A week ago, the BLS revised lower the number of employed persons by nearly 900,000. Given that revision and a slew of recent revisions in other economic statistics, we must ask if GDP is also overstated. GDP, like other data, has a history of sharp revisions. For instance, consider the following research from the San Francisco Fed:
The figure shows that the decline in real GDP growth initially seemed far less serious than it turned out to be. In fact, for the first half of 2008, the data would have been consistent with only a relatively mild recession. But by the fourth quarter of 2008, the quarterly contraction was initially listed at –3.8% annual rate. With the passing of time, the data were revised down another whopping –4.6 percentage points, thus bringing the decline in GDP to an eye-watering –8.4% annual rate.
To help us appreciate if it is overstated and potentially by how much we turn to GDI. Gross Domestic Product (GDP) and Gross Domestic Income (GDI) are two very similar measures of economic activity. The difference is that GDP measures output, while GDI assesses income. These measures should tell the same economic story. However, GDI has proven to be more reliable and often leads GDP.
Hence, if the relationship normalizes, a downward revision is likely. Currently, the difference between GDP and GDI is $615 billion. Therefore, if a revision or even a normalization were to occur, GDP would decrease by 2.7%. We have more on the GDP-GDI relationship in a section below.
What To Watch Today
Earnings
No notable earnings releases today
Economy
Market Trading Update
Yesterday, we discussed that the market was testing initial support at the 50-DMA. The market flirted with breaking that initial level of support as the sell signal deepened. However, there are two important points to consider before taking action. First, when the market moves down to previous support levels, it generally coincides with short-term oversold conditions. Secondly, the initial break isn’t validated until a failed retest of that broken support.
While the market is not deeply oversold, the selling pressure has generated enough stress to elicit a short-term bounce. Such could be the case if the employment report this morning keeps Fed rate cut expectations on the table. Secondly, look for a bounce before reducing risk. As is often the case, investors tend to make knee-jerk reactions that lead to poor outcomes when markets sell-off.
This morning’s employment report will likely decide the market’s fate over the next few trading days. A too-strong report will send interest rates higher and stocks lower as expectations for Fed rate cuts get pushed out. The opposite will likely be the case if the report is exceptionally weak. After the employment report, we should know better where the market goes next.
ADP Jobs Report
We share the commentary below from ADP to help us set expectations for today’s BLS jobs report.
Private businesses in the US added 99K workers to their payrolls in August 2024, the least since January 2021, following a downwardly revised 111K in July and well below forecasts of 145K. Figures showed the labor market continued to cool for the fifth straight month while wage growth was stable.”The job market’s downward drift brought us to slower-than-normal hiring after two years of outsized growth,” said Nela Richardson, chief economist, ADP. “The next indicator to watch is wage growth, which is stabilizing after a dramatic post-pandemic slowdown”. Year-over-year, pay gains were flat in August, remaining at 4.8 percent for job-stayers and 7.3 percent for job-changers.
It is important to note that the ADP and the BLS employment reports have not been in sync since the pandemic. Therefore, take the data below and the commentary above with a grain of salt.
More On GDP GDI And Labor Market Revisions
The following is from Anna Wong, Chief Economist Bloomberg.
There is this myth that GDI always get revised toward GDP. It is a myth, because turns out that GDI leads GDP in turning points of the economy (per BEA and Fed research). And GDP tends to get revised toward GDI in lead up to and during recessions…though obvious only several years later. The discrepancy is GDP and GDI also turns out to be predictive of unemployment rate in the lead up to cyclical peaks.
Bottomline: why do I have to spend my Friday night writing about this rather reading a nice book? I’d rather not. But people on this app put too much signal on GDP, particularly in today’s economic environment. Research would say to put more weight on GDI in turning points.
The chart below accompanies a Fed article by Jeremy Newaik. As shown, the initial 2008 GDP readings were revised sharply lower over the following few years.
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Technological Advances Make Things Better – Or Does It?
It certainly seems that technological advances make our lives better. Instead of writing a letter, stamping it, and mailing it (which was vastly more personal), we now send emails. Rather than driving to a local retailer or manufacturer, we order it online. Of course, we mustn’t dismiss the rise of social media, which connects us to everyone and everything more than ever.
Economists and experts have long argued that technological advances drive U.S. economic growth and productivity. As innovations emerge, they play a crucial role in shaping the economy, improving efficiency, and enhancing productivity across various sectors. From artificial intelligence to automation, the benefits of technological progress are widespread and profound.
For example, automation and artificial intelligence have streamlined manufacturing processes, reducing the need for manual labor and minimizing human error. This efficiency boost leads to faster production times and reduced costs, lowering prices while improving profit margins. Higher productivity levels contribute to overall economic growth, as businesses can produce more goods and services with the same resources.
Another significant benefit is the creation of new industries and job opportunities. As technology evolves, it creates demand for new skills and expertise, leading to the development of entirely new sectors. For example, the rise of the technology industry gave birth to jobs in software, data analysis, and cybersecurity, among others. These high-paying jobs contribute to economic growth by increasing consumer spending and driving innovation.
Ray Kurzweil’s 1999 book, “The Age of Spiritual Machines,” introduced the concept of “The Law of Accelerating Returns.“ Ray predicted that the rate of technological advances is exponential rather than linear. That means that technology builds on itself in a positive feedback loop, allowing each generation to advance at an increasing rate.
Kurzweil’s predictions related to this theory have proven remarkably accurate. He predicted technologies such as the internet and the growth in mobile computing power years before they emerged. Out of 147 predictions he made in the 1990s about the future up to 2009, 115 (78%) were correct.
However, were economists’ predictions about the benefit of technology as accurate as Kurzweil’s?
The Dark Side Of Technological Advancement
While technological advances seem to produce an enormous benefit, a dark side gets hidden from public discourse.
One primary concern is job displacement. Automation and artificial intelligence, while improving efficiency, often replace jobs traditionally performed by humans. This displacement mainly affects low-skilled workers in industries like manufacturing and retail, leading to unemployment and underemployment. As machines take over routine tasks, the workforce faces the challenge of reskilling to meet the demands of a more technologically advanced economy. That transition period can lead to economic slowdowns and increased inequality, as not all workers have the means or opportunity to adapt quickly.
The chart below shows the trend of employment versus actual employment. Since 1947, employment has grown with the economy, as expected. However, employment changed in the late 90s as employment fell below the previous growth trend, coinciding with the Internet adoption. The need for employees eroded as the internet fostered technological advances in everything from manufacturing automation to online sales, social media, advertising, and business management. Today, the deviation in employment from the long-term growth trend is the largest in history outside of the pandemic-driven economic shutdown.
Another issue is the increasing concentration of wealth and market power in the hands of a few technology giants. Companies like Amazon, Google, and Apple dominate their respective markets, creating barriers to entry for smaller firms. As shown, as technological advances increased, there has been a clear shift in corporate earnings and concentration. Again, starting in the late 90s, increased technological advances reduced the number of employees required to produce goods and services. At the same time, the market became increasingly concentrated in a smaller group of companies.
Monopolistic behavior stifles competition, reduces innovation, and limits consumer choice. Furthermore, corporate profitability soared by reducing labor, which is the most costly expense for any business.
The vast wealth accumulation by these companies contributes to economic inequality. That inequality can hamper overall economic growth by reducing the average consumer’s purchasing power. Since 1990, wealth inequality has soared, with those in the top 10% owning a vast majority of economic wealth. The bottom 50%, which comprises a significant portion of employee labor in the manufacturing and services industries, have barely benefitted.
Lastly, the rapid pace of technological change can lead to productivity paradoxes, where the expected gains in productivity from new technologies do not materialize as anticipated. That happens due to the significant time and investment required to integrate new technologies effectively into existing business processes. Additionally, cybersecurity threats, data privacy concerns, and technology-driven stress can undermine productivity and lead to economic inefficiencies.
But there is even a darker side that no one is talking about.
Social Loneliness
While social media and the internet have revolutionized the way we connect and communicate, they have also contributed to several severe societal issues, including increased loneliness, social and political division, and a troubling rise in teenage suicides. Understanding these negative impacts is crucial for addressing the challenges of the digital age.
One significant consequence of social media is the rise in loneliness. Despite the promise of connecting people, social media often leads to superficial interactions, which lack the depth and intimacy of face-to-face communication. As users compare their lives to the seemingly perfect lives of others online, feelings of inadequacy and isolation can increase. That can be particularly damaging for teenagers, as they are at a critical stage of developing their self-identity and sense of belonging. The constant need for validation through likes and comments can lead to feelings of loneliness and anxiety.
Social media also contributes to social and political division. The algorithms that power these platforms often promote content aligning with users’ beliefs, creating echo chambers reinforcing biases. This polarization can deepen societal divisions, making constructive dialogue and mutual understanding more difficult. The spread of misinformation and fake news further exacerbates these divisions, exposing people to misleading content that can shape their perceptions and opinions. With a growing inability to logically and rationally discuss our differences, passing laws and policies that benefit everyone has become impossible.
Lastly, and most unfortunately, the impact of social media on teenage mental health is alarming. Studies have shown a link between heavy social media use and increased rates of depression, anxiety, and suicidal thoughts among teenagers. The pressure to fit in, the prevalence of cyberbullying, and the exposure to unrealistic standards of beauty and success can create a toxic environment that negatively affects teens’ mental well-being. Tragically, this can lead to an increase in teenage suicides (as shown by the CDC) as vulnerable individuals struggle to cope with the pressures of the digital world.
In conclusion, while technology is a powerful driver of economic growth, it also presents challenges that can negatively impact productivity, equality, mental health, and societal cohesion. Addressing these issues ensures that technological advancements promote sustainable and inclusive economic growth.
After all, that was the promise of technology, to begin with.
Nvidia Legal Woes May Benefit AMD And Others
Nvidia faces legal woes as the Justice Department subpoenaed the company over antitrust concerns. This should not be too surprising, as it was recently reported that Nvidia dominates the GPU chip market and continues to increase its market share. GPU, or graphics processing unit, is a cornerstone of AI technology. As shown below, as of the end of the first quarter, Nvidia increased its market share of AIB chips to 88% from 80% at the end of the year. The names AIB and GPU are often used interchangeably to represent graphic cards. In Nivida’s wake is AMD, with approximately 12% of the market share, and Intel, with a negligible share.
While a significant market share of an immensely profitable and in-demand product is a godsend for shareholders, it is not durable over the long term. Foremost, as we led, Nvidia now faces legal challenges to its market share. The Justice Department is concerned Nvidia is making it difficult for its customers to use other chips. Furthermore, Bloomberg reports they penalize buyers who do not exclusively buy their chips. Consequently, Nvidia’s legal issues may benefit AMD and other chip makers.
Also, beyond Nvidia’s legal issues, it faces intense competition. Given the outsized profit margins on GPU chips, competition will become fierce. It may take some time for AMD, Intel, and others to make a competitive chip, but when they do, prices and profit margins of GPUs are likely to fall. In the words of Jeff Bezos: “Your margin is my opportunity.“
What To Watch Today
Earnings
Economy
Market Trading Update
Yesterday, we discussed the sharp market sell-off and noted that it was critical that buyers step in to defend the 20- and 50-DMA support levels just below Tuesday’s close. Such was the case on Wednesday, and while the market flirted with a break of support in the late afternoon, it held that level into the close. However, the not-so-bullish development is that the MACD “buy signal” triggered in early August, supporting the rally from the lows, has reversed. With the market not deeply oversold yet, such does imply that any rallies will likely be limited by the rather substantial build of overhead resistance during the last half of August.
The first half of September is typically better than the last half of the month. If we get a couple of economic reports that support the coming Fed rate-cutting cycle, it could lift stocks by the end of the week or next. However, as we cautioned heading into this recent downturn, reducing risk and raising cash levels make a lot of sense heading into the election.
JOLTS
The BLS JOLTs report was weaker than expected. Job openings fell to 7.67 million from 7.91 million last month amid expectations of an increase to 8.10 million. Furthermore, the prior month’s number was revised lower from 8.18 million. The number of job openings is at levels last seen in January 2021. Moreover, it’s quickly closing in on the 7.0-7.5 million range in the two years before the pandemic.
Also, within the data below, total job separations increased while hires rose. However, netting the two figures points to a loss of 63k jobs. A figure important to the Fed is the number of unemployed persons per job opening. The second graph shows that it is now fully back to pre-pandemic run rates. The probability of the Fed increasing rates by 50bps versus 25bps is now 50/50. ADP and the BLS employment report will likely push the odds toward one or the other.
A Bull Steepening Is Bearish
Stocks spend a lot more time trending upward than downward. However, in those relatively brief periods where longer-term bearish trends endure, investors are advised to take steps to reduce their risks and limit their losses. An active approach puts you on higher ground than you otherwise might have been.Moreover, when the market resumes its upward trend, you have ample funds to purchase stocks at lower prices and better risk-return profiles.
You may wonder why an article about bond yield curves leads off with a discussion of bear market strategies for stocks. Some yield curve shifts correlate well with positive stock market returns and others with negative returns. Prior bull steepening environments have not been friendly to buy and hold stock investors. Therefore, we hope this analysis guides you in preparing to reduce risk if needed.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
The Treasury Yield Curve Sets Off A Recession Warning
“The level of U.S. Treasury yields and the changing shape of the Treasury yield curve provide investors with critical feedback regarding the market’s expectations for economic growth, inflation, and monetary policy.” That sentence led off our article last week: Yield Curve Shifts Offer Signals For Stockholders. The Treasury yield curve has proven an accurate predictor of economic weakness and, ultimately, recessions. As fall is starting to show signs of emerging, the yield curve also warns of a new economic season. On Monday night, the 2-year note yield fell slightly below the 10-year yield. Thus, the yield curve inversion, which has lasted over two years, is over, ending one of the longest yield curve inversions on record.
The graph below charts the difference between ten and two-year Treasury yields, commonly called the yield curve. The shaded circles highlight the last four times the yield curve inverted and uninverted. Each time the yield curve inverted and uninverted, a recession followed. Next to the shaded circles, you will find the number of days between the uninversion and the start of the recession as deemed by the NBER. Bear in mind they always call the recession well after each recession started and backdate it.
If, and we stress “if,” the economy is heading for a recession and the S&P 500 is ultimately setting up for a drawdown as is typical in a recession, we best appreciate this warning. However, we have time to prepare. The table below shows that the stock market doesn’t always heed the yield curve warning mainly because the economic data at the time of the uninversion did not give the impression that a recession was imminent.
What To Watch Today
Earnings
Economy
Market Trading Update
In yesterday’s commentary, we discussed the market’s negative divergences and slowing momentum. As we stated:
“While markets can make all-time highs soon, the momentum and relative strength decline is certainly a cautionary tale. Just as a reminder, September and October tend to be weak performance months for the market, and the addition of a leadership or policy change could add to that risk.”
While we suspected a decline was likely, we didn’t expect it to occur in just one day. There are a couple of important points to yesterday’s action. First, the sell-off yesterday broke through the bottom of the recent trading range after failing resistance at all-time highs. Secondly, the reversal brought the market very close to triggering a “sell signal,” which would likely lead to lower prices over the coming days.
The good news is that the 20 and 50-DMA have converged to provide a significant level of price support for the market. Theoretically, the market should hold this level and bounce toward the bottom of the previous trading range. A failure of that support will lead to lower prices, but there are several support levels below yesterday’s close down to the 100-DMA. Unless something is brewing behind the scenes, the market should remain above the recent downtrend channel. Of course, there is always a risk that doesn’t occur, and the 200-DMA becomes a viable target.
As noted yesterday, investors got a decent reminder of the consequences of their complacency. We suggest managing risk until a better entry point presents itself. Today is not that point.
ISM Manufacturing
The ISM Manufacturing Index was a little weaker than expected, at 47.2, compared to expectations of 47.5. However, it was better than last month’s 46.8. Manufacturing Employment is still contracting at 46.0, but the latest is slightly better than last month’s 43.4. Of concern for the Fed, the price index rose to 54.0. The price index was below 50 from September 2022 through December 2023. This year, each monthly reading was above 50. It will be more critical to the Fed if tomorrow’s Services Price Index is higher than expected.
The graph below shows the ISM New Orders Index. This past month, it fell to 44.6, well below the previous reading of 47.4 and the optimistic consensus of 47.7. This index tends to be a good leading indicator for the manufacturing sector. Yields fell sharply on the release as it further cemented the market thinking that the Fed could cut rates by 50bps at the next meeting. The odds of a 50bps decrease are now up to 40%.
Risks Facing Bullish Investors
Since the end of the “Yen Carry Trade” correction in August, bullish positioning has returned with a vengeance, yet two key risks face investors as September begins. While bullish positioning and optimism are ingredients for a rising market, there is more to this story.
It is true that “a rising tide lifts all boats,” meaning that as the market rises, investors begin to chase higher stock prices, leading to a virtual buying spiral. Such leads to an improvement in market breadth and participation, which supports further price increases. Following the August decline, the chart below shows the improvement in the NYSE advance-decline line and the number of stocks trading above their respective 50-day moving averages (DMA).
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Bull Steepening Is Bearish For Stocks – Part Two
Part One of this article described the burgeoning bull steepening yield curve environment and what it implies about economic growth and Fed policy. It also discussed the three other predominant types of yield curve shifts and what they suggest for the economy and Fed policy.
Persistent yield curve shifts tend to correlate with different stock performances. With the odds growing that a long bull steepening may be upon us, it’s incumbent upon us to quantify how various stock indices, sectors, and factors have done during similar yield curve movements.
Limiting Losses With Yield Curve Analysis
Stocks spend a lot more time trending upward than downward. However, in those relatively brief periods where longer-term bearish trends endure, investors are advised to take steps to reduce their risks and limit their losses. An active approach puts you on higher ground than you otherwise might have been.Moreover, when the market resumes its upward trend, you have ample funds to purchase stocks at lower prices and better risk-return profiles.
