Monthly Archives: October 2023

Nvidia By The Numbers

With the stock price of Nvidia (NVDA) now trading at over $1,000 per share, Nvidia stock has been up 270,000% since it went public. If you bought 1000 shares of Nvidia at its IPO in 1999 for a mere $376 and held them until today, congratulations—you are now a millionaire. We present a few numbers to help you better appreciate Nvidia’s meteoric rise.

  • Nvidia is now larger than the entire German stock market and five times the size of companies like Walmart, Exxon, and Visa.
  • Nvidia posted quarterly revenue of $26 billion, up 18% from last quarter and a whopping 262% from a year ago. Its data center revenue is up 427% from a year ago.
  • The aggregate market cap of the 174 smallest S&P 500 stocks is equal to that of Nvidia.
  • Its market cap is greater than the GDP of every state except California and Texas.

To accommodate AI, we need AI data centers. These require specific chips, of which Nvidia is the leading producer. Given its dominant position and surge in data center construction, Nvidia’s stock is today’s poster child for AI. However, other less-followed industries will also greatly benefit from data center growth. On Wednesday, we published Part One of AI Data Centers and EVs Create Incredible Opportunities, describing the enormity of building out the power grid to accommodate AI and EVs. We will follow up with discussions of stocks and industries that will likely benefit. While we can’t expect 270,000% gains like NVDA, many stocks involved in the power grid buildout and modernization will see substantial growth.

As hockey great Wayne Gretzky once said: “Go to where the puck is going to be, not where it has been.

nividia nvda

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, the market was posting all-time highs ahead of the release of the FOMC minutes and Nvidia’s earnings report. However, as we have noted over the last several trading days, the market was overbought and deviated from its 20- and 50-DMA, which would likely limit upside in the near term. Even with blowout numbers from Nvidia, the market struggled yesterday as it continued consolidating recent gains over the last week. There is currently a 2% decline for a retest of support at the 20-DMA. With the market overbought and the MACD signal starting to close in on a short-term sell signal, a pullback and retest of that support seems highly probable.

Continue to manage risk accordingly. There is nothing currently “wrong” with the market that would suggest a deeper decline in the coming month or so. However, it is always a good practice to manage risk along the way.

Market trading update

PMI Surveys Scares Bond Investors

The Flash PMI manufacturing and services surveys were both better than expected. Manufacturing continues improving and has been in expansionary territory for two months. Services, which were trending lower, jumped from 51.3 to 54.8 and are now at their highest level in a year.

Bond yields rose on the news as PMI suggests the Fed will not hike rates this year. Bond investors are concerned that prices will remain at current levels, especially if the service sector remains strong. To their point, input and output prices rose, although manufacturing, not services, prices account for most of the price growth. Interestingly, companies are having trouble passing on higher prices to their consumers. Per the report:

However, the overall rate of selling price inflation remained below the average seen over the past year.

Of concern in the reports is employment. Despite what appears to be an optimistic outlook by business managers, the report notes the following:

Employment fell for a second successive month in May, contrasting with the continual hiring trend seen over the prior 45 months.

We caution that the Flash PMI is based on mid-month data and sometimes diverges from the monthly ISM report. We will wait for the next round of ISM and the regional Fed survey to confirm whether the Flash PMI survey is representative of economic activity.

flash pmi

Credit Losses Bring Back Memories of 2008

According to Bloomberg, investors in a AAA-rated CMBS tranche experienced their first loss since 2008. The graphic below, courtesy of Deutsche Bank and Bloomberg, shows that the 1740 Broadway CMBS security has wiped out holders of all classes except the highest-rated AAA tranche, which will receive 74 cents on the dollar.

CMBS, or commercial mortgage-backed securities, hold loans on one or more properties. Often, they are structured such that the loans cash flows are prioritized to classes based on risk. For instance, the AAA holders of 1740 Broadway were supposed to be paid first, then AA, and so on down the line. In this case, the loan holders went bankrupt, and based on the data in the graphic, the sale of the property, 1740 Broadway, was only worth a third of the original loan amount.

We suspect that, given that some commercial office real estate is selling for small fractions of its original worth, this won’t be the last CMBS-AAA loss we hear of.

aaa cmbs losses

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The Risk Of Recession Isn’t Zero

As we discussed recently, Wall Street economists increasingly believe the risk of recession has fallen sharply. To wit:

Economists don’t think the economy will get even close to a recession. In January, they, on average, forecast sub-1% growth in each of the first three quarters of this year. Now, they expect growth to bottom out this year at an inflation-adjusted 1.4% in the third quarter.” – WSJ

Of course, this outlook seems contradictory to numerous indicators with a long history of preceding recessionary onsets, such as yield curve inversions. As shown, we currently have the longest, consistent period in history where the yield spread between the 10-year Treasury bond and the 3-month Treasury bill is inverted. Yet, no recession has manifested itself this time.

Another historically reliable recession indicator is the 6-month rate of change of the Leading Economic Index. As with yield curve inversion, the current depth and duration of the LEI’s negative readings have always coincided with a recession. But again, the U.S. has avoided such an outcome.

Of course, the Federal Reserve’s tightening of monetary policy through one of its more aggressive rate-hiking campaigns also failed to push the economy into a recession.

Given that the economy has continued to defy recession expectations, it is understandable that economists have “given up” anticipating one.

But is the risk of recession gone?

The Risk Of Recession Isn’t Zero

There is a very funny meme circulating on social media. Yes, cute, cuddly animals seem safe, but “the risk of them murdering you is low but never zero.”

Such seems like an apropos meme, given that the economy’s recession risk may be low currently, but it isn’t zero.

As discussed previously, one of the primary reasons why the economy has defied the recessionary drag from higher borrowing costs has been the ample supply of fiscal support through previously passed spending bills such as the Inflation Reduction Act and the CHIPs Act. When combined with stimulus checks, tax credits, and moratoriums on various debt payments like rent and student loans, the amount of monetary support for consumption supported economic growth as the Federal Reserve tightened monetary policy.

What is crucial to understand is that the surge in monetary support acted as an “adrenaline” boost to the economy. Yes, many economic data series suggest the risk of recession is elevated. However, the surge of monetary injections sent the economy into overdrive, as evidenced by economic growth in 2021.

The crucial point to understand, and what eludes most economists, is that the economy slows as that “adrenaline” boost fades. Had the economy been growing at 5% nominal, as in 2019, the decline from the post-pandemic peak would already register a recession. However, given that nominal growth neared 18%, it will take much longer than normal for growth to revert below zero. To show this, we looked at the number of quarters between peak economic activity and the entrance into a recession. Using that historical analysis, we can estimate the reversion of economic growth into a recession could take roughly 22 quarters. Such would time the next recession in late 2025 to mid-2026.

Many things could certainly happen to lengthen or shorten that estimated time frame. However, the importance is that a reversal of growth from elevated economic growth rates can take much longer than normal. Another similar period was the 25 quarters of slowing economic growth before the 1991 recession.

For investors, while consensus estimates of economists put the risk of recession very low, it is not zero.

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Economic Data To Watch

Given the long lag between recessionary indicators and economic recession, it is unsurprising economists gave up anticipating a recession. However, while the recession has not happened yet, it does not mean that it still can’t. We should pay special attention to data historically correlated to economic growth.

For example, real retail sales have weakened materially since the peak of economic activity in 2021. As shown, retail sales make up roughly 40% of Personal Consumption Expenditures (PCE). Therefore, it is unsurprising that retail sales precede PCE changes. The importance of that lead is that PCE comprises nearly 70% of the GDP calculation. Therefore, as consumer demand slows, the economy slows, and inflation falls. Real retail sales are now negative as consumers run out of excess savings, likely slowing economic growth further in the quarters ahead.

Of course, without employment, it is hard to increase economic consumption further. Notably, while we count part-time employment, those jobs do not provide the wages and benefits of full-time employment to support a family. Unsurprisingly, a key leading indicator to every previous recession has been a reversal of full-time employment.

While it is certainly possible that the economy could avoid a recession given additional monetary or fiscal support, government and business investment comprise a much smaller contribution to GDP than consumer spending. As noted in “Bad News Is Good News,” with consumers strangled between declining wage growth and higher living costs, the ability to fuel the difference with debt is becoming increasingly challenging.

“The consequence of that lack of income growth is that they are the first to run into the limits of taking on additional debt.”

Pay attention to the economic data in the future. While it may take much longer than many expect, we suspect the risk of recession is likely greater than zero.

Targets Sales Woes Are The Norm In The Retail Sector

One repeated theme in the current round of earnings is that personal consumption is slowing down. Last month, McDonald’s, Starbucks, and many other retail-oriented stocks fell on weak sales. This week, we are reminded again via poor sales from Target, Lowes, and Macy’s. All three reported a decline in sales compared to last year. Target’s sales beat estimates slightly, while its earnings per share fell short. While that may not seem too bad, expectations for Target’s sales were meager. Target, which opened down 8% on Wednesday, had the following to say:

Higher interest rates, economic uncertainty, high credit-card balances and other factors have [consumers] concerned, and consumer confidence took a meaningful dip in April.

To put a broader context into the declining retail sales growth in companies like Target, Walmart, and, in general, the “cheaper” retail sectors, we compile revenue growth data for a number of similar companies and compare them to prior earnings and in the aggregate. The graph on the left shows that only two companies, Walmart and Dollar Tree, have increased sales growth compared to the 2021-2022. Walmart is the only one showing higher sales growth today versus the three years before the pandemic. The second graph weights the annual sales growth for the ten companies. As we share, the aggregate weighted sales growth has reached its lowest since 2017.

retail sales growth is slowing target walmart amazon costco

What To Watch Today

Earnings

Economy

Market Trading Update

In yesterday’s commentary, we discussed how the release of the FOMC minutes could well impact the market. Such happened as the market sold off after its release as the minutes reiterated much of the commentary from recent Fed speakers that rate hikes are likely on hold near term. While there is always some dissension among Fed members, there were a couple of quotes that spooked the market.

Various participants mentioned a willingness to tighten policy further should risks to inflation materialize in a way that such an action became appropriate.

Although monetary policy was seen as restrictive, many participants commented on their uncertainty about the degree of restrictiveness.

Participants suggested that the disinflation process would likely take longer than previously thought.

While these points were just discussions during the meeting, the Federal Reserve unifies around the decisions it makes with Chairman Powell leading the way. From all of the recent speeches from Fed members as of late, they remain clear that rate cuts will likely begin at the September meeting with the reduction of the Fed balance sheet beginning in June.

Nonetheless, with the markets overbought and well deviated from longer-term means and sentiment becoming exceedingly bullish, the market was ripe for a pullback. The 20-DMA, which has now crossed above the 50-DMA, will return as key support for the market advance, as we saw at the beginning of this year. A pullback to support should be expected; all that is needed is a short-term catalyst. Use pullbacks to add exposure as needed.

Sahm And Kantro Models Call For A Recession

The Sahm and Kantro recession indicators are closely related but process the data differently. Both rely on the unemployment rate and its current status versus prior readings. Unemployment tends to be very cyclical. It is either rising, and the economy is in or near a recession, or it is falling and the economy is growing. Neither model has missed a recession since 1953 nor given a false positive since 1970.

Given the recent uptick in unemployment, the Kantro model signals a recession, and the Sahm model is very close. The model rules and a graph showing prior data are below. In the graph, the black vertical denotes the recession signal.

sahm and kantro recession signals
sahm and kantro recession signals

Bitcoin Mining Consumes Enormous Amounts Of Electricity

Bitcoin’s halving in April means it will now take twice as much computing power to mine one bitcoin as it did prior to the halving. To put perspective on the amount of electricity that bitcoin miners use, we share some excerpts from a recent report by Paul Hoffman at Best Brokers.

Currently there are 450 Bitcoins mined daily and this costs the mining facilities a whopping 384,481,670 kWh of electrical power. This comes at 140,336 GWh yearly and is more than the annual electricity consumption of most countries, save for the 26 most power-consuming ones.

When this power expenditure was resulting in 340.82 BTC mined up until 20 April 2024 before the halving, it was still economically feasible to mine Bitcoin in the U.S. by using grid power entirely. This is no longer the case and the fact the U.S. mining facilities are still operational points to the notion that they are relying mostly on their own renewable energy sources and/or have special deals with suppliers.

electricity consumption graphic

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Market Divergence Prompts An Important Question

Recently, we have had confusing divergences in the major stock market indexes,” starts a reader’s question. He goes on to ask why there are days like Monday when one index is down by a decent amount and another posts moderate gains. On Monday, for instance, the Dow Jones Industrial Average fell by 0.50%, The Nasdaq 100 rose by 0.70%, and the S&P 500 split the difference, being up slightly.

Appreciating the weighting and composition of market indexes when considering why such divergences occur is important. For example, Nvidia was up 2.50% yesterday. It has a 6.37% weight in the Nasdaq 100, a 5.10% weight in the S&P 500, and is not in the Dow. Here’s another: Goldman Sachs fell by 1% yesterday. It is the second largest holding of the Dow at 7.7%, but it only represents .34% of the S&P 500 and is not in the Nasdaq.

As the examples highlight, the stocks in the index matter, as do their weightings. The Dow is weighted by price and is composed of stocks from a wide swath of the economy. The S&P 500 represents the largest 500 stocks by market cap traded in the U.S. Unlike the Dow, the stocks are weighted by their market caps. The Nasdaq is also market cap-weighted and comprised of large-cap companies, many with a technology orientation that is determined by a committee. The graph below shows how weightings can vary significantly between indexes. Given these significant weighting and composition differences, it’s unsurprising that stark market divergences can occur when certain stocks and sectors are in favor, and others are out of favor.

weightings of the dow versus market cap

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we discussed the extended deviations in most major markets and sectors, particularly gold and gold miners. Of course, today is probably the season’s most anticipated earnings report, which Nvidia (NVDA) will announce after the bell. There is little guesswork at their earnings report will be a beat of estimates, however, it will be the forward guidance on GPU sales that makes or breaks the stock after hours. As we have seen this year, stocks that provide in-line or weaker guidance have been decently punished. Stocks that have provided optimistic guidance have been rewarded. We can lay out a basic risk/range analysis for NVDA post-earnings with that knowledge.

First, NVDA is already trading well into the top of its 52-week range. Estimates for the current quarter are $5.59/share for the current quarter and $5.95 for the next quarter on expectations of $24.645 billion in revenue. That part is set pretty high going into next year, with full-year revenue estimates at $144.427 billion. (This data chart is found in SimpleVisor)

The chart below uses a standard Fibonacci retracement sequence to estimate the potential gain and loss following the earnings announcement. This is just a guess, and reality could be anywhere along or outside the current spectrum, depending on the announcement. However, our best guess is that if the announcement exceeds expectations, we should probably expect a 10%ish gain, given that NVDA is already trading 2 standard deviations above its 50-DMA. A disappointment could lead to a decline to retest the April lows, which would border on 20%.

Nvidia earnings chart

Given a risk/reward ratio of 2:1, such is why we reduced our position in NVDA back to model weight yesterday. Once we are past earnings, we can decide the next entry point to add back to our holdings if warranted.

Skillman Grove Research Offers Caution

In their latest piece, Jim Colquitt provides readers with a needed perspective on where the market is and what may lie ahead. To wit;

All else being equal, this would suggest that you should skew towards being long the market. With that said, there are times when the most prudent thing to do is to take some risk off the table.

While a grind higher is certainly possible, in his opinion, he offers readers caution, particularly if a recession is in the near future. He notes that the market drawdowns of the last three recessions ranged from -35.4% to -57.7%. Equally importantly, returning to prior highs can take a lot of time. While 2020 was unique and only required half a year to recover its losses, the recessions of 2008 and 2001 took 5.5 and 7.3 years, respectively.  

Throwing additional caution to the wind, Jim brings up a concerning model. To wit:

The market may continue to move higher from here; however, leveraging the work I’ve done with my “Average Investors Allocation to Equities” model (read more here), I would suggest that extended bull market runs typically do not begin from this point in the economic cycle.

His graph below shows that forward returns tend to be low when investors have high equity allocations. Based on the graph, a negative return over the next ten years is a reasonable forecast. However, the graph doesn’t show how the returns of the next ten years will play out. Might the market continue higher for five years, fall significantly in year six and then grind higher? There are infinite iterations. The advice is to be aware of the current situation and be ready to protect yourself. However, understand that bull markets are hard to predict and can often run longer and higher than most investors expect.

investor allocation to equities jim colquitt

Underlying Inflation Pressures Are Easing

The graphic below from STCA and Bloomberg shows that the share of CPI categories with more than 3% inflation (yellow) is falling rapidly. At the same time, the share of components with negative inflation readings is increasing. While this is a good measure of the breadth of inflation, it does not account for weighting. As we have noted, shelter prices account for 40% of CPI. So, as shelter prices go, so goes CPI.

breadth of inflation

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AI Data Centers And EVs Create Incredible Opportunities

Some winners from the artificial intelligence (AI) and electric vehicles (EV) boom are easy to spot. For instance, shares of Nvidia, Microsoft, Tesla, and other companies have posted significant gains, anticipating a surge in future revenue and profits.

The development of AI data centers and the continued growth of EVs will benefit industries and companies that are not yet as closely followed. As a result, the stock prices of some companies in these industries may have some catching up with those mentioned above.

This article focuses on the potential beneficiaries of the significant investment necessary to upgrade, expand, and run the nation’s power grid to accommodate AI data centers and the continued growth of EVs. We follow up with Parts Two and Three to drill down to the industries and companies that may benefit most from the coming changes to the power grid. 

