50 years may not seem like a lot, but when leverage is used, such a change can result in a relatively large duration mismatch and significant gains or losses.

Because the duration of our MBS varies and our liabilities are relatively constant, agency REITs are constantly hedging duration risk. Furthermore, the yield spread between MBS and Treasuries introduces spread risk. The more a REIT hedges to minimize potential duration mismatches or spread risk, the less risk they take. But the hedging costs eat into profits. Lesser hedging can produce more profits but poses more significant risks.

A Steeper Yield Curve Should Help REITs

Like banks, most agency REITs borrow for shorter terms than the duration of their assets. Creating such a mismatch in a positively sloped yield curve can result in additional profits as borrowing costs are less than asset yields. 

If the bull steepener yield curve trend continues, agency REIT MBS should gain value. However, the duration of the MBS will shrink due to prepayments. New MBS replacements will have lower yields. However, funding costs should decline. There are many moving parts to consider. While the environment is conducive for profits, as we noted earlier, the performance of agency REITs comes down to hedging accumen.

Several agency REITs are worth exploring, but for demonstration purposes, we focus on the oldest and largest public agency REIT, Annaly Capital Management (NLY). (Disclosure: RIA Advisors has a position in NLY in its client portfolios.)

The graph below compares NLY’s book value per share with the 10/2-year yield curve. The gray bars highlight the last five persistent bull steepener periods. Its book value and the yield curve track each other closely. The high correlation is shown in the second graph.

NLY’s BV per share has risen during bull steepeners, except for 2020.

NLY has averaged a 19% return during the five latest bull steepeners. That beats every other equity asset in the graph below, except for gold miners.

No Guarantees

While NLY has done well during bull steepeners on average, it did lose 30% during the pandemic. As such, we shouldn’t take the yield curve environment for granted. However, the rare nature of the pandemic resulted in hedging difficulties due to volatile bond markets and irregular mortgagor behaviors. A repeat of similar conditions is unlikely.

Investors should be aware of market valuations in addition to the fundamental valuation of REIT portfolios. The other reason for NLY’s steep decline in 2020 was fearful equity investors. As shown below, courtesy of Zacks, NLY’s price-to-book value fell from nearly 1.00 before the pandemic to 0.68 at the end of March 2020. Investors were fearful and discounted the stock by over 30% from its book value.

There are additional risks as follows:

• The current bull steepener ends as bond yields increase and the yield curve re-inverts. In such a scenario, book value would likely fall.
• Leverage is easy to maintain when markets are liquid; however, in 2008, REITs were forced to sell assets and reduce leverage, negatively affecting earnings and dividends.
• Management does not adequately hedge the portfolio.

Summary

Despite double-digit dividend yields in many cases and the cushion such high dividends provide, buying agency REITs is not a guaranteed home run in a bull steepener. That said, these firms offer investors a way to benefit from a steepening yield curve while avoiding an earnings slowdown that may hamper many stocks in an economic downturn.

Last week, the Federal Reserve made a significant move by cutting its overnight lending rate by 50 basis points. This marks the first rate cut since 2020, signaling the Fed is aggressively supporting the economy amid a backdrop of softening economic data. For investors, understanding how similar rate cuts have historically impacted markets and which sectors tend to benefit is key to navigating the months ahead.

In this post, we will explore the historical market performance following similar 50-basis-point rate cuts, highlight the best-performing sectors and market factors after such cuts, and outline three critical risks investors should be aware of heading into year-end.

Historical Outcomes To Rate Cuts

A 50-basis-point rate cut, especially the first one, is an aggressive action by the Fed. The Fed historically uses such a sizable cut during economic slowdowns or rising recession risks. Here are a few notable examples:

1. January 2001: Following the dot-com bubble bursting, the Fed cut rates by 50 basis points in January 2001 to stabilize the economy. While the S&P 500 initially rallied, the broader market eventually experienced continued declines due to the deepening tech recession.
2. October 2007: In the early stages of the Global Financial Crisis, the Fed implemented a 50-basis-point cut to inject liquidity into the system. As credit markets imploded due to an accelerating mortgage crisis, the immediate response from the stock market was positive, but the underlying financial instability resulted in prolonged market weakness throughout 2008.
3. July 2019: The Fed’s most recent rate cut was in July 2019, responding to concerns about global trade tensions and an economic slowdown. Again, the market initially rallied, with the S&P 500 posting positive returns in the months following the cut. That period is notable because the rate cut was more of a precautionary measure, as the most recent rate cut seems to be, rather than a reaction to an existing economic downturn.

This is just an analysis of the Federal Reserve’s most recent rate cuts. Reviewing the history of rate-cutting cycles back to 1960 reveals some interesting points. The table below shows the 3-month average of the Effective Fed Funds Rate, the total decrease during a rate-cutting cycle, and related market outcomes or events.

It is worth noting that while many analysts point to periods where the Fed cut rates and stocks initially rose over the next few months to a year, in many cases, those rate cuts preceded more significant events, as shown in the chart below.

The 1995 Analogy

For example, many analysts point to 1995 as a similar period to today, when the Fed initially cut rates, and the market continued to rise without realizing a recession. However, a difference between 1995 and today is the inversion of the yield curve. In 1995, the yield curve never inverted, signaling a healthy economy. As shown, the yield curve did not invert until 1998, and the Fed resumed its rate cuts with a recession following in 2000, triggering the “Dot.com” crisis.

It is not unusual for investors to see an initial positive response in the short term as they welcome the Fed’s efforts to stimulate economic growth. Furthermore, prevailing bullish sentiment and momentum continue pushing higher asset prices. As shown in the table above, the primary determinant of whether the market experiences a significant correction or not hinges on a recessionary impact.

Historically, performance over a six-month to two-year period is primarily dependent on whether the rate cut successfully stimulates the economy or if deeper economic issues persist. For example, in 2001 and 2007, the six-month performance following the rate cuts was negative due to underlying economic challenges, while in 2019, the market continued to perform well until the onset of the pandemic-related economic shutdown.

Given this background, where should investors focus their attention?

Best-Performing Sectors and Market Factors

When the Federal Reserve reduces interest rates, in this case by 50 basis points, the decline in borrowing costs tends to benefit different sectors and asset classes in varying ways. While there are many options, here are five areas to start your research based on historical trends.

1. Large-Cap Stocks: Large-cap stocks, and in particular, the “Mega-cap” stocks, tend to benefit the most immediately after a rate cut. With strong balance sheets and the ability to access cheaper capital, they can expand operations, boost profit margins, and, most importantly, buy back shares. Furthermore, these companies are highly liquid and benefit more from passive indexing flows than small and mid-cap companies.
2. Small-Cap Stocks: Speaking of small-cap stocks, they tend to see a delayed response. These companies primarily use floating-rate debt; lower borrowing costs improve their financial strength. However, they are more sensitive to economic cycles, so recessions remain an important risk. Investors favor large-cap stocks, but small-caps may gain momentum once economic conditions stabilize.
3. Treasury Bonds: Bonds tend to perform well during interest rate cuts. Bond prices typically rise as rates fall, providing investors with capital appreciation. Longer-duration Treasury bonds historically perform as lower interest rates drive demand for fixed-income assets.
4. Real Estate Investment Trusts (REITs): REITs benefit significantly from rate cuts, as lower interest rates reduce borrowing costs for real estate acquisitions and development. Additionally, REITs provide steady income through dividends, which become more attractive as bond yields decline.
5. Gold: Gold tends to perform well during an interest rate-cutting cycle when the economy slips into a recession and the dollar weakens. However, gold has already had a tremendous run in anticipation of the Fed’s most recent rate cut, so much will depend on the strength or weakness of the dollar and economic outcomes.

Some Areas To Consider

With that information, and given the historical performance of various sectors and market factors following rate cuts, here’s how investors might consider positioning their portfolios:

• Large-Cap Stocks: Focus on high-quality, large-cap stocks that can benefit from lower borrowing costs and have a strong track record of weathering economic uncertainty. Companies in consumer staples, technology, and healthcare tend to perform well in rate-cut environments.
• Fixed Income: To capitalize on rising bond prices, consider adding exposure to long-term bonds or bond ETFs. Fixed-income investments provide stability and income, which can be particularly attractive in a low-rate environment.
• REITs and Income-Producing Assets: Look for opportunities in REITs and other income-generating assets, which benefit from lower interest rates and provide reliable cash flow through dividends.
• Small/Midcap Companies: Consider selective exposure to small and mid-capitalization companies that have low debt levels and strong balance sheets and pay a dividend.

Three Key Risks for Investors Post Rate-Cut

While there are potential benefits to a Fed rate cut, there are also risks:

1. Presidential Election: Given the disparity between the current candidate’s economic policies, particularly around tax rates and deficit spending, there is a risk of market participants derisking ahead of the outcome. One key issue to focus on is the outcome of the congressional races. A bifurcated outcome between control of the House and Senate would be most favorable for Wall Street as it would limit any drastic changes to current economic and regulatory policies.
2. Economic Recession: As noted above, the most significant determinant between rate-cutting cycles, market corrections, and bear markets is the onset of a recession. The markets will likely respond negatively if upcoming data shows significant deterioration, particularly in employment and services-related data. In such an event, sectors such as financials and cyclicals are particularly vulnerable to prolonged economic downturns, as banks may face higher loan defaults and reduced demand for their services.
3. Geopolitical Risks: Geopolitical tensions, particularly around trade, energy supply, or global conflicts, can exacerbate market volatility. External shocks such as escalating trade wars or energy supply concerns can weigh on investor sentiment and disrupt global markets even with lower rates. For instance, disruptions in the oil market or increased trade tensions with major economies could derail the positive effects of rate cuts.
4. The Japanese Yen: In August, we discussed the impact of the “Yen Carry Trade” on the financial markets. That risk has not subsided, particularly should the Bank of Japan continue to hike interest rates while the rest of the world is cutting them. Such a move by the Bank of Japan would likely create another spike in the Japanese yen, creating another “margin call” for those highly levered positions held by Wall Street.

