Monthly Archives: May 2023

Bumpy Or Stuck Inflation Will Determine The Feds Path

With the latest round of inflation data in hand, it appears the Fed has two paths to consider. Nick Timiraos of the WSJ lays out the “bumpy” or “stuck” inflation scenarios the Fed faces in his latest article, Fed Rate Cuts Are Now A Matter Of If, Not Just When. Given Nick’s unique access to Jerome Powell and the Fed, his discussion of the most recent inflation data is essential in gauging what the Fed may or may not do.

The bumpy Fed path is the expectation that inflation is still trending lower but will do so in a bumpy manner. This bumpy but lower inflation theory is primarily based on prices of CPI shelter (rent). Rent prices constitute 40% of CPI. Rent is a lagging indicator that will decline; it’s just a question of when. The graph below from the article shows that core CPI is running below 2% without shelter prices. The other key point in the graph is that inflation is now concentrated and not as widespread as it was in 2022 and early 2023. The bumpy path entails the Fed will likely cut rates later in the year.

The second path is the stuck path. This case argues that inflation is stuck around 3% to 3.5%. Unless the economy slows and or the unemployment rate increases, the Fed may have to leave rates alone this year. Accordingly, this scenario makes it more difficult for the Fed to achieve a soft landing. They remain concerned that the lag effect will weigh on economic growth. If prices are indeed stuck, the Fed will find it more challenging to get ahead of a slowdown. Instead, they will have to wait for the slowdown to happen before they can react.

cpi breakdown

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Welcome to the kick-off of #MillennialEarningsSeason, where everyone gets a trophy after dropping earnings estimates that are enough for everyone to clear the bar. The major banks are the first to report starting today. Like the overall market, the banking sector has been under selling pressure lately, bounced off the 50-DMA yesterday, and decently oversold. Given that the likes of $JPM, $WFC, and $BLK will likely report better-than-expected earnings, we would not be surprised to see a bit of a countertrend rally today.

Market Trading Update Financials

If we examine the top 10 holdings of the financial sector ETF (XLF), we find that relative to the ETF, $PGR, $GS, $WFC, and $JPM are the most overbought. Therefore, the upside may be somewhat limited in those issues. Still, we could see better potential performance from companies like $BAC, $BRK-B, $AXP, $MA, and $V, which are getting closer to oversold following recent corrections. While XLF may see some performance pickup relative to the broader market, investors may do better by being selective in their financial exposures.

However, while Financials are kicking off the reporting season today, the Healthcare sector currently has our attention. Given its broad decline in recent weeks and the strong fundamentals of the underlying companies, there appears to be a good bit of value developing in that sector. We are starting to dig in, looking for opportunities.

Healthcare Relative Analysis.

PPI Bodes Well For PCE

The second round of inflation data, PPI, was more market-friendly than CPI. Headline and core PPI were .10% below expectations at 0.2% and below last month’s readings of 0.6% and 0.3%, respectively.

You may be confused about why PPI and CPI send different signals. The important thing to consider is that the Fed prefers PCE prices over both measures. In that light, consider that the surge in motor vehicle insurance single-handedly boosted yesterday’s CPI number above expectations. However, auto insurance within the PPI report came in much cooler at 0.1% versus CPI’s 2.6%. Most importantly, PCE uses the PPI motor vehicle insurance figure, not the one in the CPI report. The graph below, courtesy of Ernie Tedeschi, shows the divergence between the two measures. Further, shelter prices have less of a weighting in PCE than CPI. As a result of just PPI auto insurance and the lesser contribution of shelter prices, PCE will likely be 0.2% below CPI.

ppi motor vehicle insurance

The Fed Signals A Reduction In QT

Wednesday’s release of the Fed minutes implies the Fed will likely reduce the amount of QT as early as their next meeting. Currently, the Fed lets $60 billion of U.S. Treasury securities and $35 billion in mortgage-backed securities roll off their books each month. The minutes indicate that most officials favor reducing the Treasury rolloff amount by “roughly half.” Further, “the vast majority of participants judged that it would be prudent to begin slowing the pace of runoff fairly soon.

The reduction would serve two purposes. The first is to help stem the recent increase in interest rates. If investors have less Fed supply to absorb, they can take more supply from the market. Second, the Fed is concerned that the level of reserves in the banking system is getting close to “ample.” Sub-ample reserves could result in a liquidity crisis, as we saw in 2019, which followed QT in 2018 and early 2019. At that time, they reduced their balance sheet by about $.5 trillion before sparking problems. The balance sheet has fallen by $1.5 trillion since QT started in 2022.

fed balance sheet

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Immigration And Its Impact On Employment

Is immigration why employment reports from the Bureau of Labor Statistics (BLS) continue defying mainstream economists’ estimates? Many are asking this question as the U.S. experiences a flood of immigrants across the southern border. Concurrently, many young college graduates continue to complain about the inability to receive a job offer. As noted recently by CNBC:

The job market looks solid on paper. According to government data, U.S. employers added 2.7 million people to their payrolls in 2023. Unemployment hit a 54-year low of 3.4% in January 2023 and ticked up just slightly to 3.7% by December.

But active job seekers say the labor market feels more difficult than ever. A 2023 survey from staffing agency Insight Global found that recently unemployed full-time workers had applied to an average of 30 jobs only to receive an average of four callbacks or responses.”

These stories are not unique. If you Google “Can’t find a job,” you will get many article links. Yet employment reports have been exceedingly strong for the past several months. In March, the U.S. economy added 303,000 jobs, exceeding every economist’s estimate by four standard deviations. In terms of statistics, a single four-standard deviation event should be rare. Three months in a row is a near statistical impossibility.

Nonfarm payrolls monthly estimate history

Despite weakness in manufacturing and services, with many companies recently announcing layoffs, we have near-record-low jobless claims and employment. According to official government data, the economy has rarely been more robust.

Unemployment and jobless claims.

Such a situation begs an obvious question: How are college graduates struggling to find employment while the labor market remains so strong?

We may find the answer in immigration.

Immigrations Impact By The Numbers

A recent study by Wendy Edelberg and Tara Watson at the Brookings Institution found that illegal immigrants in the country helped boost the labor market, steering the economy from a downturn. Data from the Congressional Budget Office shows a massive uptick of 2.4 million “other immigrants” who don’t fall into the category of lawful immigrants or those on temporary visas. The chart below shows how this figure has spiked from a level of less than 500,000 at the beginning of the 2020s.

CBO Estimates Of Net Immigration

The most significant change relative to the past stems from CBO’s other non-immigrant category, which includes immigrants with a nonlegal or pending status.

“We indicate our estimates of ‘likely stayers’ by diamonds in Figure 2. In FY 2023, almost a million people encountered at the border were given a ‘notice to appear,’ meaning they have permission to petition a court for asylum or other immigration relief. Most of these individuals are waiting in the U.S. for the asylum court queue, which has over a million case backlog. In addition, over 800,000 have been granted humanitarian parole (mostly immigrants from Ukraine, Haiti, Cuba, Nicaragua, and Venezuela). These 1.8 million ‘likely stayers’ in FY 2023 may or may not remain in the U.S. permanently, but most are currently living in the U.S. and participating in the economy. CBO estimates that there were 2 million such entries over the calendar year 2023, which is consistent with higher encounters at the end of the calendar year.”

Border Encounters By Fiscal Year

According to the CBO’s estimates for 2023, the categories of lawful permanent resident migration, INA non-immigrant, and other non-immigrant equated to 3.3 million net entries. However, the number is likely much higher than estimates, subject to uncertainty about unencountered border crossings, visa overstays, and “got-aways.”

As such, this influx of immigrants has significantly added to payroll growth and has accounted for the uptick in economic growth starting in 2022. While the uptick in border encounters began in earnest in 2021, as the current Administration repealed previous border security actions, there is a “lag effect” of immigration on economic growth.

GDP Growth Vs Employment

However, not all jobs are created equal.

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Immigration’s Impact On Job Availability

Since 1980, the U.S. economy has shifted from a manufacturing-based economy to a service-oriented one. The reason is that the “cost of labor” in the U.S. to manufacture goods is too high. Domestic workers want high wages, benefits, paid vacations, personal time off, etc. On top of that are the numerous regulations on businesses from OSHA to Sarbanes-Oxley, FDA, EPA, and many others. All those additional costs are a factor in producing goods or services. Therefore, corporations must offshore production to countries with lower labor costs and higher production rates to manufacture goods competitively.

In other words, for U.S. consumers to “afford” the latest flat-screen television, iPhone, or computer, manufacturers must “export” inflation (the cost of labor and production) to import “deflation” (cheaper goods.) There is no better example of this than a previous interview with Greg Hays of Carrier Industries. Following the 2016 election, President Trump pushed for reshoring U.S. manufacturing. Carrier Industries was one of the first to respond. Mr. Hays discussed the reasoning for moving a plant from Mexico to Indiana.

So what’s good about Mexico? We have a very talented workforce in Mexico. Wages are obviously significantly lower. About 80% lower on average. But absenteeism runs about 1%. Turnover runs about 2%. Very, very dedicated workforce. Which is much higher versus America. And I think that’s just part of these — the jobs, again, are not jobs on an assembly line that [Americans] really find all that attractive over the long term.

The need to lower costs by finding cheaper and plentiful sources of labor continues. While employment continues to increase, the bulk of the jobs created are in areas with lower wages and skill requirements.

Where the jobs are

As noted by CNBC:

“The continued rebound of these jobs, along with strong months for sectors like construction, could be a sign that immigration is helping the labor market grow without putting too much upward pressure on wages.”

This is a crucial point. If there is strong employment growth, wages should increase commensurately as the demand for labor increases. However, that isn’t happening, as the cost of labor is suppressed by hiring workers willing to work for less compensation. In other words, the increase in illegal immigrants is lowering the “average” wage for Americans.

Wage growth of the bottom 80% of workers

Nonetheless, in the last year, 50% of the labor force growth came from net immigration. The U.S. added 5.2 million jobs last year, which boosted economic growth without sparking inflationary pressures.

While immigration has positively impacted economic growth and disinflation, this story has a dark side.

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The Profit Motive

In a previous article, I discussed an interview by Fed Chair Jerome Powell discussing immigration during a 60-Minutes Interview. To wit:

“SCOTT PELLEY: Why was immigration important?

FED CHAIR POWELL: Because, you know, immigrants come in, and they tend to work at a rate that is at or above that for non-immigrants. Immigrants who come to the country tend to be in the workforce at a slightly higher level than native Americans. But that’s primarily because of the age difference. They tend to skew younger.

You should read that comment again carefully. As noted by Greg Hayes, immigrants tend to work harder and for less compensation than non-immigrants. That suppression of wages and increased productivity, which reduces the amount of required labor, boosts corporate profitability.

Porfits to wages ratio

The move to hire cheaper labor should be unsurprising. Following the pandemic-related shutdown, corporations faced multiple threats to profitability from supply constraints, a shift to increased services, and a lack of labor. At the same time, mass immigration (both legal and illegal) provided a workforce willing to fill lower-wage paying jobs and work regardless of the shutdown. Since 2019, the cumulative employment change has favored foreign-born workers, who have gained almost 2.5 million jobs, while native-born workers have lost 1.3 million. Unsurprisingly, foreign-born workers also lost far fewer jobs during the pandemic shutdown.

Native vs Foreign Born Workers

Given that the bulk of employment continues to be in lower-wage paying service jobs (i.e., restaurants, retail, leisure, and hospitality) such is why part-time jobs have dominated full-time in recent reports. Since last year, part-time jobs have risen by 1.8 million while full-time employment has declined by 1.35 million.

Full time vs Part Time employment

Not dismissing the implications of the shift to part-time employment is crucial.

Personal consumption, what you and I spend daily, drives nearly 70% of economic growth in the U.S. Therefore, Americans require full-time employment to consume at an economically sustainable rate. Full-time jobs provide higher wages, benefits, and health insurance to support a family, whereas part-time jobs do not.

Notably, given the surge in immigration into the U.S. over the last few years, the all-important ratio of full-time employees relative to the population has dropped sharply. As noted, given that full-time employment provides the resources for excess consumption, that ratio should increase for the economy to continue growing strongly. 