To help appreciate the power grid expansion needed to run AI data centers, consider the following comment from Lal Karsanbhai, CEO of Emerson Electric.

AI data center racks consume significantly more power than traditional data centers with a search on ChatGPT consuming 6 to 10 times the power of a traditional search on Google.

A Lesson From Levi Strauss

Before revealing the lesser-appreciated beneficiaries of the AI and EV booms, we share the genius of Levi Strauss. Born in 1829, Levi Strauss opened a branch of his family’s dry goods business in San Francisco during the gold rush. Gold miners were flocking to the region and stocking up on goods. They needed items like pickaxes, food, and clothing to help them in their quest to make fortunes.

In 1873, Levi invented a more durable brand of pants for miners, made of denim and using metal rivets. Today, these pants go by the name of blue jeans. Levi smartly realized that handsome returns could be had by supplying the miners. Therefore, one needn’t risk their fortunes or life and limb to profit from a game of chance like gold mining.

Levi profited dearly from the gold rush. But, unlike most gold miners, his profits were consistent and lasting. His ingenuity still pays big dividends to his descendants.

Let’s uncover the next Levi Strauss of the AI/EV rush. These not-so-obvious companies serve as critical lynchpins to maximize AI and EVs’ value via the power grid.

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Status of the Power Grid

We start with a brief summary of the power grid from the EIA.

Electricity generated at power plants moves through a complex network of electricity substations, power lines, and distribution transformers before it reaches customers. In the United States, the power system consists of more than 7,300 power plants, nearly 160,000 miles of high-voltage power lines, and millions of low-voltage power lines and distribution transformers, which connect 145 million customers.

Local electricity grids are interconnected to form larger networks for reliability and commercial purposes. At the highest level, the United States power system in the Lower 48 states is made up of three main interconnections, which operate largely independently from each other with limited transfers of power between them.

us power grid map

The EIA estimates the US generated 4,178 billion kilowatt-hours (kWH) of electricity in 2023. Fossil fuels account for 60% of the total, with natural gas and coal being the two largest. Nuclear and renewable sources account for most of the remaining 40%.

In the future, not only will the power grid need to be modernized and expanded to supply more power, but the political and public pressure to make it environmentally cleaner will likely be more powerful. The EIA expects global power-generating capacity to increase by 30% to 76% by 2050.

Given the size of the US economy and the number of US-domiciled companies leading the global AI and EV industries, a good portion of the increased global power needs will likely occur on US soil.  

Starting From Behind

As many of you can attest, the power grid increasingly exhibits outages due to extreme temperatures. The problem is multifaceted. As renewable energy resources become a larger share of the electric generation resource base, the system grows inherently more sensitive to extreme weather events. Traditional resources that are ill-prepared for new extremes are also showing vulnerabilities. Consequently, expanding the power grid requires utility companies to also invest in significant upgrades. For example, among these upgrades are new federal regulations requiring additional cold weather preparations for electric generators.

Per the WSJ

A report last year by the American Society of Civil Engineers found that 70% of transmission and distribution lines are well into the second half of their expected 50-year lifespans. Utilities across the country are ramping up spending on line maintenance and upgrades. Still, the ASCE report anticipates that by 2029, the US will face a gap of about $200 billion in funding to strengthen the grid and meet renewable energy goals.

The article estimates that the investment shortfall could accumulate to $338 billion by 2039. That estimate will, unfortunately, prove to be too low. The article was written in February 2022, before the massive energy demands for AI data centers were fully appreciated.

The bottom line is that utility companies, other power distributors, and municipalities must invest hundreds of billions of dollars over the next decade to modernize and expand our power grids.

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The Impact of EVs and AI Data Centers on the Power Grid

EVs

Assuming the acceptance growth rate of EVs continues, the electricity demand will increase substantially. The EIA estimates that US EV sales could surpass 3.5 million in 2025. That number could rise to over 8 million by 2030. Furthermore, if improvements to EV batteries to boost the driving range per charge and the number of charging stations increase rapidly, the EIA 2030 estimate could fall well short of reality.

On a side note, as we wrote in Is Toyota The Next Tesla, solid-state batteries, expected to be produced by Toyota as early as 2027, could be a game changer that dramatically boosts demand for EVs.

For context, EV sales increased from 1 million in 2022 to 1.6 million in 2023 (per MarketWatch). Edmunds estimates there are about 3.3 million EVs in the US, accounting for only 1% of the total vehicles. 

us electric car sales

Estimates suggest that if EVs were to replace a significant portion of internal combustion engine vehicles, electricity demand could increase by 20% to 40% over the next few decades. Based on the quote below, that may be a gross underestimation.  

PG&E expects system demand to increase up to 70% over the next two decades as more EVs are added.” – Utility Dive

Not only is more electricity needed, but the power grid must also be upgraded to account for the timing of EV-related energy demands. EV charging, mainly if done simultaneously during peak hours, like early evenings, can lead to higher than current peak loads.

AI Data Centers

AI data centers alone are expected to add about 323 terawatt hours of electricity demand in the US by 2030, according to Wells Fargo. The forecast power demand from AI alone is seven times greater than New York City’s current annual electricity consumption of 48 terawatt hours. Goldman Sachs projects that data centers will represent 8% of total US electricity consumption by the end of the decade.CNBC

From the same article comes the following quote from Robert Blue, CEO of Dominion Energy

“Economic growth, electrification, accelerating data center expansion are driving the most significant demand growth in our company’s history, and they show no signs of abating,”

Dominion Energy projects that demand from data centers in Virginia will more than double by 2030. Northern Virginia hosts the largest number of data centers in the country.

While researching this article, we came across many forecasts and comments like the ones above. The bottom line is that AI data center growth will be explosive. Consequently, the power demand will grow substantially.

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Summary

AI and EVs can potentially increase the nation’s productivity growth, which would go a long way toward boosting economic growth. However, with the potential benefits come significant investments. Some companies have already made massive investments in those industries. Others, like those involving the power grid, are just getting started.

We will follow this article with two more focusing on the industries and some stocks best situated to benefit from the modernization and expansion of the power grid and those that can help the utilities meet environmental goals.

Nvidia Earnings: What To Expect

This Wednesday’s Nvidia (NVDA) quarterly earnings announcement will be the most watched earnings report of the quarter. Not only will Nvidia’s shareholders pay close attention, but many non-shareholders will watch as the results could have a big impact on the entire market. Quite simply, not only has Nvidia’s stock been the poster child for all that AI offers, but its earnings have been a massive driver of S&P 500 earnings. The graph on the left, courtesy of BofA Global Research, highlights that Nvidia’s earnings have accounted for about a third of the entire S&P 500 earnings growth over the past two quarters.

So what is the market expecting? Wall Street consensus expectations are for revenue growth of more than +230% and earnings growth of +400%, year over year. As shown on the right side, options prices imply a +/- 8.5% move on Nvidia’s earnings report. That equates to roughly $200B in market cap. Put another way, Nvidia is expected to add or lose McDonald’s market cap ($196B) Wednesday afternoon. Beating expectations may not be enough to push Nvidia’s stock higher. Given its incredible outperformance, investors may not only want revenues and EPS to come in above estimates but also be banking on the company to increase its earnings guidance for the coming quarters.

nvidias earnings

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the market continues to trade bullishly but is getting overbought on many levels. Such was evident in this weekend’s risk/range report, with many sectors and markets trading well above long-term moving averages. As noted, double-digit deviations from long-term means tend to be corrected over time. However, in the short-term, these bullish trades, driven by momentum and narrative, can last longer than you think.

One of the more extreme deviations is in gold and gold miners, which are extremely overbought and extended from long-term means. As shown in the chart below, historically, large deviations in gold from the 200-DMA typically correlate with peaks in the metal. Those peaks typically lead to larger corrections to revert those deviations. Therefore, if you are long gold and gold miner stocks, they have had a great run. Don’t forget to take profits. (That doesn’t mean sell everything.)

Is AI A Bubble, A Sustainable Trend, Or Both?

As explemplified by Nvidia, stocks related to AI have been the market leaders recently. The incredible performance of some AI stocks leads some to compare the current period to 1999. At that time, tech stocks related to the web were flying high on expectations for massive earnings growth. So, we must ask ourselves whether AI is also a bubble or if the market might be correctly pricing for significant earnings growth in the future. We rely on George Soros, one of the most successful investors, to opine.

George Soros’s theory on how stock market bubbles are formed and popped states, “Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend.”

ai bubble george soros

The Basic Materials Sector Takes The Week

As the first graph below shows, basic materials led the week up over 3%. Despite the outperformance, the sector remains oversold, as shown in the second graphic, courtesy of SimpleVisor. Utilities remain the most overbought sector. SimpleVisor allows us to compare utilities to the materials sector to see if a new rotation, away from utilities toward materials, may be at hand. The top graph in the third graphic shows the price ratio of utilities to materials. The nearly year-long downtrend has recently broken higher as utilities have significantly outperformed materials over the last month.

The relative outperformance may still have more room to run. Still, the technical indicators below the utilities materials ratio graph show the ratio will likely consolidate or trend lower in the coming weeks. The relative performance is now 2.35 standard deviations extended (fourth graphic below), which also argues for a break in the trend, even if temporary.

weekly sector performance materials
sector performance simplevisor
utilities vs materials technical indicators
utilities vs materials z score excess return

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Benchmarking Your Portfolio May Have More Risk Than You Think

During ripping bull markets, investors often start benchmarking. That is comparing their portfolio’s performance against a major index—most often, the S&P 500 index. While that activity is heavily encouraged by Wall Street and the media, funded by Wall Street, is benchmarking the right for you?

Let’s begin with why Wall Street wants you to compare your performance to a benchmark index.

Comparison-created unhappiness and insecurity are pervasive, judging from the amount of spam touting everything from weight loss to plastic surgery. The basic principle seems to be that whatever we have is enough until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to terrible decisions.

This ongoing measurement against some random benchmark index remains the key reason investors have trouble patiently sitting on their hands and letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus.

Clients are pleased if you tell them they made 12% on their account. Subsequently, if you inform them that “everyone else” made 14%, you’ve upset them. As it is constructed now, the financial services industry is predicated on upsetting people so they will move their money around in a frenzy.

Therein lies the dirty little secret. Money in motion creates revenue. Creating more benchmarks, indexes, and style boxes is nothing more than creating more things to compare against, allowing clients to stay in a perpetual state of outrage.

This also explains why “indexing” has become a new mantra for financial advisors. Since most fund managers fail to outperform their relative benchmark index from one year to the next, advisors suggest buying the index. This is particularly true as the increasing market share of indexing (and passive, or systematic, investing in general) has made markets less liquid.

However, the rise in indexing has resulted in a concentration of dollars into a decreasing number of assets. The combined market capitalization of the top seven companies in the S&P 500 index is around $12.3 trillion. That is more than four times the size of the nearly $3 trillion market capitalization of the Russell 2000 Index, which consists of 2,000 small-cap stocks.

While that statistic may be shocking, it also represents the most significant risk in benchmarking your portfolio.

Market Cap Weighting Your Portfolio

When most investors or financial advisors build portfolios, they invest in companies they like. They then compare the portfolio’s performance to an index. This benchmarking process is where the risk lies, more so today than previously. The reason is in an article we wrote previously:

In other words, out of roughly 1750 ETF’s, the top-10 stocks in the index comprise approximately 25% of all issued ETFs. Such makes sense, given that for an ETF issuer to ‘sell’ you a product, they need good performance. Moreover, in a late-stage market cycle driven by momentum, it is not uncommon to find the same ‘best performing’ stocks proliferating many ETFs.”

The issue of asset consolidation is exacerbated as investors buy shares of an indexed ETF or mutual fund. Each purchase of a passive index requires the purchase of the shares of all the underlying companies. Therefore, the rise in the overall index is unsurprising. The massive inflows into passive indexes force-fed the top-10 market capitalization-weighted companies.

Here is how it works. When $1 is invested in the S&P 500 index, $0.35 flows directly into the top 10 stocks. The remaining $0.65 is divided between the remaining 490 stocks.

Investors who benchmark their index risk failing unless 35% of the portfolio is invested in those 10 stocks. With the market capitalization weighting of the largest companies nearing a record, taking on a 35% stake in those companies increases the portfolio’s risk profile significantly more than many investors think.

Notably, we are discussing only the risk involved in “matching” the index.

Trying to beat the index consistently from one year to the next is a far more challenging process.

A perfect example is Bill Miller from Legg Mason, who achieved 15 consecutive years of beating the S&P. That put him on the cover of magazines. Investors poured billions into the Legg Mason Value Fund in 2005 and 2006. Unfortunately, that was just before his strategy ran into headwinds and stopped working. The same occurred with Peter Lynch at Fidelity.

Here is the point. The probability of beating the S&P for 15 consecutive years is 1 in 2.3 million.

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A Well Managed Portfolio Can Beat The Index Over The Long Term

The problem with mainstream benchmarking analysis is that it always focuses on the trailing one-year performance. The reality is that even if you buy an index, you will still underperform it over time. Over the last 30 years, the S&P 500 Index has risen by 1987% versus the ETF’s gain of 1916%. The difference is due to the ETF’s operating fees, which the index does not have.

Comparison of market performance index vs ETF

However, while a fund manager may NOT beat the index from one year to the next, it doesn’t mean that a sound investment strategy won’t outperform significantly, with lower risk, over the long term. Finding funds with long-term track records is difficult because many mutual funds didn’t launch until the late “go-go 90s” and early 2000s. However, I quickly looked up some of the largest mutual funds with long-term track records. The chart below compares Fidelity Magellan and Contrafund, Pioneer Fund, Sequoia Fund, Dodge & Cox Stock Fund, and Growth Fund of America to the S&P 500 Index.

I don’t know about you, but investing in quality, actively managed funds over the long term seems a better bet. Crucially, they did it without heavily concentrated positions in just a handful of stocks.

Financial Resource Corporation summed it up best; 

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

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

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

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The Only Thing That Matters

There are many reasons why you shouldn’t chase an index over time and why you see statistics such as “80% of all funds underperform the S&P 500” in any given year. The impact of share buybacks, substitutions, lack of taxes, no trading costs, and replacement all contribute to the index’s outperformance over those investing real dollars who do not receive the same advantages. 

More importantly, any portfolio allocated differently than the benchmark to provide for lower volatility, income, or long-term financial planning and capital preservation will also underperform the index. Therefore, comparing your portfolio to the S&P 500 is inherently “apples to oranges” and will always lead to disappointing outcomes.

“But it gets worse.  Often times, these comparisons are made without even considering the right way to quantify ‘risk’. That is, we don’t even see measurements of risk-adjusted returns in these ‘performance’ reviews. Of course, that misses the whole point of implementing a strategy that is different than a long only index.

It’s fine to compare things to a benchmark. In fact, it’s helpful in a lot of cases. But we need to careful about how we go about doing it.” – Cullen Roche

For all these reasons and more, comparing your portfolio to a “benchmark index” will ultimately lead you to take on too much risk and make emotionally based investment decisions.

But here is the only question that matters in the active/passive debate:

“What’s more important – matching an index during a bull cycle, or protecting capital during a bear cycle?”  

You can’t have both.

If you benchmark an index during the bull cycle, you will lose equally during the bear cycle. However, while an active manager focusing on “risk” may underperform during a bull market, preserving capital during a bear cycle will salvage your investment goals.

Investing is not a competition, and as history shows, treating it as such has horrid consequences. So, do yourself a favor and forget what the benchmark index does from one day to the next. Instead, match your portfolio to your personal goals, objectives, and time frames. 

In the long run, you may not beat the index, but you are likely to achieve your personal investment goals, which is why you invested in the first place.

Summer Driving Season is Late This Year- Signal or Noise?

Summer driving season, lasting from Memorial Day to Labor Day is fast approaching. Typically, during driving season, U.S. motor gasoline consumption is 400,000 barrels/day above the average for spring and fall. As shown below, gasoline consumption has run at its lowest since 2012.

Typically, above-average consumption rates start ramping up in April. Yet, this year, they have declined in April and early May. Whether this is related to the timing of Easter, which fell in March, or the weather has yet to be seen. However, if they continue to be below normal, especially after Memorial Day, this will serve as another indicator that consumers are cutting back on spending.

Gasoline Demand

What To Watch Today

Earnings

Economy

Market Trading Update

Last week, we discussed that the April correction was likely over.

“Notably, the breakout above key resistance and the reversal of the volatility index suggest that the recent correction is over. However, while the April correction may be over, as noted above, there is still a decent probability of another correction before the Presidential election in November. As shown below, such tends to be a statistical normality during Presidential election years.”

This past week, markets surged to all-time highs as a plethora of bad economic data and a weaker-than-expected inflation print lifted hopes of Fed rate cuts in the coming months.

From a technical perspective, the markets remain on a current MACD “buy signal” and have cleared all previous resistance levels. Furthermore, the 20-DMA is set to cross above the 50-DMA next week, providing additional support to any short-term market correction. We should expect a pullback or consolidation with the market overbought on multiple levels. Such consolidations will provide a better entry point for investors who need to increase equity exposures.

The Week Ahead

This week will be light on the economic data front. Today and tomorrow will feature a flurry of Fed speakers, including Bostic, Barr, Waller, and Jefferson. Wednesday will bring S&P flash PMIs, April New and Existing Home Sales data, and FOMC Minutes. We suspect the Fed speakers will stick to their recent narratives this week, keeping the door open for rate cuts toward the end of this year.