Conclusion: Navigating the Market Post-Rate Cut

The Federal Reserve’s 50-basis-point rate cut signals a proactive effort to support the economy amid potential risks. Historically, the S&P 500 and various sectors have responded positively to rate cuts in the short term, with large-cap stocks and bonds often leading the way. However, investors should remain cautious of risks such as the upcoming election, recession, geopolitical tensions, and the Japanese Yen that could impact market performance in the coming months.

At RIA Advisors, we remain allocated to the equity markets as momentum, relative strength, and the overall trend remain bullishly biased. However, we continue to regularly implement risk management protocols, evaluate opportunities, and closely watch the incoming economic data.

While everyone is trying to guess how this turns out, history suggests exercising some caution seems prudent. For us, it is always preferable to err on the side of caution. While it is easy to reallocate cash into equities, it is much more difficult to recoup losses.

Trade accordingly.

With a staff of over 400 economic Ph.D.s and seasoned leadership, many believe the Fed has a firm grasp on future economic and inflation trends. Accordingly, they must have a good idea of what the future holds for interest rates. Unfortunately, we share a little secret: the Fed’s latest Fed Funds forecast makes little sense. Consider the Fed’s current long-run GDP and PCE price forecasts, which are 1.80% and 2.00%, respectively. In 2019, before the pandemic, the Fed’s long-range forecast for GDP was 1.90% and PCE at 2.00%. In other words, growth prospects slipped slightly, but nothing materially changed. However, despite the same economic and inflation outlook, the lowest long-range Fed Funds rate forecast for the 19 Feb members is 2.40%, well above the average Fed Funds rate in the post-finance crisis era.

We noted that the low forecast is 2.40%, but consider the median is 2.90%, and the highest forecast is 3.80%. Why does the Fed think the Fed Funds rate will be significantly higher than their economic growth and inflation forecasts? We agree with the Fed forecast of sub-2 % economic growth and low inflation. Therefore, we also think Fed Funds will likely range between 0% and 2% over the longer run. Given that the Fed Funds futures market generally aligns with the Fed’s forecast and that the Fed and Fed Funds futures markets have poor prediction track records, the bond market may grossly overestimate future yield levels.

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, the stock market remains bullishly biased and is reaching new all-time highs. The thesis is that the Fed rate cuts will benefit stocks by providing monetary accommodation at a time when economic growth remains strong. However, oil prices have continued to suggest that the economy is weakening. As economic demand weakens, so does oil demand. It is worth noting that oil prices have fallen over the last 50 years when the Federal Reserve cut rates, even during the “soft landing” of 1995. While much will depend on the aggressiveness of those rate cuts and, ultimately, the outcome for the economy, oil prices will be worth watching for clues as to the Fed’s success or failure.

Intel Is In Play

Intel shares are being bid up as rumors are floating around the market that Qualcomm is exploring a takeover of the chip company. Furthermore, it is reported that Apollo Global Management has offered to make a multi-billion dollar investment in the company. Per Bloomberg, the offer could be as much as five billion dollars.

From a share price perspective, INTC may seem like a bargain compared to its competitors, who have seen significant upside due to AI products. However, the second graph from SimpleVisor shows the company’s earnings have floundered over the last two years. Furthermore, despite the seemingly low price, the SimpleVisor fair value model calculation is well below its current price. The stock wasn’t up much on Monday despite the news. Might the market expect any investment or buyout to occur around current price levels?

SimpleVisor Analysis

The market breadth, as judged by the SimpleVisor relative sector technical scores, remains in good shape. Accordingly, the broad market rally may likely continue as judged by the number of relative scores near zero. However, the absolute score for a few sectors is getting moderately overbought. For example, discretionary, utilities, and industrials have scores approaching 80. Therefore, we may see those sectors cool off, allowing sectors with lower scores, such as energy, to play some catch-up.

The factor analysis confirms our sector analysis above. Note the tight grouping of factors around the zero y-axis, denoting good market breadth. Moreover, like the sector analysis, the absolute scores are creeping into overbought territory.

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We’ve previously written that electricity demand is projected to outpace capacity over the next decade. The 20-year power purchase agreement signed between Microsoft and Constellation Energy, announced last Friday, highlights the potential for nuclear energy to meet the surging power demands from AI data centers. Constellation Energy will reopen the Three Mile Island reactor shuttered in 2019 to supply clean energy to Microsoft’s AI data centers by early 2028.

Nuclear power plants and AI data centers are ideal matches since both must run 24/7. Another cloud computing giant recently made a similar move. In March of this year, Amazon agreed to a deal to acquire a data center campus connected to a nuclear power plant on the Susquehanna River. Constellation Energy (CEG) has the potential to be a large beneficiary of the renewed interest in nuclear power, producing over 20% of the nation’s output. Another potential player is NextEra Energy (NEE), which is considering reopening a nuclear power center in Iowa that closed in 2020, per the Wall Street Journal.

What To Watch Today

Earnings

• No notable earnings releases today

Economy

Market Trading Update

As noted last week, the trend of higher lows and the triggering of the MACD “buy signal” all suggested the recent correction phase was over. That was confirmed this past week, as the market broke out to new all-time highs following the 50 basis point cut in the Federal Reserve overnight lending rate on Wednesday.

The market has continued to front-run the Fed’s rate cuts during the last two years. Each rally turned to disappointment as the Fed postponed while continuing to fight inflation. However, this past week, that battle was won. The question is, what happens next? A recent table from Carson Investment Research shows that near-term performance has been a mixed bag when the Federal Reserve has previously cut rates within 2% of all-time highs. However, returns over the next year are positive 100% of the time.

The difference in returns is whether there was a recession or not. There is little concern about a recession over the next 12 months, which should help support asset prices. However, since there are no guarantees, it is worth continuing to manage risk and maintain some hedges against a sharp pickup in volatility.

From a purely technical perspective, the market remains on a bullish buy signal and is not grossly overbought yet. On Friday, the market retested the breakout of the previous highs and held. Next week, if the market can hold these levels without breaking that support, the breakout will be confirmed, which should provide a bullish bias into the end of the month.

While the backdrop to the market is bullish, there is still some risk over the next month as we head into the beginning of earnings season and the November election. Speaking of earnings, analysts have been very busy downgrading estimates ahead of October.

Let me conclude: The bullish bias remains strong as the momentum chase continues. However, economic data, slowing earnings, and the upcoming election raise concerns. Risk management remains key, and we must be flexible in our positioning. Michael Lebowitz sent me a quote last week that I think sums up our views well:

“We don’t really care which way growth and inflation go. Not because it doesn’t impact our positioning, we’re just prepared to adjust.”

The Week Ahead

Federal Reserve speakers will be out in force following last week’s 50bps rate cut, the most notable of which will be Chair Powell’s speech on Thursday morning. The focus this week will be the August PCE price index on Friday. Both the headline and core PCE price indices are expected to rise 0.2% MoM, which is in line with July’s data. The Fed stated last week that it is growing more confident in the downward path of inflation. Thus, the August data has a low potential for a material upside surprise. However, the magnitude of last week’s rate cut may hint that a weak figure is in store.

This week’s economic data starts today with the September S&P Global PMI Flash. The Manufacturing PMI has weakened in recent months, while the Services PMI has continued showing strength. Thus, the composite remains well in expansionary territory. Eyes will be on the employment component for potential deterioration after both sectors reported a contraction in August. Especially with the Fed stating that it now considers inflation and employment risks balanced. August Durable Goods orders are released on Thursday. The consensus expects a decline of 2.8% MoM following the 9.9% surge in July.

Market Declines And The Problem Of Time

The average American faces a sobering reality: human mortality. Most investors don’t begin seriously saving for retirement until their mid-40s, as the cost of living during earlier years—college, getting married, having kids—consumes much of their income. Generally, incomes don’t exceed the cost of living until the mid-to late-40s, allowing for a serious push toward retirement savings. Most individuals have just 20 to 25 productive working years to achieve their investment goals.

Investment studies should align time frames with human mortality rather than focusing on “long-term” average returns. There are periods in history where real, inflation-adjusted total returns over 20 years have been close to zero or negative. Interestingly, these periods of near-zero to negative returns were typically preceded by high market valuations—as we see today.

READ MORE…

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When stock markets rise, the bullish narrative tends to dominate, overlooking the potential impact of market declines. This oversight stems from two main problems: a basic misunderstanding of math and time’s critical role in investing. Every year, I receive the following chart as a counterargument when discussing the importance of managing risk during a portfolio’s life cycle. The chart shows that while the average bull market advance is 149%, the average bear market decline is just -32%.

So, why bother managing risk when markets rise 4.7x more over the long term than they fall?

As with any long-term analysis, one should quickly realize the most critical issue for every investor—time.

The Reality of Long-Term Stock Market Returns

Yes, since 1900, the stock market has “averaged” an 8% annualized rate of return. However, this does NOT mean the market returns 8% every year. As we discussed recently, several key facts about markets should be understood.

• Stocks rise more often than they fall: Historically, the stock market increases about 73% of the time. The other 27% of the time, market corrections reverse the excesses of previous advances. The table below shows the dispersion of returns over time.

However, to achieve that 8% annualized “average” rate of return, you would need to live for 124 years.

Time is the Investor’s Biggest Challenge

The average American faces a sobering reality: human mortality. Most investors don’t begin seriously saving for retirement until their mid-40s, as the cost of living during earlier years—college, getting married, having kids—consumes much of their income. Generally, incomes don’t exceed the cost of living until the mid-to late-40s, allowing for a serious push toward retirement savings. Most individuals have just 20 to 25 productive working years to achieve their investment goals.

Investment studies should align time frames with human mortality rather than focusing on “long-term” average returns. There are periods in history where real, inflation-adjusted total returns over 20 years have been close to zero or negative. Interestingly, these periods of near-zero to negative returns were typically preceded by high market valuations—as we see today.

Time and valuations are the most important factors for those just beginning their investment journey.

The Problem with Percentage-Based Returns

Another issue with long-term analysis is the misunderstanding of basic math, as we discussed in “Market Corrections.”