Full Time Employees to Working age population

However, the reality is that the full-time employment rate is falling sharply. Historically, when the annual rate of change in full-time employment dropped below zero, the economy entered a recession.

Annual Change in Full-Time Employment

While there is much debate over immigration, most of the arguments do not differentiate between legal and illegal immigration. There are certainly arguments that can be made on both sides. However, what is less debatable is the impact that immigration is having on employment and wages. Of course, as native-born workers continue to demand higher wages, benefits, and other tax-funded support, those costs must be passed on by the companies creating those products and services. At the same time, consumers are demanding lower prices.

That imbalance between input costs and selling price drives companies to aggressively seek options to reduce the highest cost to any business – labor. 

Such is why full-time employment has declined since 2000 despite the surge in the Internet economy, robotics, and artificial intelligence. It is also why wage growth fails to grow fast enough to sustain the cost of living for the average American. These technological developments increased employee productivity, reducing the need for additional labor.

Unfortunately, college graduates expecting high-paying jobs will likely continue to find it increasingly frustrating. Such is particularly the case as “Artificial Intelligence” gains traction and displaces “white collar” work, further squeezing the demand for “native-born” workers.

How Much Time Is Left In This Bull Market Cycle?

Jurrien Timmer, Director of Global Macro at Fidelity, asks- “What time is it in the cycle? Now that we are 17 months into a bull market cycle, it’s worth asking how much life there is left. How long can this broadening bull continue?” To help assess how much time may be left, Jurrien shares a unique graphical perspective on how the current bullish cycle, which started September 2022, compares to prior cycles. The graph on the upper left shows the 18 bullish cycles since 1960. Currently, with a 51% gain, this bull market cycles has only elapsed two other cycles. The average gain, not including the current one, is 84%. This clock tells us there is plenty of upside left in this cycle.

The second spiral chart resembles a clock. The “hands” of the clock measure time in months and the scale within the hands path shows performance. Based on this clock the time is only 3 pm. Most bullish cycles make it past 6 pm and two went all the way to midnight. His graph on the right is similar to the clock but it is in a more traditional format. This graph shows the median duration of bull market cycles is 30 months. Additionally, the current performance is relatively in line with prior bull market cycles. Jurrien sums up his analysis: “Time is still on our side.”

how much time in the bull market cycle is left

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As noted yesterday, yesterday’s hotter-than-expected inflation report did indeed add a “layer of risk to market dynamics.” After recovering the 20-DMA running support line on Friday and holding it through Tuesday’s early sell-off, that support again gave way yesterday. While that running support line has found buyers recently, the market has sent a warning sign that buyers are becoming more sparse.

In early 2023, we saw a similar rally in the market as the “A.I.” chase gained traction. Then, like today, bullish sentiment was elevated, investor allocations to equities were high, and technical indicators remained stuck in overbought conditions. As shown, in July last year, the market declined for 3-weeks straight before providing a reflexive bounce to sell into. That bit of breathing room provided an exit before the next leg of the decline through October.

We are currently in the second week of decline and have not triggered “sell signals” just yet. I suspect that will happen sooner rather than later. As such, investors have an opportunity to rebalance risks now. If the market provides a reflexive rally with a sell signal intact, further reductions can be made to offset the next leg of the correction. If the market turns back up and takes out the recent high from last week, then the bullish trend remains intact. Such is why we continue to suggest moving slowly and letting the market dictate the course of action needed in your personal portfolios.

Nonetheless, the market is waking up and it is time to start paying closer attention.

Market Trading Update

CPI Runs Hot Again

Tuesday’s Commentary shared State Streets analysis calling for 50bps of rate cuts in June. After yesterday’s CPI data, that now seems all but impossible. Both headline and core CPI were 0.1% above expectations at 0.4%. The year-over-year core CPI is 3.8%, in line with the previous month’s reading. This is the fourth month in a row with higher prices than expected. Like the last few months, shelter prices remain sticky, contributing to 40% of the total. When CPI shelter prices catch up to market shelter prices, CPI should decline significantly.

This month, a 2.6% jump in motor vehicle insurance was also seen in March. Despite airfares falling in price by 7.1% over the last year, transportation services are up 10.7%, largely driven by a 22.2% annual gain in vehicle insurance prices. CPI is levelling off and possibly upticking. However, we still believe the data is temporarily too high due to delayed shelter data and other miscellaneous data, like auto insurance, that is seasonal and potentially flawed. For example, PCE, which is the Fed’s preferred inflation gauge, uses a different source for motor vehicle insurance that’s been running much cooler, per the graph below.

cpi motor vehicle insurance

The Fed Funds futures market now only implies two rate cuts, starting in September, for 2024. The graph below compares the two year U.S. Treasury yield to Fed Funds. The difference (gray bars) is the amount of rate cuts the market expects over the next two years on a time weighted basis. As it shows, the year started at 1.25% in interest rate cuts but it has receeded to slightly less than 50bps.

fed rate cuts

Inconsistency Beneath The Robust Jobs Market Data

As we have noted numerous times, recent economic data paints a robust picture. However, beneath the surface lies troubling data. For instance, the graph below shows that the economy has shed 1.347 million full-time workers over the last year. Since 1969, the annual change in full-time employment has declined in every recession. Further, other than two minimal declines occurring during the recovery from a recession, the indicator has never been negative. The dotted orange line shows the current level is on par with prior levels that existed toward the end of recessions. In all the prior cases, the change in the number of full-time jobs was positive when the recession started.

The flip side of this discussion is an increase in the number of part-time workers. 1.888 million new part-time jobs have been created in the last year, the fourth-highest annual number since 1969. One should ask why, if the economy is as strong as the data say and the jobs market is still tight, is there a major shift from full-time to part-time?

full time employment

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Is Gold Warning Us Or Running With The Markets?

Having risen by about 40% since last October, Gold is on a moonshot. Many investment professionals consider gold prices to be a macro barometer, measuring the level of anxiety in the economy, inflation, currency, and geopolitics. Therefore, we must investigate what is and isn’t driving the price of gold higher.

gold price
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The Divorce Between Gold and Real Yields

To help us figure out what may be driving the momentum in Gold, it is worth first considering that a trusty relationship that largely explained the movement in gold prices broke down about two years ago.

The graph below, courtesy of Matt Weller, shows the 15-year-old correlation between gold prices and real yields is not working. Real yields, or rates, are simply the current yield of a Treasury bond minus the rate of inflation or expected inflation.

It serves as a measure of how loose or restrictive monetary policy is. The higher the real yield, the more restrictive monetary policy is, and vice versa.

gold versus real yields

The graph below shows the current level of real yields, which is the highest in fifteen years. Accordingly, it’s fair to claim that monetary policy is very restrictive, regardless of how the Fed may have shifted its stance in recent months.

real yields monetary policy

In our article The Feds Golden Footprint we discussed why the relationship between Gold and real yields exists.

The level of real interest rates is a sturdy gauge of the weight of Federal Reserve policy. If the Fed is treading lightly and not distorting markets, real rates should be positive. The more the Fed manipulates markets from their natural rates, the more negative real rates become.

The article shared our analysis, which divided the last 40 years into three periods based on the level of real yields.

real yields since 1982

As the Fed’s monetary policy became more aggressive in 2008, the relationship between Gold and real yields grew. Before 2008, there was no statistical relationship.

Per the article:

The first graph, the pre-QE period, covers 1982-2007. During this period, real yields averaged +3.73%. The R-squared of .0093 shows no correlation.

real yields vs gold

The second graph covers Financial Crisis-related QE, 2008-2017. During this period, real yields averaged +0.77%. The R-squared of .3174 shows a moderate correlation.

real yields and gold price

The last graph, the QE2 Era, covers the period after the Fed started reducing its balance sheet and then sharply increasing it in late 2019. During this period, real yields averaged 0.00%, with plenty of instances of negative real yields. The R-squared of .7865 shows a significant correlation.

real yields and gold

Given our historical analysis and the current instance of high real yields, it is unsurprising that the relationship between the price of Gold and real yields has faded. 

Therefore, without real yields steering the price of Gold, let’s consider a few possibilities for why it is rising so rapidly.

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Fiscal Imbalance

The Federal government is running large deficits. As shown below, the annual percentage increase in federal debt is over 8%. Such significant deficit spending occurs as economic growth is running above its natural growth rate and pre-pandemic levels. Typically, deficits tend to be lower during periods of economic growth and bigger during recessions or economic slowdowns.

federal deficits and gdp

The recent increase in debt growth is significant, but not much more so than other non-recessionary peaks in the last ten years. Additionally, it is well below the debt increases associated with recessions. A $2+ trillion-dollar deficit sounds daunting, but the economy has grown by 33% or $7 trillion since 2020 and doubled in size since 2009. The graph below, showing the debt-to-GDP ratio, helps put more context on the rate at which the government borrows.

federal debt to gdp ratio

The upward trending debt to GDP ratio is not sustainable. However, the current ratio and slope of the recent trend align with the trend going back 20 years and even longer.

We have written many articles on the problem of debt growing faster than GDP and the economic damage it is doing and will do. However, when putting current deficits into proper context with the pace of economic activity, the recent growth is not glaringly different from other experiences of the last 20 years.

As such, we find it hard to believe that debt is responsible for the recent run-up in Gold.

Geopolitical

Geopolitical problems, especially regarding Ukraine and Israel, are indeed problematic.

Russia could deploy nuclear weapons or expand the war to other neighboring countries. An invasion of a NATO country would all but force involvement from the U.S. and European powers.

The Israeli-Hamas conflict appears to be a proxy war with Iran. While the theater of war is primarily in Gaza and, to a lesser degree, surrounding countries, the possibility of more direct involvement between Israel and Iran is problematic. Direct Iranian actions against Israel would likely be met with military force from the U.S. and other NATO powers.

Not to minimize the two geopolitical events and other less critical ones, but the U.S. and Europe have been in various wars in the Mideast and Afghanistan for most of the last 20 years. Is today’s global geopolitical situation much more frightening than in years past?

As we started writing this on April 4, 2023, a rumor circulated that Iran might be planning missile attacks against Israel. The S&P 500 fell by over 1% rapidly, and Gold promptly gave up $25. If geopolitical concerns are responsible for the recent gains, shouldn’t increasing tensions in the Middle East further add to Gold’s value?

Gold Predicts Inflation, Or Does It?

Some argue that Gold prices are warning that the lower inflation trends of the last 30 years are reversing.

If Gold is such a good predictor of prices, why did the price go nowhere when the Fed and government were raining money on the economy and supply lines were shut down? That period represents the most significant inflationary setup in over 40 years.

gold during pandemic
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Dovish Fed In High Inflationary Environment

Since late last year, the Fed has flipped from an uber-hawkish tone to a more dovish one. Despite easy financial conditions (LINK), high and sticky inflation, and above-average growth, the Fed seems intent on cutting rates multiple times this year. Many would argue that a more prudent Fed would keep its hawkish tone and possibly raise the specter of increasing rates further.

As we showed earlier, monetary policy, while seemingly becoming easier, is still at its tightest levels in over 15 years. Compare monetary policy today to that in 2013 and 2014. The economy was growing then, yet the Fed had rates pinned near zero percent and was doing QE. As we share below, Gold languished during that period, despite complete monetary policy carelessness.  

gold and fed funds
gold and fed balance sheet

Crypto – AI Mania  

Having discussed a few of the standard responses pundits are spewing regarding Gold’s ascent, we share one that may not be as popular with gold holders.

Gold is a speculative asset. Accordingly, it can rise and fall, and at times violently, based solely on the whims of traders and speculators.   

Might the current surge in Gold be less a function of the issues we raise above and more about the speculative mania flowing through many markets? Consider the five graphs below. The graphs show a solid visible and statistical correlation over the last two years between Gold and Bitcoin, Nvidia, Meta, Eli Lily, and the S&P 500.

gold and bitcoin
gold and nvda
gold and meta
gold and lly
gold and SPY

Summary

The previous few sections share some typical rationales to justify higher gold prices. While they sound like legitimate reasons for Gold to soar, when taken into context, they are not that different from other periods in the last twenty years when Gold was flat or trending lower in price.

The price of Gold can provide valuable insights at times. But other times, Gold can give false signals warped by irrational market behaviors. We think Gold is getting caught up in a speculative bubble, and its price is not presenting us with a warning of fiscal, monetary, or geopolitical crisis.