Growing wealth happens over decades. Within these decades are many bullish and bearish cycles. While investors tend to focus on making the most of the bullish cycles, it is equally important to avoid letting bear markets reverse your progress. The amount of time spent in bear markets is minimal, but the time lost recovering your wealth can be substantial.
You may wonder why an article about bond yield curves leads off with a discussion of bear market strategies for stocks. Simply, some yield curve shifts correlate well with positive stock market returns and others with negative returns. Prior bull steepening environments have not been friendly to buy and hold stock investors. Therefore, we hope this analysis guides you in preparing to reduce risk if needed.
The Recent Bull Steepening History
The graph below charts the 2- and 10-year yields and the 2-year/10-year yield curve. Additionally, shaded in gray are periods we deem persistent bull steepening. We defined the bull steepening periods by the curve’s movement and the trend’s consistency. To qualify, the yield curve had to be increasing, with 2-year and 10-year yields moving lower for 20 weeks or longer. Furthermore, we required at least 80% of the weeks to be in the bullish steepening trend.
As shown, there have been five such periods since 1995. The most recent stretched from May 2019 to March 2020. The current bull steepening has not been occurring long enough to meet our standards defined above.
Bull Steepening Cycles Are Bearish For Most Stocks
Having defined the periods, we then studied various stock indices, sectors, and factors to assess their performance during the timeframes. To remind you, bull steepening trades typically occur when the economy is slowing, and anticipation of Fed rate cuts grows. Those traits adequately describe the current period.
Furthermore, and of importance, the current steepening is occurring from a yield curve that has been inverted for two years. Inverted means the yield on the 10-year is less than the 2-year. An inversion reduces the incentives for banks to lend, thus further increasing the odds of economic weakness.
As noted in Part One, the yield curve inversion is a recession warning but is not usually timely. Contrarily, the yield curve un-inversion typically portends a recession is coming within a year or less.
The yield curve briefly returned to positive territory as we put the final edits on this article. Therefore, we now have a much more explicit recession warning.
The graph below shows that even though we have a firmer warning, a recession can take more than a year to enter.
Bond Returns
By definition, all Treasury bonds provide positive returns in a bull steepening. While two-year yields will fall more than ten-year yields, the duration on ten-year notes is much greater. Thus, from a total return perspective, longer-duration bonds often provide better returns than shorter-duration bonds.
The table below shows the total return (coupons and price) for two- and ten-year notes during the five bull steepening periods.
Stock Returns
The first graph below charts the average returns of 19 assets, stock indices, factors, and sectors during the five bull steepening periods. The second graph compounds their returns over the five periods.
Next, we break out the returns by similar classes of stocks. We added gold and gold miners to the factor returns graph. The graphs show the average return and the average of the maximum drawdowns during the five periods.
There are a few important takeaways:
Gold and gold miners are the best performers during bull steepening periods by a long shot.
Besides gold and gold miners, staples were the only other category with a positive compounded and average return.
Every index, sector, asset, and factor, including gold and gold miners, had a negative average return at some point during the steepening period.
The differences between S&P value and growth were not as significant as we suspected they would be.
Similarly, the differences between the S&P 500 and the S&P small and mid-cap indexes were minimal.
The lower beta, more value-oriented sectors clearly outperformed the higher beta sectors and factors during the steepening shift.
A Disclaimer About Expectations
It’s easy to extrapolate the past to the future. However, each of the five periods above was different. There is no doubt that the next persistent bull steepening, whether we are in it now or in the future, will have different characteristics. Past performance may not be a reliable indicator of the future.
We are currently 12 weeks into a bull steepening cycle. If it persists for another eight weeks, it will meet the threshold we used to calculate the results above. However, if that is the case, the data to calculate the expected returns and drawdowns will start from late May. The early start date could skew our expectations.
For instance, gold is up about 10% from the start date. If this is a persistent bull steepening cycle and gold ultimately matches the average 13% return over the prior five periods, it has limited upside. However, its average drawdown during the previous periods is about 6%.
Therefore, if this instance matches the average return and drawdown, we should expect gold to fall by 15% before rebounding to about 3% more than current levels.
Similarly, the sectors with prices higher than their late May levels could decline by more than the average return from current levels to match the average return.
Summary
The results of our study are relatively consistent across the five time frames. Therefore, if the current bull steepening continues, the likelihood that gold, gold miners, and the more conservative, lower beta sectors outperform the broader market is good.
The recent performance of the utility and staples sectors, along with gold and gold miners, might hint that investors are betting on a bull steepening.
We leave you with two graphs showing the importance of risk management during a bull steepening cycle that leads to a recession.
Share Buybacks Will Start Weakening The Markets Tailwind
Like the meteorological seasons, share buybacks also follow predictable patterns. Accordingly, as shown below, we are past the peak share buyback season. Following the peak, share buybacks will decline rapidly until early November. Declining share buybacks is not a bearish indicator per se. However, as the number of buybacks declines, the market, and specifically the stocks conducting buybacks, will have less demand for their stock. Think of share buybacks as a tailwind.
The pattern is predictable because it directly relates to corporate earnings reports. For three reasons, most companies impose a ban on share buybacks about a month before their quarterly earnings report.
Insider Trading Concerns– Employees have access to non-public information regarding their earnings. Therefore, the ban helps eliminate the perception the company might be trading its stock on such information.
Investor Perception– Similarly, investors might be suspicious if the company was actively buying its stock right before the earnings announcements. If the investors were mimicking the company’s purchases, this could create heightened volatility in the stock.
Regulatory Concerns– While there is no SEC regulation against share buybacks before earnings, most companies want to avoid an SEC investigation if the SEC suspects those buying back the shares have inside information.
What To Watch Today
Earnings
Economy
Market Trading Update
As noted last week, the rapid rally from the lows of three weeks ago had some good and bad elements.
“The positive is that the rally reversed the MACD “sell signal,” suggesting the bullish bias has returned. Furthermore, the rally cleared all-important resistance levels with ease. The market quickly crossed the 100, 50, and 20 DMAs, leaving only recent all-time highs as significant next resistance. The only negative to the advance is the nearly complete reversal of the previous oversold conditions. Such isn’t a critical issue, but it suggests we will likely see a minor pullback to retest support at the 50-DMA. Such will provide a better entry point to add exposure as needed.”
This past week, the market struggled to make gains, and as shown, its momentum has slowed. While such does not mean a major correction is imminent, it does suggest that the upside is likely limited, and a continued consolidation or pullback to previous support levels should be expected. Notably, a negative divergence is developing between momentum, strength indications, and market performance. We last mentioned such a negative divergence was in late July before the August correction.
Over the next month, two potential catalysts may lead to a short-term correction to the 100-DMA or recent lows, where most buyers were previously found. The first is that corporate buybacks, which supported the rally from the recent lows, will begin to fade starting September 5th. The second is the upcoming election in November, when managers may de-risk portfolios ahead of that event.
While markets can make all-time highs soon, the decline in momentum and relative strength is certainly a cautionary tale. Just as a reminder, September and October tend to be weak performance months for the market, and the addition of a leadership or policy change could add to that risk.
Continue to manage risk as needed.
PCE Prices & The Week Ahead
The Fed’s favored inflation indicator, PCE Prices, was exactly as the market expected. Both headline and core PCE rose 0.2% for the month. As shown below, the headline and core year-over-year rates were 2.5% and 2.6%, respectively. The market reaction was muted as the numbers were as expected.
The headline economic data this week will be unemployment. Given the Fed now seems to be heavily focused on the weakening employment market, this week’s figures will provide the market with better clarity on whether the Fed cut rates by 25bps or 50bps. Leading off on Wednesday is JOLTs. The various statistics within JOLTs have been more real-time than the BLS report in alerting the Fed and economists of the softening jobs market. In particular, pay attention to the hires and quits rate. ADP on Thursday has also been a leading employment indicator compared to the BLS report. Expectations for ADP is an increase of 150k jobs.
Lastly is the BLS report on Friday. A consensus of economists expects the total number of jobs to increase by 163k and the unemployment rate to slip by a tenth of a percent from 4.3% to 4.2%. If the labor reports come in or around consensus, we suspect the Fed will cut by 25bps.
In addition to employment data, the ISM will release its manufacturing and service sector surveys on Tuesday and Thursday, respectively. Pay attention to the labor and price components of both releases. Similarly to JOLTs and ADP, ISM employment has also led the BLS.
Japanese Style Policies And The Future Of America
With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the subsequent economic decline when it occurs.
That is the same problem Japan has wrestled with for the last 25 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size), there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 40-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:
A decline in savings rates to extremely low levels which depletes productive investments
An aging demographic that is top-heavy and drawing on social benefits at an advancing rate.
A heavily indebted economy with debt/GDP ratios above 100%.
A decline in exports due to a weak global economic environment.
Slowing domestic economic growth rates.
An underemployed younger demographic.
An inelastic supply-demand curve
Weak industrial production
Dependence on productivity increases to offset reduced employment
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Risks Facing Bullish Investors As September Begins
Since the end of the “Yen Carry Trade” correction in August, bullish positioning has returned with a vengeance, yet two key risks face investors as September begins. While bullish positioning and optimism are ingredients for a rising market, there is more to this story.
It is true that “a rising tide lifts all boats,” meaning that as the market rises, investors begin to chase higher stock prices, leading to a virtual buying spiral. Such leads to an improvement in market breadth and participation, which supports further price increases. Following the August decline, the chart below shows the improvement in the NYSE advance-decline line and the number of stocks trading above their respective 50-day moving averages (DMA).
Given that“for every buyer, there must be a seller,” this data confirms that buyers are increasingly willing to pay higher prices to bring sellers to market. That cycle continues until buyers willing to pay higher prices decline. While prices are rising, we are seeing a dwindling of buyers at current prices, as shown in the chart of trading volume at various price levels. As shown, buyers currently “live lower” between 5440-5480 and the recent correctional lows.
However, despite the diminishing pool of buyers at current levels, investors are becoming increasingly bullish as prices rise. As shown in our composite fear/greed gauge, based on “how investors are positioned” in the market, we are back to more “greed” based levels. While not at extreme levels, investors are becoming increasingly optimistic about higher future prices. Of course, such readings only confirm what market prices are already telling us.
However, two primary risks to the bullish advance are developing as we enter September.
Share Buyback Window Begins To Close
Over the next two months, a primary risk to bullish investors is removing a critical buyer in the market – corporations. For more on the importance of corporate share purchases on the financial markets, read the following:
Those articles support that corporations have comprised roughly 100% of net equity purchases since 2000. In other words, the market would be trading closer to 3000 rather than 5600 without corporate share buybacks.
However, these share buybacks also pose risks to the market in the short-term as well. As Michael Lebowitz noted this morning:
“Like the meteorological seasons, share buybacks also follow predictable patterns. Accordingly, as shown below, we are past the peak share buyback season. Following the peak, share buybacks will decline rapidly until early November. Declining share buybacks is not a bearish indicator per se. However, as the number of buybacks declines, the market, specifically the stocks conducting buybacks, will have less demand for their stock. Think of share buybacks as a tailwind.
The pattern is predictable because it directly relates to corporate earnings reports. For three reasons, most companies ban share buybacks about a month before their quarterly earnings report.
Insider Trading Concerns—Employees have access to non-public information regarding their earnings. Therefore, the ban helps eliminate the perception that the company might be trading its stock on such information.
Investor Perception– Similarly, investors might be suspicious if the company was actively buying its stock right before the earnings announcements. If the investors were mimicking the company’s purchases, this could create heightened volatility in the stock.
Regulatory Concerns—While the SEC does not regulate share buybacks before earnings, most companies want to avoid an investigation if the SEC suspects those buying back the shares have inside information.
As shown on Thursday, September 5th, the window for buybacks will begin to close. Corporate buying support will be non-existent by the beginning of October and through the end of the month. In other words, the primary buyer of equities will not be available to bid prices.
If you don’t believe that share buybacks are as crucial as we state, the following chart should answer any questions.
Unfortunately, removing that primary buyer will coincide with a secondary market risk.
Presidential Election Concerns
As we enter September and October, a secondary risk increases. Historically, these months have seen stock market declines, especially in years with a Presidential election. There are three primary reasons for this trend.
1. Uncertainty Surrounding Election Outcomes
Markets dislike uncertainty, and the outcome of a Presidential election is a significant unknown. Investors become cautious during election years, especially when the race is tight. They worry about potential policy changes impacting taxes, regulations, and government spending. That heightened uncertainty increases market volatility and often results in stock market declines as investors move to safer assets.
2. Policy Change Concerns
Depending on the election outcome, significant policy changes can occur. For instance, Harris and Trump have very different approaches to fiscal policy, regulation, and international trade this year. With the polls very tight, Wall Street may look to lock in gains before the election, fearing that new policies might negatively affect corporate profits via higher tax rates and, potentially, changes to capital gains rates.
3. Economic Data Releases
September and October are critical months for economic data releases, particularly since the Federal Reserve expects to cut rates in September. Key indicators from employment, inflation, and housing will potentially move markets over the next two months. Given the approaching election, the markets will scrutinize those releases closely as candidates try to leverage the data. Any negative surprises could result in a sharp pickup in volatility.
Conclusion
As we head into September, which already has a weak performance record, understanding these two risks can help investors navigate a potential pickup in volatility, particularly during election years.
However, the timing of such a consolidation or correction is always tricky.
We suggest maintaining risk controls, taking profits as needed, rebalancing portfolios, and holding slightly higher cash levels.
While these actions won’t entirely shield portfolios from a near-term decline, they will buffer increased volatility, allowing for more rational and controlled portfolio management decisions.
Quarter End Window Dressing Will Become Monthly
At many quarter ends, the markets often exhibit unusual behavior. Moreover, the oddities leading up to quarter ends are frequently partially or fully reversed in the days following the quarter. The irregular activity is in part due to window dressing. Mutual funds are only required to share their holdings with investors quarterly. As such, they can buy and sell securities at quarter end to change the appearance of their portfolio. For example, they may want to add a hot stock or reduce a poorly performing sector at the quarter end but not hold the hot stock throughout the quarter. Ergo, window dressing trades can be very misleading.
The SEC is changing its rules to increase mutual funds and ETF transparency. From now on, mutual funds and ETFs must report their holdings at least monthly. This new rule will reduce some volatility and odd trading at quarter ends and distribute it to month ends. The rule change will not take effect until November 2025 for larger funds and May 2026 for funds with assets of less than $1 billion.
The graph below from Statista shows approximately $25 trillion of assets under management invested in mutual funds. Furthermore, although not shown, the Investment Company Institute estimates roughly $8.1 trillion in ETFs.
What To Watch Today
Earnings
No notable earnings releases.
Economy
Market Trading Update
Yesterday’s release of Nvidia’s earnings, while strong, failed to impress and did not impact the market as widely expected. For the quarter, Nvidia reported:
Q2 Rev. $30.04B, up 122% YoY, beating estimates of $28.86B, and beating not only the upper end of the guidance ($27.44BN-$28.56BN) but also above the JPM whisper number of $29.85BN.
Q2 Data Center Revenue $26.3B, beating exp. $25.08B
Q2 EPS is $0.68, up 152% YoY and beating the exp. $0.64
Q2 Gross Margin 75.7%, up 4.5% YoY from 71.2, beating exp. 75.5%, but down from 78.9% in Q1.
The biggest worry seems to be gross margins, which slowed down and suggest Nvidia may have reached pricing limits for now. However, there is a lot of demand for Nvidia’s new Blackwell chip, which will be coming to market later this year. If sales go as expected versus expected supply, we could see margins expand once again.
Technically, the stock price is stretched with declining momentum (top panel). Notably, there is not much price support until the stock retraces to the recent lows, where buyers stepped in during the “Yen Carry Trade” correction. We have reduced our position twice since July (July 19th and August 26th) to mitigate the risk of a disappointing report. In the long term, we still like our holding in Nvidia, but we suspect we could see a more extended period of volatility until the next buying opportunity presents itself.
PCE Expectations
The table below, courtesy of the Wall Street Journal, shows major bank forecasts for today’s PCE price index. The current consensus for both monthly core and headline PCE is +0.2%. As shown below, the median forecast for the big banks is slightly below that at +0.15%. Assuming the PCE data is aligned with the median estimates below or the consensus, the Fed will most likely cut rates in September. The only thing that could stop them is a very strong employment number next week. Nothing in the weekly claims data or regional surveys leads us to believe the state of the jobs market has changed materially in the last month.
Corporate Tax Rates Rest On The Election Results
The graph below, courtesy of Gavekal Research and ISABELNET.com, shows the differences in corporate tax proposals for the two Presidential candidates.
As shown below, the Tax Cuts and Jobs Act slashed the corporate tax rate from 35% to 21% in 2017. There were also tax cuts for individuals. Both personal and corporate tax cuts stimulated the economy at the expense of less government revenue. The debate for another day is whether the extra economic growth made up for the lost tax revenue. However, at this time, we must assess whether the candidates will continue with the current rates or let them expire and revert to higher rates. Therefore, the political composition of Congress and the next President will potentially be impactful to tax policy and, ultimately, the economy and markets.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Japanese Style Policies And The Future Of America
In a recent discussion with Adam Taggart via Thoughtful Money, we quickly touched on the similarities between the U.S. and Japanese monetary policies around the 11-minute mark. However, that discussion warrants a deeper dive. As we will review, Japan has much to tell us about the future of the U.S. economically.
Let’s start with the deficit. Much angst exists over the rise in interest rates. The concern is whether the government can continue to fund itself, given the post-pandemic surge in fiscal deficits. From a purely “personal finance” perspective, the concern is valid. “Living well beyond one’s means” has always been a recipe for financial disaster.