Charts often show percentage returns, which can be deceptive without deeper analysis. Let’s take an example:

If an index grows from 1000 to 8000:

• 1000 to 2000 = 100% return
• 1000 to 3000 = 200% return
• 1000 to 8000 = 700% return

An investor who bought into the index generated a 700% return. According to First Trust, why worry about a 50% correction when you’ve just gained 700%?

However, the problem lies in the percentages. A 50% correction does NOT leave you with a 650% gain. It subtracts 4000 points from the index, reducing your 700% gain to just 300%.

Recovering those lost 4000 points to break even after a market decline is a much harder task. The real damage of a market decline becomes clear when we reconstruct the chart to display point gain/loss versus percentages. In many cases, a significant portion of a bull market’s gains are reversed by the subsequent bear market decline.

While markets do recover, mainstream analysis often overlooks one key factor: time.

Market Declines Are A “Time” Problem. 

For most of us mere mortals, time plays a crucial role in our investing strategy. As shown in previous analyses, investors typically fall short of their expected outcomes when factoring in life expectancy and the time required for recovery from market downturns.

Below is a chart assuming a $1000 investment over each period and holding the total return until death. No withdrawals are made. The orange sloping line represents the “promise” of a 6% annualized compound return. The black line represents the actual outcome. In all cases except the most recent cycle starting in 2009, the invested capital fell short of the promised return goal.

The next significant downturn will likely reverse many of the gains from the current cycle, highlighting why using compounded or average rates of return in financial planning often leads to disappointment.

At the point of death, the invested capital is short of the promised goal in every case except the current cycle starting in 2009. However, that cycle is yet to be complete, and the next significant downturn will likely reverse most, if not all, of those gains. Such is why using “compounded” or “average” rates of return in financial planning often leads to disappointment.

The reason is that market declines matter, and getting “back to even” is not the same as accumulating capital. The chart visualizes the importance of market declines by showing the difference between “actual” investment returns and “average” returns over time. The purple-shaded area and the market price graph show “average” returns of 7% annually. However, the return gap in “actual returns” due to market declines is quite significant.

Why Time and Valuations Matter for Investors

Whether you’re five years from retirement or just starting your career, there are three key factors to consider in today’s market environment:

1. Time horizon (retirement age minus starting age)
2. Valuations at the beginning of your investment period
3. Rate of return required to meet your investment goals

A buy-and-hold strategy may disappoint if valuations are high when you start investing, and your time horizon is too short or the required return rate is too high.

Mean reversion events often reveal the flaws of buy-and-hold investment strategies. Unlike a high-yield savings account, stock markets experience losses that can devastate retirement plans. (Ask any “boomer” who lived through the dot-com crash or the financial crisis.)

Investors should consider more active strategies to preserve capital during excessively high valuations.

Adjusting Expectations for Future Returns

Investors should consider the following:

• Adjust expectations for future returns and withdrawal rates due to current valuation levels.
• Understand that front-loaded returns in the future are unlikely.
• Consider life expectancy when planning your investment strategy.
• Plan for the impact of taxes on returns.
• Carefully assess inflation expectations when allocating investments.
• During declining market environments, reduce portfolio withdrawals to avoid depleting principal faster.

The last 13 years of chasing yields in a low-rate environment have created a hazardous situation for investors. It’s crucial to abandon expectations of compounded annual returns and instead focus on variable return rates based on current market conditions.

Conclusion: Don’t Chase the Market

Chasing an arbitrary index and staying 100% invested in the equity market forces you to take on more risk than you may realize. Two major bear markets in the last decade have left many individuals further from retirement than planned.

Retirement investing should focus on conservative, cautious growth to outpace inflation. Attempting to beat a random, arbitrary index with no connection to your personal financial goals is a risky game. Remember, in the market, there are no bulls or bears. There are only those who succeed in reaching their investment goals—and those who fail.

FAQ Section

Q: Why is risk management important in investing?
A: Risk management helps protect your portfolio from significant losses during market declines, ensuring you stay on track to meet your long-term goals.

Q: How do market declines affect long-term returns?
A: Market declines reduce returns; recovering from a decline can take years. This significantly impacts the overall growth of your portfolio, especially if time is a limiting factor.

Q: What is the best strategy during high market valuations?
A: During high market valuations, consider more active strategies and focus on preserving capital to minimize losses during market corrections.

Focusing on time, valuations, and proper risk management can help you better align your investment strategy with your financial goals and life expectancy.

The federal government’s fiscal year ends on September 30, and with it, a budget extension is needed to keep the government running beyond that date. Accordingly, as seems to be the norm, government dysfunction is back on full display. House Speaker Mike Johnson failed to pass a budget extension bill on Wednesday. Moreover, he doesn’t appear to have a plan B. While the threat of a minor shutdown is real, history has proven a high likelihood that a deal will be struck and a short-term patch will buy a month or two of funding before another round of government dysfunction rears its head.

From an investor’s perspective, there are two potential impacts if government dysfunction rules the day and the government shuts down for a short period. The first is political. With the Republican-led House unable to pass a continuation bill, Democrats may blame the Republicans for the shutdown. Given that the election appears very close, it may not take much to sway the results. The differences in corporate tax proposals between Trump and Harris could impact the stock market; therefore, shifting votes one way or another could be significant. Second, if the government shuts down, there will be temporary layoffs, which would worsen employment data. While temporary, an increase in the unemployment rate could make the markets anxious. Moreover, it could push the Fed to be more aggressive with rate cuts as it’s now clear they are concerned about the weakening labor markets.

What To Watch Today

Earnings

• No notable earnings reports today.

Economy

• No notable economic reports today.

Market Trading Update

Yesterday’s commentary focused on the Fed rate cut and the potential market response. While the bullish backdrop persists and continued yesterday, the negative relative strength and momentum divergences suggest some caution. One notable outlier yesterday was bonds. We discussed earlier this week that Treasury bonds were extremely overbought and needed to be corrected. Furthermore, since they had run up sharply into the Fed meeting, a “buy the rumor, sell the news” event was likely. Such seems to be the case, with bonds selling off decently over the last two days.

Yesterday, Treasury bonds (using TLT as a proxy) broke through the 20-DMA. The next level of support is the 50-DMA, at 97, with crucial support at the 100- and 200-DMA, both of which are at 94. With the MACD just turning onto a “sell signal,” the current correction in bond prices could continue for a few days. However, that is a welcome opportunity for us to rebalance our bond portfolio duration and add bonds to our holdings as needed.

In the long term, as the Fed continues to cut rates, bonds should not only continue to perform, but history suggests they tend to outperform stocks as a whole. Trade accordingly.

The Market Is Betting On Another 75bps In Cuts This Year

In its quarterly economic forecast, Fed members project, on average, that Fed Funds will end the year at 4.40%. The projection implies the Fed will cut rates by 50bps total over the next two meetings. The first table below, courtesy of the Fed, shows that of the 19 members polled, two think the Fed will not cut rates again this year. Seven members believe they will only cut once and by 25bps. Nine members are forecasting a total of 50bps, and only one thinks the Fed will cut by 75bps.

The market has a different opinion. As implied by Fed Funds futures and shown in the second graphic, the market thinks the Fed will cut rates by 75bps over the last two meetings of the year. Furthermore, it implies there is an outside shot that they cut by 100bps, equating to 50bps at each meeting. With next week’s PCE price data, a new batch of labor data early next month, and the CPI report in mid-October, the Fed and the market will likely have better insight into what the Fed may do at the November 7th meeting.

Large Caps Prosper While Small And Mid-Caps Languish

The graph below, courtesy of Yardeni Research, shows that large-cap stocks have prospered while small and mid-cap ones have languished over the last two years. His graph shows that earnings between small, mid, and large-cap stocks are often well correlated. However, the earnings divergence between large versus small and mid-cap stocks has become notable. The difference is due to many factors. In our opinion, two factors likely have had the most impact.

First, larger companies, especially those in the services field, have primarily been able to pass on inflation to their customers. Smaller companies have not had as much luck. With inflation moderating, this aspect driving the earnings gap should subside. Similarly, as a function of inflation, interest rates rose. Larger companies borrowed heavily in 2020 and 2021 at meager rates. Accordingly, in many cases, the effect of higher rates was negligible. Smaller companies do not have as much access to the bond markets and tend to rely more on floating-rate debt. As a result, their interest expense rose more than large companies. Therefore, these companies should see lower interest rate expenses and higher profit margins as rates decline.

Assuming lower interest rates and inflation, the gap in earnings growth is likely to close. Therefore, everything else equal, small and mid-cap stocks may trade better than larger-cap stocks.

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On Wednesday, the Fed embarked on an easing campaign with a somewhat surprising 50 bps cut in the Fed Funds rate. The shift toward an easy money policy follows a 2.5-year tight monetary policy regime. 11 members voted for the rate cut, with one member dissenting. The dissent was the first dissent in almost 20 years. As shown below, the Fed made several changes to its FOMC statement. Specifically, they downgraded their forecast for job growth and are showing more confidence that inflation is heading toward their 2% target. Importantly, its inflation and employment goals are now “roughly in balance.” Subsequently, they added the phrase “securing maximum employment” to its strong commitment to get inflation back to target.

Following the FOMC statement release, Jerome Powell addressed reporters. He continued to stress that the Fed has growing confidence that inflation is moving sustainably to 2%. However, they see increased risks of the labor market weakening. Their decision to by 50bps instead of 25bps was largely based on its concerns that the labor market is weaker than reported and expectations the BLS will continue to revise job growth numbers lower. Powell downplayed the dissent and said the members were mainly on the same page. He did not commit to a schedule of easing going forward. Also of interest, the Fed is comfortable letting the balance sheet shrink (QT) while cutting interest rates.

The critical takeaway from Powell’s comments and the Fed statement is that labor market data will likely steer the Fed forward. Therefore, look for more financial market volatility around labor market data releases.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we stated:

“…the rally in stocks and bonds could be a “buy the rumor, sell the news” type event, so a bit of caution ahead of the Fed announcement is prudent.“

That seemed to be the case yesterday, as the market initially rallied as the Federal Reserve cut rates by 50 bps. However, after that initial “knee-jerk” reaction to the announcement, sellers showed up, erasing the gains for the day. I asked ChatGPT how the market previously responded to the Fed’s initial 50 bps cuts.

