Monthly Archives: May 2024

Consumers Are Turning to Private Label Brands

Consumers are turning away from name-brand foods in an attempt to cut back on spending. Consumer Packaged Goods (CPG) companies such as Proctor & Gamble, General Mills, and Kellogg benefited from supply chain disruptions during the pandemic as private label products saw restricted supply. Thus, the CPG brands with more resilient supply chains used the combination of shortages and heightened demand for food at home to exercise pricing power. As shown below, the price premium between national and store brands for TreeHouse Foods, a private-label manufacturer, remains substantially higher than pre-pandemic levels.

However, this advantage also meant that CPG brands relaxed their efforts to innovate their product lines. Private-label brands are also honing in on quality, meaning CPG brands must compete through innovation or lowering prices to maintain market share. The latter seems more likely, given the recent retail sales data. Now that supply chain pressures have alleviated and inflation is straining household budgets, consumers are turning to private-label brands to control costs. Per the Wall Street Journal:

Amid elevated demand for food at home and consumer wallets flush with stimulus cash, CPG companies were able to raise prices without much resistance. But that is now quickly changing as retailers deal with price-sensitive consumers increasingly exhausted with the cumulative impact of inflation: Grocery prices are about 26% higher than they were in 2019. In a recent survey of U.S. consumers by Jefferies, some 51% of respondents said they are buying more private-label products to save money on grocery bills.

National Brands Taking Advantage of Pricing Power

What To Watch Today

Earnings

  • No notable earnings releases.

Economy

Market Trading Update

Last week, we discussed the issue of the negative divergences and bad breadth of the market. To wit:

“While the bullish trend remains intact, along with a MACD ‘buy signal,’ which suggests an increased allocation to equity exposure, we have some concerns.

While the market is making all-time highs as momentum continues, its breadth is narrowing. The number of stocks trading above their respective 50-DMA continues to decline as the market advances, along with the MACD signal. Furthermore, the NYSE Advance-Decline line and the Relative Strength Index (RSI) have reversed, adding to the negative divergences from a rising market. While this does not mean the market is about to crash, it does suggest that the current rally is weaker than the index suggests.

As we discussed, these negative divergences have often preceded short- and intermediate-term corrective market actions. Such is the point where Investors tend to make two mistakes. The first is overreacting to these technical signals, thinking a more severe correction is coming. The second is taking action too soon.

Yes, these signals often precede corrections, but there are also periods of consolidation where the market trades sideways. Secondly, reversals of overbought conditions tend to be shallow in a momentum-driven bullish market. These corrections often find support at the 20 and 50-day moving averages (DMA), but the 100 and 200-DMAs are not outside normal corrective periods.

If you remember, in March, we discussed the potential for a 5 to 10% correction due to many of the same concerns noted above. That correction of 5.5% came in April. We are again at a juncture where a 5-10% is likely. The only issue is it could come anytime between now and October.

As is always the case, timing is always the biggest risk. Therefore, be careful not to overreact or act too soon. The market will let us know when to become more aggressive in reducing risk.

The Week Ahead

The second quarter comes to an end this week. The primary focus will be PCE prices plus personal income and outlays on Friday. The all-important core PCE price index is the Fed’s preferred measure of inflation; thus, it carries extra weight. The consensus expects personal income to rise 0.4% MoM in May versus the 0.3% increase in April. Meanwhile, the consensus expects personal expenditures to rise by 0.3% MoM in May after increasing by 0.2% in April.  

This week starts slowly with speeches by the Fed’s Waller and Daly today. Tomorrow, we will hear from Bowman and Cook and get data on April home prices via the Case-Shiller Home Price Index. We’ll also get updated consumer confidence data, where the consensus forecasts a decrease to 100 in June from 102 in May. Wednesday will bring New Home Sales data for May. We don’t expect any positive surprises, given that consumers are turning down purchases due to high mortgage rates. Durable Goods Orders for May are released on Thursday. The consensus expects a slowdown in growth to 0.3% in May from 0.7% in April. As mentioned above, we cap off the quarter with PCE prices and personal income & outlays on Friday.