The Flash PMIs will provide a preliminary look at manufacturing and services trends for May. New Home Sales are expected to decline to 0.68 million from 0.693 million in March. Meanwhile, Existing Home Sales are forecast to decrease to 4.18 million from 4.19 million in March. High interest rates continue weighing on existing home sales, with many would-be sellers locked into low-rate mortgages.

We cap off this week with Durable Goods Orders data for April and May consumer sentiment figures. Growth in durable goods orders is forecast to decline to 0.5% MoM, following 2.6% growth in March. Finally, the consensus estimate is for consumer sentiment to decline to 67.4 in May from 77.2 in April.

The Everything Rally Continues

The DOW hit the 4,000 mark for the first time in history last week following a solid earnings season. As shown below, many major asset classes have risen in concert over the past six months. A combination of robust earnings, low unemployment, and optimism surrounding AI advancements have driven gains in equities. Attractive yields have pulled money into the bond market. Meanwhile, precious and industrial metals have surged on the trifecta of a bullish economic backdrop, investor interest, and tightening supply in physical markets. Meme stocks are even back in vogue, with sharp rallies in yesteryear’s favorites over the past week. The question remains whether weakening economic data will eventually catch up with markets. For now, however, the Everything Rally continues.

The Everything Rally

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Electricity Demand is Surging on the Back of Data Centers

The graph below shows that the price of electricity is surging. It has risen by about 8% annually over the last three years. Going back to 1955, there have only been three other price increases of a similar magnitude. The electricity inflation in 1973 and the early 1980s was related to the surging oil price due to our relationship with Iran. The one that peaked in 2008 occurred when the price of crude oil briefly touched $150 a barrel, and natural gas was over $14.

The current inflationary cycle is unique, driven by electricity demand rather than surging input prices. In fact, the price of natural gas is near a 30-year low of $2.40. Natural gas is the predominant energy source used in electricity generation. Some of the increases are surely related to the broader inflation impacting the economy. However, as the graph denotes, some are due to incremental demand from AI data centers and EVs.

Electricity Inflation

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the market is overbought after surging to all-time highs on Wednesday. As we stated then:

“While there is no reason to be bearish, continue rebalancing as needed to maintain risk profile tolerances in your portfolio. A pullback to retest the 50-DMA is likely within the next few days to weeks, providing a better opportunity to increase exposures as needed heading into the summer months.”

From current levels, it will be unsurprising to see the markets struggle to make further highs without a short-term pullback to the 50-DMA to reset buying conditions. The current deviation from the 50- and 200-DMA continues to move higher. While such deviations do not mean a correction is imminent, they are good indicators for becoming a bit more cautious about risk-taking, particularly when markets are overbought, as they are now. While the number of stocks trading above their respective 50-DMA is improving, it remains rather weak, considering the current exuberance in the market.

As noted yesterday, all of this remains bullish but suggests that risk management remains key.

The Big Problem for Small-Cap Performance

On Monday, we shared commentary highlighting how small-cap corporate profit margins have fallen rapidly over the last few years while large-cap margins are near record highs. Larger-cap companies are much more efficient regarding borrowing costs and passing inflation onto their customers. Those and other factors help account for some of the irregular margin divergence.

Another critical factor is the composition of the small and large-cap indices. As shown below, IT has much larger margins and Returns on Equity than every other sector.

The first heat map below shows that IT constitutes nearly 30% of the large-cap S&P 500. The second heat map below shows that IT only constitutes about 15% of IWM, the small-cap index. Given the relatively significant margin expansion in IT over the last few years, the composition of the large and small-cap indexes helps further explain the divergence discussed in the aforementioned commentary.

Sector Profitability Forecasts
Large-Cap Sector Composition
Small-Cap Sector Composition

Housing Starts Show Signs of Weakness in April

April Housing Starts of 1.36 million came below consensus expectations of 1.42 million. On an annualized basis, they rose 5.7% MoM versus expectations of a 7.6% increase. Due to the sharp decline in March, the two-month rolling change is down roughly 9%. Furthermore, Housing Starts have fallen over 25% from their peak level two years ago. Building permits also came in sluggish, falling 3% MoM compared to expectations for a 0.1% increase.  

What’s more telling is that housing starts usually outpace completions in a strong economy. However, as shown in the chart below from Zero Hedge, the past few months have seen housing starts substantially lagging completions. This could have a material impact on construction employment, given that Housing Starts are an important leading indicator for the economy.

Housing Starts Versus Completions

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Is Buffett’s Cash Hoard A Market Warning?

Every year, investors anxiously await the release of Warren Buffett’s annual letter to see what the “Oracle of Omaha” says about the markets, the economy, and where he is placing his money.

“One of the longest-running traditions in modern finance is that every year, one Saturday morning in late February, the world’s financial class – from professionals to mere amateurs – sit down as they have for the past 65 or so years – for an hour and read the latest Berkshire annual letter written by Warren Buffett. In that letter, the man seen by many as the world’s greatest investor, wrote down his reflections, observations, aphorisms and other thoughts which are closely parsed and analyzed for insight into what he may do next, what he thinks of the current economy and market climate, or simply for insights into how to become a better investor.” – Tyler Durden

This year’s letter was no different, with various tidbits about the current market and investing environment for investors to digest. The one thing that got most of my attention was his comments about the recent surge in cash holdings. Buffett’s cash and short-term investments (read T-bills) exceed $189 billion as of Q1, 2024.

Berkshire Hathaway Cash Holdings

To put that into context, that $189 billion cash pile alone would make Berkshire the 58th-largest economy in the world, only slightly smaller than Hungary.

GDP Value by Country

There are two critical messages regarding Buffett’s cash hoard. The first is that due to the size of Berkshire Hathaway, which is approaching a $1 Trillion market capitalization, acquisitions have to be of substantial size. As Warren previously noted:

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

Such was an essential statement. One of the most intelligent investors in history suggests that deploying Buffett’s cash hoard in meaningful size is difficult due to an inability to find reasonably priced acquisition targets. With a $189 war chest, there are plenty of companies that Berkshire could either acquire outright, use a stock/cash offering, or acquire a controlling stake in. However, given the rampant increase in stock prices and valuations over the last decade, they are not reasonably priced.

In other words:

“Price is what you pay, value is what you get.” – Warren Buffett

The Valuation Dilemma

The problem with the valuation dilemma is that historically, such has preceded market repricings.

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

Market Cap to GDP Ratio

As discussed in “Stock Markets Are Detached From Everything,” the current environment is anything but opportunistic for a value investor like Warren Buffett. To wit:

“While stock prices can deviate from immediate activity, reversions to actual economic growth eventually occur. Such is because corporate earnings are a function of consumptive spending, corporate investments, imports, and exports. The market disconnect from underlying economic activity is due to psychology. Such is particularly the case over the last decade, as successive rounds of monetary interventions led investors to believe ‘this time is different.’”

There is a correlation between economic activity and the rise and fall of equity prices. For example, in 2000 and again in 2008, corporate earnings contracted by 54% and 88%, respectively, as economic growth declined. Such was despite calls for never-ending earnings growth before both previous contractions.

As earnings disappointed, stock prices adjusted by nearly 50% to realign valuations with weaker-than-expected current earnings and slower future earnings growth. So, while stock markets are once again detached from reality, looking at past earnings contractions suggests such deviations are not sustainable.

GDP vs the market vs earnings

With the current market capitalization to GDP ratio data outside the historical range as economic growth slows, you can understand Berkshire’s dilemma of deploying cash.

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

The risk of overpaying for assets comes down to sustaining current profitability.

Berkshire’s issue of finding “reasonably priced” acquisitions is not just one of being overly picky about opportunities. After more than a decade of monetary infusions and zero interest rates, most companies are priced well beyond what economic dynamics can support.

The second message from Buffett’s cash hoard was more of a warning.

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Buffett’s Cash Looking For A Crash?

“Occasionally, markets and/or the economy will cause stocks and bonds of some large and fundamentally sound businesses to be strikingly mispriced. Indeed, markets can – and will – unpredictably seize up or vanish as they did for four months in 1914 and a few days in 2001. If you believe American investors are now more stable than in the past, think back to September 2008. Speed of communication and the wonders of technology facilitates instant worldwide paralysis, and we have come a long way since smoke signals. Such instant panics won’t happen often – but they will happen.

Berkshire’s ability to immediately respond to market seizures with both huge sums and certainty of performance may offer us an occasional large-scale opportunity. Though the stock market is massively larger than it was in our early years, today’s active participants are neither more emotionally stable nor better taught than when I was in school. For whatever reasons, markets now exhibit far more casino-like behavior than when I was young. The casino now resides in many homes and daily tempts the occupants.

One investment rule at Berkshire has not and will not change: Never risk permanent loss of capital. Thanks to the American tailwind and the power of compound interest, the arena in which we operate has been – and will be – rewarding if you make a couple of good decisions during a lifetime and avoid serious mistakes.” – Warren Buffett

In other words, he holds such high cash levels to take advantage of market dislocations. Such is what happened in 2008 when the prestigious “white shoe” investment firm of Goldman Sachs came begging with “hat in hand” for a bailout to avoid bankruptcy. Buffett was glad to oblige by providing a massive infusion of capital at lucrative terms. During a crisis, those who “have the gold make the rules.”

Is there such an opportunity coming in the future? The answer is most likely yes. If we examine corporate profits as they relate to economic growth, we find another measure of excess. The chart below measures the cumulative change in the S&P 500 index compared to corporate profits. Again, when investors pay more than $1 for $1 worth of profits, those excesses are eventually reversed. The current deviation of the market from underlying profitability suggests that eventual reversion will be pretty unkind to investors.

Price to profits ratio

The correlation is more evident in the market versus the price-to-corporate profits ratio. Again, since corporate profits are ultimately a function of economic growth, the correlation is not unexpected. Hence, neither should the impending reversion in both series. Currently, that ratio is approaching levels that preceded more significant market reversions to realign the markets to profitability.

Real S&P 500 market price to price to profits ratio

As noted, the high correlation is unsurprising. Investors should expect an eventual reversal with the market on the more extreme end of the valuation spectrum. However, those reversals can take much longer to occur than logic would assume.

Profits to GDP Ratio vs Market correlation

Investors believe the deviation between fundamentals and fantasy doesn’t matter as long as the Fed supports asset prices. Such a point remains challenging to argue.

Market vs Fed Operations.

However, as is always the case, the reversion of excesses will occur. Buffett’s cash hoard suggests that he realizes that such a reversion is not unprecedented. More importantly, he wants to capitalize on it when it occurs.

Retail Sales And CPI Return Hope For A September Cut

Wednesday’s retail sales and CPI data were weak enough to get investors back on the rate-cut bandwagon. As shown in the CME table below, the market now ascribes an 85% chance the Fed will cut rates in September and reduce them a second time before year-end.

Retail Sales for April were flat (0.00%) below the +0.40% expected and the downwardly revised +0.60% for March. Excluding the volatile autos and gas sales, retail sales were -0.10%, the lowest since January’s -0.80%. The control number, which feeds both GDP and PCE, was -0.30%. We suspect the Atlanta Fed’s GDP Now forecast will be revised sharply lower due to the importance of personal consumption and the fact that there is little data thus far for the quarter.

CPI for the month was +0.30%, the same as the previous month, and .10% bps lower than expected. Core CPI was also +0.30% and .10% lower than March, but in line with expectations. Shelter prices (40% of CPI) and gasoline accounted for almost three-quarters of the monthly CPI number. We know gasoline prices have fallen by nearly 10% in May, and shelter should continue to weaken. This bodes well for the coming CPI report, which helps explain the market reaction to the data.


What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we noted that:

“In the short term, the market is decently overbought, which will limit the upside currently. The exception to that statement is this morning’s CPI report, which could lead to a push to new market highs if it is weaker than expected. Given the substantial negative revisions to yesterday’s previous PPI report, today’s CPI report could show some cooling.”

That is what happened, as CPI missed estimates. This, combined with Powell’s recent dovish tones, sent markets into a steady buying binge all day, closing at all-time highs. The deviation above the 50-DMA, combined with overbought conditions, is getting slightly more extreme. While there is no reason to be bearish, continue rebalancing as needed to maintain risk profile tolerances in your portfolio. A pullback to retest the 50-DMA is likely within the next few days to weeks, providing a better opportunity to increase exposures as needed heading into the summer months.

Finding The Next GME and AMC Short Squeeze

Yesterday’s Commentary discussed the recent surge of Game Stop (GME) and AMC Entertainment (AMC). Essentially, coordinated buying is forcing a significant number of short investors to buy and cover their shorts.

A couple of readers asked how they might find the next short squeeze. As we shared yesterday, SimpleVisor provides the short interest ratio for most stocks; however, for the time being, it cannot scan for stocks with high ratios. In the meantime, we ran a scan on FinViz, looking for stocks with a market cap greater than $2 billion and with more than 25% of its shares available to the market (float) being shorted. This ratio is different than the short-interest ratio we presented in the Commentary. It uses the number of shares short versus the average daily trading volume. The table below shares our results and shows both the short interest ratio and the percentage of shares of short sales versus the float of the stock.

There are almost two shares short of DJT for every share available. However, its short-interest ratio is low as the average volume traded is 3x of the available shares. Considering both short measurements, ABR appears to be most susceptible to a short squeeze based solely on this data.

Greg Valliere – Inside Washington

Greg Valliere is a Washington insider with over 40 years of experience analyzing and assessing the political landscape. Given that the coming election will likely have a big impact on markets, we have decided to occasionally share snippets from his daily “Morning Bullets” throughout the remainder of the election season. We aim to keep you abreast of the latest thinking in Washington’s inner circles.

OF ALL THE REASONS WHY BIDEN IS SLIPPING, the most obvious is a renewed public anxiety over inflation. Voters see prices surging for virtually everything, and the White House now is resigned to a summer without rate cuts from the Federal Reserve — and more trade friction with China.

THIS ELECTION OUTLOOK COULD BE REVERSED IN AN INSTANT if there’s a fresh scandal, some new gaffe, a health crisis, or a sudden geopolitical eruption. Accordingly, we haven’t made a final call. But for now, Wall Street and Washington are planning for a Trump presidency, which seems like an increasingly safe bet. Joe Biden is the clear underdog,  

THERE’S SOME RELIEF at the White House to see Israeli troops prevailing against Hamas, but the likelihood of a simmering guerrilla war in the region has only increased the bitterness between Biden and Benjamin Netanyahu, which may never dissipate, complicating the a deep division among Democrats over the war. 


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Stimulus Today Costs Dearly Tomorrow

Since the pandemic-related bazooka of fiscal stimulus, the outstanding Federal debt has risen appreciably. In nominal dollar terms, the recent debt surge is mindboggling. However, the increase is on par with the government’s negligent ways over the last fifty years.

The red bars show the percentage increase in debt starting in 1966. The bars reset to zero every time they hit 50%. The numbers to the left of each series of bars correspond to the number of quarters it took for every 50% increase.

growth of federal debt

Over the last sixteen quarters, 2020 through 2023, the outstanding federal debt has risen by 46%. Of the 11 times the debt has increased by 50% since 1966, five occurred over 15 quarters or less.

That said, the repercussions of relying on stimulus for economic growth and growing debt faster than the ability to pay for it have significant economic consequences. The recent surge in debt will only further handicap our economy and prosperity in the future.

There are predominantly two ways our growing debt load negatively impacts economic growth, as we will share. 

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#1 Manipulated Interest Rates Cripple Capitalism

Growing debt faster than one’s income is a Ponzi scheme. No matter how politicians sugarcoat fiscal stimulus, there are no two ways around such a characterization. Individuals and corporations that run such a scheme ultimately end up bankrupt. The same holds for governments, but they tend to have much longer runways.

The Federal Reserve allows the government to perpetuate its Ponzi scheme. The Fed keeps borrowing costs lower than they should be through lower-than-market interest rates and asset purchases.

Not only is the growing ratio of debt to income problematic, but it is also a sure sign that the debt in aggregate is used for unproductive purposes. In other words, the debt costs more than the financial benefits it provides. If it were productive debt, income or GDP would rise more than the debt.

In the long run, unproductive debt reduces a nation’s productivity, aka economic potential.

Negative Real Rates And QE

A lender or investor should never accept a yield below the inflation rate. If they do, the loan or investment will reduce their purchasing power.

Regardless of what should happen in an economics classroom, the Fed has forced a negative real rate regime upon lenders and investors for the better part of the last 20+ years. The graph below shows the real Fed Funds rate (black). This is Fed Funds less CPI. The gray area shows the percentage of time over running five-year periods in which real Fed Funds were negative. Negative real Fed Funds have become the rule, not the exception.

real fed funds rate

Starting in 2008, with QE, the Fed began using its balance sheet to manipulate interest rates further. Currently, the Fed holds $8 trillion in Treasury and mortgage-backed securities. Their Treasury holdings account for almost 25% of all Treasury securities outstanding to the public.

By reducing the supply of bonds on the market, they effectively lower interest rates below where the free market would price them. This makes fiscal stimulus more appetizing for politicians and, by default, encourages even greater federal debt loads.

Like the Fed’s negative real rate interest rate policy, QE also reduces interest rates, allowing for more unproductive federal and private sector debt.

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#2 Negative Multiplier

As we note, debt increasing faster than economic growth proves that borrowing and spending are unproductive. Unproductive government debt or private sector debt also results in a negative economic multiplier. Essentially, the ultimate expense of the debt outstrips its benefits over the long run.