“A 50-basis-point rate cut is generally seen as a more aggressive form of monetary easing, signaling that the Fed is taking swift action to address economic weakness. Historically, the S&P 500’s response to such cuts has been varied, depending on the underlying economic environment.

In January 2001, when the Fed implemented a 50-basis-point rate cut, the initial response was positive, but the market ultimately declined as the economic slowdown persisted.

Conversely, in October 2007, when the Fed cut rates by 50 basis points, the S&P 500 initially rallied but soon faced the headwinds of the looming financial crisis, leading to a prolonged bear market.”

While there is little evidence currently of a worsening economic condition, the markets must question whether the Federal Reserve is aware of some rising risk that has yet to manifest itself in the economic data. However, in the short term, there are technical concerns to consider. There is a negative divergence in the relative strength and momentum of the market, which suggests a weakening of buying demand below the surface. We have previously discussed these negative divergences often precede short-term corrections, so it is something investors should pay attention to. Secondly, the market failed at key overhead resistance. While the initial failure has not yet been confirmed, the market must break out to new highs by the end of the week, or downside risk will increase.

Trade cautiously through Friday, and we will let the market dictate the next steps in our portfolios.

Fed Quarterly Economic Projections

The Fed’s quarterly economic projections, aka dot plots, show increased confidence in lower inflation and more economic weakness than they expected in June, the last time they published their forecasts. They expect the unemployment rate to be 4.4% at year-end, up from 4.0% in June and up 0.2% from the current 4.2% rate. Furthermore, they decreased their year-end GDP forecast by a tenth of a percent to 2.0%. Additionally, they cut their forecast for PCE from 2.6% to 2.3% and Core PCE from 2.8% to 2.6%. Currently, Core PCE is 2.8%.

Regarding their forecasts for 2025 and 2026, they increased their unemployment projections by 0.1% in 2025 and 0.2% in 2026. PCE was revised slightly lower for 2025.

The Fed expects the Fed Funds rate to end the year at 4.4%. Given that only two meetings are left in 2024, we now have solid guidance that the easing campaign will include another 50bps in rate cuts this year, likely 25bps at each meeting. Moreover, the Fed expects to cut an additional 1% in 2025. They think the terminal rate for this easing campaign will be 2.90%, which is in line with implied Fed Funds futures forecasts but moderately above the 2.50% peak in 2019.

Trump Or Harris: Corporate Tax Winners And Losers

Markets handicap unknown scenarios all the time. In some cases, stock prices can move violently as the odds of an event occurring change. Since corporate taxes may be the most significant short-term political factor affecting stock prices, it’s worth understanding what both candidates propose, allowing us to try to stay a step ahead of the market handicappers.

Furthermore, with the recent history of Donald Trump’s 2017 corporate tax cuts, we quantify which companies are best suited to take advantage of or be penalized by a change to the tax code.

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Not surprisingly, Donald Trump and Kamala Harris are taking opposite approaches to modifying the corporate tax code. If enacted, both proposals would significantly impact corporate profits and, thus, share prices. Currently, the plans are only campaign promises. History repeatedly reminds us that many political promises are meant to drum up votes.

“Read my lips, no new taxes” – George H.W. Bush 1988.

Predicting whether Trump or Harris will be the next president is challenging. Moreover, even if you know who will win, it’s even trickier to assess which legislation they will focus on and which bills can get through Congress.

Markets handicap unknown scenarios all the time. In some cases, stock prices can move violently as the odds of an event occurring change. Since corporate taxes may be the most significant short-term political factor affecting stock prices, it’s worth understanding what both candidates propose, allowing us to try and stay a step ahead of the market handicappers.

Furthermore, with the recent history of Donald Trump’s 2017 corporate tax cuts, we quantify which companies are best suited to take advantage of or be penalized by a change to the tax code.

Current Corporate Tax Code And History

The following graph charts the Federal corporate tax rate and the effective tax rate companies have actually paid since World War II. Trump’s 2017 Tax Cuts and Jobs Act (TCJA) reduced tax rates from 35% to 21%. The only other significant cut in America’s history of corporate taxes was in 1986, when President Reagan reduced them from 46% to 34%.

Like personal taxes, corporations have many loopholes. Thus, the effective tax rate can vary widely by company. Evaluating how tax rates affect corporate bottom lines in the aggregate is important but can be critical at a company level.

This article only addresses the proposals from the point of view of corporate profits. We do not opine on how they could impact the deficit or economy.

Donald Trump’s Tax Proposals

Trump’s current tax proposal calls for a tax reduction for corporations from 21% to 15%. However, the reduction would solely be for companies that make their products in America. Companies that “outsource, offshore or replace American workers” will not be eligible.

What’s unclear is whether companies can divide their revenue for tax purposes based on where goods are manufactured. Furthermore, how will companies providing services be taxed?

Also for consideration is the “Bonus Depreciation” tax break from the 2017 TCJA. The legislation allowed companies to depreciate 100% of equipment purchases in the year it was acquired. Previously, they could only write down the value of equipment over time according to its useful life.

The Institute of Taxation and Economic Policy (ITEP) analyzed the impact of the accelerated depreciation rule on 25 of the biggest beneficiaries (LINK). They write:

The federal statutory corporate income tax rate is 21 percent, which means that if corporations enjoyed no special breaks or loopholes at all, they would pay 21 percent of their profits in taxes. As a group these corporations used many kinds of tax breaks to drive their effective federal income tax rate down to 12.2 percent. For the whole group of companies, accelerated depreciation accounts for 86 percent of those tax breaks.

Some corporations have used accelerated depreciation to drive their effective tax rates down to single digits during this five-year period. These include Verizon, Amazon, Walt Disney, Con Edison, General Motors, Dish Network, and others.

While the accelerated depreciation has been a boon to some companies, the amount a company can depreciate declines over time. In 2024, a company can only depreciate 60% of equipment costs versus 100% from 2018 to 2022. Each year forward, the amount drops by 20%. In 2027 and beyond, it will be phased out unless it’s extended.

Kamala Harris’s Tax Proposals

Harris’s proposal is more straightforward to analyze. She supports raising the corporate tax rate to 28% for all companies. In addition, she would like to increase the corporate stock buyback tax from 1% to 4%.

Under her plan, companies would see a 7% increase in tax rates which essentially claws back half of Trump’s 2017 TCJA tax legislation.

Congress ultimately has the power to change tax rates. Ergo, whether it is Trump or Harris, it will be hard to change the tax code if one of the two houses of Congress is the opposing political party. The chart below from Gavekal Research shows the possibilities.

Analyzing The S&P 500 Companies

With some background on the candidate’s proposals, we now evaluate the constituents of the S&P 500 to assess the impact of the Trump tax cut. The analysis helps gauge which stocks are most at risk of tax hikes or could benefit from further tax reductions.

Our analysis is based on corporate tax data from 2010 to current for the 503 current S&P 500 stocks. To help improve the quality of the analysis, we only assessed companies with at least four years of earnings data before the Trump tax cuts and six years afterward. Further, we avoided companies with volatile earnings. That criteria narrowed the list to 306 companies.

Of this subset of the S&P 500, the average tax rate before the tax cut was 26.74%. Since then, it has been 17.37%. Almost 90% of the companies saw their effective tax rates decline. On average, the 306 companies’ earnings were 9.36% greater than they would have been.

We summarize the data for you because there are over three hundred companies.

The following table organizes the data by sector. Utilities were the apparent biggest beneficiary of tax cuts. This was partly from the bonus depreciation and recent tax incentives to promote green energy.  

On the other side of the coin is real estate. The cut was not meaningful because these companies tend to pay very little taxes. As shown, the rest of the sectors tended to gravitate around the average. 

The following table shows the largest stocks by market cap. We left out five stocks due to earnings volatility.

Who Pays If The Harris Plan Is Law

The following table lists the companies that saw an improvement of at least 20% to their bottom lines due to the 2017 change in the tax code. Some of these stocks may be at most risk if Harris’s tax plan to boost rates to 28% passes. Those with effective tax rates closer to 28% may be the least affected.

Part of the Harris plan is to raise the buyback tax rate from 1% to 4%. Doing so will weigh on the bottom lines of those perpetually buying back significant amounts of shares. Furthermore, some of these companies may find it more advantageous to increase their dividends instead of buybacks.

The following graph from Uptrends shows the top ten buyback programs of 2024. Clearly, Apple, META, and Google may have the most to lose from the potential tax increase.

Who Wins If Trump’s Plan Is Enacted

Conversely, those with the highest effective taxes and domestic production capabilities may benefit the most. Given that we do not have data on production facilities, we can only share the companies with the highest effective post-2018 tax rates.

In addition to the potential tax cut, we must consider any changes to the bonus depreciation roll-off schedule. Trump could try to bring back the 100% depreciation in year one or stop the bonus depreciation percentage from declining.  

To help us in this endeavor, we share the following table from ITEP with the biggest beneficiaries of the bonus deprecation.

Summary

As we sit here today and assess the stock market and individual stocks from a political perspective, it appears a Trump victory may provide investors with more potential upside. We are solely basing the argument on their respective tax cut proposals.  

The graph above shows that the S&P 500 rocketed by 35% in the two months following the passage of the legislation. Furthermore, the market rose before the legislation as investors gained confidence the legislation would pass Congress.

One can argue the gains were short-lived, as the market gave up its gains shortly after. Contrarily, higher corporate profits due to lower tax rates are an important factor driving the market significantly higher since 2017.

The VIX Index, often called the “fear gauge,” measures implied market volatility based on S&P 500 put and call options. Most often, the VIX rises when the stock market declines as investors tend to be willing to pay a higher premium for option hedges. Conversely, the VIX falls or hovers at very low levels as markets rise, and the aggregate market needs to hedge is minimal. However, there are times when the VIX Index rises alongside a rising stock market. This is occurring today, and it can be a sign that investors are suspicious of the viability of the recent stock market gains.