Boston Fed Economist: Shelter Inflation May Be Stubborn Through Year-End

A recently published paper by a Boston Fed Economist suggests that rent increases will keep inflation above the Fed’s target for longer than most expect. The Author proposes that the effect will be most notable through the end of 2024 and diminish significantly in 2025. In addition, the Author expects CPI shelter inflation to slow considerably in periods beyond the next twelve months. His research focuses on the gap between market rent and the shelter component of CPI and how those dynamics pass through to CPI and PCE. Below, we provide excerpts and a chart from the paper that sums it up nicely.

The overall trend is clear: CPI shelter is expected to grow quickly in the summer and fall of 2024 but then slow down markedly when we move into 2025. Therefore, according to the estimates, the market–shelter gap is likely to pose a significant, but diminishing, challenge to the Fed’s ability to achieve its 2 percent inflation target over the next year.

Back-of-the-envelope calculations show how high CPI shelter could raise overall inflation this year. Given that shelter comprises 36.1 percent of the CPI and 15.5 percent of the PCE, the post-pandemic pass-through estimates imply that the current market–shelter gap will lead to an additional 0.59 and 0.25 percentage point growth in headline (including food and energy) CPI and headline PCE, respectively, from June 2024 to June 2025 relative to there being no market–shelter gap. The estimates also show that the deviation will lead to an additional growth in core (excluding food and energy) CPI and core PCE of 0.74 percentage point and 0.29 percentage point, respectively, from June 2024 to June 2025.

Shelter Inflation May Be Stubborn

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A Fundamental Shift Higher In Valuations

Over the last decade, there has been an ongoing fundamental debate about markets and valuations. The bulls have long rationalized that low rates and increased liquidity justify overpaying for the underlying fundamentals. For the last decade, that view appears correct as zero interest rates combined with massive monetary and fiscal support increased market returns by 50% since 2009. We discussed this point in “Long-Term Returns Are Unsustainable.” To wit:

“The chart below shows the average annual inflation-adjusted total returns (dividends included) since 1928. I used the total return data from Aswath Damodaran, a Stern School of Business professor at New York University. The chart shows that from 1928 to 2021, the market returned 8.48% after inflation. However, notice that after the financial crisis in 2008, returns jumped by an average of four percentage points for the various periods.”

As noted, an unprecedented amount of monetary accommodation drove those excess returns. Unsurprisingly, this resulted in one of the most significant deviations from the market’s exponential growth trend.

(Usually, when charting long-term stock market prices, I would use a log-scale to minimize the impact of large numbers on the whole. However, in this instance, such is not appropriate as we examine the historical deviations from the underlying growth trend.)

Wall Street Exuberance

The fiscal policies implemented after the pandemic-driven economic shutdown created a surge in demand that further exacerbated an already extended market. As shown, those fiscal interventions led to an unprecedented surge in earnings, with current expectations through 2025 significantly extended.

Given that markets historically track the annual change in earnings, it is unsurprising that stocks have once again reached more extreme valuation levels, given the rather ebullient forecast. The table below, from BofA, shows 20 different valuation measures for the S&P 500 index. Except for market-based equity risk premium (ERP), every other measure is at some of the most extreme levels.

Unsurprisingly, when discussing more extreme fundamental valuations, the expectation is that a more significant correction will eventually occur. While historically, the markets have often experienced “mean reverting events,” we will explore how the past 20 years of monetary and fiscal interventions have potentially permanently shifted market valuations higher.

A Permanent Shift Higher

As discussed in Technical Measures, valuations are a terrible market timing tool. Valuations only measure when prices are moving faster or slower than earnings. As we noted, in the short-term valuations are a measure of psychology. To wit:

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

However, just because current valuations are elevated, does that mean a massive mean reverting event is required?

Maybe not.

Dr. Robert Shiller’s fundamental valuation method, using ten years of earnings, or the cyclically adjusted price-earnings ratio (CAPE), is over 33 times trailing earnings. While that valuation level seems elevated on a nominal basis, its deviation from the long-term exponential growth trend is not. While 33x earnings is a high price for future earnings (implying 33 years to break even), the reduced deviation from the long-term exponential growth trend exposes the shift higher in valuation levels.