Notably, excess spending is not just a function of recent events but has been 45 years in the making. The government started spending more in the late 1970s than it brought in tax receipts. However, since the economy recovered through “financial deregulation,” economists deemed excess spending beneficial. Unfortunately, each Administration continued to use increasing debt levels to fund every conceivable pet political project. From increased welfare to “pandemic-related” bailouts toclimate change agendas, it was all fair game.
However, while excess spending appeared to provide short-term benefits, primarily the benefit of getting re-elected to office, the impact on economic prosperity has been negative. To economists’ surprise, Increasing debts and deficits have not created more robust economic growth rates.
I am not saying there is no benefit. Yes, “spending like drunken sailors” to create economic growth can work short-term, as we saw post-pandemic. However, once that surge in spending is exhausted, economic growth returns to previous levels. What those programs do is “pull forward” future consumption, leaving a void that detracts from economic growth in the future. That is why economic prosperity continues to decline after decades of deficit spending.
We agree that rising debts and deficits are certainly concerning. However, the argument that the U.S. is about to become bankrupt and fall into economic oblivion is untrue.
For a case study of where the U.S. is headed, a look at Japanese-style monetary policy is beneficial.
The Failure Of Central Banks
“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.” – Keiichiro Kobayashi, 2010
Kobayashi will ultimately be proved correct. However, even he never envisioned the extent to which Central Banks globally would be willing to go. As my partner, Michael Lebowitz pointed out previously:
“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $24 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”
The belief was that driving asset prices higher would lead to economic growth. Unfortunately, this has not been the case, as debt has exploded globally, specifically in the U.S.
“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”
Not surprisingly, the massive surge in debt has led to an explosion in the financial markets as cheap debt and leverage fueled a speculative frenzy in virtually every asset class.
Soaring U.S. debt, rising deficits, and demographics are the culprits behind the economy’s disinflationary push. The complexity of the current environment implies years of sub-par economic growth ahead. The Federal Reserve’s long-term economic projections remain at 2% or less.
The U.S. is not the only country facing such a gloomy public finance outlook. The current economic overlay displays compelling similarities with the Japanese economy.
Many believe that more spending will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity. However, one should at least question the logic given that more spending, as represented in the debt chart above, had ZERO lasting impact on economic growth. As I have written previously, debt is a retardant to organic economic development as it diverts dollars from productive investment to debt service.
Japanese Policy And Economic Outcomes
One only needs to look at the Japanese economy to understand that Q.E., low-interest rate policies, and debt expansion have done little economically. The chart below shows the expansion of BOJ assets versus the growth of GDP and interest rate levels.
Notice that since 1998, Japan has been unable to sustain a 2% economic growth rate. While massive bank interventions by the Japanese Central Bank have absorbed most of the ETF and Government Bond market, spurts of economic activity repeatedly fall into recession. Even with interest rates near zero, economic growth remains weak, and attempts to create inflation or increase interest rates have immediate negative impacts. Japan’s 40-year experiment provides little support for the idea that inflating asset prices by buying assets leads to more substantial economic outcomes.
However, the current Administration believes our outcome will be different.
With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the subsequent economic decline when it occurs.
That is the same problem Japan has wrestled with for the last 25 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size), there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 40-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:
A decline in savings rates to extremely low levels which depletes productive investments
An aging demographic that is top-heavy and drawing on social benefits at an advancing rate.
A heavily indebted economy with debt/GDP ratios above 100%.
A decline in exports due to a weak global economic environment.
Slowing domestic economic growth rates.
An underemployed younger demographic.
An inelastic supply-demand curve
Weak industrial production
Dependence on productivity increases to offset reduced employment
The lynchpin to Japan and the U.S. remains demographics and interest rates. As the aging population grows and becomes a net drag on “savings,” dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.
Conclusion
Like the U.S., Japan is caught in an ongoing “liquidity trap” where maintaining ultra-low interest rates is the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go, the less economic return that is generated. Contrary to mainstream thought, an ultra-low interest rate environment has a negative impact on making productive investments, and risk begins to outweigh the potential return.
More importantly, while interest rates did rise in the U.S. due to the massive surge in stimulus-induced inflation, rates will return to the long-term downtrend of deflationary pressures. While many expect rates to increase due to the rise in debt and deficits, such is unlikely for two reasons.
Interest rates are relative globally. Rates can’t rise in one country, while most global economies push toward lower rates. As has been the case over the last 30 years, so goes Japan, and the U.S. will follow.
Increases in rates also kill economic growth, dragging rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges.
Unfortunately, for the next Administration, attempts to stimulate growth through more spending are unlikely to change the outcome in the U.S. The reason is that monetary interventions and government spending do not create organic, sustainable economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void. Eventually, the void will be too great to fill.
But hey, let’s keep doing the same thing over and over again. While it hasn’t worked for anyone yet, we can always hope for a different result.
What’s the worst that could happen?
Mortgage Rates Are Falling But Remain Too High
The graph below shows the MBA average 30-year mortgage rate, with its year-over-year change below. The good news is that mortgage rates have recently fallen rapidly. However, they remain well above rates seen since 2008. This creates a problem for the Fed. Over the last twenty years, there has been a strong correlation between mortgage refinancing and mortgage rates.
Can the Fed stimulate the economy with mortgage refinancings if most mortgage holders have interest rates below 4%? Yes, but to do so, they need to drop Fed Funds by much more than the market expects.
What To Watch Today
Earnings
Economy
Market Trading Update
In yesterday’s commentary, we discussed the long-term overbought and deviated conditions of the market. The issue with that analysis is the missing catalyst for a broader correction. One such catalyst could be a strengthening in the U.S. dollar. As shown, when the dollar weakens, it supports increased asset prices. Previous reversals in the dollar coincided with corrections in the market. While the dollar is not extremely oversold and is on a current sell signal, we should be watching for the dollar to bottom and then begin to turn higher. Such will likely precede a more corrective event in the market.
First, let’s dispel the myth of “de-dollarization.” Both Michael and I have written several articles on this, but the reality is summed up as follows:
“The pundits will be right someday. The dollar’s death as the reserve currency will come, and some other nation’s currency, cryptocurrency, gold, shells, or something else will take its place. However, that day is not coming anytime soon. The four reasons we describe in the article leave the world with no alternative.”
Secondly, what event causes the dollar to strengthen is always unknown. However, several factors contribute to the dollar’s strength. The most important is basic supply and demand. The demand for the dollar increases when international parties, such as foreign citizens, foreign central banks, or foreign financial institutions, demand more dollars. Generally, that demand is driven by the need to stable currency values between trading partners. Other factors influencing whether or not the dollar rises in value include the currency reserve status, inflation, political stability, interest rates, speculation, trade deficits and surpluses, and public debt.
Keep a watch on the dollar. It could be a key indicator as we head into 2025.
SMCI Was A Poor Addition To The S&P 500
On March 18, 2024, Super Micro Computer Inc. (SMCI) was added to the S&P 500. At the start of the year, SMCI was one of the hottest AI stocks. When the S&P included the stock, it traded at 1,018, up over threefold from January 1, 2024. The stock hit its peak on the day it was included. SMCI was down 24% on Wednesday as they announced a delay to their annual report filling. Despite falling about 60% since March, the stock is still up 45% this year.
To make room for SMCI and DECK, they removed Whirlpool (WHR) and Zions Bancorp (ZION). WHR has been flat since the announcement, and ZION is up about 20%. Furthermore, DECK, the other inclusion, has fared better than SMCI but, like WHR, has been unchanged since the announcement.
Yield Curve Shifts
Yield curves are essential indicators that bond investors closely follow. However, many stock investors do not track yield curves despite the importance of bond yields on stock returns. Therefore, in this two-part series, we start with an introductory discussion of the four primary types of yield curve shifts and what they often entail from an economic and inflation perspective.
In Part Two, we provide a quantitative perspective on what a continued bull steepening trade may mean for returns of the major stock indices, along with various sectors and factors.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Labor Sentiment Is Becoming Worrisome
Recent surveys of labor sentiment point to potential problems. For instance, last week, we shared the New York Fed consumer expectations survey, which showed that more people fear being unemployed in the next four months than at any time since 2014. Furthermore, the University of Michigan survey section regarding expected changes in household income is nose-diving. Yesterday, the consumer confidence survey by the Conference Board showed an improvement in overall sentiment, but its labor differential gauge continues to deteriorate. As shown in the Tweet of the Day section below, downward trends in this indicator have been associated with recessions.
According to the BLS, 132 million workers are in the services sector, accounting for about 80% of private employment. Therefore, labor sentiment in the services sector is vital to track to help us forecast how the Fed might manage monetary policy going forward. To that end, the graph below, is a composite of the various Fed regional service sector employment indicators. Unlike those noted above, the regional Fed surveys are from hiring managers, not employees. Therefore, it sheds a slightly different light on the topic. As shown, the composite has fallen into negative territory. Over the last 20 years, the only times it has been negative have been leading up to recessions and during them.
What To Watch Today
Earnings
Economy
Market Trading Update
Yesterday, we discussed the more extreme overbought conditions in Gold. Interestingly, on that same “monthly” chart, the stock market is exhibiting many of the same signals. While the monthly Relative Strength Index is not at extremes just yet, it is beginning to approach levels that have previously preceded larger market corrections.
However, there is an important caveat. Again, this is a monthly chart, which means things move much more slowly. Therefore, while the overbought conditions and deviations from longer-term means are present, they can remain the case for several months to a couple of years. As such, you can not use such a chart to make short-term portfolio decisions. However, it does suggest that investors should be aware of a risk on the horizon. Eventually, these more extreme conditions will matter, but as we have stated, an unexpected, exogenous catalyst will be needed to begin the reversion.
This afternoon, the markets will receive earnings from Nvidia (NVDA), which will arguably set the tone for tomorrow’s trading. If earnings meet or beat expectations, we could see the markets break out to new highs. However, a larger risk is that earnings “disappoint” rather lofty expectations, which could put downward pressure on an already overbought and extended market. Such is why we reduced our holdings in NVDA yesterday to hedge that potential risk.
More On Gold Fever
Yesterday’s Commentary touched on the risk of gold, given its recent high correlation with many other speculative assets. Furthermore, we cautioned you based on its technical situation. Per the Commentary:
In the last 50 years, there have only been three (3) other occasions when Gold was this extended, overbought, and deviated from long-term moving averages. As shown, Gold is currently trading four (4) standard deviations above its four-year moving average. Each time Gold has previously achieved such conditions, the eventual reversion was quite large.
The graph below serves as another warning that something is awry. It shows how the inflows and outflows of gold ETFs tend to track the price of gold closely. However, recently, the two have sharply diverged. One rationale is that retail is not participating in the rally. Another states that institutions or central banks are buying gold via the gold ETFs. They convert ETF shares into physical gold via the ETF managers. It could also be an arbitrage opportunity or something else entirely. However, what matters most to gold investors is how might the “alligator jaws” resolve themselves.
Overbought Conditions Set Up Short-Term Correction
That leaves the market vulnerable to a correction. When an event occurs, there are “willing buyers” for every transaction—just at much lower prices.
While the “Yen Carry Trade” quickly resolved itself, that risk has not been removed. The Bank of Japan is still intent on hiking interest rates, while the Federal Reserve is lowering them. At the same time, the Dollar has been declining, and the Yen Has Been increasing. So far, this has not triggered another “margin call” for hedge funds. However, should the underlying dynamics continue, the risk of another “event” clearly increases.
With markets overbought and sentiment bullish, such is a good time to rebalance portfolios and reduce excess risk.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Yield Curve Shifts Offer Signals For Stockholders
The level of U.S. Treasury yields and the changing shape of the Treasury yield curve provide investors with critical feedback regarding the market’s expectations for economic growth, inflation, and monetary policy. Short- and long-term yields have recently fallen, with short-term maturities leading the charge. The changes result in what bond traders call a bull steepening yield curve shift. The shift is due to weakening economic conditions, moderating inflation, and the increasing likelihood that the Fed will lower rates.
Yield curves are essential indicators that bond investors closely follow. However, many stock investors do not track yield curves despite the importance of bond yields on stock returns. Therefore, in this two-part series, we start with an introductory discussion of the four primary types of yield curve shifts and what they often entail from an economic and inflation perspective.
In Part Two, we provide a quantitative perspective on what a continued bull steepening trade may mean for returns of the major stock indices, along with various sectors and factors.
Treasury Yield Curve History
The graph below charts ten- and two-year Treasury yields and the difference between the two securities. The difference is called the 10-year/2-year yield curve. As you may have noticed, the yield curve has a recurring pattern that is well correlated with the economic cycle.
Generally, the yield curve steepens (the difference between the 10-year and 2-year yields increase) rapidly following a recession. Then, throughout most typical economic expansions, the curve flattens (the difference declines). The yield curve often inverts (the ten-year yield is less than the two-year yield) toward the end of the expansion.
One of the most accurate recession indicators occurs when an inverted yield curve steepens, returning it to positive territory. Lastly, the yield curve rises rapidly as the Fed lowers rates to boost economic activity and fight off a recession. Rinse, wash, repeat.
The Baby Bull Steepening
The recent spate of weakening labor data and broader economic activity, alongside moderating inflation, has the markets convinced the Fed will embark on a series of rate cuts starting in September. Furthermore, Jerome Powell has all but given them the green light. Per his Jackson Hole speech:
The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.
Bond yields have been falling, with the shorter-term bond yields falling the most. It’s hard to see on the graph above, but the recent bond market rally has caused the yield curve (light blue) to increase from negative 46 basis points in mid-June to negative single digits today. It is now on the verge of uninverting and consequently close to sending a recession warning.
This type of move in long and short-term bond yields is commonly referred to as a bullish steepening. The words bull or bullish relate to the fact that bond yields are falling, and subsequently, bond prices are rising. Steepening refers to the shape of the yield curve, which has increased, albeit the current yield curve is still negative.
In Part Two of this article, we will evaluate prior bull steepening cycles and quantify what it has meant for stock returns. But, to better acquaint you with yield curves, it’s worth discussing the four principal types of yield curve shifts and what they often portend.
Bull Steepening
As we just noted, a bull or bullish steepening occurs when all Treasury yields decline, but shorter maturities fall more than longer maturities. In our hypothetical example below, the two-year note falls from 3.35% to 1.50%, while ten-year notes decline from 3.80% to 2.80%. As a result, the yield curve steepens by .85%
Most often, a bull steepening trade results from traders anticipating easier monetary policy due to pronounced economic weakness and a growing likelihood of recession. Given that shorter-maturity bonds are more correlated to Fed Funds than longer-maturity bonds, it makes sense that they would fall quicker when such expectations arise.
The recent bull steepening has been textbook. The unemployment rate has risen from 3.7% to 4.3% this year, and in general, many economic indicators point to slower growth. Furthermore, inflation appears to be trending lower again, giving the Fed more comfort in lowering rates. Per Powell’s Jackson Hole speech:
My confidence has grown that inflation is on a sustainable path back to 2%.
Bear Steepening
As the name bear steepening suggests, yields for short and long-term maturities increase, with longer-term yields rising more than shorter-term yields. In the graph below, the two-year yield increases from 3.35% to 4.10%, and the ten-year yield rises from 3.80% to 5.10%. The result is an upward shift in the yield curve from .45% to 1.00%
In 2020 and 2021, the yield curve shifted this way. At the time, the Fed lowered rates to zero and did massive amounts of QE. Bond yields started to rise in anticipation of a rebound in economic activity and growing inflation concerns due to massive fiscal and monetary stimulus. Short-term yields didn’t move nearly as much as long-term yields. This occurred because the Fed pledged to keep Fed Funds very low to combat the pandemic.
In late 2023, the bear steepening reoccurred as the economy continued to run above its natural rate despite 5% Fed Funds. Higher interest rates were not impacting the economy meaningfully, and inflation stopped falling. The market thought the Fed may need to raise rates more. However, demand for money market investments was insatiable due to significant cash and money market balances, which helped keep a lid on short-term rates. At the long end of the curve, investors were forced to absorb substantial Treasury debt issuance. Accordingly, they demanded extra yield. This is referred to as an increasing term premium.
Bull Flattener
A bull flattener trade involves short and long-term-maturity bond yields declining with longer-end yields falling more. The graph below shows two-year yields declining by 0.70% and ten-year yields declining by 1.00%. The net result is a curve flattening of .30%
Bull flattening shifts tend to be the result of relative economic optimism. The market is encouraged because inflation is likely to fall, but it is not overly concerned that lower inflation is due to waning demand. Therefore, investors are not expecting much regarding Fed rate cuts.
Conversely, the market may be concerned about the economy, but if Fed Funds are at or near zero, there is no room for the short end of the yield curve to fall. 2016 is a good example. Fed Funds were already at zero, and the economy was weakening, with inflation remaining below the Fed’s target. Longer-term bonds moved lower with inflation and economic prospects, but short-term bonds were stuck with the Fed not wanting to lower rates below zero.
The graph below, courtesy of Deutsche Bank, shows that the dollar value of negative-yielding global bonds rose sharply in 2016. Despite the international trends, U.S. yields largely remained above zero percent.
Bear Flattening
In a bear-flattening trade, yields rise across the curve, with shorter maturities rising the most. The two-year note increases from 3.35% to 4.40% in the graph below. The ten-year note rises from 3.80% to 4.20%. In the process, the curve flattens and inverts from .45% to -.20%.
Summary
With an appreciation for yield curves, it is time to focus on the yield curve shift du jour.
What might a bullish steepening trade mean for various stock indices, sectors, and factors?