Economists define the multiplier effect as the change in income divided by the change in spending. Over an extended period, if the change in spending is more significant than the change in income, the effect of said spending is negative. Replace GDP for income and government debt for spending to compute the government’s spending multiplier.

Multiplier = Change Income / Change Spending

Government Multiplier = Change GDP / Change Debt Outstanding

To help appreciate the negative multiplier, let’s consider the two rounds of stimulus checks sent to the public during the pandemic. Consumers and businesses spent a large percentage of the funds on goods or services that no longer provide economic benefit. The initial result of the direct stimulus was a massive boost to economic activity. Three to four years later, the economic growth spurt is finished, and the debt and its annual interest costs remain. The interest on the debt is capital that will not be put to productive use.

Yesterday’s tailwind is slowly becoming tomorrow’s headwind.

There are other economic considerations as well.

Ricardian Equivalence

This economic theory states that when individuals anticipate tax increases to finance current and future government spending, they increase their savings to offset the expected tax burden. Therefore, any increase in government spending financed by debt may not stimulate consumption and investment, potentially resulting in a negative multiplier effect.

Crowding Out

High levels of government borrowing can lead to crowding out of private investment. This occurs when government borrowing forces higher interest rates, making it more expensive for businesses and individuals to borrow for investment. Further, as banks are asked to hold more government debt, they have less ability to lend to the private sector. Consequently, private investment, likely to be more productive than government spending, may decline.

Capitalism Is Eroding

The graph below shows why capitalism matters. It plots the Heritage Foundation’s Index of Economic Freedom, a measure of capitalism, versus the average family wealth for 137 countries. As shown, economic freedom and wealth have a strong positive correlation.

capitalism is eroding  economic freedom index and wealth

With that relationship in mind, government spending is a key component of the economic freedom index. Massive government stimulus spending reduces our index score. Further, while not a part of the score, manipulation of free market interest rates also detracts from the benefits of capitalism. As our index score falls, denoting the retreat from capitalism, so does our wealth.

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Summary

Nothing is free, it’s just a question of how it’s paid for. While the government spends like there is no tomorrow and the Fed does everything in its power to help them, we must understand that the longer-term consequences of their actions are weaker economic growth and growing wealth disparity, as we discuss in Fed Policies Turn The Wealth Gap Into A Chasm. To wit:

QE may have served as an emergency way to add bank reserves to the system and boost confidence. However, its continued use, even during economic prosperity periods, only makes the wealth gap wider.

We should take the matter personally because, as we have shown, there is a strong link between government borrowing and our prosperity. While the cost of deficits may not be higher taxes, it does show up invisibly in lesser wages and wealth than we otherwise could attain. Any wonder why millennials are on track to be the first generation to fail to exceed their parents in income?

The GME and AMC Short Squeeze Is On Again

On Monday, the popular meme stocks Game Stop (GME) and AMC Entertainment (AMC) surged higher in yet another short squeeze episode. Fundamentally, both companies have been flirting with bankruptcy. But they have been bailed out on numerous occasions by coordinated short squeezes, allowing them to raise needed capital by issuing new stock at relatively high prices. To wit, AMC raised $250mm on Monday night.

GME were both up about 75% in trading on Monday. On Tuesday morning, AMC was trading in the pre-market session another 135% higher than Monday’s closing level, and GME was 145% better. As popularized in Dumb Money, a David vs Goliath story, small retail investors coordinating via Reddit, squeeze shorts by pushing the stock prices higher. Higher prices, in turn, force short sellers to buy back their short bets and further exaggerate the push higher. Inevitably, more shorts pile in at higher prices, and the roller coaster heads back down.

Short interest information can be found on SimpleVisor. As the graphic below shows, GME’s short interest ratio is slightly over 30. This means about a third of the shares outstanding are short.

gme short interest

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Yesterday, we discussed that the longer-term trends remain bullish. However, in the short term, the market is decently overbought, which will limit the upside currently. The exception to that statement is this morning’s CPI report, which could lead to a push to new market highs if it is weaker than expected. Given the substantial negative revisions to yesterday’s previous PPI report, today’s CPI report could show some cooling.

Furthermore, Powell’s still rather dovish language sent the markets running ahead of tomorrow’s CPI report. Powell already has that data and, if it were a problem, would have likely yielded a bit more hawkish language.

The MACD signal is on a confirmed “buy signal,” but as stated, the markets are becoming more short-term overbought. A bit of a correction back to the 50-DMA seems probable and would provide a decent point to add equity exposure. Notably, the 20-DMA has turned up and will likely provide a bullish cross above the 50-DMA within the next week. Such will provide additional support to any near-term correction. Continue to manage risk through position sizing, but the near-term trajectory for the market remains higher.

Market Trading Update

NFIB Portends Lower Inflation

Tuesday’s NFIB report was slightly stronger than expected, but it still remains at recessionary-like levels. The small business survey was 89.7, better than last month’s reading and expectations but well below the fifty-year average of 98.1. With CPI coming today, investors were focusing on the inflation components of the NFIB survey. Per the report, “A net 26% (seasonally adjusted) of owners plan price hikes in April, down seven points and the lowest reading since April of last year.” The second graph below, courtesy of Steno Research, shows the strong correlation (with a 12-month lead) between Core CPI and the NFIB price plans data. Assuming the correlation holds going forward, this recent uptick in inflation may give way shortly to the downtrend that started in 2023.

nfib
core cpi and nfib price plans

PPI

PPI was hotter than expected on a monthly basis but as expected on a year-over-year basis. This is because last month’s +0.2% was revised to -0.1%, thus offsetting this month’s higher-than-expected increase. The stock and bond markets shrugged off the data as, once again, there were some anomalies. For instance, there was a 4% increase in portfolio management and investment advice services. These are not higher fees but an increase in the amount of money being managed due to recent gains in the stock market. As shown below, this is a very volatile data series.

The silver lining to the higher PPI than expected data is the contributors that also feed PCE were tame. Per Pantheon Macro:

“.. better than it looks. .. many of the PPI components which feed into the core PCE deflator rose only modestly. .. All told, then, a 0.3% print for the core PCE looks like a good bet at this stage, but we can’t rule out 0.2%.”

ppi portfolio management services

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The VVIX and VIX Highlight Complacency

After a brief spurt of volatility accompanying the 6% market decline in April, implied volatility (VIX) and volatility of volatility (VVIX) have fallen back to multi-year lows. The lesser known volatitly gague VVIX is down to levels last seen ten years ago. VVIX measures the volatility of the VIX index. While they do correlate well, the VVIX is a slightly different measure. The VVIX formula is based on options trading on the VIX contract. The VVIX is telling us investors are not buying protection via calls on the VIX. The VIX is also at low levels but not ten-year lows.

Many analysts use volatility as a gauge of investor complacency. Both volatility measures shown below highlight that investors do not concern themlseves about a correction. At times, similar volatility levels have served as a warning to be prepared to take protective actions. However, while the VVIX and VIX are extremely low, many other technical indicators are not overbought. Further, the S&P just recently cleared its 20 and 50-day moving averages, so it’s not too extended from those key moving averages. The MACD is trending up but is far from being overbought. The market is very complacent, and we must stand guard. However, unlike the last time volatility was at current levels, other technical indicators are not yet providing affirmation of a coming downturn.

vvix and vix

What To Watch Today

Earnings

earnings calendar

Economy

Economic Data

Market Trading Update

Yesterday, our discussion centered on the recent breakout above the 50-DMA and the confirming bullish “buy signals” from the MACD. Of course, that is the very short-term analysis for the next few days to weeks. However, if we slow the price action down by looking at weekly data, we see that the market is again approaching more extreme overbought levels similar to those seen at the market’s peak in 2022.

As shown, the Relative Strength Index is rising and close to levels more normally associated with overbought markets. The deviation between the 13- and 34-week moving average is becoming more extreme, with the market trading nearly 9% above the longer-term mean. Lastly, the MACD signal, bottom panel, is on a buy signal, suggesting higher prices in the near term. However, that indicator pushes levels we have not seen historically outside of the stimulus-fueled buying frenzy following the pandemic.

Sp500 Weekly Market Update

Crucially, given this is weekly data, the more overbought conditions can last much longer than logic would predict. However, the data suggests that at some point later this year, we are still likely to see a larger corrective process (~10%) to reverse some of these conditions.

Consumer Discretionary Stocks Weaken

As the SimpleVisor analysis shows below, utilities continue to lead the market. Interestingly, the S&P 500 was up almost 1.50% this past week, making this past week’s instance a little more unique compared to the prior weeks’ outperformance. One of our questions regarding the strength of utilities was whether it was a safety play in a down market or a true sign that the sector could continue to lead in an up or down market. The rotation is overbought in the short term, but our analysis portends it may last longer. Further helping the sector is the realization that AI data centers will need a tremendous amount of investment into the utilities sector.

The second table shows that utilities are becoming very overbought on a relative basis and extremely overbought on an absolute basis. The third graph also shows its correlation to other sectors. If you are considering taking some profits, the table may give you some ideas on what to do with the proceeds.

The consumer discretionary sector is now the most oversold sector. Tesla, accounting for 12% of the sector and in a bear market, is partially responsible. However, other discretionary stocks have also had trouble recently. If you recall, Starbucks was down nearly 20% a week or so ago. There are some indications the consumer may be weakening. Retail Sales data on Wednesday will help better assess personal consumption.

sector performance weekly discretionary
sector absolute and relative scores
utilities correlation to other sectors discretionary

Inflation Expectations

Yesterday, the New York Fed said three-year inflation expectations fell from 2.9% to 2.8%, but five-year expectations rose from 2.6% to 2.8%. Inflation expectations tend to run higher than actual inflation, as shown in the 3-year expectations graph below. Currently, 3-year expectations are very close to pre-pandemic levels. There is not enough data on five-year expectations to make a comparison. One-year expectations (not shown) are at 3.1%, a few tenths of a percent above pre-pandemic levels.

The Fed pays close attention to expectations, as they can be a self-fulfilling prophecy. Given that they are not surging higher, as some investors fear, we see nothing in this latest round of inflation expectations data to worry the Fed.

ny fed 3yr inflation expectations
ny fed inflation expectations five year

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Moving Average Crossovers Suggest The Bull Is Back

While there is much debate over whether another bear market is imminent, weekly moving average crossovers suggest a different outcome for now. There are many current concerns, from geopolitical risk to still inverted yield curves, slowing economic growth, high interest rates, and inflation. Yet, despite those concerns, markets are flirting with all-time highs.

While 5% money market yields are certainly enticing, investors often need to step back from the “doomsday” dripping headlines. Given that one of our behavioral investing traits is “loss avoidance,” it is easy to talk ourselves into an overly cautionary position. The mistake is that while alleviating our short-term emotional concerns, it can lead to a significant wealth impairment in the long term.

Therefore, it is often worth digging ourselves out of the media headlines and focusing on what the market tells us. After all, the stock market has a long track record of leading the economy by 6-9 months. To explain this, start with the chart of the S&P 500 index below and notice those interesting blue dots.

Stock market chart with interesting blue dots

What Did The Market Know?

Yes, those market dots represent stock market peaks. However, why did the stock market top at those particular points?

Let’s take a look at the data below of real (inflation-adjusted) economic growth rates:

Market Peaks and GDP and Recession table.

Each of the dates above shows the economy’s growth rate immediately before the onset of a recession. The table above notes that in 7 of the last 10 recessions, real GDP growth was 2% or above. In other words, according to the media, there was NO indication of a recession.

But the next month, one began.

With that understanding, let’s return to those “interesting blue dots” in the S&P 500 chart above. Each dot represents the market peak before the onset of a recession. The S&P 500 peaked and turned lower in nine of ten instances before a recession was recognized, anywhere from 6 to 16 months later.

NBER Recession dating vs market

The crucial point is that the stock market signaled a coming recession in the months ahead, but the economic data didn’t reflect it. (The only exception was 1980 when they coincided in the same month.) The table below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

Market peaks, recession and GDP table.

The problem for investors is waiting for the data to catch up.

Moving Average Signals

Understanding that the market tends to lead the economy by six months or more, we can use longer-term market signals to help us navigate the risk of a recessionary downturn.

We have produced a weekly “risk range report” in the Bull Bear Report for several years. That report contains several measures of analysis, as shown below.

  • The table compares the relative performance of each sector and market to the S&P 500 index.
  • “MA XVER” (Moving Average Crossover) is determined by the short-term weekly moving average crossing positively or negatively with the long-term weekly moving average.
  • The risk range is a function of the month-end closing price and the”“bet”” of the sector or market. (Ranges reset on the 1st of each month)
  • The table shows the price deviation above and below the weekly moving averages.
Risk Range Report Explanation

For this analysis, we will focus on the far right column. Every major market and sector (except for the U.S. dollar) is currently on a bullish moving average crossover. Given this is weekly data, it is slower to move, which tends to provide better signals for both increasing and reducing portfolio risk.

A Simple Chart

However, are these signals useful in safeguarding against the onset of a recession or just a more protracted market downturn like the one we saw in 2022? The chart below uses a simple weekly moving average crossover analysis to determine where investors should consider increasing or reducing risk to equity exposure.

Moving Average Crossover Signal

In 2000 and 2008, the moving average crossover signal warned investors that a recessionary onset was coming 9 and 12 months ahead of actual recognition. The weekly moving average signals also triggered a sell signal in early 2022 ahead of the ~20 decline, although the NBER has not recognized a recession yet.

Notably, these signals are not always perfect. The drawdown was so swift in 2020 during the pandemic shutdown that the signals to reduce and increase exposure coincided with the market. However, paying attention to these moving average signals over the longer term can provide investors with a valuable roadmap to follow.

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Bullish Buy Signals Tend To Be Correct

Returning to the”“risk range repor”” above, a review of late 2021 warned our readers that market deterioration was increasing. The report below is from the October 6th, 2022, Bull Bear Report:

“The selling pressure continued this week, taking almost every sector and market into double-digit deviations below long-term weekly moving averages. Such extremes are not sustainable, and when all markets and sectors are this oversold, a reflexive rally becomes highly probable.”

The table below shows that almost every sector and market had bearish moving average sell signals triggered. At the time, however, media headlines were filled with “death of the dollar,” recession warnings, and bear market alerts. However, such negative extremes are often coincident with market bottoms.

Risk Reward Range October 2022

Furthermore, investor sentiment and allocations were likewise extremely negative.

October 2022 Fear Greed Index

Of course, as we now know in hindsight, October 2022 marked the bottom of the market, and the recession predictions have faded into the midst.

The market has recovered since then, and those bearish moving average sell signals have reversed to bullish buy signals. As discussed in this past weekend’s Bull Bear Report, while the market is overbought, and consolidation or correction is likely, with every major equity and bond market on bullish buy signals, the market is not predicting the onset of a recession.

Risk Range Report Current

Furthermore, investor sentiment and allocations are also bullish, which supports higher prices.

Current Fear Greed Index

Corrections Tend To Opportunities

Does this mean that markets will be devoid of any short-term corrections? Of course not. We just experienced a 5.5% correction in April. Furthermore, corrections during market advances happen every year and tend to be opportunities to increase equity exposure as needed.

Intra-year market corrections 2024

While some unexpected, exogenous events could send markets reeling, the market has a long history of anticipating recessionary onsets well before economists and the mainstream media recognize them.

With the plethora of “armchair commentators” pointing at every piece of data as an indicator of economic doom to get more clicks and views, we suggest sitting back and paying attention to the markets. Given that the market represents a vast group of individuals analyzing every possible data point, the signals the market provides tend to be a more reliable signal to follow.

When those bullish weekly moving average buy signals begin to reverse, with one following another, we will know it’s time to become increasingly more conscious of risk.

As of now, the market suggests that sitting in cash may be a mistake when it comes to reaching retirement goals.

Small Cap Profit Margins Confirm NFIB Findings

A few weeks ago, we wrote Economic Warning From The NFIB to share information from the latest NFIB small business survey. While the economy appears to be in good shape, the NFIB shows that smaller businesses, including some small-cap stocks, are suffering. Per the article: “the NFIB small business confidence survey declined in its latest reading. Not only did it fall to the lowest level in 11 years, but, as far as an economic warning goes, it remained at levels historically associated with a recessionary economy.

The graph below comparing EBIT (earnings before interest and taxes) profit margins of large, mid, and small-cap companies further highlights the problems facing small businesses. Large and mid-cap non-financial corporations have EBIT profit margins near recent highs. Conversely, profit margins for small-cap companies are at the lower end of their 45-year range. Also interesting is that in the aggregate, large-cap companies have profit margins that are 4% more than mid-cap. Mid-cap companies have profit margins that are about 4% greater than small-cap companies.

Two primary reasons explain the recent divergence in profit margins. First, small-cap stocks have less price power. Therefore, they are not as efficient at passing on higher prices to their customers. Second, larger companies have much easier access to credit. In 2020 and 2021, when rates were low, many of these companies refinanced their debt. It was not as easy for smaller companies to follow suit. The two-year performance chart comparing the large (SPY), mid (MDY), and small-cap (IWM) stocks is reflective of the profit margin differentials.

profit margins and stock performance by market cap

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Last week, we discussed whether the recent rally from the lows was just a sucker rally ahead of a more significant decline. Our assessment was that was likely not the case. To wit:

“The market surged higher on Thursday and Friday, supported by Apple’s massive $110 billion stock buyback program. With a MACD “buy signal” triggered on Friday and the market not overbought yet, a push above resistance at the 50-DMA seems likely next week. That break of resistance should allow the bulls an opportunity to retest 5200 over the next month or so.