There are many reasons why valuations have shifted higher over the years. The increase is partly due to economic expansion, globalization, and increased profitability. However, since the turn of the century, changes in accounting rules, share buybacks, and greater public adoption of investing (aka ETFs) have also contributed to the shift. Furthermore, as noted above, the massive monetary and fiscal interventions since the “Financial Crisis” created a seemingly “risk-free” environment for equity risk.

The chart shows the apparent shift in valuations.

  1. The “median” CAPE ratio is 15.04 times earnings from 1871-1980.
  2. The long-term “median” CAPE is 16.52 times earnings from 1871-Present (all years)
  3. The “median” CAPE is 23.70 times earnings from 1980 to the present.

There are two critical things to consider concerning the chart above.

  1. The shift higher in MEDIAN valuations was a function of falling economic growth and deflationary pressures, and,
  2. Increasing levels of leverage and debt, which eroded economic growth, facilitated higher prices. 

So, the question is, “IF” valuations have permanently shifted higher, what will the next market mean-reverting event look like to reset fundamental valuations to a more attractive level?

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Mapping A Reversion To The Mean

Many video channels, commentators, and media types suggest another “major market correction” is coming. There are many reasons for their claims running the gamut, including de-dollarization, loss of the reserve currency, higher rates, debt defaults, etc. As we noted previously, while these are possibilities, they are pretty remote.

The chart below is a normally distributed “bell curve” of potential events and outcomes. In simple terms, 68.26% of the time, typical outcomes occur. Economically speaking, such would be a normal recession or the avoidance of a recession. 95.44% of the time, we are most likely dealing with a range of outcomes between a reasonably deep recession and standard economic growth rates. However, there is a 2.14% chance that we could see another economic crisis like the 2008 Financial Crisis.

But what about “economic armageddon?”

That event where nothing matters but “gold, beanie weenies, and bunker.” That is a 0.14% possibility.

While “fear sells,” we must assess the “probabilities” versus “possibilities” of various outcomes. Since valuations are a fundamental function of price and earnings, we can use the current price of the market and earnings to map out various valuation reversions.

As of this writing, the S&P 500 is trading at roughly $5,300 (we will use a round number for easy math). The projected earnings for 2024 are approximately $217/share. We can plot the price decline needed to revert valuations using the abovementioned median valuation levels.

  • 23.70x = 5142.90 = 3% decline
  • 16.52x = 3584.84 = 33% decline
  • 15.04x = 3263.68 = 38.5% decline

Here is the vital point.

While a near 40% decline in stocks is quite significant and would undoubtedly send the Federal Reserve scrambling to cut rates and restart “Quantitative Easing,” the reversion would only reverse the post-pandemic stimulus-driven gains. In other words, a near 40% correction would NOT be a “bear market” but just a correction in the ongoing bull market since 2009. (This shows how egregious the price deviation has become from the long-term price trend since the pandemic.)

Conclusion

While this is just a thought experiment, there are two critical takeaways.

  1. The deviation from the long-term means is extreme, suggesting a more significant decline is possible in the future and
  2. While valuations are elevated relative to long-term history, if there has been a permanent shift in valuations, the subsequent correction may not be as deep as some expect.

Importantly, investors repeatedly make the mistake of dismissing valuations in the short term because there is no immediate impact on price returns. As noted above, valuations, by their very nature, are HORRIBLE predictors of 12-month returns. Therefore, investors should avoid any investment strategy that has such a focus. However, in the longer term, valuations excellent predictors of expected returns.

From current valuation levels, investors’ expected rate of return over the next decade will be lower than it was over the past decade. That is unless the Federal Reserve and the government launch another massive round of monetary stimulus and cut interest rates to zero.

This does not mean that markets will produce single-digit rates of return each year for the next decade. There will likely be some tremendous investing years over that period and a couple of tough years in between.

That is the nature of investing and the market cycles.