Here’s a hint. The stock market seems to love the idea of the Fed lowering rates before they do so. But, when the Fed lowers rates, the result is not often friendly for stock investors.
Overbought Conditions Set Up Short-Term Correction
As noted in thispast weekend’s newsletter, following the “Yen Carry Trade”blowup just three weeks ago, the market has quickly reverted to more extreme short-term overbought conditions.
Note: We wrote this article on Saturday, so all data and analysis is as of Friday’s market close.
For example, three weeks ago, the growth sectors of the market were highly oversold, while the previous lagging defensive sectors were overbought. That was not surprising, as the growth sectors of the market were the most exposed to the “Yen Carry Trade. “
We saw much the same in the Risk Range Analysis(Note: both sets of analysis presented are published weekly in the Bull Bear Report).
As explained in the weekly report:
Two critical points. First, three weeks ago, many sectors and markets were well below their historical risk ranges. The second is that all but three sectors or markets are on long-term bullish “buy signals.” When most markets are on bullish signals, as they are currently, markets have never suffered severe bear markets. As such, corrective market actions, as witnessed three weeks ago, tend to be buying opportunities. When the number of “bearish signals” increases, the risk of a more significant drawdown increases.
How Things Have Changed
Flash forward three weeks to Friday’s close, and a very different picture emerges.
Every major market and sector has fully reversed to more extreme overbought conditions, which historically have been a precursor to short-term corrections to reverse such conditions.
However, as noted above, only ONE sector remains on a “bearish” signal. While many sectors and markets, particularly Gold Miners, Real Estate, and Utilities, are pushing double-digit deviations from their respective long-term means, a correction to reverse those extremes will not likely devolve into a deeper bear market.
In other words, investors should consider taking profits in areas that are highly deviated from their long-term means, as these areas will suffer more significant corrective reversals than those that are not.
But how significant could a correction be?
Technical Levels Of A Correction
While the recent rally from the lows has been impressive, it has also been bullish by triggering several signals that historically precede further market gains. As noted this past weekend:
“As shown below, rapid V-shaped recoveries tend to be bullish indications of both the end of the corrective period and the resumption of the bullish trend. Since 2014, periods that saw a sharp price decline, as measured by the 10-day rate of change, followed by a sharp advance, were bullish indications. However, as seen in 2015 and 2022, such a reversal does not preclude a secondary correction from occurring.”
The last sentence is the most important.
While weekly bullish buy signals and improving market breadth certainly portend further market gains, this does not preclude a short-term correction from occurring. On a very short-term basis, some nearby retracement levels would relieve some of the short-term overbought conditions without triggering larger market concerns. Those levels are as follows:
The 50-day moving average (DMA) which currently resides at 5491
The 20-DMA, which has turned up, providing another bullish signal, is just below that at 5445.
If the market fails those two supports, the top of the downtrend line and the 100-DMA are close by at 5377 and 5347, respectively.
Lastly, the recent market low at 5154 and the 200-DMA at 5100 remain critical support levels.
Between today and the election, these primary levels have the highest probability of containing any near-term market correction that would reverse most overbought conditions. Such would provide a much better entry opportunity to increase exposure for a potential year-end rally.
What About A Bigger Correction?
What about the potential for a more extensive correction? Yes, such a risk is possible, and we should not ignore it. If we look at a monthly chart, two warnings are immediately noticeable. First, the market’s deviation from the 20, 50, and 100-month moving averages (MMA) is substantial. Historically, the markets correct such large deviations. However, such a correction, while possible, would require a more severe credit-related event, a deep recession, or a financial crisis of some magnitude. While such events are possible, these events are ALWAYS exogenous and unanticipated. The technicals tell us that the market is susceptible to an exogenous shock that would lead to a more profound corrective event.
Secondly, the monthly overbought conditions are also at levels (as shown in the bottom chart) that have preceded more extensive corrections, such as in 2022, 2008, and 2000. Notably, every time the market has been as overbought as it is currently, it has suffered short—to intermediate-term corrective events.
Looking at the longer-term daily chart, should such a more significant correction occur, we can use a Fibonacci sequence to determine the depth of the retracement.
When the market reaches those levels, a pullback to the 200-DMA would also align with a 23.6% retracement level.
A retest of the April correction lows becomes the next logical support. The 38.2% retracement level is just below that level.
Any correction not coinciding with a more significant event will likely remain contained to those levels. However, a failure at the 38.2% retracement will bring the 50% retracement and the January 2022 peaks into focus. Such a correction would encompass a nearly 20% decline from current levels.
If some event triggers a break of the more extreme correction levels, there is a risk of the 2022 lows. However, we will significantly reduce portfolio exposuresbefore the market reaches those levels.
The market’s overbought condition is apparent, and a correction is likely. The only questions are the trigger and the magnitude. However, investors must keep such corrections in perspective. Given the current technical backdrop, most probabilities are weighted to corrections within 5-10% of current levels. However, we can’t dismiss the smaller possibility of a larger correction.
“As noted above, the stock market is always a function of buyers and sellers, each negotiating to make a transaction. While there is a buyer for every seller, the question is always at “what price?”
In the current bull market, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own.
Such is the very definition of the “greater fool” theory.
However, at some point, for whatever reason, this dynamic will change. Buyers will become more scarce as they refuse to pay a higher price. When sellers realize the change, they will rush to sell to a diminishing pool of buyers. Eventually, sellers will begin to “panic sell” as buyers evaporate and prices plunge.”
In other words, “Sellers live higher. Buyers live lower. “
We can see where the buyers and sellers “live.” The following chart shows where the highest volume occurred. As shown, there are few buyers at current levels. As the old Wall Street axiom states,“If everyone has bought, who is left to buy.”
That leaves the market vulnerable to a correction. When an event occurs, there are “willing buyers” for every transaction—just at much lower prices.
While the “Yen Carry Trade” quickly resolved itself, that risk has not been removed. The Bank of Japan is still intent on hiking interest rates, while the Federal Reserve is lowering them. At the same time, the Dollar has been declining, and the Yen Has Been increasing. So far, this has not triggered another “margin call” for hedge funds. However, should the underlying dynamics continue, the risk of another “event” clearly increases.
With markets overbought and sentiment bullish, such is a good time to rebalance portfolios and reduce excess risk.
Trade accordingly.
Amazon Benefits From AI But Some Doubt Its Productivity
Amazon CEO Andy Jassy has been touting the benefits his company receives from AI. In particular, he recently discussed Amazon Q, their “GenAI assistant for software development.” GenAI updates its foundational software. Per Jassey, this task is essential but dreaded by its employees. GenAI takes some of the onus off developers, allowing them to use their skills better for more financially rewarding projects for Amazon. The benefits Amazon receives from GenAI are tremendous. Per Andy Jassy:
– The average time to upgrade an application to Java 17 plummeted from what’s typically 50 developer-days to just a few hours. We estimate this has saved us the equivalent of 4,500 developer-years of work (yes, that number is crazy but, real).
– In under six months, we’ve been able to upgrade more than 50% of our production Java systems to modernized Java versions at a fraction of the usual time and effort. And, our developers shipped 79% of the auto-generated code reviews without any additional changes.
While Amazon’s benefits seem substantial, not everyone agrees AI is all it’s cracked up to be. For example, a study by the Upwork Research Institute, based on interviews with 2500 C-suite executives, finds a disconnect between increased productivity expectations of AI and actual employee experiences.
Despite 96% of C-suite executives expecting AI to boost productivity, the study reveals that, 77% of employees using AI say it has added to their workload and created challenges in achieving the expected productivity gains. Not only is AI increasing the workloads of full-time employees, it’s hampering productivity and contributing to employee burnout.
The jury is out on AI’s actual productivity benefits. However, the potential productivity gains will certainly keep corporate spending on AI immense for the time being. With that, we look forward to Nvidia’s earnings tomorrow.
What To Watch Today
Earnings
Economy
Market Trading Update
As we discussed yesterday, the market’s bullish backdrop remains, suggesting that the volatile sell-off of a few weeks ago is over, at least for now. However, two charts jumped out as I researched for the newsletter this weekend.
The first is the monthly chart of Gold prices. Precious metals have risen over the last two years as speculative fervor increases in the marketplace. As is always the case, too much money chasing too few assets is both a blessing and a curse. The “blessing” is rising asset prices. The “curse” is that when assets become highly correlated, there is no safe place to hide when something eventually breaks.
The first chart shows that gold has not risen due to debts, deficits, or inflation but rather speculative action. In fact, 2022 gold fell as inflation rose to 9%. With inflation falling and expectations of increased liquidity from the Federal Reserve, all assets have risen simultaneously over the last two years.
As noted, when something eventually breaks the S&P 500 and selling begins in earnest, all asset classes will likely revert from extended and overbought conditions. Such is the nature of highly correlated markets. Which brings us to the second chart.
In the last 50 years, there have only been three (3) other occasions when Gold was this extended, overbought, and deviated from long-term moving averages. As shown, Gold is currently trading four (4) standard deviations above its four-year moving average. Each time Gold has previously achieved such conditions, the eventual reversion was quite large.
While gold and stocks have put in a terrific performance this year, as is always the case, don’t forget to take profits.
Nvidia Implied Move
According to @unusual_whales, the options market implies that NVDA is likely to move by 10.09% on Wednesday when they announce their earnings. They claim this is the largest implied change going into earnings over the last ten quarters. It’s important to note that the implied move relates to volatility, not direction. Therefore, it implies the market thinks NVDA can rise or fall by 10% tomorrow. The first graph below highlights the potential move in red and green. Furthermore, the implied volatility is shown below the price graph.
For context, the last two earnings reports generated gains of 16% and 9% on the day after the earnings release. In both cases, the stock continued higher for two to three more weeks before forming a short-term peak. The second graph below from Unusual_Whales charts the recent action in NVDA versus its average performance over the last ten earnings reports in the 20 days leading up to earnings and 20 days post earnings. Currently, it sits about 10% above the average. Moreover, it’s about 10% below the average for the entire 40-day period.
SimpleVisor Sector Analysis
The first graph below, courtesy of SimpleVisor, shows that over the last month, the market breadth has been much more aligned than it had been. Real Estate and Utilities are the top performers, but their incremental gains over most other sectors is not large. Furthermore, Technology, which has been this year’s star sector, is underperforming. Clearly, breadth is much better today than at the market peak in mid-July.
The second table shows many sectors continue to have relative scores near zero. This tells us that the price ratio of each sector to the S&P 500 is near fair value on a technical basis. However, while the relative analysis does not offer much guidance, the absolute scores are concerning. As we highlight below, over half of the sectors have overbought absolute scores. Real estate and Healthcare are the most extreme. Likely we will see these sectors take a break from the recent steady rise. While the relative scores do not argue for a performance rotation, the absolute scores do.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Powell Signaled Rate Cuts Are Coming
On Friday, Jerome Powell signaled that a September rate cut is highly likely, and the stock and bond markets applauded.
“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
As if the statement above wasn’t a clear enough signal for a September cut, he said, “My confidence has grown that inflation is on the path to 2%.” Moreover, he expressed heightened concern for the labor market. To wit are the following statements:
We don’t seek or welcome further labor market cooling.
The cooling in the labor market is unmistakable.
Jerome Powell alluded that additional rate cuts will follow in the coming months. However, he did not provide a timetable or amounts of what we should expect. The Fed has been transparent that it is data-dependent. Accordingly, market expectations for Fed cuts will be volatile with incoming data. To that end, the BLS employment report on August 6 and CPI on the 11th will impact whether they cut by 25bps or 50bps in September. The graph, courtesy of the CME, shows the market slightly increased the odds of a 50bps rate cut to 30% after his speech.
What To Watch Today
Earnings
Economy
Market Trading Update
As noted last week, the rapid rally from the lows of three weeks ago had some good and bad elements. The positive is that the rally reversed the MACD “sell signal,” suggesting the bullish bias has returned. Furthermore, the rally cleared all-important resistance levels with ease. The market quickly crossed the 100, 50, and 20 DMAs, leaving only recent all-time highs as significant next resistance. The only negative to the advance is the nearly complete reversal of the previous oversold conditions. Such isn’t a critical issue, but it suggests we will likely see a minor pullback to retest support at the 50-DMA. Such will provide a better entry point to add exposure as needed.
That analysis mostly remains the same heading into this week.
On Friday, the market rallied strongly following Powell’s dovish comments at the Jackson Hole Summit, where he signaled that rate cuts are coming in September. However, while the market is not grossly overbought yet, it is approaching such levels. Furthermore, this has been a very rapid recovery from the correction lows, and a healthy pullback would provide a better entry point to increase exposure.
Trade carefully for now. With earnings, Powell, and the big economic reports behind us, there isn’t much data to drive markets higher until September.
The Week Ahead
While the pre-holiday trading will likely be quiet as the market digests what Jerome Powell and the Fed signaled regarding monetary policy, there are two significant events on the calendar.
On Friday, we get the Fed’s preferred inflation gauge, the PCE Price Index. The current consensus is for the monthly core PCE to rise by 0.2% and the year-over-year measure to remain at 2.6%. Second, and maybe the most important for the stock market this week, is Nvidia’s earnings report on Wednesday. Per Zacks:
This maker of graphics chips for gaming and artificial intelligence is expected to post quarterly earnings of $0.63 per share in its upcoming report, which represents a year-over-year change of +133.3%. Revenues are expected to be $28.24 billion, up 109% from the year-ago quarter.
Their future earnings and sales guidance will likely be more important than the most recent quarter. Nvidia’s executives have been very optimistic in prior earnings calls. Accordingly, we should expect statements that are bullish for the stock. However, with the stock price near all-time highs and up over 150% year to date, the shares are priced for perfection. The options market implies the stock will increase or decrease by 10% after earnings. Therefore, some volatility is expected in both Nvidia and the broader markets.
Red Flags In The Latest Retail Sales Report
The latest retail sales report seems to have given Wall Street something to cheer about. Headlines touting resilience in consumer spending increased hopes of a “soft landing” boosting the stock market. However, as is often the case, the devil is in the details. We uncover a more troubling picture when we peel back the layers of this seemingly positive data. Seasonal adjustments, downward revisions, and rising delinquency rates on credit cards and auto loans suggest a more cautious view. The consumer—the backbone of the U.S. economy—may be in more trouble than the headline numbers indicate.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
The CFNAI Bark Is Worse Than Its Bite
Peter Schiff tweeted the following in regards to the Chicago Fed National Activity Index (CFNAI):
The July Chicago Fed National Activity Index ‘unexpectedly’ plunged to minus 0.34, its lowest since April 2020, when the economy was initially shut down by the COVID pandemic.
Peter’s commentary is undoubtedly concerning. However, if you examine the CFNAI data and its long-term history, you will quickly realize the most recent data point is not as irregular as he alludes.
The Chicago Fed generally considers periods of economic expansion to be when the three-month moving average of the CFNAI is above –0.35. The graph below shows that the recent reading is near the -.35 line in the sand. However, the CFNAI tends to be volatile; thus, we and most economists look at this data using trends. Despite the “unexpected plunge,” the three-month moving average fell 0.01 to -.07. Accordingly, it is well above the -.35 level we note above.
We like CFNAI a lot due to its breadth of economic indicators across all major parts of the economy. Once you recognize the nature of the data and its volatility, it’s hard to find anything concerning about the recent reading. Our tone will change if the next few months are similar to the current reading, but Peter Schiff’s comments are not too concerning for now.
The Cash On The Sidelines Myth Debunked Again
It seems like a day doesn’t go by without someone presuming the stock market is due to rally, as there is a tremendous amount of cash on the sidelines. The Tweet below exemplifies this common sentiment.
The graph shows that the amount of cash in money market funds has increased threefold over the last four years. This cash is the supposed fuel for a coming surge in stocks. We think the argument is nonsense. If the money on the sidelines bought stocks, by default, they would give their cash to the stock sellers. The seller’s cash would replace that cash coming off the sidelines.
The second graph should give you a reason to pause if you buy into the cash-on-the-sidelines argument. The amount of cash available to buy stocks may have increased significantly, but so has the size of the asset markets. As a percentage of the market cap of the S&P 500, money market fund balances are at the same level as in 2018. There are reasons to be bullish, but the graph in the tweet above is not one of them.
More Concerning Employee Sentiment
Wednesday’s Commentary shared pessimistic data from the University of Michigan sentiment survey on the expected change in incomes for 2025. As we discussed, the survey is at levels associated with prior recessions. Weak sentiment regarding wages or job security can lead to weak consumer confidence, which in turn can negatively impact the economy. In its latest labor survey, the Federal Reserve of New York confirms the growing negative sentiment in the labor markets. Per the survey:
The proportion of individuals who reported searching for a job in the past four weeks rose to 28.4 percent from 19.4 percent in July 2023, marking the highest reading since March 2014, according to the July 2024 SCE Labor Market Survey. The expected likelihood of moving to a new employer increased to 11.6 percent from 10.6 percent in July 2023. Satisfaction with wage compensation, nonwage benefits, and promotion opportunities at respondents’ current jobs deteriorated by 3.2, 8.6, and 9.3 percentage points from July 2023, falling to 56.7 percent, 56.3 percent, and 44.2 percent, respectively.
The report’s graph below shows that 4.4% of those surveyed expect to enter unemployment in the next four months, the highest level since at least 2014. Accordingly, we will seek confirmation in broader consumer sentiment surveys and retail sales data.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Red Flags In The Latest Retail Sales Report
The latest retail sales report seems to have given Wall Street something to cheer about. Headlines touting resilience in consumer spending increased hopes of a “soft landing” boosting the stock market. However, as is often the case, the devil is in the details. We uncover a more troubling picture when we peel back the layers of this seemingly positive data. Seasonal adjustments, downward revisions, and rising delinquency rates on credit cards and auto loans suggest a more cautious view. The consumer—the backbone of the U.S. economy—may be in more trouble than the headline numbers indicate.