Gold is likely to have a more reliable and sustainable run higher when the Fed returns to its careless ways with real yields near 0% or even negative, and QE is again in operation. 

State Street Has A Unique View On Fed Cuts

There’s a lot to suggest that this is still a very fragile recovery despite the fact it continues to look resilient on the surface. -State Street CIO Lori Heinel

While most Wall Street economists have backed down their forecast for Fed Fund rate cuts from six to two, State Street remains very aggressive. They believe the Fed will cut rates by 50bps at the June meeting and cut another full percent before the end of the year. Per a Bloomberg article summarizing State Steet’s bold prediction, they have three reasons to buck the consensus. First, as Lori notes, economic data is strong but very inconsistent. For instance, today’s Tweet of the Day shows that FHA delinquencies due to unemployment are higher than 2008 levels, contradictory to robust jobs data from the BLS. But then again, so is the notion that part-time jobs are increasing rapidly while full-time employment declines.

State Street also believes that even with inflation running higher than normal, the current level of Fed Funds is too restrictive. As we share below, real Fed Funds are 2% above inflation, which is by far the most restrictive policy we have seen in fifteen years. Lastly, State Street believes the Fed does not want its actions to be seen as politically motivated. Per the article: “Obviously, the Fed will say they are not political, but there will be a lot of scrutiny, and they won’t want to be active in that window right around the election.”

restrictive real monetary policy

What To Watch Today

Earnings

Earnings Calendar

Economy

Earnings Calendar

Market Trading Update

As discussed yesterday, the break of the 20-DMA from last week remains a significant crack in the market’s bullish armor. On Friday and Monday, the market regained that previous support level. However, as noted in Monday’s morning brief:

“We are specifically looking at where the market closes for the week. The break of support on Thursday is important, and regardless of what happens intra-week, if the market closes below Thursday’s close, the break of support will be confirmed. We give the market time to reduce the “whipsaw effect” of daily market moves. “

Yesterday, the market again broke below the 20-DMA, although it recovered by the end of the day. The loss of momentum is notable and suggests that weakness is spreading. But, as we discussed, we are waiting to see where we close trading for this week before making any specific strategy changes.

It is worth noting that the Chaikin Money Flow index has turned negative, which is consistent with weaker market performance. Notably, the bullish trend remains intact, and bullish sentiment remains elevated. However, as noted, there are visible cracks in performance that are worth noting. We have previously recommended hedging risk accordingly, and that mandate is becoming more pressing. Today’s “inflation report” could add another layer of risk to market dynamics.

Market trading update

NFIB Declines And Is At Odds With GDP And Employment Data

For the seventh time in the last eight months, the NFIB small business survey has declined. The survey index now sits at 12-year lows. Further, it is now lower than at the trough of the Pandemic economic shutdown. There are a few areas of particular concern within the report. First, those businesses reporting higher selling prices rose moderately back to levels last seen in October. The second graph shows a robust correlation between the NFIB selling prices gauge and CPI. The second is that those expecting higher sales declined to new lows. We find it odd that small business firms plan on raising prices as expected sales are falling.

The third graph shows that hiring intentions continue to fall. This index has a solid three-month leading correlation with payrolls. Small businesses account for nearly 50% of private sector workers and about 45% of GDP. Accordingly, this latest round of small business data does not jibe with the strong employment and GDP trends but does give credence to State Street’s concern about weak data lurking underneath the surface.

nfib sentiment
nfib prices vs cpi
nfib hiring intentions

Chick-fil-A Takes The Crown

Chick-fil-A just announced that its average sales per restaurant for 2023 was $9.3M. That number is exceptionally high compared to its competition. The graph below shows that Chick-fil-A’s revenue per store is more than double that of all its competitors except Raising Canes. Unfortunately, Chick-fil-A is a private company, so investors can not take advantage of its significant productivity advantage.

chick fil a average sales per restaraunt

Tweet of the Day

FHA delinquencies due to unemployment

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Margin Debt Surges As Bulls Leverage Bets

In the most recent report from FINRA, margin debt levels have surged as bullish investors leverage their bets in the equity market. The increase in leverage is not surprising, as it represents increased risk-taking by investors in the stock market.

We previously discussed that valuations, in the short term, reflect investor optimism. In other words, as prices increase, investors rationalize why paying more for current earnings is rational.

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

Consumer confidence vs valuations

The same holds for margin debt. Unsurprisingly, as consumer confidence improves, so does the speculative demand for equities. As stock markets improve, the “fear of missing out” becomes more prevalent. Such boosts demand for equities, and as prices rise, investors take on more risk by adding leverage.

Consumer confidence vs margin debt.

Adding to that exuberance is the increased demand for share repurchases, which has been a primary source of “buying” since 2000. As CEO confidence improves, a byproduct of increased consumer confidence, they increase the demand for share repurchases. As buybacks boost asset prices, investors take on more leverage and increase exposure as a virtual spiral develops.

CEO Confidence vs Share Buybacks

However, should investors be afraid of rising margin debt?

A Byproduct Of Exuberance

Before we dig further into what margin debt tells us, let’s begin with where we are currently. There is clear evidence that investors are once again highly exuberant. The “Fear Greed” index below differs from the CNN measure in that our model measures positioning in the market by how much professional and retail investors are exposed to equity risk. Currently, that exposure is at levels associated with investors being “all in” the equity “pool.”

Fear Greed Gauge

As Howard Marks noted in a December 2020 Bloomberg interview:

“Fear of missing out has taken over from the fear of losing money. If people are risk-tolerant and afraid of being out of the market, they buy aggressively, in which case you can’t find any bargains. That’s where we are now. That’s what the Fed engineered by putting rates at zerowe are back to where we were a year ago—uncertainty, prospective returns that are even lower than they were a year ago, and higher asset prices than a year ago. People are back to having to take on more risk to get return. At Oaktree, we are back to a cautious approach. This is not the kind of environment in which you would be buying with both hands.

The prospective returns are low on everything.”

Margin debt vs SP500

Of course, in 2021, that market continued its low volatility grind higher as investors took on increasing margin debt levels to chase higher equities. However, this is the crucial point about margin debt.

Margin debt is not a technical indicator for trading markets. What it represents is the amount of speculation occurring in the market. In other words, margin debt is the “gasoline,” which drives markets higher as the leverage provides for the additional purchasing power of assets. However, leverage also works in reverse, as it supplies the accelerant for more significant declines as lenders “force” the sale of assets to cover credit lines without regard to the borrower’s position.

The last sentence is the most important. The issue with margin debt is that the unwinding of leverage is NOT at the investor’s discretion. That process is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) When lenders fear they may not recoup their credit lines, they force the borrower to put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen simultaneously, as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

As shown, Howard was eventually right. In 2022, the decline wiped out all of the previous year’s gains and then some.

So, where are we currently?

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Margin Debt Confirms The Exuberance

As noted, margin debt supports the advance when markets are rising and investors are taking on additional leverage to increase buying power. Therefore, the recent rise in margin debt is unsurprising as investor exuberance climbs. The chart shows the relationship between cash balances and the market. I have inverted free cash balances, so the relationship between increases in margin debt and the market is better represented. (Free cash balances are the difference between margin balances less cash and credit balances in margin accounts.)

SP500 vs Free cash Balances

Note that during the 1987 correction, the 2015-2016 “Brexit/Taper Tantrum,” the 2018 “Rate Hike Mistake,” and the “COVID Dip,” the market never broke its uptrend, AND cash balances never turned positive. Both a break of the rising bullish trend and positive free cash balances were the 2000 and 2008 bear market hallmarks. With negative cash balances shy of another all-time high, the next downturn could be another “correction.” However, if, or when, the long-term bullish trend is broken, the unwinding of margin debt will add “fuel to the fire.”

While the immediate response to this analysis will be, “But Lance, margin debt isn’t as high as it was previously,” there are many differences between today and 2021. The lack of stimulus payments, zero interest rates, and $120 billion in monthly “Quantitative Easing” are just a few. However, some glaring similarities exist, including the surge in negative cash balances and extreme deviations from long-term means.

Technical Model

In the short term, exuberance is infectious. The more the market rallies, the more risk investors want to take on. The issue with margin debt is that when an event eventually occurs, it creates a rush to liquidate holdings. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral. The decline in value then triggers further margin calls, triggering more selling, forcing more margin calls, and so forth.

Margin debt levels, like valuations, are not useful as a market-timing device. However, they are a valuable indicator of market exuberance.

While it may “feel” like the market “just won’t go down,” it is worth remembering Warren Buffett’s sage words.

“The market is a lot like sex, it feels best at the end.”

Amazon Stock Hides Weakness In Discretionary Stocks

Amazon stock accounts for 25% of the Consumer Discretionary sector (XLY), and it has been up 23% year to date. However, as represented by XLY, the sector is barely eking out a 1% gain for the year. The SimpleVisor proprietary Relative and Absolute analysis on the left highlights that the sector is the most oversold sector on a relative and absolute basis. The screenshot on the right shows our Absolute and Relative sector scores for the top ten holdings of the sector. While Amazon is extremely overbought compared to S&P, most of the remaining discretionary stocks are grossly underperforming the index.

The data makes us question just how confident investors are in the economy. And at the same time, it presents another view of how the largest market cap stocks, like Amazon, are resulting in a very imbalanced market. Discretionary stocks tend to do well in environments like today, with solid growth, rising consumer confidence, and low unemployment. Consumers have money and the confidence to consume. Throughout much of the pandemic recovery, the sector was among the leaders. While Amazon is up 25% this year and the S&P 500 10% higher, the sector, sans Amazon, is down 6%. For instance, Nike, Starbucks, and McDonald’s are down 16%, 7%, and 10%, respectively. Our analysis tells us that discretionary stocks are grossly underperforming. Additionally, it would be much worse if not for Amazon’s strength.

The analysis suggests that investors may be bracing for high unemployment rates and a loss of confidence in the next six to nine months.

discretionary, amazon, relative absolute analysis SimpleVisor

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As noted yesterday, the market did break below the all-important 20-DMA on Thursday. However, yesterday, it managed to reclaim that level by closing above it. This is important as it does NOT confirm the break of support. As of now, the running bullish trend remains intact.

However, that is just for today. We are specifically looking at where the market closes for the week. The break of support on Thursday is important, and regardless of what happens intra-week, if the market closes below Thursday’s close, the break of support will be confirmed. We give the market time to reduce the “whipsaw effect” of daily market moves. But as of yesterday’s close the 20-DMA support level remains intact, and it appears that last Thursday’s sell-off was countered by algorithms “buying the dip.”

Market Trading update

There is still a good bit of buying momentum in the market as bullish investors remain committed, but that momentum is waning. Such leaves the market susceptible to a trend change, and a good bit of economic data this week could spook investors. Furthermore, as shown, we are now at a peak “blackout” period for share buybacks, which has been a critical support for the market since November.

Peak Blackout Period

Bonds Under Pressure

The bond market is on edge due to the recent spate of stronger-than-expected economic data and continued sticky inflation figures. This week may prove pivotal for bonds. CPI on Wednesday and PPI on Thursday will help us better appreciate if the recent uptick in inflation is seasonal or may last a while. Further weighing on the bond market are the 10 and 30-year Treasury auctions on Wednesday and Thursday, respectively.

Often, the banks that bid on the auctions will try to establish a short position going into the auction. The logic is they can sell at higher prices and cover their positions in the auctions at lower prices. The combination of the auctions and inflation worries may entice Wall Street to take larger short bets heading into the auctions. If, however, CPI and PPI are as expected or lower, there could be a strong bid as the banks may not want to go into the auctions as short as they previously anticipated.

The graph below shows the channel in which the long bond future has traded since the start of the year. The channel shows the upside versus downside potential is about 2:1. However, a break below 115 could trigger further selling.

30 year bond futures channel

Buybacks Come To Temporary Halt

With earnings season kicking off in earnest this week, many companies will be restricted from buying back shares in their companies. As the Market Ear graph below shows, 75% of S&P 500 companies will be in a blackout period through April 23. Buybacks are a predominant driver of market returns and help account for some of the over/underperformance of many stocks. The second graph shows a very high correlation (R-squared =.85) between the four-week change in buybacks and the change in the S&P 500.