The current instance of an elevated VIX during alongside a record high suggests that investors are hedging more than is typical at market highs. Despite the positive momentum, investors are uneasy about the rally’s sustainability. Likely, the combination of the Fed starting to cut rates and the coming election are putting investors at unease. Furthermore, investors could be concerned that recent market gains are driven by short-term speculative trades rather than long-term fundamentals. Such a condition would leave the market vulnerable to corrections. The positive correlation between the VIX Index and the market should keep us alert for sudden changes in market conditions. Still, it doesn’t preclude the bull market from marching higher over the coming months.

What To Watch Today

Earnings

Economy

Market Trading Update

If you missed it, yesterday’s discussion focused on a question I have received several times about buying bonds. As I stated, short-term bonds are overbought heading into today’s Fed meeting, and a disappointment could lower bond prices. However, the same can be said for the equity market, which has also pushed into resistance at recent highs. As stated yesterday, the rally in stocks and bonds could be a “buy the rumor, sell the news” type event, so a bit of caution ahead of the Fed announcement is prudent.

As noted, the market is struggling with recent highs and is back in its previous consolidation range. From a bullish perspective, moving averages are trending higher, and the market is not egregiously overbought. With the market trading above the 20—and 50-day moving averages, the downside is somewhat limited. After today’s FOMC announcement, we should be better able to assess the next entry point to increase exposure. Furthermore, given the rather significant outperformance of defensive stocks as of late, a rotation to more cyclical growth stocks may be likely if the Fed signals lower rates are coming.

Regret Management

It’s easy to argue that the Fed should cut by 25bps, but the case for 50bps is more challenging. Given economic growth remains resilient and inflation is still 1%+ above the Fed’s inflation target, there is a reasonable case for lowering rates in 25bps increments. The risks of moving by 50bps are the market and political responses. Taking such a big first step may spark concern that the Fed is worried economic growth will slow rapidly. There is also politics the Fed must grapple with. Indeed, with any rate cut, but more so with 50bps, Donald Trump will blame the Fed for picking sides. If Trump wins, the Fed’s aggressiveness may move Trump to try to fire Powell. This potentially has big implications further down the road.

That said, Nick Timiraos, aka the Fed Whisperer, published a WSJ article Fed Prepares To Lower Rates, indicating the Fed could likely cut rates by 50bps this afternoon. The rationale appears to be regret management. Per the article:

If officials think about which mistake they are less likely to regret at this week’s meeting, the case for starting their rate-cutting cycle with a half-point move makes sense, said Robert Kaplan, who served as Dallas Fed president from 2015 to 2021.

“If I were in my old seat, I’d say, ‘I could live with 25, but I’d prefer 50,’ ” said Kaplan, now vice chairman at Goldman Sachs. Given where inflation and unemployment sit, the Fed’s benchmark rate should be about 1 percentage point lower than it is, he said. “If I started with a clean sheet of paper, I’d say rates should be at 4.5%-ish.”

The article raises an important consideration. The quarterly economic projections will be released at today’s meeting. The projections cover the rest of 2024, as well as 2025, 2026, and the “longer term.” Because only two meetings are left this year, the board’s Fed Funds projections for the remainder of 2024 will provide a road map for the market.

If more officials project a total of 1 percentage point of cuts this year, that would imply at least one move of 50 basis points this year. Withholding that larger cut until later this year could raise awkward questions over why that is the best approach. Another option is to cut by 25 basis points now and project cuts of a similar magnitude at the last two meetings of the year, reserving the option to accelerate the pace if the economy worsens.

Lastly, Timiraos brings up the possibility of a dissent from one or more Fed members. There has not been a dissent in two years. Per the article, that is the longest streak in the “past half century.”

The graph below shows the rate increases of the past two years have been much more aggressive than the previous five rate-cutting cycles. Might aggressively removing said rate increase also involve an aggressive stance?

Momentum Investing Gives You An Edge, Until It Doesn’t

Do you buy a “momentum” fund and forget about it?

Well, not so fast, says Brett. However, while I agree with Brett, it is for a different reason. The issue with “Momentum investing” is that it is not a passive strategy. For example, if we look at the top 10 holdings of MTUM, we can see the changes being made to the ETF as momentum changes in the market.

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As we share below, the market is betting on a 50 bps Fed rate cut at tomorrow’s FOMC meeting. Given tame inflation and labor data, the question is why there is a sudden change in expectations. Might the Fed think the labor market is weakening more substantially than the market? Moreover, deflation could be a more significant threat than many appreciate. Remember that CPI, less lagging shelter prices, has been lower since March 2024.

While the Fed may want to move the ball faster with a 50 bps rate cut, doing so potentially poses risks. In our mind, the market’s perception is the most considerable risk of the Fed cutting 50 bps. Might such a move elicit concerns that the Fed is behind the curve? If so, investors may lower their growth and inflation forecasts. Both factors have driven outsized corporate profits. Therefore, a 50 bps cut by the Fed risks an equity market re-pricing. Or will the market rally because the market perceives lower interest rates as bullish?

There are many questions to be answered with bullish and bearish potential outcomes. Jerome Powell can soothe the markets in his press conference or spark concern. Buckle up; the next few days will undoubtedly be interesting, especially if the Fed cuts by 50bps.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

Yesterday, we discussed the market’s strong rally from the recent lows. However, the bond market has rallied just as strongly ahead of this week’s highly anticipated Federal Reserve meeting and the expected rate cut. As shown, Treasury bonds (as represented by TLT) are quite deviated from the 50-DMA and overbought on multiple levels. While we remain bullish on bonds in the longer term, particularly as the economy slows, the current overbought conditions and “exuberance” into the bond trade over the last few months is a bit overdone.

With the Fed meeting this week, the current setup suggests that even if the Fed cuts rates as expected, this could be a “buy the rumor, sell the news” setup for bonds. Of course, as is always the case, overbought conditions can remain overbought longer than most imagine, so trade accordingly.

Apple iPhone 16s Post Disappointing Sales

The good news for Apple is that they sold an estimated 37 million new iPhone 16s in the first weekend of pre-orders. The bad news is that figure is down over 10% from last year’s iPhone 15 launch. It appears many potential buyers are waiting for Apple to introduce Apple Intelligence, its version of AI. It is currently expected that the first Apple Intelligence features may not be released until after Thanksgiving. While the delay is longer than initially expected, Apple could see a rush of sales with the new features. Such would coincide with increased holiday sales.

As shown, the stock opened on Monday morning lower by 4%. If sales are merely delayed and a big rush of orders comes after it releases AI features, Apple shares, down about 10% from recent highs, may be worth keeping an eye on.

Market Breadth Normalizes With Record Highs In Reach

The SimpleVisor sector analysis below shows that many sectors have relative scores near zero. Therefore, these sectors are neither overbought nor oversold compared to the S&P 500. On its own, good market breadth is what we want to see in a bull market. However, the safety sectors continue to lead the way, and the energy sector is grossly lagging. Therefore, while breadth is decent, it appears there are some recession concerns creeping into investors’ minds.

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Since 2020, momentum investing has generated significantly better returns than other strategies. Such is not surprising, given the massive amounts of stimulus injected into the financial system. However, Brett Arends for Marketwatch noted in 2021 that momentum investing can give you an edge. To wit:

“Its success ‘is a well-established empirical fact,’ and can be demonstrated across multiple assets and over 212 years of stock market data, argues money manager Cliff Asness and his colleagues. It is ‘the premier market anomaly,’ writes analyst Gary Antonacci. It trounces a simple ‘buy and hold’ stock market strategy going back almost 100 hundred years, estimates money manager Meb Faber.”

While momentum investing is appealing in a liquidity-driven bull market, is it always the best strategy? As noted in the “Best Way To Invest:”

The last decade has been a boon for the index ETF industry, financial applications, and media websites promoting ‘buy and hold’ investing and diversification strategies. But is the ‘best way to invest’ during a bull market also the best way to invest during a bear market? Or, do different times call for different strategies?

That is the question we will explore further.

Momentum Investing Isn’t Passive

Brett compares several ETF funds over the past five years in his discussion. To simplify our analysis, we will use the following three ETFs from 2014 to the present. (2014 is the earliest date that all three ETFs have performance data.)

• SPDR S&P 500 ETF (SPY) as the “buy and hold” proxy,
• IShares Momentum ETF (MTUM) as the “momentum” proxy; and,
• IShares Value ETF (IVE) as the “value” proxy.

For our analysis, we calculated the growth of $1 invested in each ETF from January 2014 on a nominal capital appreciation basis only.

At first blush, the obvious choice for investors was momentum when compared to the S&P 500 or value.

So, is that all there is to it?

Do you buy a “momentum” fund and forget about it?

Well, not so fast, says Brett. However, while I agree with Brett, it is for a different reason. The issue with “Momentum investing” is that it is not a passive strategy. For example, if we look at the top 10 holdings of MTUM, we can see the changes being made to the ETF as momentum changes in the market.

At the end of 2020, Danaher Corp (DHR) and Thermo Fisher (TMO) were among the top 10 holdings as the market chased healthcare-related stocks due to the pandemic. By September 2021, with the steepening yield curve and developments related to vaccines and bitcoin, Paypal (PYPL), Moderna (MRNA), and major banks dominated the top 10. By the end of 2021, PayPal was replaced by Nvidia (NVDA), Costco (COST), and accounting stocks.

Looking at the present, following the 2022 correction and subsequent rebound, the holdings have once again shifted. After a strong run in 2024, Costco has returned to the top 10, replacing Netflix (NFLX) and Microsoft (MSFT).

The outperformance in Momentum is due to the changes in holdings to capture price trends. However, if you hold SPY, the only changes over the last few years are due to the weighting in the top-10 holdings.

Again, momentum seems to be the obvious choice.

But it isn’t.

Momentum Investing Doesn’t Always Win

Brett makes a very important point about momentum investing.

Researchers say investing in so-called “momentum” stocks, is the best documented and most durable “edge” in the market.

Critically, that applies to owning individual equities in a portfolio. Not passively holding an ETF.

There is a difference.

Yes, on a passive basis since 2014, momentum has outperformed the benchmark and value indices. However, passively holding an ETF negates the value of momentum investing.