The Mirage of Seasonal Adjustments
The July retail sales report showed a sharp increase of 1.0% month-over-month, surpassing expectations. However, while that number supports the idea of a resilient consumer, these spikes have been more anomalous than not. Since 2021, real retail sales have virtually flatlined. Such is unsurprising as consumers run out of savings to sustain their standard of living.
The following chart of real retail sales clearly shows the consumer dilemma. Over the past two years, retail sales have not grown to support more robust economic growth rates. Notably, flat real retail sales growth was pre-recessionary and a “red flag” of weakening economic growth. However, given the massive surge in spending driven by repeated rounds of Government stimulus, the reversion of retail sales to the long-term trend has taken longer than previous periods, leading economists to believe “this time is different.”
But before we break out the champagne, let’s examine how these numbers are calculated. Retail sales data is notoriously volatile. Factors like weather, holidays, and even the day of the week play a significant role. To smooth out these fluctuations, the data is seasonally adjusted. The chart shows the magnitude of these seasonal adjustments since 1992. Interestingly, the magnitude of these adjustments is increasing over time.
But what happens when those adjustments paint an overly rosy picture?
Downward Revisions: A Growing Trend
Seasonal adjustments are a double-edged sword. While they aim to provide a clearer view of underlying trends, they can also distort reality, especially in an economy as dynamic and unpredictable as ours. Unfortunately, these adjustments are often revised in hindsight as more data becomes available. For example, a “red flag” is that eight of the past twelve-monthly retail sales reports were revised significantly lower, making the recent monthly “beat” much less impressive.
Why are retail sales being revised downward so frequently? One possible explanation is that initial estimates are overly optimistic, perhaps due to seasonal adjustments. As more accurate data becomes available, the true picture emerges, and it’s not as pretty as many believe. So, is there potentially a better method?
As noted, monthly retail sales are volatile due to various events. Christmas, Thanksgiving, Easter, summer travel, back-to-school, and weather all impact consumer spending. Therefore, “seasonally adjusting” the raw data may seem necessary to smooth out these periods of higher volatility. However, such a process introduces substantial human error. Using a simplistic 12-month average of the non-seasonally adjusted data (raw data) provides a smoother and more reliable analysis of consumer strength. Historically, when the 12-month average of the raw data approaches or declines below 2% annualized, it is a “red flag” for the economy. Again, the massive spike in COVID-related stimulus is reversing towards levels that should concern investors.
In other words, if we strip out the seasonal adjustments and apply a smoothing process to volatile data, the issue of consumer strength becomes more questionable.
Another “red flag” is realizing that retail sales should grow as the population grows. If we look at retail sales per capita, we see that before 2010, retail sales grew at a 5% annualized trend. However, that changed after the “financial crisis,” retail sales fell well below the previous trend despite an increasing population. While that gap improved following the Covid-stimulus supports, the gap is once again widening.
As you can see, the data shows a much more subdued picture of consumer spending, which raises a critical question: Are we being lulled into a false sense of security by the headline numbers? The reality is likely far more sobering.
The Debt Bomb: Rising Delinquency Rates
Perhaps the most alarming signal comes from the rising credit card and auto loan delinquency rates. Consumers have been relying heavily on credit to maintain their spending habits in the face of high inflation and stagnant wage growth. The spread between retail sales and consumer credit to disposable personal income rises as COVID-related stimulus runs dry and inflation is outstripping wages, forcing consumers to turn to credit.
But there’s a limit to how much debt consumers can take on before the house of cards tumbles.
According to the latest data, delinquency rates (more than 90 days) on both auto loans and credit cards have reached their highest level since 2012. Notably, delinquency rates are rising the fastest for younger generations that tend to have lower incomes and less savings. (Charts courtesy of Mish Shedlock)
These rising delinquency rates are a warning sign that consumers struggle to keep up with their debt obligations. As more consumers fall behind on their payments, the risk of a broader economic slowdown increases. After all, consumer spending accounts for nearly 70% of U.S. GDP. If the consumer falters, the entire economy is at risk.
The Implications for Future Consumption
Given these “red flags,” it is difficult to see how the current level of consumer spending can be sustained. Rising delinquency rates, downward revisions to retail sales, and questionable seasonal adjustments all suggest the consumer is running out of spending power.
In the near term, we may continue to see headline retail sales numbers that appear healthy, especially if seasonal adjustments continue to provide a tailwind. However, the underlying data tells a different story. As more consumers reach their debt limits and delinquency rates continue to rise, we could see a significant spending slowdown later this year.
That slowdown would have far-reaching implications for the broader economy. Retailers could see further revenue declines, leading to potential layoffs and further weakening of consumer spending. Banks and financial institutions could also face higher loan losses, particularly in the credit card and auto loan sectors.
In summary, while the latest retail sales report may have given the market a short-term boost, suggesting a “soft landing” economically, the underlying data suggests we should be cautious. Seasonal adjustments and downward revisions are masking the actual state of consumer spending, while rising delinquency rates are a clear sign of trouble ahead.
Investors and policymakers would do well to look beyond the headlines and focus on the economy’s real risks. The consumer may be hanging on for now, but the cracks are starting to show. Ignoring these red flags could lead to a rude awakening in the months ahead.
Jackson Hole Takes Center Stage
The Fed’s annual symposium in Jackson Hole, Wyoming, kicking off yesterday, will keep traders on edge over the next few days. The Fed often uses the Jackson Hole meeting to elaborate on its expected policy path for the months ahead. Furthermore, they expound on their economic views and the economic data points most likely to impact the Fed’s thinking. Therefore, with the Fed on the cusp of easing, this meeting will shed more light on their longer-term Fed Funds outlook.
While many speakers will address the audience at Jackson Hole, including Fed members, guest economists, and other nation’s central bankers, the most important will be Jerome Powell. He is slated to address the conference on Friday. As discussed below, hearing Powell opine on yesterday’s massive downward revisions to the BLS employment data will be interesting. Had they known that there were 818k fewer jobs formed, would they have favored lowering rates before September? Moreover, does the revision provide more impetus for the Fed to cut in larger increments? The table below shows the market, before Powell’s speech, is assigning 100% odds of a rate cut in September, with a 34% chance they cut by 50bps. Furthermore, Fed Funds futures imply 1% of easing by year-end.
What To Watch Today
Earnings
Economy
Market Trading Update
“This market just won’t stop going up. It’s crazy.”
I got such an email this morning. As noted yesterday, mounting bullish signals support the market currently as momentum builds. Of course, corporate share buybacks are certainly helping.
“BofA corporate client buybacks continued to track above seasonal levels as a % of S&P 500 market cap for the 23rd straight week, and YTD, are on pace for a record year in our data history.”
With Jerome Powell’s speech from Jackson Hole tomorrow, the markets will likely continue to hold above the 50-DMA while awaiting his comments. If Powell suggests a move dovish poster, such could quickly send stocks to all-time highs. A more hawkish tone could result in a short-term pullback to support at the 100-DMA. With the markets on a bullish buy signal and not dramatically overbought, there is certainly potential for further upside if resistance at previous highs is removed. The downside risk is fairly contained with several levels of key support.
Until we get through Friday, and into September, continue to manage portfolio risk for now. Around mid-September, we should have a clearer view of market health and what actions must be taken next.
The Labor Market Was Weaker Than Advertised
Yesterday, the BLS revised the prior year’s employment data (April 2023-March 2024) lower by 818,000 jobs. With the revisions, job growth over the period was 174k, not the 242k initially reported. That puts average monthly job growth at about 20k less than the run rate from 2012-2019.
As shown below, professional and business services accounted for nearly half of the revision. The second graph, courtesy of ZeroHedge, shows that the revision was much more significant than prior years.
New Bussiness Formation
One reason for the lower revisions is poor data on new business formations. The so-called birth-death rate forecast, which feeds the BLS employment data, accounts for new jobs resulting from new businesses. At first blush, as shown in the first graph below, it may appear that people are starting new businesses faster than before the pandemic. However, the second graph shows that the new companies may have been Door-Dash, Instacart, and Uber Eats drivers, not new businesses.
Fed Funds Futures Offer Bond Market Insights
Profitable bond trading opportunities arise when your expectations about Fed policy differ from those of the market. Therefore, with the Fed seemingly embarking on a series of interest rate cuts, it behooves us to appreciate how many interest rate cuts the Fed Funds futures market expects and over what period. Equally important, Fed Funds futures help us assess the market’s economic growth and inflation expectations.
Currently, Fed Funds futures imply the Fed will start cutting rates in September and reduce them by 2.25% to 3.09% in early 2026. From that point, the market expects the Fed to slowly increase Fed Funds to 3.50%. The limited rate cuts and relatively high trough in Fed Funds tell us the market is not pricing in a recession but a normalization of GDP with inflation running at or slightly above the Fed’s 2% target.
If the Fed Funds futures market is correct, the upside in bond prices may be limited, especially compared to prior easing cycles. However, suppose the market underestimates the probability of a recession or a sharper-than-expected inflation drop over the coming few years. In that case, there is significant upside potential in bond prices.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Extreme Volatility Is A Distant Memory
If you went off the grid for the last month and are just returning, you may think you missed a typical boring August. The S&P 500 is within 2% of its July 15 high, and volatility is low, as when you left a month ago. What you missed was an extreme spike in implied volatility (VIX) accompanying significant losses for some of the market’s favorite stocks.
The graph below shows the extreme volatility cycle of the last month. The lines represent the VIX futures prices for each future month out to March. The current VIX curve (blue) and the one when the market peaked on July 15 (dotted blue) are virtually identical. However, the orange and red lines show the tremendous movement in the VIX curve between July 15 and today. To wit, spot VIX peaked at 39, almost 3x what it was only a few days prior. The extreme volatility of the prior few weeks is far from ordinary. Accordingly, we must be on guard for more rounds of volatility, as is typical following volatile market conditions. However, the yen-carry unwind culprit may be complete, and therefore, the spike may have been a one-off anomaly.
On a side note, it’s worth pointing out the kink in the VIX curve. The current curve shows the October VIX contract a little higher than where a linear line connecting September to November should be. This is a function of the coming election and some associated hedging. Such behavior before well-known events that could be volatile is typical.
What To Watch Today
Earnings
Economy
Market Trading Update
Yesterday, we discussed the rapid recovery in the markets from two weeks ago. As shown below, rapid V-shaped recoveries tend to be bullish indications of both the end of the corrective period and the resumption of the bullish trend. Since 2014, periods that saw a sharp price decline, as measured by the 10-day rate of change, followed by a sharp advance, were bullish indications. However, as seen in 2015 and 2022, such a reversal does not preclude a secondary correction from occurring.
Notably, Sentiment Trader recently did a similar study on V-shaped bottoms and concluded:
“Stocks are already overbought on some measures, and sentiment is quickly recovering from the brief freak-out a couple of weeks ago. The run has been astounding, but past performance after impressive v-shaped bottoms suggests that there should be more gains in store over the next couple of months.
The biggest caveat is that it has been exceptionally unusual to see this type of move during uptrends, and the only other times it happened, gains were capped in the weeks and months ahead. An objective look at what is inherently emotional trading behavior suggests that we should be modestly confident that this rapid shift in momentum should carry stocks even higher. However, since it’s occurring so near record highs, we shouldn’t be overly confident that we can rely on the types of gains after more protracted declines.”
We agree that the upside is likely somewhat capped, particularly with the election looming. Therefore, while there is little reason to be overly bearish, there is likewise some caution to being overly bullish. Continue to manage risk in the near term until a better entry point presents itself.
A Historic Winning Streak For The S&P 500
In the aftermath of early August’s extreme volatility, the S&P 500’s eight-day winning streak is nearing historic proportions. Since January 1993, there have been 7,945 trading days. Of them, only 17 days have registered a streak of 8 or more positive days. The last instance was only four months ago, in May 2024, when the S&P 500 rose for ten days straight.
So what comes next?
To help answer that, we created the table below the graph. It shows that the returns for the following 5, 10, and 20 days are, on average, following 8-day or longer streaks are much better than periods following shorter streaks.
Expected Incomes Are Concerning
As we wrote in Confidence Is The Underappreciated Economic Engine, consumer confidence is an essential factor driving changes in economic activity. Furthermore, incomes and job security are a primary driver of confidence. Therefore, the University of Michigan sentiment chart below, which shows that the expected change in incomes in 2025 is at levels associated with prior recessions, should give us some concern. Francois Trahan posted the graph below with the following commentary:
I try to not make too much from one series, but this series is not looking good. It’s from the University of Michigan survey of confidence and measures income expectations. It’s rarely been this bad, and markets certainly don’t jive with the other two times it plunged like this.
If you found this blog useful, please send it to someone else, share it on social media, or contact us to set up a meeting.
Fed Funds Futures Offer Bond Market Insights
Profitable bond trading opportunities arise when your expectations about Fed policy differ from those of the market. Therefore, with the Fed seemingly embarking on a series of interest rate cuts, it behooves us to appreciate how many interest rate cuts the Fed Funds futures market expects and over what period. Equally important, Fed Funds futures help us assess the market’s economic growth and inflation expectations.
Currently, Fed Funds futures imply the Fed will start cutting rates in September and reduce them by 2.25% to 3.09% in early 2026. From that point, the market expects the Fed to slowly increase Fed Funds to 3.50%. The limited rate cuts and relatively high trough in Fed Funds tell us the market is not pricing in a recession but a normalization of GDP with inflation running at or slightly above the Fed’s 2% target.
If the Fed Funds futures market is correct, the upside in bond prices may be limited, especially compared to prior easing cycles. However, suppose the market underestimates the probability of a recession or a sharper-than-expected inflation drop over the coming few years. In that case, there is significant upside potential in bond prices.
Fed Funds Futures Caveat
Before we provide historical context for what the Fed might do and a historical track record of Fed Funds futures estimates, it’s important to caveat that market beliefs about future Fed actions and, consequently, the economy and inflation can swing wildly.
The graph below shows that expectations for the Fed Funds rate at the coming September 24th FOMC meeting have whipped around over the past year. Fed Funds futures currently imply that the Fed will cut rates by 34 bps at the September meeting. This includes a 100% chance of 25 bps and a 36% (.34-.25)/.25) chance of 50 bps. Only two months ago, it was priced at a 50/50 chance of only one 25-bps rate cut. Furthermore, at the start of the year, the market thought the Fed would cut rates by 1.34% by next month’s meeting. The data suggest that the markets’ collective assessment of economic conditions can be volatile.
Fed Funds and Fed Funds Futures
The graph below charts the effective Fed Funds rate since 1955. As implied by Fed Funds futures, we added the future rates for the next three years.
The market expects Fed Funds to decline from the current rate of 5.33% to 3.09% by March 2026. Following that, Fed Funds futures imply Fed Funds will slowly rise to 3.50% by the end of 2027.
The table below quantifies the thirteen easing cycles shown above. Of these easing cycles, only two periods saw declines of less than 2.23%. 2.23% represents current market expectations. Of the two instances, the economy did not enter a recession (1966-1967 and 1995-1998).
Since 1980, only two easing cycles have seen the Fed cut Fed Funds by less than 5%. The most recent, 2020, was limited as the Fed could only bring rates down to 0%. The other was 1995-1998.
Based on history, the market is betting on an anomaly, like 1995-1998, and not normal monetary policy behavior.
What Is The Market Expecting?
Given that the market expects a relatively minimal rate cut, we should suppose it’s expecting a 1995-1998 economic scenario, i.e., no recession.
John Authers of Bloomberg recently opined what Fed Funds futures may imply regarding inflation. To wit:
So even if markets buy the notion that the Fed will have to cut soon, they also seem convinced by the theory that the very low rates of the last three decades were an aberration, and that the norm for monetary policy will be tighter in future. That presumably goes hand-in-hand with slightly higher inflation rates.
Presuming the collective market thinks this time is different, they must believe that economic growth and inflation trends of the pre-pandemic have been reversed. We have discussed such a forecast many times. To wit, we share a section from Our Elevator Pitch For Bonds, published in July 2023.
Our view of the attractiveness of bonds can be honed into an elevator pitch. It essentially boils down to a straightforward question – Is this time different?Have the forty-year pre-pandemic economic trends reversed, and the economy’s inner workings changed permanently over the last three years?More specifically, are slowing productivity growth, weakening demographics, and rising debt levels about to reverse their prior trends and become a tailwind for economic growth?
If you think, as we do, that the last three years are an economic, fiscal, and monetary anomaly, then the opportunity to earn 4% or more on a longer-term bond is a gift.
We think yields will revert to low levels when the pre-pandemic economic and inflation trends reemerge. Negative interest rates are not out of the question.
Traders Consistently Underestimate The Fed
While the market appears to be pricing a “this time is different” scenario, it frequently prices in such a scenario, only to find out this time is no different.
In 2019, we quantified how accurately Fed Funds futures predict the future. The graph below shows our results. We recently released the article describing our analysis HERE.
The graph compares the effective Fed Funds rate to what was implied by the futures contract for that same period six months earlier.
The gray shading represents periods in which the Fed consistently raised or lowered the Fed Funds rate. The three easing cycles shown are 1989-1991, 2000-2003, and 2007-2009. At one point during each of those cycles, the market underestimated the amount of Fed rate cuts by roughly 2.50%. The yellow-shaded circles highlight these gross underestimations.
While not pertinent to this article, the futures market also underestimates rate increases but to a much lesser extent.
In late 2019, when we published the findings, we theorized:
“If the Fed initiates rate cuts and if the data in the graphs prove prescient, current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see.”
It turns out we were prescient. Fed Funds went to 0%.
What Do Economists Think?