The blackout period is only three weeks long, so any effect on the market will be short-lived. However, if the market declines, some support for propping up stock prices may be missing. Accordingly, the lack of buybacks may result in a little more volatility than we have grown accustomed to over the last six months.

stock buyback blackout periods
stock buybacks vs S&P 500 returns

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The Jobs Market Remains Hot

The average Wall Street forecast for job growth was 200k, with the highest individual at 290k. Per Friday’s BLS employment report, the number of new jobs is 303k, beating every estimate. The latest job numbers continue to outperform analysts’ expectations seemingly every month. The three-month moving average has also been rising steadily. Currently, it stands at 276k. Also, the unemployment rate ticked down by .1% as the participation rate rose.

While analysts underestimated job growth, they correctly forecasted the average hourly earnings. Year-over-year wage gains are at 4.1%, the lowest level in almost three years. A strong job market typically results in rising wages as employees have more leverage over their employers. Our theory as to why wages are not rising more rapidly is that the quality of jobs is decreasing. For example, we shared data in Friday’s Commentary showing that a third of the job growth is coming from the leisure and hospitality industry, which is the lowest-income industry. In Friday’s BLS report, the second lowest paying sector, healthcare, and government accounted for 50% of the jobs. The highest-paid sector, information technology, saw zero job growth. Additionally, higher-paying full-time employment is down 1.3% over the last year, while lower-paying part-time employment is up 7.5%.

Given their mandate to maximize employment and maintain stable prices, the Fed should like this data.

part time vs full time jobs

What To Watch Today

Earnings

  • No notable releases today

Economy

  • No notable releases today

Market Trading Update

Last week, we discussed the current bullish trend’s ongoing, mind-numbing, narrow channel. We have suggested there was little to worry about until the 20-DMA was violated. That “crack” to this “unstoppable” bullish rally happened Thursday.

However, as we previously noted, just because the market breaks the 20-DMA does not mean that action must be taken immediately. What we need to see is a confirmation of that break with either a failed retest of previous support or a further decline. On Friday, the stronger-than-expected employment report sent stocks higher as “good news is good news” as stronger economic growth should support earnings. However, “bad news also remains good news,” as it would mean Fed rate cuts.

In other words, we continue to be in a “heads I win, tails I win” market.

On Friday, that market rally failed to retake the previous support trend of the 20-DMA. If the market is lower on Monday and takes out Thursday’s low as shown, this would confirm the break of support and suggest lower prices. The 50-DMA will quickly become the next major support level.

Market Trading Update

While the market may remain range-bound between recent highs and the 50-DMA over the next month or so, we expect a deeper correction (~10%) before the election. Such a correction would likely test the 200-DMA and reverse much of the recent bullish market exuberance, as shown by both retail and professional investors.

Investor Sentiment vs SP500

A reversal of sentiment and price deviations would provide a better entry point for increasing portfolio equity exposures. Of course, the market has been so complacent for so long that even a completely normal 5-10% correction will “feel” far worse than it actually is.

With the market overbought and extended currently, we want to remain cautious about aggressively committing our cash reverses to the broad market. However, such can be very hard to do in a rising bull market that seems unstoppable.

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

The Week Ahead

With the latest round of jobs data behind us, the market will focus on inflation and corporate earnings.

Expectations for Wednesday’s core and monthly headline CPI figures are +0.3% and +0.1% below the prior month’s readings. On Thursday, the PPI report is expected to rise 0.3% and 0.2% on a headline and core basis. The estimates are 0.3% and 0.1% lower than last month. Also, the FOMC will release the minutes from the prior meeting on Wednesday. Given that one Fed speaker after another has offered caution about cutting rates too soon but at the same time offering the Fed will likely cut rates 2-3 times this year, we suspect the minutes will affirm a similar outlook. Anything other than that is likely to affect the stock and bond markets. In addition to the Fed and inflation data, the bond market will also be focused on Wednesday’s 10-year Treasury auction and Thursday’s 30-year auction.

With the exception of the large banks, smaller, lesser-known companies will report earnings predominantly this week. JPM, Wells Fargo, Citigroup, and Blackrock report their Q1 earnings on Friday. Loan write-offs and adjustments to loan loss reserves will be of particular interest as they provide information about the consumer’s health. Further, net interest margins inform us of how much incentive banks have to lend.

More On Market Rotations

Thursday’s Commentary led with a report from Sentimentrader, which points to a potential market rotation favoring the equal-weighted S&P 500 (RSP) versus the well-followed market-cap-weighted S&P 500 (SPY). We thought it might be helpful to provide further guidance based on what our SimpleVisor proprietary sector and factor performance technical models show. The top graph below shows our relative technical score based on the RSP/SPY price ratio. The score has been below zero most of the last year, signaling strength in the SPY versus the RSP. From early December to mid-January, the score rose into moderate overbought territory as RSP gained on SPY. That was short-lived, as we can see in the lower graph.

The lower graph tracks the prices of RSP and SPY and the performance difference between them. It shows that both indices have been up decently over the past year. However, the price ratio of RSP to SPY is down by about 12%. Therefore, owning RSP instead of SPY produced positive returns but were well below what an investor in SPY earned.

The score is currently in neutral territory and has been steadily rising since early February. Over the same period, the return differential has improved by about 1.5% in favor of RSP. While the negative trend in the price ratio may have been arrested, the SimpleVisor relative analysis score is not yet signaling that a rotation to RSP has legs to run. We will closely monitor this analysis to help us better track the potential for a significant market rotation.

market rotation rsp spy

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Investing Lessons From Your Mother

Your mother likely imparted valuable investing lessons you may not have known. With Mother’s Day approaching and bullish market exuberance present, such is an excellent time to revisit the investing lessons she taught me.

Personally, when I was growing up, my Mother had a saying, or an answer, for almost everything… as most mothers do. Every answer to the question “Why?” was immediately met with the most intellectual of answers:

“…because I said so”.

Seriously, my Mother was a resource of knowledge that has served me well over the years, and it wasn’t until late in life that I realized that she had taught me, unknowingly, valuable investing lessons to keep me safe.

So, by imparting her secrets to you, I may be violating some sacred ritual of motherhood knowledge, but I felt it was worth the risk of sharing the knowledge that has served me well.


1) Don’t Run With Sharp Objects!

It wasn’t hard to understand why she didn’t want me to run with scissors through the house – I think I did it early on to watch her panic. However, later in life, when I got my first apartment, I ran through the entire place with a pair of scissors, left the front door open with the air conditioning on, and turned every light on in the house.

That rebellion immediately stopped when I received my first electric bill.

Sometime in the mid-90s, the financial markets became a casino as the internet age ignited a whole generation of stock market gamblers who thought they were investors. There is a vast difference between investing and speculating; knowing the difference is critical to overall success.

A solid investment strategy combines defined goals, an accumulation schedule, allocation analysis, and, most importantly, a defined sell strategy and risk management plan.

Speculation is nothing more than gambling. If you are buying the latest hot stock, chasing stocks that have already moved 100% or more, or just putting money in the market because you think you “have to,” you are gambling.

The most important thing to understand about gambling is that success is a function of the probabilities and possibilities of winning or losing on each bet.

In the stock market, investors continue to play the possibilities instead of the probabilities. The trap comes with early success in speculative trading. Success breeds confidence, and confidence breeds ignorance. Most speculative traders tend to “blow themselves up” because of early success in their speculative investing habits.

When investing, remember that the odds of making a losing trade increase with the frequency of transactions. Just as running with a pair of scissors, do it often enough, and eventually, you could end up hurting yourself. 

2) Look Both Ways Before You Cross The Street.

I grew up in a small town, so crossing the street wasn’t as dangerous as in the city. Nonetheless, she yanked me by the collar more than once as I started to bolt across the street, seemingly anxious to “find out what’s on the other side.” It is essential to understand that traffic does flow in two directions. If you only look in one direction, you will get hit sooner or later.

Many people want to classify themselves as a “Bull” or a “Bear.” The savvy investor doesn’t pick a side; he analyzes both sides to determine what the best course of action in the current market environment is most likely to be.

The problem with the proclamation of being a “bull” or a “bear” means that you are not analyzing the other side of the argument and that you become so confident in your position that you tend to forget that “the light at the end of the tunnel…just might be an oncoming train.”

Valuation Model

It is an essential part of your analysis, before you invest in the financial markets, to determine not only “where” but also “when” to invest your assets.

3) Always Wear Clean Underwear

This was one of my favorite sayings from my Mother because I always wondered about the rationality of it. I always figured that even if you wore clean underwear before an accident, you’re still likely left without clean underwear following it.

The investing lesson is: You are only wrong – if you stay wrong.

However, being an intelligent investor means always being prepared in case of an accident. That means simply having a mechanism to protect you when you are wrong with an investment decision.

You will notice that I said “when you are wrong” in the previous paragraph. Many of your investment decisions will likely turn out wrong. However, cutting those wrong decisions short and letting your right decisions continue to work will make you profitable over time.

Any person who tells you about all the winning trades he has made in the market – is either lying or hasn’t blown up yet.

One of the two will be true – 100% of the time.

Understanding the “risk versus reward” trade-off of any investment is the beginning step to risk management in your portfolio. Knowing how to mitigate the risk of loss in your holdings is crucial to your long-term survivability in the financial markets.

4) If Everyone Jumped Off The Cliff – Would You Do It Too?

Every kid, at one point or another, has tried to convince their Mother to allow them to do something through “peer pressure.” I figured if she wouldn’t let me do what I wanted, she would bend to the will of the imaginary masses. She never did.

“Peer pressure” is one of the biggest mistakes investors repeatedly make. Chasing the latest “hot stocks” or “investment fads” that are already overvalued and are running up on speculative fervor always ends in disappointment.

Investors buy stocks that have moved significantly off their lows in the financial markets because they fear “missing out.” This is speculating, gambling, guessing, hoping, praying – anything but investing. Generally, when the media begins featuring a particular investment, individuals have already missed the major part of the move. By that point, the probability of a decline began to outweigh the possibility of further rewards.

The investing lesson is to be aware of the “herd mentality.” Historically, investors tend to run in the same direction until that direction falters. The “herd” then turns and runs in the opposite direction. This continues to the detriment of investors’ returns over long periods.

Investor Performance Over Time

This is also generally why investors wind up buying high and selling low. To be a long-term successful investor, you must understand the “herd mentality” and use it to your benefit – getting out from in front of the herd before you are trampled.

So, before you chase a stock that has already moved 100% or more, figure out where the herd may move to next and “place your bets there.” This takes discipline, patience, and a lot of homework, but you will often be rewarded for your efforts.

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5) Don’t Talk To Strangers

This is just good, solid advice all the way around. Turn on the television, any time of the day or night, and it is the “Stranger’s Parade of Malicious Intent.” I don’t know if it is just me or if the media only broadcasts news revealing human depravity’s depths. Still, sometimes, I wonder if we are not due for a planetary cleansing through divine intervention.

However, back to investing lessons, getting your stock tips from strangers is a sure way to lose money in the stock market. Your investing homework should NOT consist of a daily regimen of CNBC, followed by a dose of Grocer tips, capped off with a financial advisor’s sales pitch.

To succeed in the long run, you must understand investing principles and the catalysts to make that investment profitable. Remember, when you invest in a company, you buy a piece of it and its business plan. You are placing your hard-earned dollars into the belief that the individuals managing the company have your best interests at heart. The hope is they will operate in such a manner as to make your investment more valuable so that it may eventually be sold to someone else for a profit.

This also embodies the “Greater Fool Theory,” which states that someone will always be willing to buy an investment at an ever higher price. The investing lesson is that, in the end, someone is always left “holding the bag.” The trick is to ensure that it isn’t you.

Also, you must be aware of this when getting advice from the “One Minute Money Manager” crew on television. When an “expert” tells you about a company you should be buying, remember he already owns it and most likely will be the one selling his shares to you.

6) You Either Need To “Do It” (polite version) Or Get Off The Pot!

When I was growing up, I hated to do my homework, which is ironic since I now do more homework than I ever dreamed of in my younger days. Since I wouldn’t say I liked doing homework, school projects were rarely started until the night before they were due. I was the king of procrastination.