“And there is an inbuilt cautious bias to this portfolio as well, because it only holds stocks that have positive trailing returns. In a bear market you may be invested in nothing whatsoever. As Meb Faber and others have pointed out, momentum strategies can help you avoid the worst market turmoil.” – Brett Arends

Read that again.

As a strategy, momentum investing raises cash when the momentum of holdings turns negative. Such is not the case for an ETF that must always remain invested. If we break the comparative performance down into specific periods, the value of the momentum strategy gets lost.

In 2105 and 2016, momentum provided no hedge against the Fed’s “taper” and Brexit.

Similarly, in 2018, relative performance was worse than the benchmark during the Fed’s “taper tantrum.”

Holding a momentum ETF in early 2020 did little to shield you from the downturn. However, momentum benefited from the recovery fueled by trillions in monetary and fiscal policies.

During 2022, holding a momentum ETF significantly underperformed the value index.

As Brett noted, momentum investing’s value, when applied to a portfolio of individual equities, is that it can help avoid significant capital destruction during market downturns.

However, the value of the momentum strategy gets lost when applying an active strategy to a passive holding.

Choosing The Right Strategy At The Right Time

As a strategy, momentum investing works well when properly applied to a portfolio of individual securities.

One of the most interesting aspects of this portfolio though is not only that it has a lot of hard numbers backing it up, but that it is in theory accessible to any ordinary investor who can screen stocks by monthly performance.

He is correct, and it is something that we provide at SimpleVisor daily, as shown:

Momentum investing works exceptionally well during a strongly trending bull market. However, it is critical to remember that strategies change during a bear market. As shown below, market cycles tend to precede economic cycles, so investment strategies should change with both economic and market cycles.

Such will be critically important when the next bear market begins.

The Return Of Value

As Brett aptly concludes:

My biggest problem with “momentum” as an investment strategy is that you are basically abandoning any attempt to do your own fundamental analysis whatsoever. It feels to me like the stock market equivalent of “social” media, jumping on the latest crowd mania regardless of any merits. 

But maybe that’s why I should do it. If Rome is falling, and the Dark Ages are coming, shouldn’t I just give up and bet on the Vandals?”

I wouldn’t give up just yet.

The chart shows the difference in the performance of the “value vs. growth” index. (Fidelity Value Fund vs S&P 500 Index)

Notable are the periods when “value investing” outperforms.

While it may seem like the current bull market will never end, abandoning decades of investment history would be unwise. As Howard Marks once stated:

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

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

The realization that nothing lasts forever is crucial to long-term investing. To “buy low,” one must first “sell high.” Understanding that all things are cyclical suggests that investment strategies must also change.

The rotation from “momentum” to “value” is inevitable. It will occur against a backdrop of economic weakness and price discovery for investors quietly lulled into complacency following years of monetary interventions.

“Relative valuations are in the far tail of the historical distribution. If, as history suggests, there is any tendency for mean reversion, the expected future returns for value are elevated by almost any definition.” – Research Affiliates

The only question is whether you will be the buyer of “value” when everyone else is selling “momentum?”

Despite improving investor sentiment as the markets approach all-time highs, recent price action in the yen and Fed Funds futures warns that it may be too early to think the recent volatility is over.

Let’s start with the yen and what it has done since wreaking havoc on the markets in early August. The graph on the left shows the yen started rallying against the dollar in early July as the BOJ raised rates while prospects of a Fed rate cut were increasing. Few paid attention to the yen until August 5th, when it spiked and created havoc in the asset markets. The volatility resulted from some investors quickly unwinding the yen carry trade. The BOJ verbally responded, easing market concerns; with it, the yen gave up some ground versus the dollar. However, the yen has slowly been appreciating compared to the dollar and is now trading above the August 5th levels. There should be some concern that further appreciation will force more yen carry unwinds, resulting in downward pressure on U.S. equities.

Following the CPI and BLS employment reports, the Fed Funds futures market reduced the odds the Fed would cut rates by 50bps to a mere 5% chance. On Thursday, it spiked back to nearly 50%, as shown in the graph on the right. With no real economic data to sway the Fed’s decision, the quick change in odds is curious. It may not mean much, but it certainly bears paying attention to. Both the appreciation of the yen and the quick change in Fed expectations may prove to be nothing. But given the recent spate of volatility, up and down, complacency is ill-advised.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

As noted last week, the market broke the 50-DMA and closed the week at the 100-DMA. Things did not look good heading into this week. However, the market rallied off the 100-DMA and retraced to the 50-DMA. Then, on Wednesday morning, a hotter-than-expected CPI report led to a sharp 1.5% selloff that retested the 100-DMA a second time. Things looked a bit dire, but strong words from Nvidia’s (NVDA) CEO sent stocks surging higher to a 1% gain by the close. That reversal cleared resistance at the 50-DMA, confirming the retest of the previous support. That bullish action continued through Friday, clearing the 20-DMA as well.

The market will challenge the recent highs next week. The trend of higher lows and the triggering of the MACD “buy signal” all suggest the recent correction phase is over for now. While the backdrop to the market is bullish, there is still some risk over the next month as we head into the beginning of earnings season and the November election.

We continue to suggest remaining somewhat hedged against potential market volatility by taking profits, rebalancing risk, increasing cash levels, and raising stop loss levels. Outside of those “defensive” actions, the market remains bullishly biased, and there is little reason for more negative positioning at this time.

Does that mean there is “no” risk to the markets? Of course not. This past weekend’s newsletter discussed three market risks, including one from Friday, which we are watching closely heading into year-end.

The Week Ahead

The Wednesday Fed FOMC will be the highlight of the week. As we noted above, the odds have moved to 50/50 of whether they cut by 25bps or 50bps. A 50bps rate cut may concern investors as the economic data doesn’t warrant such an aggressive move. If they cut by 50bps, investors may wonder- what does the Fed know that the market doesn’t? We will look for indications of how many more rate cuts will likely follow in the months ahead. Moreover, we think there is the possibility they further reduce the monthly amount of QT.

Retail Sales will come out on Tuesday before the Fed meeting. The current estimate is for a gain of 0.3%, which would be well below the 1% from the prior month but in line with the majority of 2024.

Labor Market Impact On The Stock Market

The August jobs report highlighted a critical reality: the labor market is cooling off. While the headline figures seemed decent, the underlying data reveals clear warning signs that worker demand is slowing. Investors should pay attention because the link between employment and its impact on the economy and the market is undeniable. While often overlooked, as we will discuss, there is an undeniable link between economic activity and corporate earnings.

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As we share in the graph below, crude oil prices peaked at $95 a barrel a year ago. More recently, in July, they were as high as $85. Today, they are below $70 and threatening to take out long-term support. So, why are oil prices falling so rapidly? We lean on the International Energy Agency (IEA) to answer the question. In their monthly Oil Market Report released on Wednesday, they place much of the blame on China. Per the article:

The rapid decline in global oil demand growth in recent months, led by China, has fuelled a sharp sell-off in oil markets. Brent crude oil futures have plunged from a high of more than $82/bbl in early August to a near three-year low at just below $70/bbl on 11 September, despite hefty supply losses in Libya and continued crude oil inventory draws.

Furthermore, they introduce some eye-opening statistics. For example, global oil demand in the first half of 2024 was the lowest since 2020, when the pandemic crippled the global economy. Also, they note that China’s consumption has contracted for four months in a row. It’s not just China.

Outside of China, oil demand growth is tepid at best. Latest data for the United States show a sharp decline in gasoline deliveries in June, following unexpected strength in May.

Falling oil prices and demand are good predictors of economic activity and inflation. Consequently, oil is warning of an economic slowdown and likely lower inflation.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

Yesterday, we discussed the strong reflexive rally that took the S&P 500 from retesting support at the 100-DMA to crossing above the 50-DMA resistance. Interestingly, Bitcoin, an effective S&P 500 proxy, did not participate in that rally. Notably, as shown, Bitcoin has been consolidating within a trading range since April, which has reversed the previous overbought conditions from the runup since October 2022.

Technically, bitcoin trades below important moving averages, limiting near-term upside. However, another rally becomes more probable if this consolidation can continue without breaking down. Given the correlation to the S&P 500 index, I suspect that whatever happens next will hinge on how the market does from here.

One concern with the S&P 500 index and Bitcoin remains the expectation for Fed rate cuts. As noted this week, if bitcoin is a proxy for the S&P 500 index, it is also a proxy for Fed rate cuts. Historically, when the Fed cuts rates, speculative risk assets get repriced for slower economic activity. Could this time be different? Sure. However, given the correlation to the S&P 500, I would be reticent to completely disregard the potential risk.

The ECB Cuts Rates Again

As we led, falling oil prices and demand suggest that economic growth is slowing worldwide. The ECB provides another similar indication. At yesterday’s ECB meeting, they cut interest rates by 25bps to 3.50%, partly because they cut their economic growth forecast through 2026. Further, they remain very confident that inflation will fall to 2% through the course of 2025. The graph below shows the ECB deposit rate (Fed Funds equivalent) was cut for the second time this year. Also, note that the deposit rate is still well above inflation. Such has been a rarity in the last 25 years and it argues they still have plenty of room for rate cuts.

With the rate cut, Europe’s benchmark lending rate stands at 3.5%, down from 4%. Central banks typically prefer to keep their monetary policies aligned so as not to upset the currency markets. Therefore, it’s highly likely the ECB cut rates yesterday and will continue to do so with confidence and probably assurances from Jerome Powell that the Fed will follow with a rate cut next week and more in the following months.

PPI Retail Markups

Like the CPI report, the PPI data was pretty much as expected. Year-over-year, it fell to 1.70% from a downwardly revised 2.10% and below expectations of 1.8%. The monthly headline figure was +0.2%, with the monthly core rising 0.3%. PPI is now at its lowest level since February. There was some slight concern that PPI, which tends to lead CPI, was creeping higher in recent months. Yesterday’s report should extinguish some of those fears.

The following comment and graph are courtesy of Ernie Tedeschi.