With an idea of what the market forecasts for longer-term economic growth and inflation, let’s compare that to economists’ expectations.
The table below is from the Fed’s most recent series of economic projections. As circled, they forecast the long-term economic growth rate of the U.S. is 1.80%. The second table compares the projections below with those from December 2019.
The difference column shows that the Fed doesn’t believe this time is different. On the contrary, it thinks real GDP in the “longer run” will run 0.1% less than before the pandemic. Furthermore, it expects a slightly higher long-term unemployment rate. The Fed believes inflation will run around 2% in the future, as it did in 2019.
The CBO also forecasts that pre-pandemic GDP and inflation trends will prevail over the next decade.
Don’t believe the government?
The following commentary is from the Blue Chip Economic Indicators, compiled by Wolters Kluwer. The report polls 50 leading business economists to arrive at its forecasts.
In general, the longer-term outlook in the most recent survey is little changed from that in the March survey. Forecasters usually anticipate that the real GDP will grow on average at its potential rate over the longer term. The BCEI consensus looks for 1.9% growth in real GDP over the 2025- 29 period, the same estimate as in March but much slower than the 2.5% growth experienced during the five years prior to the Covid pandemic. On inflation, the consensus expects the Federal Reserve to essentially achieve its 2% target with the PCE price index inflation rate (the measure that the Fed targets) expected to average 2.1% from 2025-29. This is slightly higher than the 2.0% estimate in the March survey.
Both public and private sector economists are forecasting that this time is not different. They believe the pre-pandemic trends of lower economic growth and stable 2% inflation will prevail.
Summary
History shows that Fed Funds futures are volatile and consistently underestimate the amount of Fed easing in a cycle. Their forecast of relatively minimal Fed Fund rate cuts implies that the economy will remain strong and, to some degree, start reversing the economic and price trends existing before the pandemic.
Economists, however, believe that the major factors that drove a steady trend of declining economic growth before the pandemic will continue.
We side with the economists. There is little evidence that productivity and demographic trends have changed. The nation is more indebted today than it was before the pandemic. Given those essential economic factors remain intact, it’s difficult for us to believe that this time is different. Therefore, should we expect this coming rate-cutting cycle to differ from the past?
If the answer is no, bond investors could be on the cusp of outsized returns.
Price Gouging For Food: Reality Or Campaign Rhetoric?
Recently, Kamala Harris proposed that if elected, she would implement a ban on price gouging for food and groceries. Her goal is to lower inflation, as food prices have risen by about 20% over the last four years. The Harris campaign says the price gouging measure sets “clear rules of the road to make clear that big corporations can’t unfairly exploit consumers to run up excessive corporate profits on food and groceries.”
Currently, many states have rules banning companies from unduly profiting when a sudden change in the supply or demand of goods occurs. For instance, during hurricane preparation, states try to prevent hardware stores from increasing the price of plywood. While such rules make perfect sense, Harris’ price gouging proposal is flawed.
The graph below shows Krogers’s profit margin of 3.50%. Their grocery store competition has similar profit margins. Walmart and Costco, also competitors, although they sell non-food items, have profit margins of 4.00% and 3.50%, respectively. The point is that many grocery stores and other food sellers are not making excessive profits. For context, the S&P 500 has an aggregate profit margin of about 12%.
If grocers had to reduce their prices, their already slim margins would force them to reduce their expenses. Such would result in layoffs and store closures, both of which would harm the economy. The food inflation problem is not due to price gouging but excessive fiscal and monetary stimulus during the pandemic.
What To Watch Today
Earnings
Economy
Market Trading Update
As noted yesterday, the recovery from the recent lows has been rapid, and the momentum continued again yesterday as the markets are now focused on all-time highs as the next resistance level. Currently, there is little to stop the rally as corporate share buybacks continue, and trading programs must accumulate roughly $10 billion daily through the end of the month.
However, once we get into September, things should cool down following the Jackson Hole Summit (Powell speaks on Friday), and the election will begin to take center stage. While we didn’t get an opportunity to add to exposures, small dips can be used to rebalance portfolios. It is worth noting that the oversold condition has been primarily reversed in the short term, so the upside will likely become more challenging. Trade accordingly.
Bankruptcies On The Rise
The Bloomberg graph below shows that new Chapter 11 bankruptcy cases are rising. Bankruptcies tend to fall during economic expansion. Conversely, they increase sharply during or after the recession. The recent increase puts the number of bankruptcies above the rate in the pre-pandemic era.
Let’s hope this time is different!
SimpleVisor Shows Market Breadth Has Improved
The first graphic from SimpleVisor’s proprietary sector and factor relative and absolute analysis tool shows that eight of the twelve sectors have relative scores near zero. The second graphic highlights that many factors have similar relative scores. Both graphics tell us that much of the market has been trading in line with the S&P 500. Therefore, market breadth is back to a more normal state. Over the last five years or so, in which we have run this analysis, we have never seen such even breadth. So, what comes next?
The third graphic can provide some hints. The SimpleVisor 2 Symbol Money Flow Daily graphs the price ratio of securities. Furthermore, the SimpleVisor propriety momentum model is shown beneath the price ratio graph. We ran the equal-weighted S&P 500 (RSP) to the S&P 500 (SPY). This pair is a good indication of market breadth. The graph shows the recent outperformance of RSP vs SPY. In addition, the SV momentum model is turning into a sell indicator. This indicates that SPY may likely outperform RSP in the coming days.
If the large-cap stocks again dominate performance, then SPY will beat out RSP, and the price ratio will decline further. However, this may be a rest before RSP gains further versus SPY. Lastly, the ratio may start to flatline, and the SV indicator may oscillate around zero. If that happens, breadth is likely to remain healthy.
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Market Decline Over As Investors Buy The Dip
The market’s 8.5% decline during August sent shockwaves through the media and investors. The drop raised concerns about whether this was the start of a larger correction or a temporary pullback. However, a powerful reversal, driven by investor buying and corporate share repurchases, halted the decline, leading many to wonder if the worst is behind us.
However, the picture becomes more nuanced as we examine the technical levels and broader market conditions. While the recent bounce suggests the market decline may be over, risks remain—particularly with the November election looming. Let’s dive into the details.
The August Decline: What Caused It?
August has historically been volatile for markets; this year was no exception. A combination of factors drove the S&P 500’s 8.5% drop:
Elevated Interest Rates: The Federal Reserve’s continued commitment to fighting inflation led to increased concerns about economic growth slowing. That spooked investors betting on a soft landing for the economy when recent economic data deteriorated.
Weak Economic Data: A string of weaker-than-expected economic reports fueled the fire, including slowing job growth and declining consumer confidence. Concerns about a potential recession started the sell-off in equities.
The Yen Carry Trade: A significant rise in the Japanese Yen led to a rapid unwinding of leverage used by institutions to increase portfolio returns. For more information on the carry trade, read the linked article.
Technically Overbought: As we discussed repeatedly in June and July, the markets were technically overbought and extended from long-term means. Only an appropriate catalyst was needed for a 5-10% market decline.
The correction, however, was unsurprising and something we repeatedly discussed in June and July.
“Reversals of overbought conditions tend to be shallow in a momentum-driven bullish market. These corrections often find support at the 20 and 50-day moving averages (DMA), but the 100 and 200-DMAs are not outside regular corrective periods.
If you remember, in March, we discussed the potential for a 5 to 10% correction due to many of the same concerns noted above. That correction of 5.5% came in April. We are again at a juncture where a 5-10% is likely. The only issue is it could come anytime between now and October.“ – June 22nd
With that 5-10% correction complete, many investors wonder what caused the rapid reversal last week, given that many factors leading up to the market decline remain.
The Reversal: Investor Buying and Share Repurchases
Despite the sharp decline, the market found support as a wave of investor buying and corporate share repurchases helped stem the losses. Here’s how these factors played out:
Investor Buying at Key Support Levels: The S&P 500 found support at the 5153 level, which coincides with the lows of the trading range back in April. Buyers stepped in as the market declined 3% during the “Yen Carry” blowup. From there, buying volume began to accelerate.
The chart shows that the S&P 500’s bounce off that support was pivotal. With the markets oversold, the reversal of the decline began. As the market low held, it provided the confidence needed for investors to step back into the market.
Corporate Share Repurchases: August also saw a significant increase in corporate share buybacks. With stock prices down, many companies took the opportunity to repurchase shares at a lower cost as the “blackout window” reopened, providing additional support to the market. This corporate activity helped absorb some of the selling pressure and stabilized the market.
As we noted last week, we expected the “Mega-cap” stocks to lead the way higher, and we were not disappointed.
Notably, the market leadership, primarily growth stocks, has regained its footing, suggesting that the recent correction is complete and the bull market has resumed.
However, the recent rally has been very sharp and likely needs a breather before further gains can be made.
Technical Levels to Watch
With the market rebounding, it’s crucial to identify the key technical levels that will determine the following potential entry points to increase equity exposures.
Resistance at 5673: The first significant resistance level for the S&P 500 is at 5673, which coincides with the recent all-time highs. If the index can break above this level, it would signal a continuation of the recovery and potentially set the stage for a continuation of the rally. However, if the S&P 500 fails to break through this resistance, it could lead to another market decline to retest current support at the 50-DMA.
Support at 5330: On the downside, the 5,330 level remains a critical support zone. That number will continue to adjust higher as that is the 100-DMA. However, if that level fails to hold, there is only minor support at the recent lows before a test of the 200-DMA near 5100. Investors should watch the 100-DMA level closely, as a failure to hold here could signal that the market’s recent bounce was just a temporary relief rally.
While a pullback to support levels to increase equity exposure is likely, are there more substantial risks that investors should be aware of?
The Risks Ahead: November Election and Economic Uncertainty
While the market’s recent recovery is encouraging, several risks could derail the rally over the next few months.
November Election: The upcoming election adds another layer of uncertainty to the market. Historically, elections tend to increase volatility as investors react to potential policy changes. We could see sharp moves in sectors like healthcare, energy, and technology depending on the outcome. That uncertainty may lead to increased selling pressure, particularly if the election results are contested or lead to a significant shift in policy.
Economic Data: The market will remain highly sensitive to economic data releases. Any signs of further economic weakness could reignite fears of a recession, leading to another wave of selling. In particular, investors will watch for updates on inflation, employment, and consumer spending. If weakening economic data impairs earnings estimates, the risk of market revaluation increases.
Federal Reserve Policy: The Fed’s decisions will also shape market sentiment. If the Fed is willing to start cutting rates, the market may temporarily see that optimistically. However, historically, a Fed rate-cutting cycle has not benefited higher asset prices, as rate cuts tend to coincide with slower economic growth.
Risk management is always crucial when managing portfolios, as “no one” knows with certainty what markets will do over the next week, much less over the next month or quarter.
Conclusion: Is the Decline Over?
The market decline in August and subsequent reversal highlight the market’s volatility and the importance of critical technical levels. While the bounce off minor support and the surge in corporate buybacks suggest that the worst may be over, significant risks remain.
With the polls now very tight between Trump and Harris, the potential for managers to “de-risk” portfolios remains elevated, given the uncertainty of outcomes. Furthermore, that potential “de-risking” process will coincide with the October blackout period for share repurchases, removing another supportive buyer of equities. That combination could set up a likely “flash point” for volatility before the November election.
We remain underweight equities and overweight cash in the near term with our core Treasury bond holdings intact to hedge against a sharp increase in volatility. That positioning is unlikely to change over the next two months, and we are willing to sacrifice some performance in exchange for control over risk.
While we have discussed these simplistic rules over the last several weeks, we continue to reiterate the need to rebalance risk if you have an allocation to equities.
Tighten up stop-loss levels to current support levels for each position.
Hedge portfolios against significant market declines.
Take profits in positions that have been big winners
Sell laggards and losers
Raise cash and rebalance portfolios to target weightings.
If a further correction occurs, the preparation allows you to survive the impact. Protecting capital will mean less time spent getting back to breakeven afterward. Alternatively, it is relatively easy to reallocate funds to equity risk if the market reverses and resumes its bullish trend.
Investing during periods of market uncertainty can be difficult. However, you can take steps to ensure that increased volatility is survivable.
Oil And Bond Yields Are Tied At The Hip
Over the last year or so, crude oil and ten-year U.S. Treasury bond yields have been highly correlated. The graph on the left shows how oil and bond yields have moved step for step with each other. However, as we highlight with circles, it’s worth noting that short-term trend changes in crude oil prices have led to bond yield trend changes by a couple of weeks. The graph on the right shows some historical periods where the two prices are correlated, such as 2015-2018. Conversely, there are plenty of periods with little correlation. The average 100-day correlation since May 2023 has been statistically robust at 0.60. Over the 25-year time frame graphed on the right, the correlation has been about half the recent rate (0.28).
Given the impact oil prices can have on economic activity, the long-term relationship with bond yields is not surprising. Assuming the relationship holds and oil prices continue to lead the way, bond traders should follow crude prices closely. Accordingly, the bullish case for oil is heightened hostilities in the Middle East and or a resurgence in economic growth. The bear case is essentially the opposite. A peace treaty in the Middle East would provide confidence that Iranian oil will continue to flow unabated. Second is the further weakening of economic activity in the U.S. and globally. To this point, economic activity in China is slowing rapidly. China consumes 13% of the world’s oil, second to the U.S., which accounts for 20%.
What To Watch Today
Earnings
Economy
No notable economic releases
Market Trading Update
As noted last week, events like the “Yen Carry Trade” blow-up are temporary and rarely devolve into more extreme market corrections. However, there is always that risk, so we suggested rebalancing portfolio risk as needed. The good news is that the 5-10% correction we warned about in June and July has been completed, as we will discuss in a moment.
However, with that said, the rally from the lows of two weeks ago has been rapid and has some good and bad elements. Starting with the positive, the rally from the lows reversed the MACD “sell signal,” suggesting the bullish bias has returned. Furthermore, the rally cleared all-important resistance levels with ease. The 100, 50, and 20-DMAs were crossed quickly, leaving only recent all-time highs as important next resistance.
The only negative to the advance is that the previous oversold conditions have mostly been reversed. Such isn’t a major issue, but it suggests we will likely see a small pullback to retest support at the 50-DMA. Such will provide a better entry point to add exposure as needed.
Last week’s economic reports from PPI and CPI to retail sales helped boost the market’s confidence that while the economy is slowing down, it is not recessionary. A “soft landing,” if the Federal Reserve can navigate one, would suggest that stable economic growth rates could support current earnings estimates. However, as history suggests, such optimistic outlooks rarely come to fruition, but that is a challenge the markets will face later this year and into 2025.
Continue to manage risks, but the correction is over for now.
The Week Ahead
The Fed’s Jackson Hole symposium will be the highlight this week. The meeting, starting Tuesday, allows the Fed to discuss and debate their longer-term outlooks along with thoughts on current monetary policy. They often use this event to steer the public mindset regarding how they will or won’t change rates. Jerome Powell will address the symposium on Friday. We suspect the Fed will tell the market they plan to cut rates in September. However, more important will be any guidance on what they expect regarding the number of rate cuts and what data impacts their decision-making the most.
Other than Jackson Hole, it will be a quiet week with little economic data. The Fed will release its minutes from the July meeting, which may also provide some clues on future rate cuts.
Million Dollar Homes On The Rise
In a recent housing market study, Redfin claims that 8.5% of U.S. homes are worth at least $1 million. That is the highest share of all time and quadruple the share of ten years ago. Furthermore, the rich are getting richer. Per Redfin:
Prices are rising even more for homes that are already expensive: The median sale price of U.S. luxury homes rose 9% year over year to a record $1.18 million in the second quarter. Prices of luxury homes rising has an outsized impact on the share of homes worth at least $1 million because a major portion of them have long been on the cusp of hitting the million-dollar mark, and just did.
One of the most critical factors behind rising home prices is the minimal supply of homes for sale. Redfin says the inventory of homes for sale has improved, but it is “still 30% below pre-pandemic levels because many homeowners are locked in by low rates.“
The article claims the share of million-dollar-plus homes rose in all but three of the most populated MSAs. Austin, Indianapolis, and Houston saw slight declines in large part because “rampant new construction in Texas has pushed up supply, putting a lid on price growth.” Despite a migration trend out of California, Redfin claims they are gaining the most million-dollar homes. In fact, nearly 60% of homes in Anaheim are worth at least one million dollars. Conversely, Detroit, Cleveland, Pittsburgh, and Kansas City have less than 1% of homes worth a million or more.
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Walmart Gives Investors A Ray Of Hope
Walmart’s earnings report gives investors hope that weakening retail spending trends may be ending. Walmart’s earnings and sales exceeded expectations. Furthermore, Walmart gave increased earnings guidance for the year ahead. Investors loved the news, as witnessed by Walmart shares initially trading 8% higher on the news.
Most retail earnings this year have been accompanied by concerns from its executives that consumers were slowing their spending habits and unwilling to pay up for goods. As we have recently seen, many retail establishments, including Walmart, are now offering their customers price deals or special sales. Walmart’s CFO gives us hope that the weakening trend in personal consumption may be changing. To wit:
“We don’t see any additional fraying of consumer health.”
Is Walmart seeing increased business from consumers shunning higher-priced stores, or are they providing the first signs of a turnaround in spending habits? As we write below, Thursday’s Retail Sales report echoed Walmart’s sentiment.
What To Watch Today
Earnings
Economy
Market Trading Update
We noted yesterday that the 50-DMA was the next resistance level to challenge the market rally. With weak inflation reports this week and a surprisingly strong retail sales number, the 50-DMA provides little resistance to the strong market rally. As shown, the market has pushed easily through all the moving averages and broke out of the corrective downtrend channel from the July peak.