My Mom was always there to help, giving me a hand and an ear full of motherly advice, usually consisting of many “because I told you so…”

Interestingly, many investors tend to watch stocks for a very long period, never acting on their analysis but idly watching as their instinct proves correct and the stock rises in price.

The investor then feels that they missed his entry point and decides to wait, hoping the stock will go back down one more time so that he can get in. The stock continues to rise. The investor continues to watch, becoming more frustrated until he finally capitulates on his emotion and buys the investment near the top.

The investing lesson is to be aware of the dangers of procrastination. On the way up and down, procrastination is the precursor of emotional duress derived from the loss of opportunity or the destruction of capital.

However, if you do your homework and can build a case for the purchase, don’t procrastinate. If you miss your opportunity for the correct entry into the position – don’t chase it. Leave it alone, and come back another day when ole’ Bob Barker is telling you – “The Price Is Right.”

7) Don’t Play With It – You’ll Go Blind

Well…do I need to go into this one? All I know for sure is that I am not blind today. What I will never know for sure is whether she believed it or if it was just meant to scare the hell out of me.

However, kidding aside, the investing lesson is that when you invest in the financial markets, it is very easy to lose sight of your intentions in the first place. Getting caught up in the hype, getting sucked in by the emotions of fear and greed, and generally being confused by the multitude of options available can cause you to lose your focus.

Always return to the basic principle you started with. That goal was to grow your small pile of money into a much larger one.

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Putting It All Together

My Dad once taught me a fundamental investing lesson as well: KISS: Keep It Simple Stupid.

This is one of the best investment lessons you will ever receive. Too many people try to outsmart the market to gain a small, fractional increase in return. Unfortunately, they take disproportionate risks, often leading to negative results. The simpler the strategy is, the better the returns tend to be. Why? There is better control over the portfolio.

Designing a KISS portfolio strategy will help ensure that you don’t get blinded by continually playing with your portfolio and losing sight of what your original goals were in the first place.

  1. Decide what your objective is: Retirement, College, House, etc.
  2. Define a time frame to achieve your goal.
  3. Determine how much money you can “realistically” put toward your monthly goal.
  4. Calculate the return needed to reach your goal based on your starting principal, the number of years to your goal, and your monthly contributions.
  5. Break down your goal into achievable milestones. These milestones could be quarterly, semi-annual, or annual and will help ensure you are on track to meet your objective.
  6. Select the appropriate asset mix that achieves your required results without taking on excess risk that could lead to more significant losses than planned.
  7. Develop and implement a specific strategy to sell positions during random market events or unexpected market downturns.
  8. If this is more than you know how to do – hire a professional who understands essential portfolio and risk management.

There is much more to managing your portfolio than just the principles we learned from our Mothers. However, this is a start in the right direction, and if you don’t believe me – just ask your Mother.

The Service Sector Weakens As Manufacturing Strengthens

This past week’s ISM service and manufacturing surveys continue to show divergence between the two major economic sectors. However, this divergence differs from what we have seen over the past few years. For the first time in 16 months, the ISM manufacturing was above 50. 50 is the distinction between economic expansion and contraction. The manufacturing sector may be coming out of a recession, but the service sector is weakening. Keep in mind the service sector accounts for over three-quarters of economic activity. This explains why economic growth has been robust despite the weakness of manufacturing. It is also worth noting that the divergence between the two indices is abnormal. Typically, they are closely aligned.

The graph below from IFM Investors helps us compare the two reports and their components. The two most important to the Fed are prices and employment. The manufacturing prices index surged to its highest level since July 2022. However, the services price index dropped to its lowest level since March 2020. Employment in both services and manufacturing remained below 50, pointing to net job losses, but both rose slightly. Today’s Tweet of the Day points to a divergence between the aggregate manufacturing and service sector surveys and the BLS employment data. 8 of the 11 service sector components were lower than last month, while 9 of the 11 manufacturing components were flat or higher.

breakdown of ISM survey and manufacturing reports

What To Watch Today

Earnings

  • No notable earnings releases

Economy

Economic Calendar

Market Trading Update

As noted yesterday, the market bounced off the 20-DMA and followed through early yesterday morning, rallying out of the gate. However, a rash of Fed speakers left the markets uncertain about the “certainty of rate cuts” this year, sending stocks lower mid-afternoon. Furthermore, international tensions between Iran and Israel raised commodity prices, weighing on market outlooks as the risk of war increased. That selloff broke the market below the 20-DMA trend line, violating that support. Furthermore, Relative Strength (RSI) and the MACD sell signal triggered, suggesting that the risk of a deeper correction may increase.

While the initial break is a warning, it is not valid until that break is confirmed. A close below the 20-DMA and trendline on Friday will be important. However, we need a failed attempt to retake the 20-DMA to confirm the trend has broken. Such would suggest raising cash levels somewhat and rebalancing risk across portfolios. We will watch the market close today for our first sign of the bears regaining short-term control of the narrative.

Recent Job Growth Has A Lot To Be Desired

The graph below shows that recent net new additions to the job forces are not all it’s cracked up to be. The chart below, provided to us by one of our clients, highlights that about 30% of the job growth this year has been in the leisure and hospitality industry. This industry has a median annual salary of approximately $34k, which is not only the lowest-paid industry but 15k below the next lowest one in line. More disturbing is that job growth in the two highest-paid industries, information and professional and business services, has been flat this year. Our client also put historical context around the recent data.

  • Notice that the average contribution for Leisure jobs was around 13% from 2011 to 2019; however, recently, that has ratcheted up to roughly 33%, or a third of the jobs.  
  • Professional jobs contributed around 22.5% before COVID-19, but their contribution post-COVID-19 has more than halved recently to only 10%, with most of that contribution in 2021 – 22.  
job growth and median salary by industry

Eclipse Economics

During this coming Monday’s solar eclipse, those business owners and towns in the path of totality will receive a nice economic boost. For instance, the graph below, courtesy of AIRDNA, shows that Airbnb bookings are near 100% for those in the path. Most other locations are 50% or less. Hospitality, transportation, and retail merchandise businesses should benefit on Monday as tourists flock to see the total eclipse.

A Bloomberg article entitled Eclipse Boomtowns Await Their Moment In The (Blocked) Sun sheds light on Carbondale, Illinois, one of the towns in the path of totality. The town of 32,000 people is expecting anywhere from 50,000 to 150,000 visitors. The extra spending should nicely pad the business owners’ pockets and the town’s coffers.

air bnb bookings total eclipse

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Is A Market Rotation At Hand

Markets often experience periods, like today, where specific sectors or factors lead the market. Identifying such trends is essential to attain market-like returns. Equally important is accurately forecasting when a market rotation is at hand. To that end, we share the work from Sentimentrader.

Sentimentrader presented the graph below charting the one-year performance of the price ratio of the equal-weighted S&P (RSP) and the market cap-weighted S&P. Over the last year, the equal-weighted index has been underperforming the S&P 500 to a degree not seen since 1998. Then, internet and technology stocks were powering markets higher while most other stocks lagged. Sentimentrader considers a market rotation favoring RSP over larger cap stocks may be occurring now.

In their article, Sentimentrader provides performance data on similar instances. When the ratio (RSP/SPY) hit a ten-year low and then rebounded 5%, three-month and one-year forward returns favored RSP over SPY in four out of the five instances since 1973. The four positive performances of such market rotations averaged a one-year gain of 5.23%. In 1999, the market rotation signal was false, resulting in a one-year loss of 8.30%. The returns we quote are for the RSP:SPY price ratio, not the performance of holding either of them.

sentimentrader rsp vs spy

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As discussed yesterday, the “Bernie Madoff” bullish trend remains intact as computer algos bought the dip to the 20-DMA. So far, the market continues its bullish advance despite a stronger jobs report, which will likely keep the Fed on hold for longer.

Market Trading Update

Despite the selloff early in the week, volatility remains compressed as bullish exuberance remains unquenched.

Market vs VIX

While the message remains boring, there is little to be concerned with momentarily. Continue to maintain equity exposures in portfolios until there is a confirmed break of the 20-DMA. At such time, we will discuss becoming more defensive in positioning and allocations.

However, that is not today…at least not yet.

Three Rate Cuts This Year Yet “No Urgency” To Cut Rates

In what appears to be coordinated messages, several Fed members have said over the last couple of days that the Fed remains ready to cut rates three times this year. The messages come against a backdrop of easier financial conditions, sticky inflation, and robust economic data. Given where inflation was and the strong desire to get it to 2%, one would think they would back off their rate-cut estimates. Yet most members, including Jerome Powell, continue forecasting three cuts but stress there is no urgency to do so. If correct, they are likely to reduce rates at three of the final four meetings of the year, spanning from July to December.

“At this point, the economy and policy are in a good place.” “Inflation is coming down, but it’s slow, it’s bumpy and slow. The labor market is still going strong, and growth is going strong. So there’s really no urgency to adjust the rate.” -Mary Daly San Francisco Fed.

Cleveland Fed President Loretta Mester, one of the more hawkish Fed members, also acknowledges the economy’s strength but says, “Three rate cuts are still reasonable.

The Fed appears to be walking a tightrope. On the one hand, it is concerned that hiking too soon will prevent inflation from falling to its target. On the other hand, it cautions that keeping monetary policy restrictive will weaken the economy and harm the labor market. As such, they are “data dependent.”

While it may seem odd that the Fed is talking about cutting rates despite inflation running above its target, it’s worth keeping in mind that the Fed Funds rate is the highest it’s been compared to inflation in fifteen years. Such tight policy will, in time, dampen economic growth and weaken the labor markets.

As the table below shows, the Fed Funds futures market implies the Fed will cut rates three times this year.

fed policy is restrictive
fed funds futures fed probabilities

ADP Jobs Report Points To A Strong Labor Market

ADP reported that 184k jobs were added to the economy last month. Such is the biggest gain in nine months. Keep in mind that the ADP data has shown much weaker job growth than the BLS data, and the correlation between the two has recently been weaker than it has historically been. Of importance to the Fed, the median change in annual pay for people remaining at their jobs was 5.1%, but for people changing jobs, it was 10.1%. While the quits rate in the JOLTs report has normalized, the ADP report may signal that wage pressures are heating up. Obviously, one report does not make a trend, but wage growth bears watching in Friday’s BLS report. Per the ADP report:

“March was surprising not just for the pay gains, but the sectors that recorded them. The three biggest increases for job-changers were in construction, financial services, and manufacturing,” said Nela Richardson, chief economist, ADP. “Inflation has been cooling, but our data shows pay is heating up in both goods and services.”

adp jobs data

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Credit Stress Is Brewing As Market Complacency Rises

Typically, credit spreads and yields on junk bonds align with credit stress and anticipated stress in the credit markets. Today, however, an aura of complacency reigns over the junk bond market as credit stress for junk-rated companies increases. The top graph, entitled Credit Stress is Building, courtesy of Bloomberg shows that defaults on junk-rated bank loans, aka leveraged loans, have steadily risen since 2022 when the Fed started hiking interest rates. Per data from Moodys, the default rate on leveraged loans is now near 6%, double the 3% average over the last 25+ years.

Despite above-average and rising loan defaults on companies with significant credit risk, B-rated junk bond spreads to Treasuries are at 3.08%, their lowest levels in 15 years. The spread is 2.25% below the average since 1997. So why do junk bond spreads reflect complacency while leveraged loan debt exhibits credit stress? For starters, the supply of junk debt hitting the market has been low as many companies refinanced debt at lower levels in 2000-2021. Second, speculators are chasing risky assets and junk bonds are no exception. Lastly, a Goldilocks economic forecast is commonplace. Accordingly, with no recession in sight, complacency is taking over. The effective yield is around 7.50% on B-rated debt. If the junk bond market experiences similar rising default rates as junk loans, its investors will be in for quite a rude awakening. Until then, party on!

credit stress and junk bond spreads

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

In yesterday’s commentary, we noted:

“One day in the new quarter does not mean much, but it remains ripe for further corrective action with the market extended and deviated above long-term means. Also, with the market putting in a double-top, a violation of the 20-DMA will confirm a large correction is in process. There is no reason to be overly concerned with one day’s action, but we watch closely for evidence of a turn. It is worth remembering that the last time we had such a long stretch of overbought condition was in 2017. We then had two sizable corrections in 2018.”