However, while the bullish market setup is intact in the near term, we continue to expect another decline this summer before the election. Historically, institutional players are reticent about holding long exposures heading into an election, so we often see weakness in September and October.”

This past week, the market broke above the 50-DMA with a solid confirmation of the MACD “buy signal.” Currently, the market is decently overbought after the advance, so a pullback to retest the 50-DMA would be welcome. Such a pullback would turn the 50-DMA from previous resistance into support and reduce some overbought conditions.

Market Trading Update

Importantly, the breakout above key resistance and the reversal of the volatility index suggest that the recent correction is over. However, while the April correction may be over, as noted above, there is still a decent probability of another correction before the Presidential election in November. As shown below, such tends to be a statistical normality during Presidential election years.

Presidential Election Years

Of course, that is just the “average.” This means that Presidential election years have been better and worse. As such, we must continue monitoring and reacting to the market as the macro and micro environments evolve.

The Week Ahead

Inflation week is upon us, with PPI on Tuesday and CPI on Wednesday. PPI is expected to show producer prices, often a leading indicator of CPI, rose 0.2% last month. CPI and CPI core are expected to increase by 0.3%, 0.1% below last month’s levels. As we have noted numerous times, the eventual catchup between market rental prices and those the BLS uses to compute CPI will result in lower inflation. Standard Charter echoes our thoughts. Per their article Will OER Bail Out The Fed:

Our regression analysis suggests that Powell’s optimism may be justified. It points to a sharp decline in OER in coming months based on a regression that has proved stable in recent years (Figure 1).

oer cpi inflation fed

In addition to CPI, the market will also get the latest retail sales report. Wall Street economists think last month’s hot reading of 0.7% growth will moderate to +0.4%.

Chairman Powell will give a speech on Tuesday, further clarifying the Fed’s stance on inflation and the economy. He will likely have the CPI and retail sales data in hand when delivering the speech. Accordingly, the market will look for clues he may have on those two data releases.

The Williams R% Convinces BofA Of More Upside

The graph below is courtesy of BofA and ISABELNET.com. Looking at the technical indicator Williams %R and the pattern that played out in 2022 and 2023, BofA believes the S&P 500 rally may have much more to go. The top graph plots the S&P 500, and the bottom shows the corresponding Williams %R for the last ten years. The Williams %R tends to stay in overbought territory during bull market runs with an occasional minor correction to fair value. Large market downdrafts spike the Williams %R to oversold territory. Based on the graph, BofA’s bullish case has the S&P 500 running to 5600 – 6350.

Their estimate is based on a cup-and-handle pattern that played out in 2022 and 2023. The recent decline looks like a minor correction to fair value on the Williams %R, in what they think will be a longer string of oversold readings on the indicator. If you believe their logic is valid, 4953 is critical support. A break of that level could invalidate their projection.

The Williams %R quantifies an asset’s daily closing level in relation to its highest and lowest prices over a specific period. For instance, a stock that closes at the high for the period would have a Williams %R of 0. Conversely, a stock settling equally between the high and low would record a score of -.50. For more information on the indicator, click HERE.

Caveat: The BofA analysis is based on one technical indicator and one technical pattern. There are literally hundreds available. Some are equally bullish, while others are more bearish. Do your own research and consider not only technical indicators and patterns but also fundamentals, the coming elections, and geopolitics when making investment decisions.

S&P 500 williams %r

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Stock Buybacks Are Growing Again

Apple’s stock surged 7% after reporting flat earnings and revenue growth. Investors didn’t seem to mind that Apple is struggling to generate growth. What mattered more to Apple investors was their pledge to buyback $110 billion of stock. According to Buybacks are Back by the Wall Street Journal, S&P 500 companies completed $181bn of buybacks in the first quarter, up 16% from the first quarter a year ago. The quote below from the article caught our eye.

“Corporate America thinks their fundamentals are fine. They’re not worried about rates, not worried about their balance sheets,” said Jeffrey Yale Rubin, president of Birinyi Associates. “If people that know the companies the closest are comfortable buying their stock, why wouldn’t I be?”

Rubin’s quote is very misleading. Companies buyback their stock for two reasons. First, they have excess cash and would rather pay it back to shareholders via buybacks as opposed to dividends. Second, executives are paid heavily in stock options, so pushing the stock price higher is in their best interest. Not only does it personally reward them, but a higher stock price is now the standard for executive performance. Unlike Rubin’s sentiment, stock buybacks are not really a function of fundamentals and confidence. For most companies, it comes down to a decision of how to spend excess cash. Buybacks help executives and current shareholders. Investing it back into the company results in future earnings growth and rewards long-term investors.

stock buybacks S&P 500

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

On Monday, I laid out three paths for the market to follow. So far, the market has followed Path A, which we assigned the highest possibility in the short term. The market is overbought, as the rampant reversal in stocks has led to a sharp rise in investor bullishness. A pullback to support would be both logical and beneficial to increase equity exposure in portfolios as needed.

Market Trading Update

Next week, the all-important inflation report will be released. If weaker than expected, it could lead to a continued push higher in both stocks and bonds as a bullish repricing for rate cuts occurs. There are a ton of Fed speakers today ahead of that report, which could move stocks as well. However, as noted, with markets overbought, be patient and look to “buy the dip” for now.

Is Phantom Debt Keeping Consumption Strong?

In yesterday’s Commentary, we wrote:

With limited income and savings, consumers often rely on credit card debt. As a testament to the growing economic headwinds facing consumers, credit card debt outstanding is now growing above pre-pandemic trends.

ZeroHedge recently wrote The Missing Piece of the Puzzle, which adds more to our analysis of personal consumption. The puzzle is that consumers are financially exhausting their means to spend, yet personal consumption is seemingly doing well. The culprit could be phantom debt, as Bloomberg calls it. It may also mean that untraditional debt is warping our understanding of consumers’ spending ability. Per ZeroHedge:

But staggering as the mountain of household debt may be, at least we know how huge the problem is; after all the data is public. What is far more dangerous – because we have no clue about its size – is what Bloomberg calls “Phantom Debt“, and we have repeatedly called Buy Now, Pay Later debt. How much of that kind of debt is out there is largely a guess.

The article states that phantom debt masks consumers’ financial health and ability to consume. The problem for economists is that disclosure requirements for buy-now-pay-later loans and other types of phantom debt are poor. Furthermore, credit agencies may avoid reporting the data as it “could harm consumers’ credit scores, which are key to securing mortgages and other loans.” The second graph below shows that many who take buy-now-pay-later loans are not financially in good shape.

The takeaway is that the consumer may have more ability to spend than we believe, but this added ability only weakens their financial health, thus negatively impacting their ability to spend in the future.

consumer debt balances
buy now pay later consumer debt survey

More On Q1 Earnings

Yesterday’s Commentary noted a common theme in the market’s reaction to Q1 earnings reports. Specifically, companies reporting bad earnings in Q1 were penalized more than is typical. To wit, “conversely, companies that missed got penalized much more than usual, underperforming the S&P 500 by 5.1% versus the historical average of 2.4%.”

SocGen provides more interesting data on Q1 earnings. According to their data, over three-quarters of those who reported earnings beat EPS expectations by +1 standard deviation or more. While that is good news, the not-so-good news is that only 60% of companies beat market expectations on their revenues. This is the lowest percentage in the last year. In other words, higher margins and financial engineering are making earnings look better than they otherwise would be.


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The Investment “Holy Grail” Doesn’t Exist

When it comes to the financial markets, investors have a litany of investment vehicles to choose from. The choices are nearly unlimited, from brokered certificates of deposit to complex derivative instruments. Of course, investment vehicles’ proliferation comes from investors’ demand for everything from excess benchmark returns to income generation to downside protection.

Of course, every investor wants “all the upside, with none of the downside.” While there are vehicles, like indexed annuities, that can provide no downside risk, they cap the upside return. If you buy an index fund, you can get “all the upside” and “all the risk.”

However, an email from a reader last week got me thinking about the perfect “investment vehicle” and the search for the “holy grail” of investing.

“My wife and I are looking for a place to position some of our ’emergency funds’ for a better return. Our requirements are pretty simplistic:

  • Guarantee at least a 4% rate of return.
  • Allow me to withdraw cash without penalty when needed.
  • Reinvest all income
  • If bond yields decline as expected, the value of the investment increases.

At this point, I was confident in just suggesting purchasing a 10-year Treasury bond. At current rates, the investment would yield greater than 4% and guarantee the principal. If yields decline, the bond rises in price, reinvestment of income is an option, and the investment is highly liquid.

Theoretically, this would be the “perfect investment” vehicle for their needs. I said “theoretically” because they added one more requirement just as I was about to spout off my terrific idea.

“Oh, and one more thing, the dollar value of the account must remain stable at all times.”

And that, as they say, quickly ended the “perfect investment” vehicle for their needs.

Why did the addition of “price stability” make their request impossible?

The 3-Components Of All Investments

In portfolio management, you can ONLY have two of three components of any investment or asset class:

  • Safety – The return of principal without loss due to price change or fees
  • Liquidity – Immediately accessible without penalties or fees
  • Return – Appreciation in the price of the investment

The table below is the matrix of your options.

3 Components Of All Investments

The takeaway is that cash is the only asset class that provides safety and liquidity. Safety comes at the cost of return. Equities are liquid and provide returns but can suffer a significant loss of principal. Bonds can offer returns through income and safety if held to maturity. But in exchange for that safety, investors must forego liquidity.

In other words, no investment can provide all three factors simultaneously. While the table above uses only Equities, Bonds, and Cash, those three factors apply to any investment vehicle you may consider.

  • Fixed Annuities (Indexed) – safety and return, no liquidity. 
  • Certificates of Depositsafety and return, no liquidity.
  • ETFs – liquidity and return, no safety.
  • Mutual Funds – liquidity and return, no safety.
  • Real Estate – safety and return, no liquidity.
  • Traded REITs – liquidity and return, no safety.
  • Commodities – liquidity and return, no safety.
  • Gold – liquidity and return, no safety. 

You get the idea.

Let’s revisit our email question.

While I initially focused on the cash requirements, these were also funds set aside for an “emergency.” In other words, these funds must be readily available when an unexpected event arises. Since “unexpected events” tend to happen at the worst possible time, these funds should never be put at risk. The need for “safety” and “liquidity” eliminates the third factor: Return.

No matter what investment vehicle you choose, you can only have two of the three components. Such is an essential and often overlooked consideration when determining portfolio construction and allocation. 

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8-Reasons To Focus On Liquidity

Liquidity is the most essential factor in making any investment. Without liquidity, I can not invest. Therefore, liquidity should always remain a high priority when managing your portfolio.

I learned a long time ago that while a “rising tide lifts all boats,” eventually, the “tide recedes.” Over the years, I made a straightforward adjustment to my portfolio management, which has served me well. When risks begin to outweigh the potential for reward, I raise cash.

The great thing about holding extra cash is that if I’m wrong, I simply make the proper adjustments to increase the risk in my portfolios. However, if I am right, I protect investment capital from destruction and spend far less time ‘getting back to even.’ Despite media commentary to the contrary, regaining losses is not an investment strategy. 

Here are 8-reasons why you should focus on liquidity first:

1) We are speculators, not investors. We buy pieces of paper at one price with hopes of selling at a higher price. Such is speculation in its purest form. When risk outweighs rewards, cash is a good option. 

2) 80% of stocks move in the direction of the market. If the market is falling, regardless of the fundamentals, the majority of stocks will decline also.

3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb, each believed in “buying low and selling high.” If you “sell high,” you have raised cash to “buy low.”

4) Roughly 90% of what we think about investing is wrong. Two 50% declines since 2000 should have taught us to respect investment risks.

5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this. 

6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also merely transfers the “risk of being wrong” from one side of the ledger to the other. Cash protects capital and eliminates risk. 

7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that without cash you can’t take advantage of opportunities.

8) Cash protects against forced liquidations. One of the biggest problems for Americans  is a lack of cash to meet emergencies. Having a cash cushion allows for handling life’s “curve-balls,” without being forced to liquidate retirement plans.Layoffs, employment changes, etc. are economically driven and tend to occur with downturns that coincide with market losses. Having cash allows you to weather the storms. 

Importantly, I want to stress that I am not talking about being 100% in cash.

I suggest that holding higher cash levels during periods of uncertainty provides both stability and opportunity.

With the political, fundamental, and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more critical. 

Chasing yield at any cost has typically not ended well for most.

Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.

Economic Headwinds Are Starting To Gust

With just a few graphs, we can visualize how economic headwinds are about to get stiffer. Additionally, the graphs help us understand why President Biden has such low economic polling numbers, even among Democrats, despite such a strong economy. There are four predominant means by which consumers can spend. Income is typically the largest and most consistent. Savings and other forms of wealth provide money for spending as well. Lastly, a large majority of consumers borrow to fund their consumption.

  1. Real disposable income is now below the lowest levels of the pre-pandemic era. Further highlighting this economic headwind from income is the Tweet of the day with a more inclusive version of real disposable income.
  2. Extreme fiscal stimulus massively boosted savings, but as shown, the total savings as a percentage of GDP is at 10-year lows. Tuesday’s Commentary further supports this, showing that the pandemic-related excess savings have been depleted.
  3. With limited income and savings, consumers often rely on credit card debt. As a testament to the growing economic headwinds facing consumers, credit card debt outstanding is now growing above pre-pandemic trends.
  4. While asset prices have done very well and enriched quite a few people, the pie chart shows that a significant majority of stocks are held by a small percentage of the population. The benefits are not widespread.

The graphs highlight that consumers, which had been able to spend at above-average rates, are now becoming constrained. Two-thirds of economic activity depends on consumption. The trends below represent a formidable economic headwind.

real disposable income, personal savings, credit card debt, wealth

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Yesterday, we noted that the breakout above the 50-DMA signaled that the recent correction is complete, particularly given the MACD “buy signal” now triggered. However, another buy signal is also in place that may signal another opportunity.

As we will discuss in this weekend’s Bull/Bear Report (Subscribe for free email delivery), Morgan Stanley recently commented on “residual seasonality.” To wit:

“Residual seasonality isn’t a new thing, but what was a small observed factor from 2010 to 2019 has emerged as a giant one now. To quantify the impact, Morgan Stanley employs a technique comparing the average annualized numbers for a quarter to the four-quarter average. For the preceding two years, core PCE prices — the inflation numbers that mean the most to the Fed — have seen a giant 1.32 percentage point boost to first-quarter numbers that erode as the year progresses.

This residual seasonality has also been seen elsewhere, in the employment cost index series and unit labor cost data in the productivity numbers. When so many price metrics display residual seasonality and a similar strengthening pattern, investors would be forgiven for gaining confidence that the pattern will continue in the coming year.

Translated into hard numbers, Morgan Stanley expects the three-month annualized rate of core PCE inflation to fall to 1.81% for the Dec. 2024 data released in January 2025 and the six-month annualized to fall to 1.96%.”MarketWatch

Residual Seasonality

If that is the case, weaker economic data will start influencing the Fed to cut rates, which supports lower yields. The bond market may already be sniffing out that outcome, as bonds have also triggered a MACD buy signal.

Bond Trading Chart

While we will likely see some additional near-term pressure on bonds over the next couple of months, we may be approaching the end of the bond market correction that began in 2020.

Earnings Season Punishments Were Worse Than Normal

With many companies having reported earnings, there was a definitive theme worth discussing. The theme is highlighted by Shopify and Uber, which fell 20% and 10%, respectively, on Wednesday based on their earnings announcements. To the naked eye, the punishment doled out for weak earnings this past quarter was worse than is typical. BofA confirms this as follows:

Companies that have beat on both sales and EPS outperformed the S&P 500 by 1.1% the next day, slightly lower than the historical average of 1.5%. Conversely, companies that missed got penalized much more than usual, underperforming the S&P 500 by 5.1% versus the historical average of 2.4%.

shopify

Druckenmiller Pares Back On AI

Famed investor Stanley Drunkenmiller is selling some of his holdings in the AI space. He is still very optimistic about AI’s potential but thinks that stock prices for companies directly related to AI are a little overdone. Per CNBC:

“So AI might be a little overhyped now, but underhyped long term,” he said. “AI could rhyme with the Internet. As we go through all this capital spending, we need to do the payoff while it’s incrementally coming in by the day. The big payoff might be four to five years from now.”

On Squawk Box, he said his fund cut Nvidia and “a lot of other positions in late March.” Drunkenmiller readily admits he is not a buy-and-hold investor like Warren Buffett. Based on the interview, Drunkenmiller thinks AI stocks are great long-term plays but understands that profit-taking can be very rewarding when stocks get too far ahead of themselves. Microsoft, for instance, rose 9400% from 1990 to 1999. While it turned out the company would be a huge beneficiary of the internet, its stock, at the time, rose too far, too fast. The stock would not revisit the 1999 highs until 2014. Since then, it has done extremely well. However, “taking a break” from a hot stock, as Drunkenmiller says, can be smart in the short to medium term.

microsoft AI

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Finding The Next Apple Using Buffetts Logic

On the heels of Apple’s latest earnings report, the Wall Street Journal shared an article discussing how Apple became such an oversized investment of Warren Buffett’s company, Berkshire Hathaway. Given their success with Apple shares we think it is worth understanding the logic that drove Buffett to accumulate such a large position in Apple.

Unbeknownst to most, Todd Combs, a member of the Berkshire portfolio management team, is responsible for bringing Apple to Buffett’s attention. However, not all credit goes to Combs. Buffett presented Combs with a challenge that ultimately highlighted Apple’s value proposition. With this same challenge, we will take a stab at finding the next Apple.