With the MACD “buy signal” triggered and the market not overbought yet, there appears to be further upside for the near term, particularly as corporate buybacks take center stage. For all intents and purposes, the 5-10% correction we discussed in June and July is now complete and the bullish market backdrop remains intact. For now, traders can use pullbacks to key support levels opportunistically to add exposure as needed.
Retail Sales Rock
Retail Sales for July were much stronger than expected, rising 1% versus expectations for a 0.4% increase. This was the best headline retail sales number in over two years. However, the retail sales control group, which feeds the GDP number directly, only rose by 0.3%, and excluding auto sales, retail sales rose by 0.4%. The graph below shows that motor vehicle sales contributed heavily to the beat, offsetting its negative influence last month.
The Tweet of the Day below points out that retail sales are still below pre-pandemic levels despite the robust data. Furthermore, when inflation is factored in, retail sales are on par with prior recessions. Hopefully, the latest retail sales print and Walmart earnings report are the start of a more positive trend and not a one-off anomaly.
Is Japan Awakening?
After decades of economic slumber, the Japanese economy shows signs of life. Second-quarter GDP rose 3.1%, 1% more than estimates. Furthermore, it should help quell recession fears, as first-quarter GDP fell by 2.3%.
The growth was driven by a surge in private consumption, which rose by 1.0%, and an increase in business spending of 0.9%. The data supports the case for more rounds of interest rate hikes by the BOJ. Accordingly, improving growth, growing inflationary pressures, and rising interest rates may also result in the continued strengthening of the yen versus the dollar. While economic recovery for Japan is good, an appreciating yen risks more unwinding of the yen carry trade. We suspect the BOJ and Fed will try to reduce volatility in the yen to limit the adverse market effects like we saw last week. Despite the good news, the yen was weaker against the dollar, as shown below.
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Economic Growth Myth & Why Socialism Is Rising
I was recently asked about the seemingly strong “economic growth” rate as the Federal Reserve prepares to start cutting rates.
“If economic growth is so strong, as noted by the recent GDP report, then why would the Federal Reserve cut rates?”
It’s a good question that got me thinking about the trend of economic growth, the debt, and where we will likely be.
Since the end of the financial crisis, economists, analysts, and the Federal Reserve have continued to predict a return to higher levels of economic growth. The hope remains that the Trillions of dollars spent during the pandemic-driven economic shutdown will turn into lasting organic economic growth. However, the problem is that while the artificial stimulus created a surge in inflationary pressures, it did little to spark organic economic activity that would outlive the stimulus-related spending.
Pulling Forward Growth
Pulling forward growth over the last decade remains the Federal Reserve’s primary tool for stabilizing financial markets while economic growth rates and inflation remain weak. From repeated rounds of monetary and fiscal interventions, asset markets surged, increasing investor wealth and confidence, which, as Ben Bernanke stated in 2010, would support economic growth. To wit:
“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.” – Ben Bernanke
That certainly seemed to be the case as Federal Reserve interventions kept the financial markets and economy stable each time the economy stumbled. However, there is sufficient evidence that “monetary policy” leads to other problems, most notably a surge in wealth inequalitywithout a corresponding increase in economic growth.
The inherent problem of pulling forward consumption is that while it may solve short-term economic concerns, it leaves an ever-larger “void” in the future that must be filled. The problem, unsurprisingly, is that “monetary policy” is not expansionary. As shown, since 2008, the total cumulative growth of the economy has been just $6.1 trillion. In other words, each dollar of economic growth since 2008 required nearly $6.7 of monetary stimulus. Such sounds okay until you realize it came solely from debt issuance.
Of course, the apparent problem is that sustaining this amount of debt-driven monetary policy is not realistic. But therein lies the issue of the “strong economic growth” narrative.
The Lack Of Economic Growth
While economists, politicians, and analysts point to current data points and primarily coincident indicators to create a “bullish spin” for the investing public, the underlying deterioration in economic prosperity is a much more critical long-term concern.The question that we should be asking is, “Why is this happening?”
From 1950-1980, nominal GDP grew at an annualized rate of 7.55%, accomplished with a total credit market debt to GDP ratio of less than 150%. The CRITICAL factor is that economic growth trended higher during this span, going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower debt levels allowed personal savings to remain robust, which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing, which had a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates, which peaked with economic expansion in 1980.
However, beginning in 1980, the shift of the economic makeup from a manufacturing and production-based economy to a service and finance economy with a low economic multiplier is partially responsible for this transformation. The decline in economic output was further exacerbated by increased productivity through technological advances and manufacturing outsourcing, which plagued the economy with steadily decreasing wages. Unlike the steadily growing economic environment before 1980, the post-1980 economy has experienced a steady decline. Therefore, a statement that the economy has had an average growth of X% since 1980 is grossly misleading. The growth trend is far more important and telling than the average growth rate over time.
The Drag On Consumers
This decline in economic growth over the past 40 years has kept the average American struggling to maintain their standard of living. As their wages declined, they turned to credit to fill the gap and maintain their current standard of living. This demand for credit became the new breeding ground for the financed-based economy. More accessible credit terms, lower interest rates, easier lending standards, and less regulation fueled the continued consumption boom. While the economy surged with the “free money” sent to households, reversing that benefit will eventually return the economy, wage growth, and consumption to the ongoing long-term downtrend.
That is why the economic prosperity of the last 40-years has been a fantasy. While America, at least on the surface, was the world’s envy for its apparent success and prosperity, the underlying cancer of debt expansion and declining wages was eating away at the core. The only way to maintain the “standard of living” was to utilize ever-increasing debt levels. The now-deregulated financial institutions were only too happy to provide that “credit” as it was a financial windfall of mass proportions.
Why “Socialism” Is Rising
The massive indulgence in debt, what the Austrians call a “credit-induced boom,” has likely reached its inevitable conclusion. The unsustainable credit-sourced boom, which led to artificially stimulated borrowing, has continued seeking ever-diminishing investment opportunities. Ultimately, these diminished investment opportunities repeatedly lead to widespread mal-investments. Not surprisingly, we saw it play out “real-time” in everything from subprime mortgages to derivative instruments in 2008, which were only to milk the system of every potential penny regardless of the apparent underlying risk. We see itagain in the “chase for yield” in everything from junk bonds to equities. Not surprisingly, the result will not be any different.
The struggle of the American middle class continues growing, with the wealth gap between the rich and poor glaringly apparent. That is why the cries for socialism are becoming so loud. The demands for free healthcare, education, and housing are the “siren’s song” for politicians to enact more legislation to expand Government control and redistribute wealth from the middle class and poor to the ruling elite.
The Tytler Cycle
But such shouldn’t be a surprise. It is the cycle of all economic civilizations over time as we “forget our history” and become doomed to repeat it. Scottish economist Alexander Tytler, who, in 1787, commented on the then-new American Republic as follows:
“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship.
The average age of the world’s greatest civilizations has been about 200 years. These nations always progressed through this sequence:“
The idea of socialism sounds excellent in theory. However, debt for non-productive investments such as social welfareand free collegedoesn’t produce the promised economic benefit. Instead, the resulting inflation from the influx of “free money” crimps economic growth. Furthermore, inflation “taxes” the bottom 50% of income earners the most.
The promise of something for nothing will never lose its luster. However, no society ever prospered through socialism or communism. The poor remained poor, the middle class became poor, and the wealthy prospered. Therefore, we should view socialism as political propaganda rather than economic or public policy. And like all propaganda, we must fight it with appeals to reality. Socialism, where deficits don’t matter, is an unreal place.
Conclusion
It is likely that “something has gone wrong” for the Federal Reserve as the efficacy of pulling forward future consumption through monetary interventions has been reached. Despite ongoing hopes of “higher growth rates” in the future, such will likely not be the case until the debt overhang is eventually cleared.
Does this mean that all is doomed? Of course not. However, we will likely remain constrained in the current “spurt and sputter” growth cycle we have witnessed since 2009. Such will be marked by continued volatile equity market returns and a stagflationary environment as wages remain suppressed while living costs rise. Ultimately, clearing the excess debt levels will allow personal savings rates to return to levels promoting productive investment, production, and consumption.
The end game of four decades of excess is upon us, and we can’t deny the weight of the debt imbalances that are currently in play.
But more socialism is not the answer.
Without Shelter Prices Deflation Is Raising Its Head
Unlike yesterday’s cooler-than-expected PPI report, CPI was right on the screws. As expected, CPI and CPI core rose 0.2% for the month. On a year-over-year basis, they run 2.9% and 3.2%, respectively. The data pretty much locked the Fed into a 25bps ease at the September meeting, as Nick Timiraos states in today’s Tweet of the Day. However, despite the as-expected CPI print, the Fed may soon worry about deflation if you consider CPI without shelter prices. Sound crazy?
Core CPI without shelter prices was negative for the third month in a row. The last time it was negative for three consecutive months was from March through May 2020, when the pandemic had shut down the global economy. The CPI shelter index is up 5.1% over the last year. Furthermore, it accounts for 70% of the total year-over-year core CPI figure. We have harped on shelter prices on many occasions. To summarize, CPI shelter costs, accounting for 40% of CPI, lag significantly from real-time independent market data and the Fed’s New Tenant Rent Index. When, not if, CPI shelter costs catch up to market costs, 40% of CPI will head toward 0%. With it, the Fed may likely be moaning about insufficient inflation or dreaded deflation.
Remember, we are not alone in telling this story. The Fed and most economists know that inflation without shelter prices is below the Fed’s target. Moreover, they also understand the flaws in the CPI shelter data.
What To Watch Today
Earnings
Economy
Market Trading Update
As noted yesterday, one of the market’s most important drivers is share buybacks, returning quickly as the earnings season ends. Those buybacks have helped propel a rather sharp market rally from the lows posted Monday before last and triggered a short-term MACD “buy signal.”
While this rally has been notable, the market currently faces resistance at the 50-DMA and is wrestling with the downtrend from the July highs. If the market can clear that resistance, a push towards 5600 becomes likely. However, given the magnitude of the advance, we still suspect a bit of a retracement back to the 100-DMA, which will likely provide key support in the near term. A successful retest of that support would likely provide an entry point to increase exposure slightly heading into October. Remain cautious for now.
Google Is In The Justice Department’s Cross Hairs
The Justice Department is considering various options for dealing with Google after it won its monopoly case against the company. One option being discussed is breaking up the company. Specifically, if this is the remedy, it would likely have to spin off its Android operating system. The Justice Department could take less drastic actions, like forcing Google to share customer data with its competitors.
At the center of the Google case are exclusive contracts. For instance, Google pays Apple approximately $20 billion a year to make Google a search engine default on Apple devices. Per Evercore ISI, courtesy of Reuters:
“The most likely outcome now is the judge rules Google must no longer pay for default placement or that companies like Apple must proactively prompt users to select their search engine rather than setting a default and allowing consumers to make changes in settings if they wish,”
Apple will also suffer if the Justice Department bans Google from entering exclusive contracts. Reuters claims that losing the $20 billion fee from Google could negatively impact Apple’s bottom line by 4-6%. The graph below shows Google is about 15% off of recent highs. Despite the recent market recovery, Google has been lagging. This Justice Department case is likely weighing on the stock.
Mortgage Refinancing Is Surging, Sort Of
The Fed tries to manage economic activity through its interest rate and QE policies. One critical aspect of their policy is its effect on the real estate markets. Low mortgage rates make home-buying cheaper and thus can spur home sales, which boost economic activity. Conversely, as we have recently seen, high mortgage rates curtail real estate transactions.
A second aspect of Fed policy and its effect on mortgage rates is the refinancing of mortgages. When people refinance their mortgage into a new lower-rate mortgage, they reduce their interest costs. Therefore, they have more money to spend on other items. Over the last twenty years, mortgage refinancings have had a powerful economic effect.
With mortgage rates approaching 6.25%, down almost 2% from last year’s high, some recent mortgagees are incentivized to refinance their mortgages. The first chart below shows that the MBA mortgage refinance index has nearly tripled over the last year. While this may appear significant, a glance at the longer-term graph shows that the index is still far from average. In fact, it is still below the troughs of the prior 25 years. Because the number of homes sold over the last few years has been below average, the number of potential refinancing will also be below average. This means that when the Fed does cut rates, its effect on the mortgage refinancing market will be much less than they are accustomed to.
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Stealth QE Or Rubbish From Dr Doom?
A recent article co-authored by Stephen Miran and Dr. Nouriel Roubini, aka Dr. Doom, accuses the U.S. Treasury Department of using its debt-issuance powers to manipulate financial conditions. They liken recent Treasury debt issuance decisions to stealth QE. Per the first paragraph of the article’s executive summary:
By adjusting the maturity profile of its debt issuance, the Treasury is dynamically managing financial conditions and through them, the economy, usurping core functions of the Federal Reserve. We dub this novel tool “activist Treasury issuance,” or ATI. By manipulating the amount of interest rate risk owned by investors, ATI works through the same channels as the Fed’s quantitative easing programs.
Is their accusation reasonable?
Given the significant impact that liquidity has on financial markets, the answer is much more important for investors than it may appear.
Reviewing The Allegation
The authors claim that recent Treasury debt issuance patterns were intentionally implemented to boost economic activity and support the financial markets, thus easing financial conditions. Even more damning, the article insinuates the Treasury is using ATI “to stimulate the economy into election season.“
Below, we share a few quotes and our summarization of the article to bring you up to speed on their thesis.
Whereas Treasury has historically striven for “regular and predictable”-read: boring-issuance, recent aggressive changes to the relative levels of long- and short-term security auction sizes have made issuance irregular and unpredictable. Because Treasury is using this novel tool for managing financial markets and through them, the economy, we dub it “activist Treasury issuance,” or ATI.
Essentially, they assert the Treasury has purposely issued less long-term debt in favor of more short-term bills. The authors hypothesize its actions equate to an approximate one percent cut in the Fed Funds rate.
The article likens ATI to QE as follows:
Whereas QE works by removing interest rate risk from the market and hiding it away on the Fed’s balance sheet, ATI works by limiting the production of interest rate risk at the source. The net effect, however, is similar.
The paper states there are two channels through which ATI and QE operate.
The Portfolio Balance Channel
The portfolio balance channel argues that the financial markets have a fixed amount of total risk investors can hold in aggregate. If the Treasury were to issue bonds, thus adding duration risk to the market, investors would have to reduce other risks, i.e., sell different assets, to buy Treasury bonds. Therefore, investors can more easily absorb Treasury debt if the Treasury reduces or limits sales of its longer-term notes and bonds, which possess more duration risk.
Money Supply Channel
The money supply channel says issuing bonds instead of bills requires a more significant drawdown in bank reserves. Ergo, because Treasury bills require fewer reserves than bonds, the banking system retains more reserves when it owns bills versus bonds. Therefore, banks are less restricted in making loans that stimulate the economy and financial markets.
The following table summarizes their argument that ATI is stealth QE.
Historical Precedence
To further make their case, the article introduces “historical precedent.” They claim ATI is like the Fed’s “Operation Twist.”
Operation Twist, which originated in 1961, involved the Fed buying long-term Treasury notes and bonds and offsetting the purchase by selling short-term notes and bills. Such activity doesn’t change the Fed’s balance sheet size, but it has a market and economic impact.
Similarly, the paper argues that the Treasury can accomplish a comparable feat by issuing fewer bonds and more bills.
The authors deem such an act a “creative issuance policy to achieve unorthodox economic goals.” They believe that because the Fed has done Operation Twist numerous times with some success, the Treasury certainly appreciates the same game plan.
Debt Issuance Patterns
The authors write that in 2015, the Treasury decided to increase its share of bills to total debt issuance to 15% for various reasons. In 2020, they extended it to 15-20%. Per the authors, the motivation for the changes was not interest rates or the business cycle.
The graphs from the article show that bills as a percent of debt outstanding have recently risen to their long-term average of 22.4% due to significantly more bill issuance than other debt, as shown on the right. While the percentage of bills outstanding is only slightly above the 15-20% target, in dollar terms, the difference is substantial.
Our Take On Stealth QE
At first blush, the article makes an excellent case the Treasury is conducting stealth QE.
However, before drawing conclusions, let’s consider what the U.S. Treasury Department is tasked with regarding government funding. Per its website:
The Treasury Department’s primary goal in debt management policy is to finance the government at the lowest cost over time. To meet this objective we issue debt in a regular and predictable manner, provide transparency in our decision-making, and seek continuous improvements in the auction process. In creating and executing our financing plans, we must contend with various uncertainties and potential challenges, such as unexpected changes in our borrowing needs, changes in the demand for our securities, and anything that inhibits efficient and timely sales of our securities. To manage
Simply put, the Treasury Department is responsible to the taxpayers for funding the country as efficiently and cost-effectively as possible. To do so, it must foster healthy markets.
Let’s address their primary low-cost goal and “uncertainties and potential challenges” that they face in their task.
Reducing Debt Costs
In trying to fund the nation at the lowest cost over time, the Treasury Department always tries to determine how current interest rates compare to expected future rates. They have skilled market personnel and a committee of Wall Street executives to help them in this endeavor.
As shown below, short- and long-term Treasury yields have been decreasing for the last 40+ years. This is the result of slowing economic growth and lower rates of inflation. Suppose the numerous factors impacting yields over the previous 40 years continue to exert themselves as we and many economists expect. In that case, the pre-pandemic rate levels and trends are likely still intact. Accordingly, it’s fair to assume that short-term and long-term rates will gravitate back to pre-pandemic levels.
Let’s revisit the debt issuance graphs we showed earlier.
From 2012 through 2022, the issuance of Treasury bills as a percentage of all debt was well below average. During this period, longer-term note and bond yields were at or near historical lows. The Treasury was smartly terming out its debt needs instead of issuing short-term debt and risking reissuing it at higher interest rates when the debt matures.
That was an opportunistic funding decision that proved wise. It was not manipulation.