That correction gained some traction yesterday, with the market predictably falling back to support at the 20-DMA. While buyers stepped in at support, there is a rising weakness in the underlying action, which suggests some caution. As shown, the Chaikan Moneyflow Index has turned negative. There is historically a high correlation between the ebbs and flows of the moneyflow index and the market. With the moneyflow index turning negative and the market testing the 20-DMA, we may see the early stages of a larger correction developing. When we get to Friday’s close, we may have our answer if we are below the 20-DMA with some conviction. It is worth noting that we have violated the 20-DMA a couple of times since November. However, each violation was quickly reversed. Such is always the case during a bull run until it ends.

Market Trading Update

A Technical Take On Oil Prices

The first graph below is a five-year daily graph of crude oil futures. Of note is that the price has neatly formed an arc. If it continues to follow the pattern, there will be plenty of potential upsides. Also arguing for more gains is a potential golden cross whereby the 50dma crosses above the 200dma. That could occur in the next week. However, the Williams %R and RSI point to short-term overbought conditions. The MACD is bullish but at levels where it could flip to a bearish short-term trade. Most important is the blue diagonal line linking prior peaks. A break above the blue line and the September 2023 peak would signal the potential for crude oil trading at $100 or more. However, a rebuke of the resistance line is quite possible.

The second graph, which is weekly going back 25 years, shows the longer term price range between $110 and $35. Currently, crude is in the upper end of the range, but it has plenty of room before it gets there. $110 a barrel makes sense if the price breaks out higher from the large orange triangle. While the short-term graph highlights the golden cross possibility, the longer-term graph has a death cross in the making. The price may consolidate in the orange triangle for another month or two before breaking out. A break out above or below the orange lines and above or below the prior peak and trough would likely signal a longer trend. Our more significant concern would come if it breaks below the orange support line, which has proven valuable since 2016. It would likely take a recession to break below the line.

crude oil short term
crude oil futures long term graph

JOLTs Jobs Data “Little Changed”

The JOLTs jobs report was largely as expected and in line with the prior report. In fact, the BLS summary of the report includes the phrase “changed little” five times and “little changed” 4 times. The number of job openings was 8.756 million up slightly from 8.748 last month. However, the number from last month was revised lower by over 100k jobs. We have seen similar lower revisions consistently in the BLS jobs report. The three graphs below show the trends toward a normalization of the labor force is in tact.

Unlike the BLS and ADP reports, JOLTs is released on a two month delay. Therefore yesterday’s was for February. Given its somewhat stale and little changed we doubt the report will impact expectations for Friday’s BLS report.

jolts job opening rate
jolts quit rate
jolts hires rate

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Japans Lost Decades: Are We On The Same Path

Back in 1989, Japan was taking over the world. The country’s economy had grown 6.7% in 1988. Sony had just bought Columbia Pictures, one of the largest Hollywood studios, for $3.45 billion. Japanese property company Mitsubishi Estate took control of Rockefeller Center in New York City that October. When land prices peaked in Tokyo, Japan’s Imperial Palace grounds were more valuable than all the land in Florida. – WSJ

At its height, in 1989, real estate in Tokyo sold for as much as $139,000 a square foot—more than 350 times as much as choice property in Manhattan.Vanity Fair

Some say the U.S. economy and financial markets are in epic bubbles. Undoubtedly, our increasing dependence on debt to fund economic expansion and years of prior debt is unsustainable without central bank intervention in markets. Furthermore, there are hints of irrational exuberance in the stock, credit, and crypto markets. While we are in a bubble of sorts, our current situation pales compared to Japan’s bubble and subsequent lost decades.

US debt to income and profits

Japan’s situation then and ours now are in no way an apples-to-apples comparison. However, there are similarities. Accordingly, the lessons Japan learned and the price they continue to pay for extreme leverage and irrational exuberance are worth understanding in hopes we can take steps today and avoid Japan’s lost decades.   

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Japan’s Twin Bubbles

In the first week of January 1990, Japan’s Nikkei 225 stock market index peaked at 38,916. As shown below, the Nikkei index surged 488% in just ten years preceding that record high. At the time, its P/E ratio stood near 60. Today, thirty-five years later, the Nikkei has finally set a new record high. Over the same period (1990 to current), the S&P 500 has risen by 1350%!

nikkei 225 and S&P 500

It wasn’t just the stock market that was in a bubble in the late 1980s. Real estate values, bolstered by extreme leverage, were skyrocketing. At the time, it was estimated that the total property market in Japan was worth four times the United States’ property value. That is unbelievable, considering the U.S. has about 26 times more acreage. The real estate valuation stats in the opening quotes further highlight the mind-boggling valuations.

Out Of The Rubble And Into The Bubble

After rebuilding from the devastation of World War II, Japan embarked on an economic boom. It quickly became one of the world’s leading economic and financial powerhouses. In 1970, Japan’s GDP was $217 billion. By 1990, it had grown to $3.19 trillion, an astonishing 14.4% annual growth rate. In context, economists have marveled at China’s single-digit growth rate since 2000.

Their massive economic gains came to a complete halt in the mid-1990s, marking the beginning of “Japan’s Lost Decades.”

Since then, Japan has been plagued by economic stagnation and deflation. The first graph below shows Japan’s GDP has shrunk since 1995. Similarly, prices have been flat over the same period, with numerous bouts of deflation.

japan gdp growth rate
japan CPI
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The Long Road To Recovery

There are many factors contributing to Japan’s lost decades.

At the bubble’s apex, in December 1989, the government and Bank of Japan (BOJ) implemented policies to prick its asset bubbles. Hindering the banking system’s ability to create new debt and refinance old debt put a pin in the stock and real estate bubbles. The banking system was in grave danger, with asset values falling precipitously and the loans backing said assets lacking sufficient collateral.

For better or worse, the government supported the banks to prevent catastrophic failures. Japan likely avoided a banking crisis and economic depression on par or possibly worse than our own experience in the 1930s. Unfortunately, the banks became zombies. They could not write off bad loans; thus, their ability to create new loans or refinance maturing loans was severely limited. Japan effectively avoided a massive depression but ended up with decades of economic stagnation. Pick your poison!

Lingering Demographic Effects

Further accentuating Japan’s lost decades of economic woe is its declining and aging population. The first graph below, courtesy of Macro Trends, shows that Japan’s population growth peaked in 2009 and has declined since. Further concerning, the second graph shows that a large percentage of their population is over 50 and supported by a shrinking base of younger people.

japan population demographics
japans population by age group

One significant consequence of Japan’s prolonged economic stagnation was its impact on the labor market and demographic landscape. High unemployment rates, particularly among the youth, and stagnant wages became the norm. The result was poor sentiment, which led to declines in personal consumption and confidence. Consequently, the desire to have children declined broadly across their population.

Many adult children continue to live with their parents and refuse to work or get married and start families.

Making demographic matters worse, Japan has strict immigration laws. Its net immigration rate is .74 per 1,000 people compared to 3 per 1,000 for the U.S. Given its low net migration rate, Japan has been unable to offset its negative birth/death rate with foreigners.

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The BOJ

The Bank of Japan (BOJ) has done everything it can to support the economy and banks. The graph below from Trading Economics shows that its key lending interest rate has been near zero for over 20 years. They recently raised their lending rate to 0-.10%. If you squint, you might see the rate increase highlighted with the red circle.

boj lending rate

Furthermore, they have heavily relied on asset purchases (QE). The World Bank estimates that the BOJ’s assets are a stunning 89% of Japan’s GDP. That is nearly triple that of the Fed. Furthermore, the BOJ owns approximately 60% of the stock ETF market and is the top shareholder of over one-fifth of the Nikkei 225 companies. They also hold over half of the nation’s Treasury securities.

They claim they are trying to normalize policy. However, with the yen trading at 20-year lows and depreciating versus the dollar, the BOJ will have to prove its claim via higher rates and less QE. Is Japan’s banking system and economy able to handle such a normalization?

Summary

Japan made critical mistakes in the 1970s, fostering one of the largest financial bubbles in history. It can also be criticized for its handling of the bubbles’ fallout.

Their struggle to regain economic and monetary policy normalcy highlights how the bubble still dramatically impacts the nation.

It’s not too late for America to manage her finances better. Unfortunately, most politicians want to get re-elected and will not do what is best for America. Continuing down our path will eventually lead to Japan circa 1989. But do not mistake our situation with that of Japan forty years ago.

Powell Indicates Balance Between Inflation and Employment

For the better part of the last two years, Jerome Powell and the Fed have clearly indicated that monetary policy is primarily focused on bringing inflation back to its 2% target. Over the period, Powell indicated he was comfortable with weakness in the labor market if it meant inflation would normalize. Powell’s FOMC press conference and a speech on Good Friday provide hints that they are getting comfortable with inflation. Accordingly, the labor market will play a more prominent role in setting monetary policy. To wit the following sentence from Powell:

If we were to see unexpected weakness in the labor market that could draw a policy response.”

The graph below shows the 2% difference between Fed Funds and Core PCE is the most restrictive policy since 2007. Given that policy is tight, their new focus on employment is logical. BLS headline labor data has been robust. However, other data, like their household survey and part-time versus full-time employment, have shown weakness. Further, a report by ZeroHedge reviews a Philadelphia Fed report stating that job growth has been overstated. Is Powell trying to tip the market off that the BLS may revise lower job growth? Or might the headline jobs data start catching down to other sources, indicating weak job growth? It could be, but the important takeaway, in our view, is that Powell indicates that employment is now on par with inflation as a good signal for when the Fed may cut rates.

fed funds and pce powell fed

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Yesterday was a good “April Fools” joke by the market. In early morning trade, futures suggested a fairly strong open, pointing to new all-time highs for the index. However, that failed to materialize, and the market sold off with small and mid-caps leading the way. Notably, on Friday, we discussed the rotation trade and that other markets were finally showing some relative strength to play “catch up” to the S&P 500. Much of that “catch-up” trade was likely end-of-quarter rebalancing by managers as yesterday’s biggest laggards were the recent winners.

One day in the new quarter does not mean much, but it remains ripe for further corrective action with the market extended and well deviated above long-term means. Also, with the market putting in a double-top, a violation of the 20-DMA will confirm a large correction is in process. There is no reason to be overly concerned with one day’s action, but we watch closely for evidence of a turn. It is worth remembering that the last time we had such a long stretch of overbought condition was in 2017. We then had two sizable corrections in 2018.

Market Trading Update

The 50% Problem Driving The Wealth Gap

Our latest article, Wealth Gap and the Road to Serfdom, reviews the vast difference in wealth between the rich and poor. While there are many reasons for the gap, a good portion of it is due to the populace’s inability to invest. As the article notes,

The advice to build wealth is quite simplistic. Investment money into the financial market consistently over long periods. That’s it.

Again, considering that most Americans alive today participated in either one or both of the most significant secular bull markets in history, the lack of wealth is quite appalling. If individuals had invested $1000 in 1980 into the S&P 500 index and added just $100 per month, they would have roughly $1.4 million in retirement savings today.

The advice to invest is simple, but most Americans do not have the means to invest. Per the article:

The cost of raising a family of four continues to increase with inflation, so the bottom 80% are forced to live paycheck-to-paycheck, primarily leaving no money for retirement savings.

Therefore, while the stock market surges to all-time highs, the wealth gap leaves increasing numbers of Americans behind. For the average American, it isn’t a choice of not wanting to participate; they simply can’t.

stock ownership by wealth brackets

The Equal Weighted S&P Shows Promise

Our SimpleVisor proprietary Relative and Absolute analysis of sectors aggregates 13 technical studies to assess which sectors are over or underperforming versus each other and against the broader S&P 500. The graphics provide a sneak peek of the updated SimpleVisor website. We hope to roll out the new version this month.

The new layout plots the relative and absolute scores side by side. The first graphic is sorted from most overbought to most oversold. Energy, financials, industrials, and materials are the most overbought sectors. After having been the best-performing sector for the better part of the last six months, technology is now the most oversold on a relative and absolute basis. Communications, another market leader over the previous six months, including META and GOOG, are at fair value on a relative basis but still decently overbought (+.51) on an absolute basis.

The second graph points to a similar rotation when assessing stock factors. For instance, the laggards of late 2023 and early 2024 are now the most overbought stocks versus the S&P 500. Some of these include mid-and small-cap stocks along with the equal-weighted S&P 500.