One of the most interesting things the PPI tracks that the CPI doesn’t is retail markups. Retail markup growth has slowed considerably & this has been a contributor to disinflation. In August in particular, growth in grocery markups fell to 0.7% YY, the slowest in 3 years.

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The August jobs report highlighted a critical reality: the labor market is cooling off. While the headline figures seemed decent, the underlying data reveals clear warning signs that worker demand is slowing. Investors should pay attention because the link between employment and its impact on the economy and the market is undeniable. While often overlooked, as we will discuss, there is an undeniable link between economic activity and corporate earnings. Employment is the driver of a consumption-based economy. Consumers must produce first before consuming, so employment is critical to corporate earnings and market valuations. We will discuss these in order.

Slowing Labor Market: The First Red Flag

The August jobs report indicated that job creation has slowed dramatically, particularly in crucial manufacturing, retail, and services sectors. For months, we’ve relied on the narrative that a strong labor market could buoy the economy through rough patches. But that narrative quickly falls apart as hiring freezes and job cuts become more common. The data trend is always more critical than the actual employment number. The message is simple: employment is weakening.

However, as discussed in the “Sahm Rule,” full-time employment is a far better measure of the economy than total employment. As noted, the U.S. is a consumption-based economy. Critically, consumers can not consume without producing something first. As such, full-time employment is required for a household to consume at an economically sustainable rate. These jobs provide higher wages, benefits, and health insurance to support a family, whereas part-time jobs do not. It is unsurprising that, historically, when full-time employment declines, a recession typically follows.

If full-time employment drives economic growth, it is logical that more robust trends in full-time employment are required. However, since 2023, the economy lost more than 1 million full-time jobs versus gaining 1.5 million part-time jobs. That does not scream economic strength.

Furthermore, a comparison of full-time employment to the working-age population shows why the U.S. can not sustain annual economic growth rates above 2%.

Since the turn of the century, as the U.S. has increasingly integrated technology and outsourcing to reduce the need for domestic labor, full-time employment has continued to wane. If fewer Americans work full-time, as a percentage of the labor force, the ability to consume at higher rates diminishes as disposable income decreases.

Since corporate earnings depend on economic activity, companies continue to adopt technology and other productivity-enhancing tools to reduce the need for labor. If slower economic demand begins to weigh on corporate profit margins, earnings forecasts will be revised downward in the coming months.

Corporate Earnings Are in Jeopardy

Understanding how a weakening labor market translates into weaker earnings is essential. When companies are uncertain about future demand, they stop hiring and look to cut costs. These cost-cutting measures appear in numerous ways, such as layoffs, automation, outsourcing, or increasing temporary hires. Such measures can buy companies some time but don’t solve declining revenues. When fewer people have jobs or wage growth stalls, consumer spending slows down, and that hits the top line for many companies, particularly in consumer-driven sectors. Unsurprisingly, there is a relatively high correlation between the annual change in GDP and corporate earnings.

As such, given that market participants bid up stock prices in anticipation of higher earnings and vice versa, the correlation between the annual change in earnings and market prices is also high.

In past economic cycles, we’ve seen how quickly earnings can disappoint when the labor market weakens. Analysts have been overly optimistic about earnings growth, and now the reality of slower consumer demand will force them to adjust their projections. As earnings expectations come down, investors will need to rethink current valuations. This is a straightforward equation—lower earnings lead to lower stock prices as markets reprice current valuations.

Investors should prepare for a slowing labor market’s impact on stock prices. The market is a forward-looking mechanism, and it’s already starting to price in the effects of weaker job growth. Sectors most exposed to consumer spending, such as retail and travel, are likely to see the sharpest declines in stock prices as investors adjust to the reality of softer earnings.

Technology companies, which have driven much of the stock market’s performance this year, will also be vulnerable. These companies rely on high growth expectations to justify their lofty valuations. If the labor market weakens, consumer demand for tech products and services will also fall, leading to earnings misses and stock price declines.

Investor Implications

The broader financial markets are potentially at risk of a “bumpier ride” as the effects of the weakening labor market ripple through the economy. As we’ve seen in previous cycles, investors will begin to move away from riskier assets like stocks and into safer investments such as Treasury bonds. Such a shift could exacerbate market volatility if earnings get revised lower to reflect slower economic activity.

There’s also the question of how the Federal Reserve will respond. A slowing labor market often leads to lower inflation, which might allow the Fed to cut interest rates more aggressively and reverse the current reduction in its balance sheet. However, if inflation remains well above the Fed’s 2% target, despite weaker job growth, the Fed could find its hands tied. A potential market risk is when the Fed gets forced to keep rates elevated while the economy slows. Such would prolong the economic downturn and increase stock price pressure.

Recent employment reports show a clear trend: the labor market is losing momentum. That spells trouble for the economy and the stock market. The slowdown in job creation, coupled with weaker corporate earnings, is setting the stage for increased market volatility.

As noted, with markets still near all-time highs, it is an excellent time to reassess portfolio risk exposures. Rebalancing positions in overvalued growth stocks and shifting toward more defensive assets could be prudent. As we have often said, capital preservation should be the priority in times of uncertainty. The labor market indicates that uncertain times are ahead, and investors should prepare accordingly.

The Adobe Digital Price Index claims to use data from over one trillion online consumer transactions comprising over 100 million unique product SKUs. While those are massive numbers, Statista estimates only 16% of retail sales will come from online transactions in 2024. Despite the relatively small percentage, over 75% of adults shop online, and over half shop online at least once a week. Therefore, in-store prices must stay somewhat competitive with online prices. As such, Adobe’s price index provides a decent price gauge for consumer goods and may even prove to be a leading indicator of consumer price trends. With that, we present a few interesting data points and graphs from the latest Adobe data.

• Monthly grocery prices fell 3.7% in August and are running +.48% year over year. That is the lowest monthly figure since the index started in 2014.
• The graph below shows that of the 18 price categories they track, 11 have been declining on average over the last three months.
• Adobe claims prices fell .24% in aggregate last month, bringing the year-over-year rate to -4.37%.

Austan Goolsbee and Pete Klenow created the Adobe model. Goolsbee was recently appointed as the President of the Chicago Federal Reserve. The data we present may help explain why he seems more confident than other Fed members that inflation will return to the Fed’s 2% target.

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we discussed how bonds were overbought short-term and needed a bit of a correction. Yesterday’s CPI print, with core inflation rising, may have started that correction. However, today’s PPI print will also be important. The inflation print was cool enough at the headline to spark a stock market rally as investors settle in on a 25 basis point cut at the Fed meeting next week.

Notably, yesterday’s rally was a return of the “Magnificent 7,” which has been under pressure lately. However, these companies, in particular, generate a vast portion of the overall earnings growth in the index. With inflation coming down and personal consumption remaining steady, the earnings for these companies will likely continue to drive the markets for now.

Technically speaking, yesterday’s rally was extremely bullish. In the morning, the market initially sold off following the CPI report. However, as the markets digested the data, buyers entered at the 100-DMA and drove the market above the 50-DMA by the end of the day. That successful test of support and break of overhead resistance sets the market up to retest recent highs. With the market not overbought and the MACD beginning to turn higher, we should see some follow-through buying today if the Producer Price Index confirms the trend of weakening inflationary pressure.

Continue to manage exposures. While the market does not have an “all clear” just yet, yesterday’s action was very encouraging.

The CPI Report

Headline CPI came in as expected, rising 0.2% monthly and 2.5% annually. Core CPI was a tenth higher than expectations at 0.3%, but on a year-over-year basis, met expectations of 3.2%. Notably, the annual inflation rate fell from 2.9% to 2.5%. The decline was due to a monthly annualized inflation reading of 4.3% from 13 months ago dropping out of the calculation. This is the lowest inflation reading since March 2021.

Once again, shelter prices account for nearly all of the monthly gains. Shelter prices were up 0.5%. As shown below, CPI less shelter has been at zero for the last two months and is slightly negative for the previous three months. As we continually harp on, when CPI shelter prices catch up with real-time price indicators of rents, CPI will take another leg lower, possibly into deflationary territory.

The data further confirms that the Fed will likely cut rates by 25 bps next week. As implied by Fed Funds futures, the odds of a 50bps cut is 12%, down from over 50% a week ago.

Cash Cows Inform Us On Yields

We have written many articles and commentaries forecasting interest rates. The analysis has used prior and current inflation and economic activity. Additionally, we have looked at market data on inflation expectations, Fed Funds futures, and other factors that influence interest rates. Today, we add an unorthodox factor to the list: cash cows.

This article introduces a unique way to imply where dividend investors think interest rates will be in the future.

READ MORE…

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Yesterday’s commentary answered a question from a reader about our thoughts on owning gold or gold miners during a bull steepening period. Hours after publishing the commentary, we got a similar question asking how bitcoin might do when the Fed cuts rates. If bitcoin trades as a proxy of monetary policy and the dollar’s viability, then the question and answer are very important to grasp as the Fed embarks on a rate-cutting period. Bear in mind that we only have ten years of bitcoin data, so take the following analysis with some skepticism.

We separated the graph below charting Fed Funds and Bitcoin into the three Fed policy cycles: rate cutting, easing, and doing nothing. The two blue-shaded areas show mixed results when the Fed raises rates. In 2017-2018, bitcoin rose sharply but then gave up most of its gains. More recently, bitcoin fell as the Fed raised rates. The green bar shows one experience with rate cuts that was not friendly for Bitcoin holders. Its price was nearly cut in half during the period. However, what stands out most are the yellow circles highlighting periods when the Fed was doing nothing. Bitcoin surged in the three instances.

If bitcoin is indeed a proxy for rate policy, a rate cut should be good for it. However, our limited history argues otherwise.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

Yesterday, we discussed the initial test of the 100-DMA, which was held yesterday, but the 50-DMA currently provides decent overhead resistance for equities. However, Treasury bonds continue to extend their rally as anticipation for rate cuts builds and economic growth weakens. In August 2023, I discussed how I doubled down on my bond positions in anticipation of the coming bond rally despite arguments to the contrary from many mainstream analysts.