The inspiration for our challenge and a few quotes in this article come from a Wall Street Journal article entitled Apple is Buffett’s Best Investment.

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Berkshires Massive Stake Of Apple

Before finding the next Apple stock, it’s worth visualizing how Berkshire’s investment in Apple has grown over time as a percentage of Berkshire Hathaway and of Apple’s total shares outstanding.

The bar graph below compares Berkshire’s percentage ownership of Apple to that of the four largest mutual fund and ETF complexes. Berkshire had no position in Apple in 2015 and now holds over 5% of the company. Only Vanguard has a more significant position.

largest apple shareholders

The following graphs plot the surge in the number of shares owned by Berkshire and the value of its shares.

berkshire number of shares of apple
berkshire value of apple

The pie chart below shows that Apple comprises almost half of Berkshire’s portfolio. The next largest holding is Bank of America at 10%.

Berkshire holdings

Buffett Doesn’t Like Tech

Ironically, when Berkshire started buying Apple shares, Warren Buffett had an aversion to technology stocks. When asked why, he said he didn’t invest in companies he didn’t understand. He now admits that was a mistake.

While it may have been a mistake not to buy more technology companies in the mid twenty-teens, Buffett was able to appreciate what Apple truly was. While it is classified as and widely considered a technology company, Buffett got his head around Apple by likening it to a consumer goods company. Per the aforementioned Wall Street Journal article:

Considering the stock, though, Buffett began to see it as a consumer-goods company with enviable, latent pricing power, rather than as a tech or an electronic-device maker, according to people who have spoken to him. The loyalty consumers had for Apple products, especially the iPhone, suggested to Buffett that they would be willing to pay much more for upgraded versions of the phone in the years ahead, a sure way to boost profits.

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Todd Combs- The Unknown Mastermind

The Wall Street Journal article introduces Todd Combs, one of Berkshire Hathaway’s lesser-known portfolio managers. According to the article, around 2016, Buffett challenged Combs to find a stock that met specific criteria.

Among the stocks Combs found meeting the fundamental criteria and large enough for Berkshire to purchase was Apple. The rest is history. Since they started accumulating Apple in 2015, it has gained 650%, more than four times the S&P 500 over the same period.

Given Combs’ success, we thought it would be interesting to use the logic Buffett challenged Combs with and produce a similar scan. Let’s see if we can find the next Apple.  

Buffett’s Logic

The following paragraph from the WSJ article is the logic Buffett imparted to Combs, leading to their ownership of Apple.

This time, Buffett asked Combs to identify a stock in the S&P 500 that met three criteria. The first: a reasonably cheap price/earnings multiple of no more than 15, based on the next 12 months’ projected earnings. The stock also had to be one the managers were at least 90% sure would enjoy higher earnings over the next five years. And they had to be at least 50% confident that the company’s earnings would grow by at least 7% annually for five years or longer.

What made the search a little more difficult was that the companies that met the criteria also had to have a market cap large enough so Berkshire could buy enough of to move the needle of its portfolio but not overly impact the demand for the stock.

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The Combs Scan

In addition to the criteria in Buffett’s challenge, we added sales growth of at least 5% over the last five years. This helps us thin the list of companies to those already exhibiting strong top-line growth. We also removed financial, limited partnerships, REITs, and real estate stocks as their valuations and growth rates are not as easily comparable using traditional valuation metrics. Lastly, we disqualified Chinese companies due to the potential for political implications.

The following are the factors we used to screen for the next Apple.

  • Market cap > $50 billion
  • Price to Forward Earnings <15
  • Five-year expected earnings growth >5%
  • Sales growth in last five years > 5%
  • No financial, limited partnerships, REITs, real estate, or Chinese companies.

Many stocks meet the size, earnings, and sales growth criteria. But only two companies have cheap enough valuations to make the cut as shown below. 

the Buffett Combs stock scan

Currently, Berkshire has 5.242 million shares of T-Mobile, which is .20% of the portfolio. T-Mobile met our criteria, but its 5-year expected earnings growth is slightly below Buffett’s 7% bogey.

Berkshire does not hold EOG but has other oil and gas exploration companies, including Occidental Petroleum and Chevron.

Summary

Warren Buffett is an investing legend and one of the wealthiest people in the world. He takes a value orientation with a long-term investment horizon.

The Berkshire Hathaway portfolio, which also owns private companies, has done exceptionally well versus the market, as shown below. However, he goes through prolonged periods of poor relative performance versus the market.

The graph shows that over the last 30 years, Berkshire’s price return has tripled that of the S&P 500. However, there are four notable extended periods where he grossly underperformed the market. Also of note is that Berkshire handily beat the market in the recession and drawdowns of the dot com bubble and financial crisis. Such attests to his value orientation.

berkshire hathoway stock performance

Could ACDC Bring Needed Growth To Apple?

In June, Apple is expected to announce its progress on AI development, including Project ACDC, which stands for Apple Chips in Data Center. In a partnership with chip maker Taiwan Semiconductors, Apple hopes to make ACDC a competitor in what some are calling the AI arms race. Accordingly, ACDC will face tough competition from companies like Microsoft and Google, which are currently leading the AI charge. Project ACDC aims to create chips to run AI, unlike Nvidia apps that train AI. Consequently, Apple’s ACDC project should add to the demand for Nvidia’s chips.

Apple’s earnings release last week marked another disappointing earnings report. While the share price surged by nearly 7%, the results continue to indicate that Apple is a company with little growth. As we wrote in Apple’s Magic, its share buybacks are the primary source of EPS growth. The graph below shows its one and three annualized growth rates for sales and net income are lackluster. However, EPS has grown over the last three years as its share count has shrunk. While Apple can continue to financially engineer its stock higher, Project ACDC offers the company a new source of growth. Investors should pay close attention. ACDC could help Apple emerge from its growth doldrum.

apples annualized growth

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As discussed yesterday, the break above the 50-DMA likely confirms the recent correction is now over. Given the recent runup, the bit of intraday selling pressure was unsurprising, but it doesn’t change the technical backdrop. We recently noted that while the correction was expected, we repeatedly warned to take profits and rebalance holdings. The correction also provided opportunities. To wit:

Continue to remain long equities and look for opportunities to add to positions opportunistically. When the MACD issues its next buy signal, it will coincide with an improvement in the overall market and provide a better entry point for investors.

As shown, the MACD “buy signal” has been triggered, suggesting that, at least in the short term, the bullish bias has regained its hold. However, the markets are near-term overbought. Investors should use pullbacks to add exposure as needed.

Market Trading Udpate

As Goldman Sachs noted yesterday, several key drivers for the market exist over the next couple of months. However, the most important is reopening the “buyback window” until June 14th, and the “rate cut hope cycle” is now back in full swing.

Buybacks

For now, continue to remain long equities, as the next few months tend to be historically biased towards the upside.

Monthly Returns

Sloos Points To Weak Business Outlook

The quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) released by the Fed on Monday continues to point to weak demand for commercial and industrial loans for small, medium, and large businesses, as well as consumer demand for loans. As shown below, the current level of demand from all-size companies has improved, but it is still aligned with levels seen during recessions. This aligns with the NFIB data, pointing to a downturn for small businesses. Consumer demand for loans is worsening after seeing significant demand from 2020 to 2022. With excess savings largely depleted, as we discussed HERE, the demand for consumers to borrow may start increasing if they are to keep pace with current levels of consumption.

Bank lending standards also tightened or remained unchanged for most business segments and consumers. Per the report:

While banks, on balance, reported having tightened lending standards further for most loan categories in the first quarter, lower net shares of banks reported tightening lending standards than in the fourth quarter of last year across most loan categories

sloos business demand
sloos consumer demand

Melting Cocoa

In our Commentary about a month ago, we wrote a short piece entitled: Add Cocoa To The List Of “Mooning” Assets. Per the article:

While everyone is following the prices of Bitcoin, Nvdia, and a handful of other assets whose prices are soaring, few appreciate the recent price action of cocoa. The graph below shows that the year-to-date performance of cocoa is nicely aligned with that of Bitcoin and Nvidia.

A lot has changed since we wrote that. As shown below, the price of Cocoa futures peaked about a week after we published that article. Since then, it has nearly given up 50%. The price is still double where it started the year. Similar price declines have occurred in some other commodities that were “mooning.”

cocoa price

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Excess Savings Wanes Likely Eliminating Excess Growth

Personal consumption accounts for two-thirds of economic activity. Therefore, the means by which consumers can spend is essential for forecasting economic growth. The San Francisco Fed just released an article warning that a significant source of spending since the pandemic is no longer available. Per their article, Pandemic Savings Are Gone: What’s Next for U.S. Consumers?– “The latest estimates of overall pandemic excess savings remaining in the U.S. economy have turned negative, suggesting that American households fully spent their pandemic-era savings as of March 2024.

Since 2021, GDP has grown by 2.93% on an annualized basis, about half a percent greater than during the post-financial crisis – pre-pandemic era. The $2.5 trillion of excess savings, boosted by fiscal stimulus, helped GDP grow above its natural rate. However, excess savings from the pandemic have been depleted. This does not spell imminent recession. However, it argues growth should return to pre-pandemic levels. Per the Fed article, consumers still have some savings and healthy income growth to support consumption. Higher asset prices may also help. Lastly, per the Fed: “Consumers could use debt—such as credit cards and personal loans—to further support their current spending habits, although the current elevated interest rate environment means that the cost of using credit is higher than in the decade preceding the pandemic recession.

cumulative pandemic era excess savings

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable economic reports today

Market Trading Update

In yesterday’s commentary, we noted the market was on the verge of breaking above resistance at the 50-DMA. Furthermore, in yesterday’s blog, we laid out 3-potential market outcomes. To wit:

“The stock rally is at a critical juncture, and what happens next will determine whether the current market correction is over. Three possible scenarios over the next month or so exist.

Path A: The market breaks above the 50-DMA and retests previous highs. While this path is indeed possible, the markets are overbought on a very short-term basis, suggesting further price appreciation will become more challenging.

Path B: Many investors were surprised by the recent market decline. As such, these “trapped longs” will likely use the current stock rally as an opportunity to reduce risk. Another retest of the 100-DMA seems probable before the next leg of the current bull rally ensues.

Path C: With earnings season mostly behind us and stock buybacks set to resume, a reversion to the 200-DMA seems the least probable. However, as is always the case, it is a risk that we should not ignore. A sharp uptick in inflation or stronger-than-expected economic data could spark concerns about a “higher for longer” Fed policy. Such an event would likely lead to a further repricing of risk assets.

Sp500 market potential paths for a rally

Yesterday, the market broke above the 50-DMA, putting “Path A” as the potential scenario to consider in the near future. However, if it is going to be confirmed, the market must maintain that breakout through Friday. A failure in the next day or so that takes the market back below the 50-DMA will be considered a “failed breakout,” reinforcing resistance at the 50-DMA. In such an event, expect a retest of the 100-DMA shortly thereafter.

The bullish case is improving short-term, but continue to manage risk until the break above the 50-DMA is confirmed.

Market Trading Update

Berkshire Is Sitting On A Mountain Of Cash

At Berkshire Hathaway’s annual meeting this past weekend, Warren Buffett stated: “We only swing at pitches we like.” Accordingly, given that they are sitting on $189 billion in cash, they probably don’t like many investment ideas. Indeed, the 5% interest rate on cash lessens the opportunity cost of not being more fully invested. Buffett plans to use some excess cash to buy back its shares but admits the stock “isn’t that liquid, so it’s hard to do.”

The graph below shows that Berkshire generates nearly $30 billion of free cash flow a quarter. Unless Buffett puts cash to work, the amount of cash and marketable securities will continue to grow rapidly. Given that valuations are generally high and Buffett tends to have a value orientation, it’s quite likely that Berkshire will wait for a correction. At that time, they will have significant funds to supply liquidity to the market.

berkshire buffett free cash flow

Staples Following Utilities Lead

Two weeks ago, we shared a SimpleVisor sector analysis, showing that the utility sector was leading the market. While the sector continues to outperform every other sector and the broader S&P 500, consumer staples (XLP) stocks are now following their lead. The first SimpleVisor graphic below highlights that staples are now the second most overbought sector behind utilities. The graph on the right side plots the rotation of its absolute and relative SV scores for the past six weeks. As we often find, stocks and sectors rotate from oversold on an absolute and relative basis to overbought. Currently, the staples sector is overbought but only moderately so. There is plenty of room to become more overbought.

The second graph charts its relative score in the top graph. The bottom graph highlights the relative performance versus the S&P 500. As shown, its recent scores in the top graph are the highest or most overbought in a year. The relative performance of staples has been lousy this past year. However, that leaves plenty of room for it to catch up with the market.

The third graph below is from the TPA weekly RRG report. TPA is a standalone service within SimpleVisor offering its subscribers a unique way to take advantage of sector and stock rotations. The third graph below from Monday’s relative rotation report shows the rotations of 27 sectors and subsectors. As we circle, utilities (XLU) and XLP are “improving” and likely headed toward the “leading” quadrant. TPA’s analysis argues that both sectors have more relative upside performance. The following link shows TPA’s RRG model and how sectors and subsectors move in and out of favor over time: https://youtu.be/jl7nGbZKWa0  

simplevisor sector analysis
staples versus the market simplevisor
sector rotation tpa

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Stock Rally As Powell Sparks A Buying Frenzy

The latest FOMC meeting caused a stock rally as Jerome Powell turned more “dovish” than expected. While Powell did note that progress on inflation has been lackluster, the announcement of the reversal of “Quantitative Tightening” (QT) excited the bulls.

Beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage‑backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities”

Of course, the reversal of QT means a buyer of Treasury bonds is returning to the market, increasing overall market liquidity. It also means the Treasury will issue $105 billion less in gross in Q3. The bond market also got the memo, as the Fed’s return to the bond market suggests lower yields in the months ahead, easing financing pressure in the economy.

We have previously discussed the following chart of “liquidity,” which subtracts the Treasury General Account and Reverse Repo from the Federal Reserve’s balance sheet. The recent market decline coincided with a sharp drop in liquidity as the TGA account surged to almost $1 trillion from April tax receipts. Over the next few months, that liquidity in the TGA will get released into the economy. At the same time, the Federal Reserve will reduce its balance sheet runoff, which will further add to overall liquidity.

Liquidity Index vs Sp500

Notably, the market has weathered the reduction in liquidity to date. While higher rates and the reversal of “Quantitative Easing” led to a 20% market decline in 2022, investors began to “front run” the Fed in anticipation of rate cuts and a return to balance sheet expansion.

Fed QE vs Sp500

Given that “QE” programs increase bank reserves by crediting their reserve accounts for bonds bought, the introduction of the tapering of “QT” is the first step in increasing system liquidity.

Sp500 vs Bank Reserves vs Fed Balance Sheet

This is why there was a vicious stock rally last week. For the markets, this rang “Pavlov’s Bell.”

The Correction May Not Be Over Just Yet

While the stock rally last week certainly surprised many, given the weaker-than-expected economic data, there are some reasons to suspect the correction may not be complete just yet.

In mid-March, we suggested that due to the “buyback blackout” window, a 5-10% correction was likely. To wit:

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

The following month, the market violated that 20-DMA, and selling commenced, leading to a 5.5% drawdown. However, buyers initially stepped back in at the 100-DMA, which has now acted as support over the last two weeks. With the rally last week, the stock rally is now testing crucial resistance at the 50-DMA.

Market Trading update 1

The stock rally is at a critical juncture, and what happens next will determine whether the current market correction is over. Three possible scenarios over the next month or so exist.

Path A: The market breaks above the 50-DMA and retests previous highs. While this path is indeed possible, the markets are overbought on a very short-term basis, suggesting further price appreciation will become more challenging.

Path B: Many investors were surprised by the recent market decline. As such, these “trapped longs” will likely use the current stock rally as an opportunity to reduce risk. Another retest of the 100-DMA seems probable before the next leg of the current bull rally ensues.

Path C: With earnings season mostly behind us and stock buybacks set to resume, a reversion to the 200-DMA seems the least probable. However, as is always the case, it is a risk that we should not ignore. A sharp uptick in inflation or stronger-than-expected economic data could spark concerns about a “higher for longer” Fed policy. Such an event would likely lead to a further repricing of risk assets.

Sp500 market potential paths for a rally

I am less concerned about “Path C” for three reasons.

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Little Evidence Of Market Stress

While a more profound decline is certainly possible, there is little evidence of market stress. For example, even during the latest correction, volatility remained very subdued. Yes, volatility increased during the decline but failed to reach the levels witnessed during the 10% correction last summer.

VIX vs Sp500

Secondly, a substantially deeper market decline would likely widen credit spreads between junk bonds and treasuries. That was not evident during the latest market decline, as spreads remain well below the long-term average. Watching credit spreads is the best indicator for investors to determine market risks.

Credit Spreads CCC vs AAA

Third, the window for stock buybacks reopens this week, and with Apple and Google announcing $110 and $70 billion programs, respectively, those two companies alone will account for roughly 18% of this year’s slated activity.

Annual change in buybacks vs Sp500

Combining current sentiment, buybacks, and liquidity hopes makes the stock rally over the last two weeks logical. Furthermore, given that early summer months tend to be bullish for markets during election years, it is likely too soon to be overly bearish.

Presidential Election Year stock market performance by month.

However, we are also not completely oblivious to the numerous risks that lie ahead. Weaker economic data, the lag effect from higher rates, and sticker inflation pose portfolio risks worth monitoring. Furthermore, in the two months before the election, investors tend to de-risk their portfolios. This year, we could see a larger-than-normal event, given the risks associated with the current matchup.