With this analysis, we are left to consider whether the reign of the mega-cap and Magnificent Seven is ending or just taking a pause. The third SimpleVisor analysis below provides some context. The price ratio of the equal-weighted S&P 500 (RSP) versus mega-cap stocks (MGK) has been flatlining recently after declining for over a year. Further, indicating that the equal-weighted index may be starting to outperform, the three technical studies below the graph are trending upward. As long as these indicators continue trending higher and the price ratio does not break below the prior lows, RSP may likely outperform the broader S&P 500 and mega-cap stocks over the coming month or two.

simplevisor relative analysis by sectors
simplevisor relative analysis factors
relative analysis rsp vs mgk

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Market Corrections Matter More Than You Think

During running bull markets, much commentary is written on why this time is different and why investors should not worry about market corrections. One such piece was written recently by Fisher Investments. To wit:

“After the S&P 500’s 26% return last year and this year’s strong start, many investors are worried – understandably – that this bull run is getting ahead of itself. 

They shouldn’t. The strange-but-true fact is that, statistically speaking, average returns — which have amounted to about 10% a year over nearly a century of trading — aren’t normal in the stock market for any given year. A second, surprisingly pleasant fact is that so-called “extreme” returns are far closer to what we’d call normal — and they’re mostly on the positive side.”

There are a lot of problems with that statement, which we will get into. However, there are some essential facts about markets that should be understood. First, indeed, stocks rise more often than they fall. Historically speaking, the stock market increases about 73% of the time. The other 27% of the time, market corrections are reversing the excesses of the previous advance. The table below shows the dispersion of returns over time.

Average Returns Annual

However, fairly substantial corrections have not been uncommon in those positive return years. As shown in the table below, intra-year corrections, which average roughly 10%, are common.

There is little to be concerned about as 38% of the time, the market is cranking out greater than 20% returns versus just 6% of 20% or more market corrections. As Mr. Fisher notes:

“The upshot? Big returns simply aren’t the rarity that “too far, too fast” bears claim. In bull markets, they are more normal than not. Why? The roughly 10% long-term annual average includes bear markets. Strip out the bears and you’ll find that during the 14 S&P 500 bull markets before this one, stocks annualized 23%.

The problem with Mr. Fisher’s statement is that he doesn’t understand the math behind market corrections. As we will explain, a significant difference exists between a 20% advance and a 20% market correction. Such is particularly the case if you are in or approaching retirement.

Market Corrections And The Function Of Math

Notice that the table above uses percentage returns. As noted, that is a deceptive take if you don’t examine the issue beyond a cursory glance.

For example, assume an arbitrary stock market index that trades at 1000 points. Over the next 12 months, the index will increase by 20%. The index value is now 1200 points.

During the next 12 months, the index declines by one of those rare outliers of 20%. The index doesn’t just give up its gain of 200 points.

  • 1200 x (-20%) = 240 points = 960 points

The investor now has an unrealized capital loss.

Let’s take this example further and assume the index goes from 1000 to 8000.

  • 1000 to 2000 = 100% return
  • From 1000 to 3000 = 200% return
  • The next 1000 to 4000 = 300% return
  • The final 1000 to 8000 = 700% return

No one would argue that a 700% return on their money wasn’t fantastic. However, let’s do some math:

  • 10% loss equals an 800-point decline, nearly wiping out the last 1000-point advance.
  • 20% market correction is 1600 points
  • 30% decline erases 2400 points.
  • 40% loss equals 3200 points or nearly 50% of all the gains.
  • 50% decline is 4000 points.

The problem with using percentages to measure an advance is that there is an unlimited upside. However, you can only lose 100%. 

A Graphic Example

That is the problem of percentages. We can also show this graphically.

One of the charts often used by the “perma bulls” like Ken Fisher to coax individuals into not worrying about portfolio risk is measuring the cumulative advances and declines of the market in percentages. When presented this way, the bear market corrections are hardly noticeable. This chart is often used to convince individuals that bear markets don’t matter much over the long term.

Cumulative Percentage Returns

However, as noted above, this presentation is very deceptive due to how math works. If we change from percentages to actual point changes, the devastation of market corrections becomes more evident. Historically, the subsequent declines wiped out huge chunks of the previous advances. Of course, at the bottom of these market corrections, investors generally sell due to the mounting losses’ psychological pressures.

Cumulative Point Returns

This is why, after two of the most significant bull markets in history, most individuals have very little money invested in the financial markets.

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Average And Actual Returns Are Not The Same

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. Thus, in any given year, the impact of losses destroys the annualized “compounding” effect of money.

The chart below shows the difference between “actual” investment returns and “average” returns over time. See the problem? The purple-shaded area and the market price graph show “average” returns of 7% annually. However, the return gap in “actual returns,” due to periods of capital destruction, is quite significant.

Average versus actual retunrs

In the chart box below, I have taken a $1000 investment for each period and assumed the total return holding period until death. There are no withdrawals made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)

The orange sloping line is the “promise” of 6% annualized compound returns. The black line represents what happened with invested capital from 35 years of age until death. At the bottom of each holding period, the bar chart shows the surplus, or shortfall, of the 6% annualized return goal.

Real Total Return vs Life Span

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

Three Key Considerations

Over the next few months, the markets can extend the current deviations from the long-term mean even further. But that is the nature of every bull market peak and bubble throughout history as the seeming impervious advance lures the last stock market “holdouts” back into the markets.

As such, three key considerations exist for individuals currently invested in the stock market.

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

Suppose valuations are high at the beginning of the investment journey. In that case, if the time horizon is too short or the required rate of return is too high, the outcome of a “buy and hold” strategy will most likely disappoint expectations.

Mean reverting events expose the fallacies of “buy-and-hold” investment strategies. The “stock market” is NOT the same as a “high yield savings account,” and losses devastate retirement plans. (Ask any “boomer” who went through the dot.com crash or the financial crisis.”)

Therefore, during excessively high valuations, investors should consider opting for more “active” strategies with a goal of capital preservation.

As Vitaliy Katsenelson once wrote:

Our goal is to win a war, and to do that we may need to lose a few battles in the interim. Yes, we want to make money, but it is even more important not to lose it.”

I agree with that statement, so we remain invested but hedged within our portfolios.

Unfortunately, most investors do not understand market dynamics and how prices are “ultimately bound by the laws of physics.” While prices can certainly seem to defy the law of gravity in the short term, the subsequent reversion from extremes has repeatedly led to catastrophic losses for investors who disregard the risk.

Just remember, in the market, there is no such thing as “bulls” or “bears.” 

There are only those who “succeed” in reaching their investing goals and those who “fail.” 

Christopher Waller The Fed’s Biggest Hawk Is Turning Dovish

In a speech last Thursday, Fed Governor Christopher Waller showed how even the most hawkish Fed members are turning dovish. The transformation from a hawkish to a dovish Fed began last October. In late summer and early fall of 2023, the Fed talked about rate increases and was steadfast about beating inflation. At the November and December meetings, the “hawkish” Fed backed off of further rate increases. More importantly, their December policy projections forecasted their rate cuts. This has occurred despite signs inflation is not falling as it was, and the economy continues to fire on all cylinders. To appreciate the Fed’s change in stance, let’s consider the dovish comments from the Fed’s most hawkish member, Christopher Waller.

In a speech at the Economic Club of New York, Christopher Waller acknowledges inflation is too high. To wit, “various inflation measures have continued to come in hot.” Yet, instead of taking a hawkish tone, he is just delaying the timing of rate cuts. He states: “I continue to believe that further progress will make it appropriate for the FOMC to begin reducing the target range for the federal funds rate this year.” As comments from Christopher Waller and other Fed members show, the Fed is worried about something. Otherwise, rate increases would be in their discussions. Might they foresee the lag effect of prior rate hikes catching up with the economy or a liquidity problem this summer or fall? Time will tell, but Waller and his colleagues’ shift toward a dovish tone is surprising, given robust economic growth and sticky inflation data alongside very easy financial conditions.

fed meeting probabilities

What To Watch Today

Earnings

  • No notable earnings releases

Economy

Economic Calendar

Market Trading Update

The market is closed today for the Easter holiday. However, that spate of economic reports will be looked at closely by the markets for signs of stronger inflation that may curtail the Fed from cutting rates in June. With the market finishing March in the green, the S&P 500 index is now up 5-straight months in a row, a decently long stretch of uninterrupted gains. As shown below, the S&P 500 and the Nasdaq are the clear winners over other major markets year-to-date. Notable, Midcaps have performed better as of late, with Small Caps, Russell 2000, and Emerging Markets trailing furthest behind.

Market Comparison Update

The extension of the S&P 500 index above its respective 200-DMA remains a significant risk to a short-term correction. As we have noted previously, between the very compressed volatility index, very bullish sentiment, and long-positioning by investors, only a catalyst is needed to spark a reversal. Currently, 4990 remains first support, but 4650 is a very likely probability at some point. While such would provide a much better entry point to add exposure, such a decline will “feel” much worse than it actually is.

Market Trading Update

However, such was also the case last summer.

The Week Ahead

A new cycle of economic data kicks off this week with an update on the employment situation. The BLS jobs report is expected to show that the economy gained 200k jobs and that the unemployment rate remained steady at 3.9%. JOLTs on Tuesday and ADP on Wednesday will also tell us more about the labor markets. The ISM manufacturing and services index reports come out on Monday and Wednesday, respectively. The labor and price components of these indices will be closely watched.

Earnings season kicks off this week, but the larger, more followed companies will not report until the end of next week, when many banks and airlines will report their earnings.

Is Another Round Of QE Closer Than We Think?

In our article, QE By A Different Name Is Still QE, we discussed how large deficits and significant amounts of outstanding force the Fed to help the Treasury’s funding pressures. Specifically, the article discusses a rumor about how the Fed might meet this task. To wit:

Rumor has it that the regulators could eliminate leverage requirements for the GSIBs. Doing so would infinitely expand their capacity to own Treasury securities.

Once banks have the ability to buy unlimited amounts of Treasury securities, the Fed must resurrect some version of the BTFP program to help the banks fund the purchases. While we haven’t heard anything about the BTFP or some other method to fund the banks, the calls for unlimited leverage are growing. The International Swaps and Derivatives Association has asked banking regulators to exempt banks from holding capital against Treasury holdings. Keep in mind this is not unprecedented. From April 2020 to March 2021, U.S. Treasury securities were exempted from banks supplementary leverage ratio (SLR). This time, the move could become permanent and the first step to what may amount to unlimited Treasury funding ultimately sponsored by the Fed. Or as we call it, version 2.0 of QE.

If the trend in the graph below of federal debt to GDP continues, the Fed and banks must find a new way to accommodate the extra debt. Version 2.0 is a good answer.

federal debt to gdp qe fed

A Tribute To Daniel Kahneman, The Master Of Behavioral Economics

Daniel Kahneman, a Nobel Prize winner for his work in behavioral economics, passed away last week. He devoted significant time and effort toward studying human judgment and decision-making. His work helps us appreciate our biases and those of the market pundits, Fed officials, and corporate leaders we tend to rely upon.

Given his expertise, the importance of decision-making, and biases in our investment performance, we share a few of his quotes.

  • We’re blind to our blindness. We have very little idea of how little we know. We’re not designed to know how little we know.
  • If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea. It’s the worst possible thing you can do because people are so sensitive to short-term losses. If you count your money every day, you’ll be miserable.
  • We’re generally overconfident in our opinions and our impressions and judgments.
  • All of us would be better investors if we just made fewer decisions.
  • Economists think about what people ought to do. Psychologists watch what they actually do.
  • Frequent repetition is a reliable way of making people believe in falsehoods because familiarity is not easily distinguished from truth.
daniel kahneman

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Wealth Gap And The Road To Serfdom

One of the most interesting conundrums is the surging wealth gap in America. Despite two of the largest bull markets in history since 1980, most Americans struggle with making ends meet and are unprepared for retirement. Such a reality starkly differs from the belief that rising asset prices benefit the masses.

For example, in a recent St. Louis Federal Reserve Bank analysis, total household wealth was $139.1 trillion, covering 131 million families. Of that total wealth, 74% was owned by just 13.2 million families, or roughly 10% of the population.