While our thesis was proven correct, bonds are now extremely overbought in the near term, with declining volume and deviating above the 50-DMA. For investors looking to add Treasury bond exposure at current levels, such will likely be painful as yields should retrace somewhat from current levels towards 4%. What causes such a retracement is unknown, but traders who were previously very short on Treasury bonds are now very long. Such positioning shifts often precede short-term retracements to previous support levels.

Using the 20-Year Duration Treasury Bond ETF (TLT) as a proxy for bond prices, I will become much more interested in increasing current exposure between 95 and 96. While prices could increase in the near term, waiting for an eventual correction to build positions will likely yield better long-term results.

NFIB Disappoints Again

The NFIB – Small Business Optimism Index continues to show small business owners are under a lot of strain and have a dim outlook on the future. The optimism index fell to 91.2 from 93.6. Hiring plans decreased. Only 4% of those surveyed said it was a good time to expand. In addition, the uncertainty Index, at 92, is the highest since October 2020. Moreover, positive profit trends are down a seasonally adjusted net -37%, -7% lower than last month, and now lower than the early months of the pandemic, as shown below.

So, the question is, what might help improve the outlook of small business owners and ultimately boost their businesses? The election is clearly hampering the outlook for many. The election in November will likely improve the outlook for some and worsen it for others. That said, policies by the new president to help small businesses could improve the outlook for business owners of both political parties.

The Fed may have the most sway regarding profit concerns. Small businesses are typically heavy users of debt. Furthermore, their interest rates tend to be much higher than those of larger companies. Therefore, lower interest rates will reduce their interest expenses and potentially lift their pessimism.

S&P 500 – A Bullish and Bearish Analysis

The S&P 500’s technical landscape presents both opportunities and challenges. Bullish indicators such as support at the 200-day moving average and oversold RSI levels suggest a “buy the dip” opportunity could be on the horizon. However, bearish patterns like lower highs and weakening volume during rallies warn of further downside risks.

We don’t know what will happen next, nor does anyone else. Therefore, we suggest a regular diet of risk management and portfolio rebalancing to navigate periods of elevated uncertainty.

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We have written many articles and commentaries forecasting interest rates. The analysis has used prior and current inflation and economic activity. Additionally, we have looked at market data on inflation expectations, Fed Funds futures, and other factors that influence interest rates. Today, we add an unorthodox factor to the list: cash cows.

This article introduces a unique way to imply where dividend investors think interest rates will be in the future. The impetus for this article came from a recent SimpleVisor Friday Favorites article in which we reviewed the Campbell Soup Company (CPB). Friday Favorites typically analyzes a company’s fundamental and technical conditions and valuations.

This time, however, because the company was a cash cow, we took it further and studied its dividend yield. In the process, we arrived at an implied ten-year U.S. Treasury yield based on the current and historical spread between Campbell’s dividend yield and the ten-year U.S. Treasury yield.    

Implying future interest rates based on CPB is somewhat laughable. However, implying future interest rates on a larger population of cash cows may be more telling.

What Is A Cash Cow?

Cash cow is a term dairy farmers use to describe mature cows that generate milk regularly with minimum maintenance.

Wall Street adopted the term cash cow to label companies that deliver reliable cash flows (milk), require little investment (maintenance), and have little to no sales and earnings growth (mature).

CPB is a good example of a cash cow. Not surprisingly, the soup business is a low-growth venture; therefore, it has negligible earnings and sales growth. Moreover, it has consistently paid dividends since 1989 and produces plenty of excess cash flow that should ensure future dividend payments.

While CPB lives up to the definition of a cash cow, we do not analyze it in this article as its dividend yield is below our threshold dividend yield. However, we did find fifteen other cash cows, which we will share.

Screening For Cows

In this analysis, we used the following screening criteria:

• Market Cap > $10 billion
• Five-Year EPS Growth < 5%
• Five-Year Sales Growth < 5%
• Dividend Yield > 2.50%
• Ten Years of Consecutive Dividend Payments

The table below shows the fifteen stocks that met the screening criteria.

What Can We Imply With Dividend Yields?

The following table shares our analysis of the fifteen companies.

After the ticker and name of each respective stock, we show the current dividend yield and the average dividend yield over the last five years. The next column, “Price Return to Avg. Div. Yield”, quantifies how much the stock price would have to change to bring the current dividend yield in line with the five-year average. Obviously, a company can increase its dividend or cut it, which would change the return.

The first set of analyses, which we just described, helps us compare the current dividend yield to recent yield history on an absolute basis.

Since some investors consider bonds a substitute for dividend stocks, we must also do a relative analysis of dividend yields. In other words, has the dividend yield risen accordingly with interest rates? To do this, we calculate the current dividend yield minus the current ten-year yield (“Spread to Tsy”). We also compute the average Spread to Tsy. for the last five years. With this data, we can calculate how much the stock price would have to change to make the dividend yield equal to its five-year average spread to Treasury yields.

Lastly, assuming the dividend yield reasonably predicts where rates are headed, we can imply where the ten-year U.S. Treasury yield may be in the near future. We share this in the column furthest to the right.

Cash Cow Conclusions

While there are many stories within the table, we focus on the averages of the fifteen stocks in this article. The current dividend yields are slightly higher than average. This is primarily a function of investors shunning dividend stocks in favor of higher-yielding bonds or stocks with better performance. Declining stock prices push the dividend yield higher, helping them stay competitive with bonds. Dividend yield is only one of many factors determining the price; however, it is a much more critical price determinant for cash cows than other stocks.

While the dividend yield may be higher than its norm for the last five years, it has not kept up with Treasury yields. Based solely on the yield spread, prices, on average, would need to fall by about 15% to bring the meager .41% spread over the 10-year UST back to normal.

But might stock investors be locking in higher dividend yields, anticipating a lower interest rate/yield environment? If so, our cash cows imply the 10-year UST yield would need to fall to 3.05%. Doing so will bring the average dividend yield spread versus Treasury yields back to its average.

Coincident or not, the market also thinks that the Fed Funds rate will trough at 2.87% when the coming rate-cutting cycle ends.  

Summary

Between our article Fed Funds Futures Offer Bond Market Insights and the cash cows we highlight, the Fed Funds futures market and stock market appear to be on the same page regarding future interest rates.

Some may find comfort in their similar predictions. However, caution is warranted. The bond market often underappreciates how much the Fed will cut interest rates. Furthermore, it has been proven to be a poor judge of where long-term Treasury bond yields will fall. Quite often, yields fall much more than anticipated. If this is again the case, some of our cash cows may see decent price appreciation if their dividend yield declines with lower bond yields.

This past weekend, we received this question from a reader. The question is in reference to our recent article, Bull Steepener is Bearish. Specifically, the article points out that historically, stocks tend to do poorly when the yield curve exhibits a bullish steepening. However, gold miners and gold have both averaged positive returns during such yield curve shifts. Moreover, during these periods, gold miners produced a better return than gold. Therefore, the question from our reader is, are gold miners better than gold if the yield curve continues to steepen bullishly?

While our data on the last five bull steepenings argues the answer is yes, historically, gold miners have been a poor substitute for gold. As shown in the graph below, since 1994, the NYSE Gold BUGS Index (HUI), which tracks gold miner stocks, has been up a mere 38%. At the same time, gold has risen over 10x that amount (540%). Miners should provide better returns during gold bull markets as they are leveraged to the price of gold. However, time and time again, we find that faulty management decisions more than offset the benefits of leverage. This is not to say all gold miners underperform or will underperform gold. But choose wisely if you decide to invest in a gold miner over gold.

What To Watch Today

Earnings

Economy

• No notable economic reports today.

Market Trading Update

As noted yesterday, the market broke through the 50-DMA on Friday testing initial support at the 100-DMA. The good news is that the market bounced off the initial test of support. The bad news is that the bounce was rather weak, with sellers showing up repeatedly throughout the day knocking down the gains. During a correctional period, as we are in now, bounces tend to be very short-lived as sellers look for an exit.

The good news is that the markets are decently oversold, and a rally to the 50-DMA remains a likely first test. However, there is no guarantee this market will not go lower first, so manage risk accordingly. As is always the case, markets can and do remain overbought or sold for longer than many imagine. Therefore, use rallies opportunistically and take nothing for granted until this correctional process is complete.

Private Jobs Don’t Signal A Recession Yet

There are many ways to slice and dice the BLS employment report. Most analyses point to a steady weakening of the labor market but not a net loss of jobs and certainly not a recession. One of our clients closely follows economic data and shared with us a unique way to use the BLS report as a potential recession indicator. To wit, he says that every time the year-over-year change in employment was negative for consecutive months, a recession was soon to follow, or the economy was already in a recession.

Currently, as he shows below, the year-over-year rate is still positive. But he warns:

The point being is the recent YoY% change in Private Employment has been decreasing for some time now as shown in the chart below. Currently that annual growth rate is a positive +140 bps. However, this could turn negative in the next couple of months and just something to keep an eye out.  

SimpleVisor Weekly Sector And Factor Analysis

The two SimpleVisor tables below show investors are gravitating toward sectors and factors with the least risk and higher dividends. Conversely, higher beta, technology, and growth have been lagging. This shift to safety occurs as the yield curve un-inverts and the Fed is set to embark on a rate-cutting campaign. The market seems to appreciate the slowing economy and is paying attention to some warnings.

Another warning comes from our weekly SV Money Flow Weekly. This analysis uses weekly data and three indicators to help spot longer-term bullish and bearish trends. To produce a buy or sell signal, all three indicators must confirm a trend change. The green arrows show that the three indicators turned bullish in late 2022 and early 2023. Moreover, the “strong buy” alert was added to the graph when the third indicator flipped bullishly.

Currently, the shorter-term MACD has had a bearish crossing, as shown by the red arrow. However, the other two are still in bullish trends. but the longer-term MACD is very close to turning bearish. The top indicator shows the converging 13- and 34-week moving averages but it could still be weeks or even a month or two from crossing bearishly. It’s important to wait for all three to cross. For example, in late 2023, the lower two indicators crossed, but the 13- and 34-week moving averages didn’t. Thus a sell signal was not generated and after a slight pause the market continued upward.

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