Communication Data Implies Remote Work is Here to Stay

The chart below, courtesy of @KobeissiLetter on X, depicts downtown cell communication data for several major metropolitan areas as of March 2024. Cell phone activity during working hours is significantly below pre-pandemic levels in almost every major city across the country, including areas with significant population growth. The second chart below, from Macrotrends, shows Nashville’s population growth since 2019. While the high pre-pandemic growth rate has slowed, Nashville’s population still expanded by 1.4%, 1.6%, 1.7%, and 1.8% in the last four years, respectively. Yet, downtown Nashville’s cell communication data during working hours has declined by 24%.

Given that the labor market has remained tight in the days since the pandemic, the dip in communication data serves as a reminder that remote work is still going strong. Thus, the troubling devaluation in commercial real estate is likely not temporary. It’s only a matter of time until regional banks accept the losses as permanent, and hopefully, it will stop there. Jerome Powell has expressed confidence that any problems will be containable. However, GSIBs have exposure to regional banks, whether directly or indirectly.  

Cell Phone Communication Data Across Major Metropolitan Areas
Nashville Population Growth

What To Watch Today

Earnings

Economy

Market Trading Update

We discussed the current concern with the market’s overbought condition and weakening breadth yesterday. Not much changed, with the exception of the shear meltup in Nvidia shares. However, yesterday morning on the Real Investment Show,” I had a question about energy stocks and their recent lag relative to oil prices.

We agree. About a month ago, we noted that oil prices had become very oversold and were due for a bounce. Based on that analysis, we added to our portfolios’ current energy exposures. Subsequently, oil prices rose as expected, but energy company prices did not. Such got me to discuss that issue with our audience, where I produced the following chart of West Texas Intermediate Crude versus the SPDR Energy Sector ETF (XLE).

It should be unsurprising that oil prices and energy stocks generally have a high correlation. This is because oil prices drive energy companies’ revenue. However, since 2022, energy stocks have massively deviated from the underlying commodity. The chase for yield, market speculation, and other factors explain the current deviation. History suggests that the current deviation in performance is unsustainable, and the energy sector could see rather substantial declines during the next period of oil price weakness. Such a downturn in oil prices would result from a demand drop during a recessionary cycle.

Given that historically, energy stocks catch “down” to oil prices during such events, the next correction in energy stock prices could be rather substantial.

Could Nuclear Energy End Up Powering the Future?

There’s likely a bright future in Uranium, as nuclear energy could power the digital economy. Growth in electricity demand is projected to outpace capacity in coming years due to increased consumption by data centers and electrification in general. Although the reactors can take many years to come online, nuclear energy certainly aligns with energy transition goals as a carbon-free energy source. Bill Gates’ nuclear power startup, TerraEnergy, broke ground on its first commercial reactor earlier this month. Gates expects the project to be complete by 2030. A downside to the energy source is that perceived risks, long lead times to completion, and high costs may make these projects less compelling investment opportunities. While nuclear energy projects are expanding globally, unfortunately, the US is lagging in terms of capacity in the works. As shown in the chart below from @chigrl, China and India currently lead the world in reactors under construction.

Nuclear Power Expansion

Home Builder Sentiment is Struggling

The home construction industry is showing signs of slowing down lately. May housing starts posted the fifth decline in the past six months (-5.5% MoM). Meanwhile single-family permits fell for the fourth consecutive month (-3.8% MoM). The picture looks grim as both housing starts and permits fell to their lowest since the pandemic. The slowing home builder data aligns with other evidence we’ve seen that indicates the economy is beginning to slow. What’s contradictive, however, is that residential construction employment has been charging on to record highs. Given housing starts as a leading indicator, we believe the residential construction employment market will begin showing signs of loosening sooner rather than later.

Home Builder Sentiment is Struggling

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Global Diversification Might Not Be Dead

The chart below suggests that global diversification could be dead. The S&P 500 notched a total return of 13.3% annually over the past 15 years, while the MSCI EAFE and MSCI Emerging Markets indices returned 5.9% and 3.2% per annum respectively. The performance gap primarily stems from differences in earnings growth. S&P 500 earnings grew 14.1% annually over the past 15 years, while developed international and emerging markets grew earnings of 10.6% and 2.9% per annum, respectively. In addition, the global market has afforded the S&P 500 higher P/E multiples since the global financial crisis- a reflection of both more confidence and higher growth expectations.