Wealth Distribution

Notably, this measure of wealth includes the equity of the family’s home. While home equity is essential, it is not readily spendable without taking on debt to extract the value. Therefore, Americans’ “liquid wealth” is far more unequally distributed. However, such is hard to fathom given the endless parade of media and social media influencers extolling the virtues of “building wealth through investing.”

Interestingly, that survey came after the Government injected nearly $5 trillion into the economy, a massive surge in deficit spending, and the Fed’s $120 billion monthly injections doubled asset prices from the March 2020 lows. Unsurprisingly, in February, Fidelity published its latest analysis showing the number of retirement accounts with balances of more than $1 million surged toward a record. To wit:

The number of seven-figure 401(k) accounts at Fidelity Investments jumped 20% in 2023’s final quarter to 422,000, marking a sharp recovery from the previous quarter’s 7.7% drop.

Gains in the stock market helped swell retirement balances last year as the S&P 500 advanced 24% following 2022’s 19% decline. The impressive run was powered in large part by the so-called “Magnificent 7” stocks that now make up roughly 30% of the market-cap weighted S&P 500 Index. The only time when the ranks of 401(k) millionaires at Fidelity was higher was in 2021’s fourth quarter, when there were 442,000 such accounts. Elsewhere, the number of seven-figure IRAs is at a record 391,600 accounts.” – Bloomberg

Fidelity 401k retirement plans

However, that data obfuscates the stark wealth gap below the surface. While the “number of retirement millionaires” made headlines, an essential piece of the analysis was overlooked. Those 422,000 accounts comprised only a tiny fraction of Fidelity’s 27.2 million retirement accounts. How small of a fraction? About 1.6%. That number aligns with America’s Top 1% of equity ownership.

Breakdown of current equity ownership

But indeed, after two booming bull markets since 1980, most Americans would be well saved for retirement. Unfortunately, that is not the case.

Average retirement savings

So, what went wrong?

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The 50% Problem

The advice to build wealth is quite simplistic. Investment money into the financial market consistently over long periods. That’s it.

Again, considering that most Americans alive today participated in either one or both of the most significant secular bull markets in history, the lack of wealth is quite appalling. If individuals had invested $1000 in 1980 into the S&P 500 index and added just $100 per month, they would have roughly $1.4 million in retirement savings today.

Dollar cost average into S&P 500 market

However, if it is so simple, why do most Americans have little or no savings?

“One in 4 Americans have no retirement savings and those who are saving aren’t saving enough. Those that are [saving], on average, what they have saved will afford them like $1,000 a month of actual cash while they’re in retirement.”Price-Waterhouse Retirement In America.

The report found that the median retirement account balance for 55-to-64-year-olds is $120,000. Dividing over 15 years would generate a modest monthly distribution of less than $1,000. The bigger problem is the large percentage of individuals with no retirement savings.

Chart showing "Percent of Americans With No Retirement Savings."

There are two primary reasons individuals do not save and invest for retirement. While psychological reasons account for 50% of the problem, such as buying high and selling low, the other 50% comes down to a lack of capital to invest.

3 reasons for not investing

We have previously written about the various psychological pitfalls investors make in destroying their investment capital. However, for many, it is a problem of being unable or unwilling to save money.

  1. Lack of knowledge about budgeting and saving. (15%)
  2. The cost of living exceeds income. (70%)
  3. Bad previous investing experience (bear market). (15%)

If you ask anyone who doesn’t save money, you will likely get one of those three answers. It is hard to “save and invest” when there simply isn’t enough income.

However, this is where the disconnect between the economic data and the “average American” is exposed.

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Not Enough Income

Most mainstream analysis utilizes “averages” to discuss the economy’s health. For example, disposable incomes (DPI), personal savings rates, and debt-to-income ratios suggest that the average American family is flush with cash with little debt. However, most of these calculations, like DPI (income minus taxes), are generalizations due to the variability of household income and individual tax rates.

More importantly, the measure becomes skewed by the top 20% of income earners, notably the top 5%. The chart below shows those in the top 20% saw substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.). The cost of raising a family of four continues to increase with inflation, so the bottom 80% are forced to live paycheck-to-paycheck, primarily leaving no money for retirement savings.

Reasons why Americans can't save money

Furthermore, disposable and discretionary incomes are two very different animals.

Discretionary income is the remainder of disposable income after paying for all mandatory spending like rent, food, utilities, health care premiums, insurance, etc. For the bottom 80% of income earners, the cost of living outstrips most of those individuals’ incomes. Debt must make up the difference.

DPI of bottom 80% vs debt

In other words, given the bulk of the wage gains are in the upper 20%, any data that reports an “average” of the information skews the results higher. This is why there is a vast difference between the debt service levels (per household) between the bottom 80% and the top 20%.

Debt service ratio bottom 80%

Yes, saving money and investing it into the financial markets is tough when you must go further into debt every month to make ends meet.

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The Wealth Gap And The Road To Serfdom

The rise and fall of stock prices has little to do with the average American’s participation in the domestic economy. Interest rates and inflation are entirely different matters. Since interest rates affect “payments,” and inflation increases the “costs of living,” changes negatively impact consumption, housing, and investment.

Therefore, while the stock market surges to all-time highs, the wealth gap leaves increasing numbers of Americans behind. For the average American, it isn’t a choice of not wanting to participate; they simply can’t.

Inflation adjusted household equity ownership

The reality is that middle-class America continues to shrink as the wealth gap increases. The rich can invest, save, and use little debt to sustain living standards. People experiencing poverty rely on debt, making long-term prosperity an impossible goal.

Furthermore, as the peasants demand “more free stuff” from the Government, such requires more debt and higher taxes. Those demands divert more capital away from productive investment, leading to slower economic growth. As growth slows, businesses shift to the lowest labor costs, or automation, to lower income growth for domestic workers. Such leads to more demands from “free stuff” from the Government, and the cycle intensifies, pushing more of the middle class downward.

The share of annual incomes between the bottom 80% and the top 5% is evidence of that wealth transfer from the middle class.

Share on income by bracket

The “road to serfdom” is paved with good intentions. After decades of piling on increasing debt levels to generate economic growth, the damage to economic growth is becoming more visible. Economic growth trends are already falling short of previous long-term growth trends.

GDP new New normal

Of course, this analysis also underscores why bitter economic sentiment persists even as the bull market registers all-time highs. It is hard to be excited about a booming stock market when you don’t participate much, if at all.

For 80% of Americans, the end game of too much debt, an aging demographic, and the push for “socialistic policies” is the continued extraction of wealth from the “middle class” to the “rich.”

Of course, we don’t have to look much further than Japan to see how this eventually works out. They don’t have a middle class, either.

Small Cap Returns Point To Interest Rate Worries

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

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

correlation of small cap stocks to yields rates

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

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

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

Market Trading Update

A Relative Opportunity In Apple

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

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

If The Fed Is Done Hiking Bonds Look Tempting

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

bond returns if fed is done hiking

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Financial Conditions Butt Heads With Borrowing Conditions

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

His comments seem sensible, given the following:

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

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

chicago fed financial conditions

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

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What Are Financial Conditions?

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

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

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

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

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

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

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

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

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

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

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

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

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

simplevisor sentiment gauge
cnn fear and greed sentiment guide

What Are Borrowing Conditions?

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

consumer loan interest rates

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

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

commercial paper and BBB rated interest rates

What Can And Can’t The Fed Manage?

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

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

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

fed qe vs s&P 500

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

Powell’s Predicament

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

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

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

fed real monetary policy graph
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Another Fed Predicament Coming Soon

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

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

Summary

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

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

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Tesla And EVs Fall Out Of Favor

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

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

ev share of all auto sales

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable economic releases

Market Trading Update

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

Market Trading Update

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

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

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

It is how markets work.

Apartment Loss-to-Lease Ratio Signals Lower Rent Inflation

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

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

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

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

apartment loss to lease ratio rents

Baltimore Harbor Shuts Down

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

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

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

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

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

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

port of baltimore harbor

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Apartment Supply Will Surge This Year

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

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

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

new apartment supply

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

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

Oil prices update

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

BOnd chart

FedEx Revenue Decline As Does Hiring In The Transportation Sector

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

all employmees transportation fedex

Fisker Shares Point To Bankruptcy

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

fisker fsr share price

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Technical Measures And Valuations. Does Any Of It Matter?

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

Risk Appetite Index

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

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

Consumer confidence vs valuations

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

Valuation Model

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

Technical Measures Are Getting Extreme

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

Household equity ownership vs SP500

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

Technical Model

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

Quarterly risk based market model

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

Fundamental and Technical Model
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The Ingredients Are Missing A Catalyst

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

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

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

Holding periods for investors

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

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

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

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

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

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

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

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

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

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

CRE Pain is Just Getting Started

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

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

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

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

CRE Pain is Still Subdued

What To Watch Today

Earnings

  • No notable earnings releases

Economy

Economic Calendar

Market Trading Update

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

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

Fed Dot Plot

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

Financial Conditions

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

Market Trading Update

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

Market Trading Update 2

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

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

The Week Ahead

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

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

Market Forces Contribute to State Migration Losing Sparkle

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

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

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

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

State Migration is Losing Sparkle

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Retirement Crisis Faces Government And Corporate Pensions

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

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

Note the last sentence.

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

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

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

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

Ratio of workers to SSI Beneficiaries

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

A Massive Shortfall

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

Four layers of massive debt and liabilities

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

However, therein lies the actuarial problem.

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

Difference between compound and actual returns

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

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

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

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

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

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A Retirement Crisis In The Making

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

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

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

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

Fertility rate of women

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

Working age vs Elderly Population

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

Sharp uptick in retirements

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

This employment problem is critical.

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

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

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

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

QE Light May Allow the Fed to Help the Treasury

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

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

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

Federal Budget Situation and Debt

What To Watch Today

Earnings

  • No notable earnings releases

Economy

Economic Calendar

Market Trading Update

The most perfect trading trend continues uninterrupted.

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

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

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

Market Trading Update

Flash PMIs Signal We’re in Good Shape

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

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

Flash PMI Prices Index

Swiss National Bank Surprises with a Rate Cut

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

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

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

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Fed Dot Plot Projections Point To Stronger Growth And Rate Cuts

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

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

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


What To Watch Today

Earnings

Economy

Market Trading Update

Might The BOJ Rate Hike Signal A US Recession?

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

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

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

boj japan monetary policy and recessions

The Lag Effect Of Higher Interest Rates Is Hitting Households

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

household higher interest rates lag effect

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The BOJ Ends Historic Run Of Negative Rates

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

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

boj policy rate

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

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

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

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

Market Trading Update

MicroStrategy Insiders Are Selling

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

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

microstrategy insider sell mstr
microstrategy mstr graph

Warren And Sanders Warn The Fed

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

real monetary policy is tight fed

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QE By A Different Name Is Still QE

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

history of QE

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

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

The Sad Fiscal Situation

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

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

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

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Borrowing For Deficits

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

treasury deficits expenditures and tax revenues debts

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

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

treasury debt

Fiscal Dominance

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

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

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

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2019 Revisited

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

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

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

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

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

The Fed Is In Handcuffs

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

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

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

Spreading Rumors

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

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

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

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

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BTFP To The Rescue Again

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

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

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

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

Summary

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

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

Quartz The Underappreciated Economic Lynchpin

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

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

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

quartz

What To Watch Today

Earnings

  • No notable earnings releases.

Economy

Economic Calendar

Market Trading Update

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

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

Market Trading Update

Equity Allocations Are At Cautionary Levels

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

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

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

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

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

average investor allocation vs ten year returns

Got Energy?

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

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

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Blackout Of Buybacks Threatens Bullish Run

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

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

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

Yes, buybacks are that important.

As John Authers pointed out:

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

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

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

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

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

Share buybacks vs SP500

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

A High Correlation

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

Share buybacks vs earnings

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

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

Share buybacks 4-week percent change versus the market.

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

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

Investors Are Really Bullish

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

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

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

Sentiment vs the market.

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

Professional managers buy tops.

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

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

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The Fed Will Support Buybacks

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

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

m2 and the deficit as a percentage of the economy.

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

Buybacks vs the Fed funds rate

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

Goldman Sachs estimates of share repurchases.

Conclusion

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

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

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

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

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

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

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

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

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