While Powell’s “dovish” twist fueled the current stock rally, continue to manage risk accordingly. There is a reasonable chance this correction is not over just yet.

A Stock And Bond Friendly Labor Report

Last week’s Employment Cost Index (ECI) shook the stock and bond markets as investors worried that higher wages would keep inflation sticky, thus forcing the Fed to push off rate cuts. However, Friday’s BLS report provided optimism for stock and bond investors as it aligned with other wage data that did not show a jump in wages in the first quarter. As witnessed by the initial surge in stock prices and bond yields, investors appear relieved.

Average hourly earnings in the BLS report rose 0.2%, 0.1% below expectations. Year-over-year wage growth fell to 3.9% from 4.1%. That marks the first annual reading below 4% since June of 2021. Furthermore, the average workweek declined by 0.1. We share the graph below to appreciate the totality of wages, hours worked, and the number of people employed. The orange line shows average hourly earnings have been steadily rising, but the number of hours worked has been falling for three years. The red line shows that the annual growth rate of the product of hours, earnings, and number of employed is back to pre-pandemic levels.

The economy added 175k jobs in April, below estimates of 248k and last month’s 315k. The shortfall versus expectations was the biggest miss since 2021. That says something, considering economists have grossly underestimated job growth over the previous 18 months. The unemployment rate ticked up 0.1% to 3.9%. The household survey, used to calculate the unemployment rate, shows the economy lost 25k jobs last month.

aggregate wages, wage inflation

What To Watch Today

Earnings

Earnings Calendar

Economy

  • No notable economic reports

Market Trading Update

Last week, we discussed whether the recent rally from the lows was just a sucker rally ahead of a bigger decline. Our assessment was that was likely not the case. To wit:

On Friday, following blowout earnings from Google and Microsoft, the market challenged the intersection of the 20- and 50-DMA. With the market not overbought yet and the MACD ‘buy signal’ approaching, the bullish case is building. However, the initial resistance of the 50-DMA could prove challenging.”

On Wednesday, Jerome Powell’s speech following the conclusion of the latest FOMC meeting provided a more “dovish” than expected message. While Powell did note that progress on inflation has been lackluster, the announcement of the reversal of “Quantitative Tightening” (QT) excited the bulls.

Beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage‑backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities”

Of course, the reversal of QT means a buyer of Treasury bonds is returning to the market, increasing overall market liquidity. It also means the Treasury will issue $105 billion less in gross in Q3. The bond market also got the memo, as the Fed’s return to the bond market suggests lower yields in the months ahead, easing financing pressure in the economy.

The market surged higher on Thursday and Friday, supported by Apple’s massive $110 billion stock buyback program. With a MACD “buy signal” triggered on Friday and the market not overbought yet, a push above resistance at the 50-DMA seems likely next week. That break of resistance should allow the bulls an opportunity to retest 5200 over the next month or so.

Market Trading Update

However, while the bullish market setup is intact in the near term, we continue to expect another decline this summer before the election. Historically, institutional players are reticent about holding long exposures heading into an election, so we often see weakness in September and October.

The Week Ahead

This week will be quiet after last week’s deluge of important economic data, corporate earnings, and the Fed meeting. Earnings for the major companies that report on the traditional quarter-ending March-June-September-December cycle are primarily done. There are few companies like Nvidia that report off-cycle. There is little economic data for the week. Stock and bond investors will likely anticipate the CPI and PPI releases next week.

Given the lack of headlines, Fed speakers coming out of their media blackout will take center stage. We suspect they will broadly align with the sentiment Powell gave last week. However, they may have some thoughts on last week’s jobs data or the upcoming inflation reports.

Another Look At Inflation

With CPI being the next major economic release to help guide the Fed, we thought it would be helpful to review a Fed inflation measure that views prices with a different lens.

Multivariate Core Trend Inflation (MCT) is a mouthful but influential gauge the Fed uses to measure how persistent or transitory price changes are. MCT assesses whether price changes are a common trend amongst many goods and services or if a few sector-specific factors drive the underlying price changes.

The New York Fed starts with PCE data to compute MCT. Last Monday we learned that this version of PCE fell to 2.6%, down from 2.7% last month. Last month was revised lower from 2.9%.  MCT excludes food and energy. In comparison, Core PCE runs at 2.8%. Like PCE, it doesn’t show a resurgence of inflation as CPI alludes to. The reason is that the MCT model helps strip out seasonal and one-off price changes that are not deemed to be statistically persistent. In other words, the model doesn’t think the recent bump in inflation will be lasting.

To help you further understand this inflation measure, we share a FAQ from the New York Fed website:

How does the MCT measure differ from the core personal consumption expenditures (PCE) inflation measure?

The core inflation measure simply removes the volatile food and energy components. The MCT model seeks to further remove the transitory variation from the core sectoral inflation rates. This has been key in understanding inflation developments in recent years because, during the pandemic, many core sectors (motor vehicles and furniture, for example) were hit by unusually large transitory shocks. An ideal measure of inflation persistence should filter those out.

mct cpi core inflation fed

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Starbucks Earnings Warn Of Belt Tightening

Starbucks latest earnings report sends the message that consumers may finally be retrenching after a few years of spending above their means. Cheap luxury items are low in price by definition and include items that we do not necessarily need but are nice to have. When consumers have confidence in the economy and their jobs, they tend to reward themselves by consuming more cheap luxury items. Conversely, concerns about their job status or doubts about whether they will get a raise lead many consumers to tighten their wallets. For many consumers, cheap luxury items are the easiest items to cut back on when their confidence wanes.

Starbucks coffee is an excellent example of a cheap luxury item. It is relatively inexpensive, but the alternatives of making coffee at home or getting free coffee from the office are much cheaper. Starbucks shares fell 20% on Wednesday as their earnings were poor. The following statistics from Starbucks point to a more frugal consumer:

  • Same-store sales fell 4%, and traffic fell 6% in the quarter.
  • International same-store sales were down 6% versus expectations of a 1.4% gain.
  • Starbucks lowered its revenue growth guidance from 7% to the low-single digits.
  • Per Starbucks: “Most loyal customers are looking for discounts.”
starbucks

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

With the bulk of earnings season behind us, the market’s focus will return to economic data and the Federal Reserve. Today is the much-anticipated employment report and hourly earnings. While the Fed suggested they will not hike rates further, a much hotter-than-expected report suggesting “higher for longer” will negatively impact stocks and rates.

As discussed yesterday, the market continues to trade above the 100-DMA, establishing a pattern of higher lows. If the market can weather today’s employment report, it could set it up for a rally next week. Notably, we are beginning to build a pattern of price compression. A break out to the upside will likely lead to a retest of this year’s highs. A downside break will lead to a test of the 200-DMA. Unfortunately, the odds for either outcome are currently 50/50. Therefore, continue to manage risk accordingly until we can confirm the next direction for the market.

Market Trading Update

JOLTs Portends Higher Unemployment

The JOLTs report published by the BLS shows the labor market continues to normalize. The number of job openings fell to 8.488 million, well below the peak in 2022 but still above the pre-pandemic levels.

The quits rate, on the other hand, has fallen back to levels last seen in 2017. The quits rate is a good measure of employee confidence. When employees feel confident in finding a better-paying job, the quit rates tend to be higher. Conversely, the quits rate tends to be lower in a weaker labor market. The second graph below shows that the quits rate (on an inverse scale) and the unemployment rate are well correlated. As we circle, the last time the quits rate was at current levels, the unemployment rate was between 4.5% and 5%. The unemployment rate is 3.8% and has yet to increase with the quits rate.

The third graph shows the same data in scatter plot format. Again, the current instance is an outlier, arguing the unemployment rate may increase in the coming months. Further making the case for higher unemployment, the JOLTs hires rate is also below pre-pandemic levels.

jolts job openings
quits rate and unemployment jolts
quits rate and unemployment

But… Jobless Claims Points To A Strong Labor Market

Recent jobless claims data seem to conflict with our thoughts in the prior section on the quits rate and what it may portend for unemployment. Yesterday’s initial jobless claims were 208k. As we share below, the rate is historically low and does not show any signs of turning up. The data is weekly, so it is among the best real-time job data available, or so many think.

Based on a Bloomberg article entitled Why Jobless Claims Fail As A Recession Gauge, jobless claims may not be a good gauge of the jobs market. Per the article:

Jobless claims have been a reliable indicator in the past of loosening labor-market conditions — but not at the moment. That’s because a smaller share of today’s unemployed persons are eligible for benefits — and even among those eligible, fewer are applying for benefits that haven’t kept up with inflation.

The article estimates that 78% of unemployed workers are eligible for unemployment benefits; typically, the number is closer to 85%. Further, while people may be eligible, they may not file a claim as unemployment benefits have not kept up with inflation. The following paragraph highlights the situation in California, which accounts for 11% of the nation’s total employment.

In California, for instance, unemployment benefits have not been raised in two decades, with the state’s massive budget deficit a barrier to raising the payout. While the number of unemployed in California has increased by more than 40% since mid-2022 — the state’s unemployment rate reached 5.3% in March (from 3.8% in August 2022), highest in the US — jobless claims have been persistently flat.

The authors summarize as follows:

Bottom line: Weekly UI claims figures may overstate the labor market’s resilience. Given current low levels of the recipiency, eligibility and take-up rates, claims will likely continue to present a distorted picture even if the labor market deteriorates swiftly.

jobless claims

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Behavioral Traits That Are Killing Your Portfolio Returns

Investor psychology is one of the most significant reasons individuals consistently fall short of their investment goals. While one of the most common truisms is that “investors buy high and sell low,” the underlying reason is the behavioral traits that plague our investment decision-making.

George Dvorsky once wrote that:

“The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.

Behavioral traits and cognitive biases are anathemas to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process.

In other words:

“The most dangerous element to our success as investors…is ourselves.”

Here are the top five most insidious behavioral traits keeping us from achieving our long-term investment goals.

Confirmation Bias

Probably one of the most insidious behavioral traits is “confirmation bias.” Confirmation bias is a term from cognitive psychology that describes how people naturally favor information that confirms their previously existing beliefs.

“Experts in behavioral finance find that this fundamental principle applies to investors in notable ways. Because investors seek out information that confirms their opinions and ignore facts or data that refutes them, they may skew the value of their decisions based on their cognitive biases. This psychological phenomenon occurs when investors filter out potentially useful facts and opinions contradicting their preconceived notions.” – Investopedia

In other words, investors tend to seek information that confirms their beliefs. If they believe the stock market will rise, they tend only to read news and information that supports that view. This confirmation bias is a primary driver of individuals’ psychological investing cycles. As shown below, there are always “headlines” from the media to “confirm” an investor’s opinion, whether it’s bullish or bearish.

Confirmation bias vs market headlines

As investors, we want “affirmation” that our current thought process is correct. That is why we tend to join groups on social media that confirm our thoughts and ideals. Therefore, since we hate being wrong, we subconsciously avoid contradicting sources of information.

For investors, it is crucial to weigh both sides of each debate equally and analyze the data accordingly.

Being right and making money are not mutually exclusive.

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Gambler’s Fallacy

The “Gambler’s Fallacy” is another of the more common behavioral traits. As emotionally driven human beings, we tend to put tremendous weight on previous events, believing that future outcomes will be the same.

At the bottom of every piece of financial literature, Wall Street addresses that behavioral trait.

“Past performance is no guarantee of future results.”

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns, expecting similar results in the future.

This particular behavioral trait is a critical issue affecting investors’ long-term returns. Performance chasing has a high propensity to fail, pushing individuals to jump from one late-cycle strategy to the next. The periodic table of returns below shows this. Historically, “hot hands” last 2-3 years before going “cold.”

Periodic table of investment returns

I highlighted the annual returns of both Emerging and Large-Cap markets for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom in subsequent years. 

“Performance chasing” is a significant detraction from investors’ long-term investment returns.

Probability Neglect

Third, when it comes to “risk-taking,” there are two ways to assess the potential outcome.

There are “possibilities” and “probabilities.” 

When it comes to humans, we tend to lean toward what is possible, such as playing the “lottery.” The statistical probabilities of winning the lottery are astronomical. You are more likely to die on the way to purchasing the ticket than winning it. However, it is the “possibility” of being fabulously wealthy that makes the lottery so successful as a “tax on poor people.”

As investors, we neglect the “probabilities” of any given action. Such is specifically the statistical measure of “risk” undertaken with any given investment. As individuals, our behavioral trait is to “chase” stocks that have already shown the largest increase in price as it is “possible” they could move even higher. However, the “probability” is that the price reflects investor exuberance, and most gains have already occurred.

Psychological impact of buy high and sell low.

Probability neglect is another contributory factor as to why investors consistently “buy high and sell low.”

Herd Bias

Though we are often unconscious of this particular behavioral trait, humans tend to “go with the crowd.” Much of this behavior relates to “confirmation” of our decisions and the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, I must do it also if I want to be accepted.

In life, “conforming” to the norm is socially accepted and, in many ways, expected. However, the “herding” behavior drives market excesses during advances and declines in the financial markets.

As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.

Investors generate the most profits in the long term by moving against the “herd.” Unfortunately, most individuals have difficulty knowing when to “bet” against the stampede.

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Anchoring Effect

Lastly, “Anchoring,” also known as the “relativity trap,” is the tendency to compare our current situation within the scope of our limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for. However, can you tell me exactly what you paid for your first soap bar, hamburger, or pair of shoes? Probably not.

The reason is that the home purchase was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event, and therefore, we assume that the next home purchase will have a similar result. We are mentally “anchored” to that event and base our future decisions around very limited data.

When it comes to investing, we do very much the same thing. If we buy a stock that goes up, we remember that event. Therefore, we become anchored to that stock instead of one that lost value. Individuals tend to “shun” stocks that lost value even if they were bought and sold at the wrong times due to investor error. 

After all, it is not “our” fault that the investment lost money; it was just a bad stock. Right?

Make Better Bad Choices

My nutrition coach had a great saying about dieting; “make better bad choices.”

We are all going to make bad choices from time to time. The goal is to try and make bad choices that don’t have an outsized effect on our plan. When it comes to dieting, if you eat a burger, order it without cheese and mayonnaise.

If you make speculative bets in your portfolio, do it in smaller amounts. Or, if you are leaning towards “panic selling” everything, start by selling some but not all of your holdings.

Importantly, focus on the rules and your investment discipline.

  • Do more of what is working and less of what isn’t. 
  • Remember that the “Trend Is My Friend.”
  • Be either bullish or bearish, but not “hoggish.” (Hogs get slaughtered)
  • Remember, it is “Okay” to pay taxes.
  • Maximize profits by staging buys, working orders, and getting the best price.
  • Look to buy damaged opportunities, not damaged investments.
  • Diversify to control risk.
  • Control risk by always having pre-determined sell levels and stop-losses.
  • Do your homework.
  • Not allow panic to influence buy/sell decisions.
  • Remember that “cash” is for winners.
  • Expect, but do not fear, corrections.
  • Expect to be wrong, and will correct errors quickly. 
  • Check “hope” at the door.
  • Be flexible.
  • Have the patience to allow your discipline and strategy to work.
  • Turn off the television, put down the newspaper, and focus on your analysis.

Importantly, keep your market perspectives and behavioral traits in check. Our goal is to ensure that our decisions are influenced by reliable data and psychological emotions.

Most importantly, if you don’t have an investment strategy and discipline you are stringently following, that is an ideal place to begin.

Rate Cuts Do Not Appear To Be On The Horizon

As was widely expected, the Fed left interest rates unchanged. Jerome Powell alluded that it’s much more likely the next Fed move will be rate cuts, not an increase in interest rates. Given the November elections and the internal pressure on the Fed to remain independent, it now seems likely that barring a sharp upturn in unemployment or a renewed decline in prices, rate cuts are not likely this year. The FOMC statement was largely unchanged, but there are two important changes from the prior meeting. First, as highlighted in the first paragraph below, the Fed acknowledges that inflation has become sticky. However, in the second paragraph, they note that supply and demand are in better balance, which should allow for more disinflation.

Second, and more importantly, for the markets, the Fed will start reducing the amount of QT in June. While this was expected based on their FOMC minutes released three weeks ago, the reduction was larger than expected. Further, the entire reduction will be in U.S. Treasury securities, not mortgage-backed securities. This action will help ease market concerns of heavy Treasury debt issuance. During the press conference, Jerome Powell sent mixed messages. While he firmly believes the Fed will meet its 2% inflation goal, they do not want to cut rates too soon. He doesn’t expect to, but they would raise rates if needed. The highlight of the press conference occurred when Powell was asked about stagflation. His reply: “I don’t see the stag or the ‘flation.”

fed rate cuts fomc meeting

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

Following yesterday’s discussion, the market failed at the 50-DMA and is continuing its correction to retest the 100-DMA. The FOMC meeting concluded its 2-day meeting, and even though rate cuts may not occur this year, the larger-than-expected reversal of Quantitative Tightening (QT) surprised the market. Given that the Federal Reserve is now positioned to start monetizing more debt from the Treasury, it suggests more liquidity for the financial markets and lower yields. As such, stocks and bonds rallied sharply yesterday following the announcement, but day-end sellers emerged, taking away the gain.

There is still likely some near-term downward pressure on stocks, and Apple reports after the bell today, wrapping up the bulk of the earnings season for the S&P 500. Continue to monitor risk accordingly, but with the Fed on hold, stocks will likely find a bottom soon.