Borrowing Needs and Market Demand For Treasury Securities
Federal Deficits have been running well above average, forcing the Treasury to issue more debt than typical. Accordingly, the Treasury must carefully distribute its debt so they don’t overwhelm the demand for a specific maturity while not meeting the demand for another.
Money market balances have been soaring, causing retail and institutional investors to clamor for Treasury bills. At the same time, longer-term bond investors have been shying away from bonds due to inflation and worries that yields will increase further.
The Treasury doesn’t manage demand for its products; it only controls the supply. Given market conditions, it has made the most sense to meet the insatiable demand from short-term investors and try to limit the supply to longer-term bond investors choking on what could be deemed an oversupply of bonds.
Again, shifting issuance amongst different debt maturities constitutes smart funding decisions, not manipulation.
Fostering Healthy Markets
Headlines like the ones below occurred regularly through most of 2023 and the first half of 2024.
“10-year Treasury yield rises above 4.5% following weak auctions” CNBC March 2024
“Treasury yield end at four-week highs after another poorly received auction” Morningstar May 2024
“Why Treasury Auctions Have Wall Street on Edge” WSJ December 2023
Large Treasury auctions, particularly longer-term maturity ones, overwhelmed the markets, resulting in poor auctions and extreme volatility. The graph below highlights that bond market volatility (MOVE) in 2022 and 2023 was the highest since the financial crisis. Volatility is a sign of market instability.
Should the Treasury have been issuing even more notes and bonds into a market exhibiting signs of instability?
From a market perspective, the Treasury was trying to limit the volatility in the bond markets, not elevate it. Taking such responsibility for market conditions is appropriate, not manipulation.
Lou Crandall, chief economist at Wrightson ICAP and a longtime follower of the bond market, rejected the paper’s conclusions in a report shared with MarketWatch. “The bottom line is that Treasury issuance over the past year has evolved in ways that are consistent both with its historical behavior and with more recent Treasury guidance,” Crandall said. “The Treasury is simply doing what it said it was going to do.“
“I can assure you 100% that there is no such strategy. We have never, ever discussed anything of the sort,” said Treasury Secretary Yellen in a comment shared with MarketWatch.
One Treasury official who spoke with MarketWatch but asked for anonymity said the paper misrepresented the importance of guidance issued by the Treasury Borrowing Advisory Committee. The paper’s authors used this guidance as a benchmark when calculating excess bill issuance by the Treasury.
Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, said in an interview with MarketWatch. LeBas made a similar point about the impact of the Treasury’s bill issuance. “The authors are claiming when Treasury issues more short-term debt, that’s constructive for financial conditions, and when they issue more long-term debt, that’s negative for financial conditions,” he said. “Nothing in the world is that simple.”
LeBas added that the more likely scenario is that the Treasury is simply issuing debt along the segment of the curve where there is the most demand. Right now, that is on the short end.
Summary
Is the Treasury manipulating the bond market with stealth QE to boost the financial market and economy to help the Democrats win the election in November?
While it’s certainly possible, we think Treasury Secretary Janet Yellen did what was best for the taxpayers and the financial markets by adjusting its issuance patterns. Had the Treasury Department ignored troubling market signals and its low-cost funding objective, it would have significantly raised borrowing costs and possibly introduced bond market turmoil that could have easily spread to the equity and currency markets.
Recent Treasury debt issuance patterns are appropriate and will likely have and will save the nation significantly.
What Is NIXT?
The Wall Street Journal shared an interesting investment strategy that Research Affiliates (RA) championed in its article, Wall Street’s Trash Contains Buried Treasure. Going by the index name NIXT, the strategy is designed to focus on a market inefficiency resulting from the overwhelming popularity of passive investment strategies. The NIXT index is simple: it buys stocks that have been kicked out of the indexes. RA claims investors would have earned 74x on their money since 1991 following the strategy. Per the article:
The basic idea isn’t revolutionary: Plenty of hedge funds make money, or try to, by buying stocks that are about to enter a widely held index such as the S&P 500 and selling short those about to leave. They know that there will be forced buyers and sellers who don’t care about the price. Instead of a speculative one-night stand with those stocks, though, NIXT includes them after they have been dumped. And, while not being wedded to those losers forever, it dates them for five years—an eternity for fast-money types. The surprising thing is how long the good performance lasts.
When stocks are added to an index, passive investors of the said index, by default, have to buy those stocks. Conversely, when a stock is removed, they must sell the stock. Not surprisingly, stocks taken out of indexes tend to be smaller and cheaper than most other stocks in the index. The article notes that between 1991 and 2022, stocks removed from indexes traded at a 26% P/E discount to the S&P 500 P/E. There is a catch with the NIXT model. The strategy can only afford a limited number of investments before the benefit of buying seemingly cheap stocks fades. The graph below, courtesy of RA and the WSJ, shows the average performance of NIXT index holdings in the year before being removed from its index and the five years following.
What To Watch Today
Earnings
Economy
Market Trading Update
As noted yesterday, the market rally continues, and we are approaching a short-term MACD “buy signal.” While we are likely not done with the current correction process, one aspect that will provide support to the market in the near term is share buybacks.
With the Q2 earnings season behind us, the “blackout” window for buybacks is now mostly reopened.
Those buybacks are important because they continue to provide a bulk of the net purchases of equities in the open market. It was also a very active week for new repurchase authorizations, with 38 new programs authorized for $15.1 Billion.
Importantly, as I noted in yesterday’s blog post, there is a high correlation between the annual change in buybacks and the market.
The coming surge of buybacks will be an essential support for stocks in the near term. Such is particularly the case given the low liquidity of the overall market. As noted by Goldman Sachs:
“S&P 500 top book liquidity is currently at $5M. This is down from $26M in July. This is a decline in the worlds equity liquidity instrument of-80% in the last 3 weeks. Top book liquidity hit $3M on Monday, the lowest level since March 2023 (15 months). ETFs represented 43% of the overall market volume on Monday compared to 29% YTD.”
While there are certainly some concerns over the recent market decline, buybacks will substantially support the market in the near term heading into the October blackout period. Such sets October as a likely “flash point” for volatility heading into the Presidential election.
NFIB Improves – Trump Bump?
The NFIB small business survey was much better than expected, jumping to 93.8 versus 91.5 a month ago. As shown in the first graph below, the improvement is positive, but the level is still well below normal. However, the readings within the survey results are not as optimistic as the headline. For example, economic uncertainty has risen to levels last seen in 2020. Moreover, a net 16% of those surveyed saw a decline in sales over the past three months. That is about four points worse than last month.
Two factors may explain the strong headline result and weak underlying data.
First, the bump in confidence aligns with a surge in Donald Trump’s polling numbers following the assassination attempt. Small business owners tend to favor the Republican party. Thus, confidence that Trump appeared to be a lock for president was running high. Furthermore, consider the bump primarily occurred in the “soft” indicators, as shown in the fourth graph. These include expectations. Based on current earnings, hiring plans, and capital expenditures, the hard results did not jump nearly as much. With the presidential race seemingly back to even, next month’s results will help us appreciate if the positive result was a “Trump Bump.”
The second factor boosting optimism is interest rates. Many small businesses are heavily indebted and often find it harder to get credit. Thus, expectations for lower interest rates and easier credit conditions should also create optimism for some small business owners.
PPI Cools
PPI came in lower than expected across the board. The headline monthly figure rose 0.1%, a tenth below expectations. Core PPI was 0.0%, which brought down the year-over-year core PPI from 3% to 2.4%. Assuming today’s CPI print is tame, the case for a September rate cut strengthens. The graph below shows that the PPI would likely have been slightly negative without energy prices. The Tweet of the day shows corporations are having a much more difficult time passing on inflation to their customers. Ergo, profit margins, and, ultimately, earnings are at risk for some companies.
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Newsletter Writers Freaked Out Last Week
The graph below from Bianco Research shows a stunning change in sentiment among stock market newsletter writers. The top graph shows that on July 23rd, newsletter writers were extremely bullish. In fact, such a high level of bullish optimism has only been recorded twice since 1990. The Investor’s Intelligence survey of newsletter writers fell to its long-term average in only two weeks. Accordingly, such a decline in such a short period is one for the books.
The second graph charts two-week changes in newsletter writers’ bullishness. The recent decline was the sharpest since the crash of 1987. That is stunning, considering that on Black Monday in 1987, the S&P 500 had its largest one-day decline in history, falling over 20%. The recent decline was 8%, but over two weeks. Jim Bianco summarizes newsletter writers’ sentiment over the last couple of weeks as follows:
Did the world end in the last 14 days and I did not get the memo? This metric suggests that investment professionals who get paid to write newsletters freaked about the stock market over the last 14 days to a degree not seen in the last 37 years.
What To Watch Today
Earnings
Economy
Market Trading Update
Asnoted yesterday, patience pays in a volatile market. Often, during sharp market corrections, our initial reaction is to “do something.” However, as is often the case, remaining calm tends to be more prudent. Stocks have essentially wiped out all the losses from last week’s market meltdown, and traders await key inflation data that will help shape the outlook for the Federal Reserve’s next steps.
We continue to suggest using near-term rallies to reduce risk and rebalance portfolios. This week’s economic data will very likely instill some volatility into the markets between PPI, CPI, and Retail Sales. Don’t sleep on this morning’s NFIB report, which is highly correlated to the annual ROC for the Russell 2000.
The most likely path for equities remains a restest of recent lows at some point. However, there is no guarantee of that, which is why we continue to navigate markets from one week to the next. For now, markets remain oversold enough to elicit a further rally, and the MACD has turned towards a “buy signal.” However, overall market action remains weak, so we suggest caution. For now, do not try to anticipate what the market will do next. Just respond tactically to the changes as they come.
Don’t Be Fooled – It’s Not Over Yet, Says TPA
TPA is a valuable add-on service available to SimpleVisor subscribers. It uses TPA’s unique brand of relative rotation analysis to help subscribers stay abreast of market and stock rotations.
Their latest analysis is worth heeding. TPA warns that recent market trends are not over. To wit:
The 4 charts below show that:
The decline of stocks is not over
The decline in rates is not over
Chart 1: The S&P500 broke down through its 9-month uptrend line. It did this on a huge gap-down day, confirming the move.
Chart 2: The recent rally will run into resistance at the break at about 5370.
Chart 3: The downtrend in the 10-year yield since late April led to a breakdown below support at 4.20%
Chart 4: Long-term support for the 10-year is far below Friday’s close of 3.93%; all the way down at 3.4%.
Stocks down and rates down mean that the former stock market leaders will stall, and new leaders will emerge.
TPA subscribers have access to all of TPA’s research, as well as its trades and portfolios.
SimpleVisor Sector Analysis- Technology
Believe it or not, the markets closed the week relatively flat despite the rollercoaster ride. Check out the Tweet of the Day below for a summary of last week’s activity. Moreover, the technology sector and the largest cap stocks, most negatively affected on Monday, finished relatively well for the week. The first table below, courtesy of SimpleVisor, shows the relative performance of each sector versus the S&P 500 for the last five days and the twenty days before last week. Technology beat the market by about half a percent last week but is still down over 8% versus the S&P 500 over the prior 20 days.
Because our relative sector analysis uses short and mid-term technical gauges, the technology sector remains oversold, as shown in the second graphic. Furthermore, the scatter plot to the right of the relative sector data shows how technology went from very overbought on an absolute and relative basis to decently oversold on both measures.
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Are Mega-Caps About To Make A Mega-Comeback?
Are the “Mega-Cap” stocks dead? Maybe. But there are four reasons why they could be staged for a comeback. The recent market correction from the July peak certainly got investors’ attention and rattled the more extreme complacency. As we noted previously:
“While there have certainly been more extended periods in the market without a 2% decline, it is essential to remember that low volatility represents a high “complacency” with investors. In other words, the longer the market moves higher without a significant correction, the more confident investors become. They respond by raising their allocations to equities (risk) and reducing their allocations to cash (safety).”
As repeatedly discussed in June and July, a 5-10% correction is normal and occurs almost yearly.
“Historically, when the 37-week rate of change is greater than 30%, such events typically precede short—to intermediate-term corrections. While the bulls are very confident, the risk of a 5% to 10% correction over the next three months remains elevated.”– July 13th
Unsurprisingly, retail and professional investors have witnessed a more extreme amount of selling of large-cap positioning over the last three weeks.
“The level of de-grossing by some strategies, alongside the correlated drawdowns in alpha / crowding performance, suggests that we could be mostly done with the drawdown and de-grossing. However, performance/alpha/gross flows could remain choppy over the next few months.” – John Schlegel, JPM
As John notes, the question is whether the correction process is over and whether investors will return to the “mega-caps” in their portfolios.
4-Reasons Mega-Caps Are Not Dead Yet
The recent sell-off in “Mega-cap” stocks, in particular, is unsurprising. We have warned about investors crowding into relatively few stocks to chase market returns.
“The bifurcation between the top 10 companies, as measured by market capitalization, and the other 490 stocks in the index has created an illusion of market bullishness. Despite the extremely crowded trade into the three sectors comprised of those ten stocks, we continue to see professional investors crowd into those shares at a record clip.”
There are four (4) reasons why investors, both professional and retail, were chasing a handful of stocks. They are also the same reasons that “Mega-caps” will likely regain their favor.
First, these stocks are highly liquid, and managers can quickly move money into and out without significant price movements. The importance of liquidity cannot be overlooked for insurance companies, pensions, hedge funds, and endowments. These investors must move millions of dollars at a time, and small companies are not liquid enough for sizeable inflows and outflows.
Secondly, the passive indexing effect has not gone away. As investors change their investing habits from buying individual stocks to the ease of purchasing a broad index, capital inflows unequally shift into the largest capitalization stocks in the index. Over the last decade, capital inflows into exchange-traded funds (ETFs) have exploded.
“The top-10 stocks in the S&P 500 index comprise more than 1/3rd of the index. In other words, a 1% gain in the top-10 stocks is the same as a 1% gain in the bottom 90%.As investors buy shares of a passive ETF, the shares of all the underlying companies must get purchased.“
Third, the “Mega-cap” companies have more substantial earnings growth than their small—and mid-cap brethren. For now, the large-cap, primarily the “Mega-Cap” companies, are driving most of the earnings growth. With the economy showing clear signs of deterioration, earnings of small and mid-cap companies remain the most vulnerable to changes in economic demand.
Lastly, and probably most importantly, large-cap, predominantly “Mega-cap” companies engage in share repurchases much more than small and mid-caps. Corporate share buybacks will approach $1 trillion this year and exceed that in 2025, with Apple alone accounting for more than 10% of those purchases.
As we noted previously, this is not an insignificant factor supporting the rise in asset prices. Since 2000, corporate share buybacks have provided 100% of all the “net equity purchases.”
Therefore, it should be unsurprising that there is a high correlation between the ebbs and flows of corporate share buybacks and market performance.
With earnings season mostly behind us, the “buyback window” for the largest companies is now open. Such will allow the “Mega-caps” to start repurchasing shares.
However, while the support for the “Mega-caps” remains, the current correction process is likely incomplete.
Correction Is Likely Not Over Yet
So are “Mega-Caps” likely becoming a “mega-buy?” That may be stretching it a bit, but what is likely is that the recent underperformance is likely near its conclusion.
From a purely technical perspective, the “Mega-Cap” stocks have witnessed a sharp contraction over the last few weeks. Using the Vanguard Mega Cap Growth ETF (MGK) as a proxy for the largest companies, the recent correction has reversed most of the previous overbought and extended conditions.
MGK is oversold on multiple levels, and the MACD indicator is well below zero, which has previously coincided with short-term market bottoms. Furthermore, MGK tested and held the 200-DMA, which was also the lowest in October 2023. However, while technically oversold, many investors are “trapped” by the recent decline, so we will likely see some “selling pressure” as they look to exit, which would set up a retest of the 200-DMA before the correction is complete.
MGK already completed an initial 38.2% correction level using a Fibonacci retracement sequence from the recent high. While the 200-DMA is providing initial support to MGK, a failure of that support would bring a 50% retracement level into focus. Such would align with the lows of the April correction.
Given the short-term oversold conditions and the decline in sentiment, the reflexive bounce in the “Mega-Caps”we saw last week was unsurprising. However, as we suggested, given such a sharp rotation from recent highs, it may only be a “tactical trading opportunity”before the completion of the correction process. This is because “bullish sentiment” remains elevated, historically not what is seen at corrective lows.
We suspect that while we could see an oversold bounce following the recent sell-off, “trapped longs” will likely use any such opportunity to exit positions. Therefore, we suggest the following rules for whatever comes next.
The Rules
The rules are simple but effective.
Raise cash levels in portfolios.
Reduce equity risk, particularly in areas highly dependent on economic growth.
Add or increase the duration of bond allocations, which tend to offset risk during recessionary downturns.
Reduce exposure to commodities and inflation trades as economic growth slows.
If a further correction occurs, the preparation allows you to survive the impact. Protecting capital will mean less time spent getting back to breakeven afterward. Alternatively, it is relatively easy to reallocate funds to equity risk if the market reverses and resumes its bullish trend.
Investing during periods of market uncertainty can be difficult. However, you can take steps to ensure that increased volatility is survivable.
Have excess emergency savings, so you are not “forced” to sell during a decline to meet obligations.
Extend your time horizon to 5-7 years, as buying distressed stocks can get more distressed.
Don’t obsessively check your portfolio.
Consider tax-loss harvesting (selling stocks at a loss) to offset those losses against future gains.
Stick to your investing discipline regardless of what happens.
If I am correct, and this current corrective process is incomplete, the risk reduction will lower portfolio volatility. However, if I am wrong, we can reallocate to equities and rebalance our portfolios for growth as needed,
Follow your process.
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