Market Trading Update

Nvidia And The Fabulous Three

The S&P 500’s market cap was up 6.27% through April 26, as shown by the black line in the graph below, courtesy of Bianco Research. Last year, the Magnificent Seven accounted for almost all of the market gains. This year, the Magnificent Seven is being widdled down to the Fabulous Three and Nvidia. Four stocks account for 62% of the year’s gains. AMZN, MSFT, and META contributed about 19% of the increase in market cap. Nvidia doubles the Fabulous Three, accounting for 38% of the increase. In fact, as shown below, Nvidia single-handedly contributed more to the S&P 500 than the remaining 496 stocks. Nvidia reports its earnings on May 22, a month after most other companies. Accordingly, it has avoided the volatility that has impacted many of the Magnificent Seven stocks this earnings season.

nvidia and the fabulous three and S&P 500

The Dallas Fed Services Sector Bemoans Higher Rates

Over the past two years, the service sectors have generally prospered while manufacturing has been in a recession. Recently, manufacturing has shown signs of life, but the service sector is starting to exhibit problems. The service sectors represent almost 90% of the economy. Consequently, the recession in manufacturing did not put the economy into a recession. However, avoiding a recession would be difficult if the service sector struggles. The graphic below shows the March ISM Services survey is still above 50%, an indication of economic expansion. However, the trend is heading toward 50, and a few of its components are below 50.

The most recent Dallas Fed services survey for April indicates that Friday’s ISM services could be weaker than expected. More importantly, it appears that high interest rates are starting to impact the economy negatively. The quotes below, with the respondent’s industry, are from the survey.

Publishing– The impact of the higher rate environment seems to be catching up, with general purchase intent among customers flattening out.

Credit Intermediation– We recently renegotiated our $600 million debt facility. Our cost of funds went from 9 percent to 14 percent—that’s a pretty big hit to our bottom line and resulted in us increasing prices to our customers. Our business focus has been on forecasted easing; however, the reality of rates staying higher longer is creating uncertainty. The Federal Reserve signaling it will hold the rate at the current level for longer has affected our outlook negatively.

Securities– Recent movement in long-term rates, combined with the Fed holding rates longer, have delayed the expected value of investment recovery until 2025 or later.

Real Estate– Cost of capital is weighing on our customers and decreasing volume. The increase in treasury yields since last fall has negatively impacted deal-making activity in the income property industry.

Professional, Scientific and Technical– Persistent inflation and the Fed potentially delaying rate cuts are causing uncertainty for the second half of 2024. This real estate market is hard to figure out. With the 10-year rate still moving in the wrong direction, and the likelihood of a rate cut not coming this year due to inflation and the strength of the economy, we just can’t see the market improving until next year.

Administrative and Support– Continued high interest rates, inflation and general economic malaise has caused employers to be very reluctant to hire professional level talent. High interest rates have drastically hindered our ability to grow our business, and it looks like a rate cut is not likely happening in 2024.

ism survey results

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Weight Loss Drugs Power Eli Lilly Earnings

Eli Lilly (LLY) shares have risen significantly as the company is proving to be a leader in a new class of drugs that help with weight loss and diabetes. For the quarter, its total revenue was $8.77 billion, which is 26% higher than the first quarter of 2023. Revenues for their four drugs that help with weight loss and diabetes are as follows: Trulicity ($1.46bn), Mounjaro ($1.81bn), Zepbound ($515mm), and Humalog ($538mm). These drugs single-handedly account for almost half of Lilly’s revenue.

Bloomberg estimates that by the year 2030, annual sales of weight-loss medications will reach $80bn, making them among the largest class of drugs in history, as measured by sales. Further, they expect Eli Lilly and Novo Nordisk to garner more than 90% of the market. The revenue from these weight loss and diabetes drugs is snowballing, and plenty of potential remains. First, consider that 83% of Mounjaro’s sales are domestic, and Novo Nordisk reports that 90% of Ozempic sales are domestic. Rapid revenue growth can continue as sales in the U.S. and worldwide increase. Further driving growth, Medicare’s decision to subsidize Wegovy for heart disease patients and similar actions by the insurance companies provide another impetus for growth.

The graph below shows the tremendous growth in Eli Lilly (LLY) and Novo Nordisk (NVO) shares as compared to the broader healthcare sector (XLV).

eli lilly lly nvo and xlv

What To Watch Today

Earnings

Earnings Calendar

Economy

Economic Calendar

Market Trading Update

As discussed yesterday, the market failed at the test initial resistance at the 50-DMA. While that failure is unsurprising, given the recent rally from the lows, it is now paramount the market holds crucial support at the 100-DMA. This correction continues to be a low volatility event, which suggests it is unlikely to devolve into a deeper decline. However, it is always important to never discount a possibility entirely. The outcome of the FOMC meeting today is expected to be a non-event, with Fed Chair Powell continuing to hold the line on economic data and rate cuts later this year. Of course, going into the meeting, it is unsurprising traders took some of the recent gains just in case the Fed comes out more “hawkish” than expected.

Earnings continue to be okay, with Apple (AAPL) reporting tomorrow and the employment report on Friday. However, there is plenty of room for additional volatility until next week.

Market Trading Update

Higher Wages Spook Markets

The employment cost index (ECI) rose more than expected, prompting concern that the Fed may further delay rate cuts. The ECI for the quarter was up 1.1%, above estimates of 0.9% and last quarter’s 0.9% reading. The graph below shows that the private and civilian sectors are closely aligned.

For the last few years, the Fed has been worried that higher wages will feed more inflation. Such a feedback loop is known as a price-wage spiral. Per Nick Timiraos of the Wall Street Journal, “The ECI is seen inside the Fed as the highest-quality measure of compensation growth.” While ECI adds to concerns that inflation could stay sticky, Nick caveats the increase, saying that the higher-than-expected increase in wages may be a function of cost-of-living increases and minimum wage adjustments given at the start of the year. Again, this is a quarterly number, so the data encompasses January, February, and March.

Thus far, the monthly BLS labor report has not confirmed the latest ECI data. The second graph shows average hourly earnings continue to decline. The monthly changes in hourly earnings also do not show a recent upward bias, as we see in ECI. This Friday’s BLS will provide an update on wages.

employment cost index eci
average hourly earnings BLS

Chicago PMI And Consumer Confidence

Manufacturing in the midwest, as evidenced by the well-followed Chicago PMI index, may not be recovering. While only one month of data, if the national ISM survey follows the Chicago PMI, the recent optimism that the manufacturing sector may exit an 18-month recession may fade quickly. Other than 2020, when Chicago PMI plunged for just two months during Covid and spiked back, the Chicago PMI hasn’t been this low since 2009.

Moods are not only dour in the manufacturing sector. As the second graph shows, Tuesday’s consumer confidence survey is heading lower. Like the Chicago PMI report, consumer confidence was worse than expected. The index fell to 97.0 from a downwardly revised 103.1. The estimate was 104. Both the present situation and expectations indexes were lower. Changes in consumer sentiment often precede changes in consumer spending. Again, one month does not make a trend, but given that consumers account for two-thirds of the economy, this reading, like the Chicago PMI, cautions that the economy may slow in the coming months.

chicago pmi vs national ISM
consumer confidence

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Fed Policies Turn The Wealth Gap Into A Chasm

In an op-ed for the Washington Post on November 5, 2010, Ben Bernanke did a victory lap, praising the Fed’s efforts in stemming the financial crisis. In the article, he discusses how QE and other Fed policies eased financial conditions, bolstering investor confidence.

And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. 

If Bernanke wants credit for his Fed policies that boosted stock prices, he should also take responsibility for the costs. Those same monetary policies, which have been repeated many times since 2008, have played an important role in exacerbating the wealth gap in America. Accordingly, we should question his use of the term “virtuous circle” to describe how modern monetary policy works.

Graphing The Wealth Gap

Inspiration for this article comes from our recent article, Wealth Gap and the Road to Serfdom.

Before discussing the Fed’s role in widening the wealth gap, we put context to the problem. The graphs and quote below are from the article.

wealth distribution
percentage of americans with no savings
why americans cant save money

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.”

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Trickledown Economics and Monetary Policy

Trickledown economics” was coined by John Kenneth Galbreth in 1982 and made famous by President Ronald Reagan. The expression is another name for supply-side economic policy. The policy theorizes that the populace benefits when government interference in the economy is minimal. For example, lower taxes and reduced regulations should promote economic activity and prosperity for the entire populace.

The theory is logical, but politicians have done a poor job enacting it.

In 2008, the Fed took a page from the supply-side economic playbook to stem the financial crisis. From that point forward, the Fed’s modus operandi has been trickle-down monetary policies.

Does QE Trickle Down?

Ben Bernanke wasn’t the first Fed Chair or central banker to use QE. But he did make it a household name and seemingly a permanent tool in the Fed’s toolbox.

QE has two significant impacts on the financial markets and the banking system.

First, removing assets from financial markets alters the supply-demand balance in favor of higher prices. Additionally, when investors believe QE is positive for asset prices, as is the case, demand increases, which provides even more impetus for higher asset prices.

Second, the Fed buys bonds from the banks with reserves. Reserves are a form of money that is only viable in transactions between banks or with the Fed. Reserves support bank loans and asset purchases. Therefore, when more reserves are available, banks can more easily make loans and buy assets. Further, some bank loans, specifically margin or repo loans, generate additional demand for assets.

The scatter plot below shows the positive correlation between the one-year percentage change in margin debt and the Fed’s balance sheet.

margin debt and fed balance sheet

Higher stock and asset prices coupled with more leverage is a winning combination for investors.

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The Graph of All Graphs

With that explanation of how trickledown monetary policy bolsters asset prices to accomplish the Fed’s goals, we share a graph explaining why the Fed’s policies widen the wealth gap.

the S&P 500 beats inflation

Since 1990, the dollar’s purchasing power has declined by over 50%. At the same time, the S&P 500 has risen by over 1,300%. Those with a sufficient portfolio of stocks could more than offset the decline in the dollar’s purchasing power. Those without stocks are left behind.

Further, it doesn’t help that real household income for the lowest 20% has been unchanged since 1990. Over the same period, they have risen by about 50% for those in the upper 20% of incomes.

change to real household income by wealth
average salary for college graduates
purchasing power

Share Of Wealth

The wealthier have seen their wages and the value of their financial assets rise much more than inflation. At the same time, the lower wealth and income classes have seen marginal real income gains at best and little in the way of benefits from rising stock prices. 

The two graphs below show how the percentage of the wealth owned by the top 1% and the change in the S&P 500 are well correlated.

share of wealth versus the stock market
share of wealth versus the stock market  higher wealth

On the contrary, the aggregate wealth of much of the bottom half of the nation, as a percentage of total wealth, has a negative relationship with the S&P 500.  

share of wealth versus the stock market
share of wealth versus the stock market - lower wealth

There is a straightforward explanation as to why the correlation between the share of the wealth of the rich versus that of the rest of the population has opposing correlations to the S&P 500. 10% of the population holds nearly 90% of the stocks.

stock holdings by wealth
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Trickledown Monetary Policy Handicaps Capitalism

QE and other Fed policies may help the economy on the margin and save some jobs. However, there is little evidence that, over the longer term, the economic benefits increase the prosperity of most of the populace. Further, as we share, there is compelling evidence it further exacerbates the wealth gap.

Capitalism has proven to be the best economic system for growing the wealth of the entire population. A key tenant of capitalism promises financial incentives for those who work hard and have unique skill sets. That incentive results in productivity gains, which benefit economic growth and allow for higher wages and a broad distribution of wealth.

Unfortunately, when financial incentives are not only a function of capitalism but also an offshoot of government and Fed policies, the benefits of capitalism are reduced.

For example, Elon Musk is extraordinarily wealthy and should be rewarded handsomely for everything he has accomplished. However, how much of his wealth is based on his hard work and ingenuity, and how much was gifted to him by the Fed via their stock-boosting monetary policies. While slightly off-topic, we should also question how much of his wealth is attributable to government subsidies for electric vehicles. 

Summary

President Biden’s poll numbers on economic confidence are poor despite robust economic growth and a historically low unemployment rate. While there are many reasons for the odd divergence, we think it’s fair to say that the benefits of the post-pandemic growth spurt have disproportionately accrued to those in higher-income classes and those with stocks. Those left behind, representing a large majority of the population, are not confident in Biden’s handling of the economy and suffer from higher prices.

Most Americans continue to see wages that cannot combat inflation and have little to no wealth invested in the stock market. Can you blame them for lacking confidence?

QE may have served as an emergency way to add bank reserves to the system and boost confidence. However, its continued use, even during economic prosperity periods, only makes the wealth gap wider.

Bullish Sentiment Index Reverses With Buybacks Resuming

Over the last two weeks, the bullish sentiment index has reversed from extreme greed to fear. The composite net bullish sentiment index, comprised of professional and retail investors, fell from 38.15 to 9.9 in two weeks. The previous drop between July and October last year was similar and marked the bottom of the correction.

Net bullish sentiment vs the market

While the bullish sentiment index can indeed fall further, what is notable is the sharp reversal of market “exuberance” in such a short span. However, as discussed in “Just A Correction,” there was a significant gap between buyers and sellers.

However, at some point, for whatever reason, this dynamic will change. Buyers will become more scarce as they refuse to pay a higher price. When sellers realize the change, they will rush to sell to a diminishing pool of buyers. Eventually, sellers will begin to “panic sell” as buyers evaporate and prices plunge.”

Like clockwork, that correction came quickly, with the market finding initial support at the 100-DMA. With solid earnings from GOOG and MSFT, the market rallied to initial resistance at the convergence of the 20- and 50-DMA. It would be unsurprising if the market failed this initial resistance test and ultimately retested the 100-DMA soon. Such a pullback would solidify that support and complete the reversal of the bullish sentiment index.

Stock market trading update

In early April, we wrote:

“Whatever trigger causes a reversal in the bullish signals, we will act accordingly to reduce risk and rebalance exposures. But one thing is sure: investor sentiment is extremely bullish, which has almost always been a good “bearish signal” to be more cautious.

While we have warned of a potential correction over the past few weeks, it reminds us much of June and July last year, where similar warnings for a 10% correction went unheeded. We are now seeing many individuals ‘jumping into the pool’ in some of the most speculative areas of the market. Such is usually a sign we are closer to a market peak than not. As such, we want to make adjustments before the correction comes.”

Very quickly, as supported by the bullish sentiment index, those bulls are turning bearish and are now calling for a more profound decline.

While such is possible, I suspect most of this correction is complete for two reasons.

Earnings Continue To Remain Strong

The first reason is that despite higher interest rates, earnings growth continues to remain robust, at least among the “Magnificent 7,” where Google (GOOG) and Microsoft (MSFT), in particular, exceeded estimates by a wide margin. However, overall, and most importantly, earnings growth has continued since the October lows of 2022. Notably, the support for improving earnings comes from the increased fiscal policies such as the Inflation Reduction Act and CHIPS Act.

Earnings vs money supply growth

While those policies will eventually fade, making forward estimates subject to downward revisions, the current earnings environment remains relatively robust. Furthermore, forward estimates remain optimistic that the Federal Reserve will cut rates later this year, lowering borrowing costs and supporting economic activity.

Earnings versus Fed funds rate

Notably, the increase in earnings, at least for now, remains a strong indicator of rising asset prices. The risk of a deeper market correction (greater than 10%) is significantly reduced during previous periods of improving earnings. While such does not mean a deeper correction can not happen, historically, corrections between 5% and 10% in an earnings growth environment tend to be buying opportunities and limit deeper reversal in the bullish sentiment index.

Annual change in earnings versus the market.

Improving earnings also precedes improving CEO confidence, which has provided pivotal support to financial markets since 2000.

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Buybacks Returning

We discussed the most critical reason we expected a market correction in mid-March. To wit:

“Notably, since 2009, and accelerating starting in 2012, the percentage change in buybacks has far outstripped the increase in asset prices. 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.”March 19, 2024

Furthermore, the “blackout” of corporate buybacks coincided with more extreme readings in the bullish sentiment index. Buybacks are crucial to the market because corporations have accounted for roughly 100% of net equity purchases over the last two decades.

Equity flows since 2000

Here is the math of net flows if you don’t believe the chart:

  • Pensions and Mutual Funds = (-$2.7 Trillion)
  • Households and Foreign Investors = +$2.4 Trillion
    • Sub Total = (-$0.3 T)
  • Corporations (Buybacks) = $5.5T
    • Net Total = $5.2 Trillion = Or 100% of all equities purchased

Unsurprisingly, that blackout window coincided with a sharp contraction of more than $367 billion in buybacks over the last 4-weeks. Consequently, when you remove a critical “buyer” from the market, the ensuing correction is unsurprising.

4-week buyback chart vs the market

However, corporate share buybacks will resume in the next couple of weeks, and with more than $1 trillion slated for 2024, many buybacks remain to complete. Such is particularly the case with Google adding another $70 billion to that total.

Goldman Sachs estimates of share repurchases.

As noted above, improving earnings and a decent outlook for the rest of this year also boost CEO confidence. (If you don’t understand why buybacks benefit insiders and not shareholders, read this.)

With robust economic activity supporting earnings growth, that improvement boosts CEO confidence. As CEOs are more confident about their business, they accelerate share buybacks to increase executive compensation.

CEO Confidence vs Buybacks

The liquidity boost from buybacks and stronger earnings will likely provide a floor below the market. This doesn’t mean the current correction doesn’t have more work to do. However, it is unlikely that it will resolve into something more significant.

At least for now.