But is Global Diversification really dead? It hasn’t worked in over a decade, but a recent Bloomberg article postulates that the lack of global diversification in the post-GFC period is an exception rather than a new norm. From 1973 to 2009, earnings growth was 5.7% annually for both EAFE and the S&P 500. Valuation multiples grew at 0.9% annually in EAFE compared to 0.5% for the S&P 500. There used to be a semblance of parity between domestic and international stocks.

On top of that, since 2015, a handful of US companies have driven a large share of S&P 500 earnings growth. The Bloomberg Magnificent Seven Index has seen annual earnings growth of 36% since 2015, while the rest of the S&P 500 grew earnings by roughly 6% annually. Ultimately, the Author’s idea is that a mean reversion is likely. It’s certainly possible that global diversification isn’t dead, but it doesn’t mean the US is bound for underperformance. It could simply mean the S&P 500’s days of drastic outperformance are numbered.  

Is Global Diversification Dead?

What To Watch Today

Earnings

  • No notable earnings releases today.

Economy

  • The market is closed for Juneteenth. No data releases today.

Market Trading Update

Tuesday, the market held somewhat firm despite a retail sales report that suggests the consumer is slowing down. Furthermore, the already weak April retail sales data was revised lower. Such is not surprising given some of the recent reports from retailers like Walmart.

However, while weak economic data has been causing rather strong market rallies lately, increasing hope for Fed rate cuts, such was not the case yesterday. The reason is that following Monday’s rally, the market deviation from the 50-DMA is getting extreme. Furthermore, the market is very overbought, which limits the upside further. The Relative Strength Index is pushing limits that have previously marked short-term market peaks. A retracement to the 50-DMA would entail a roughly 4.5% decline, which, while not significant, will “feel” much worse given the high level of complacency. This is likely a good point to take profits, rebalance positions to target, and raise some cash as needed heading into quarter-end rebalancing.

Retail Sales Disappointed in May, Price Cuts May Be on the Way

Retail sales came in weaker than expected across the board on Tuesday. Growth was 0.1% in May versus a consensus estimate of 0.2%. Excluding auto sales, retail sales dipped 1%. The control group, which feeds GDP, is now running at -0.1% on a two-month basis. After a year’s long runup in prices that has caused many to pull back on spending, analysts sense a turning point, according to a recent report in the Washington Post. This weak retail sales number adds further credence to the idea that more price cuts may be in store. The article cites several examples of price cutting by major retailers which we summarize below:

  • Ford marked down its electric Mustang Mach-E by 17%.
  • Target is slashing prices on 5,000 items, including Persil laundry detergent by 5%, Clorox wipes by 14% and Purina One cat food by 7%.
  • Walgreens is discounting swim goggles and Squishmallows by as much as 40%.
  • Ikea has lowered prices three times in the past year, while Best Buy has been marking down appliances.
  • Arts and crafts chain Michaels says it’s slashing prices on 5,000 items including stickers, canvases and T-shirts.
  • Several fast food chains, like McDonalds and Burger King, are offering lower-priced options. 

The spate of lower prices, combined with slowing spending, suggests the economy is losing some steam after last year’s rapid momentum. That could create room for the Fed to start cutting interest rates by the end of the year. Some Wall Street economists say rate cuts could begin as early as September, especially if inflation continues its descent.

But the economy’s direction is still very much up in the air. Fresh jobs data on Friday showed that employers added 272,000 jobs in May — far more than expected — suggesting that growth is still running hot.

Mega Cap Growth Stocks Are Stretched

The two graphs below show the SimpleVisor proprietary factor analysis tool. It helps users identify factor trends as they occur and notice when relationships are becoming stretched. The tool focuses on the relative performance of various factors to the S&P 500 and plays on the concept of reversion to the mean with negatively correlated factor pairs. One of the most reliable pairs compares the excess return of MGK (Mega Cap Growth) to that of VYM (High Dividend Yield). The pair has a 252-day correlation in excess returns of -0.94.

The first table depicts the factors’ performance relative to the index over discrete periods, forming a type of heat map. As shown below, Mega Cap Growth and Large Cap Growth are two of the few factors that have outperformed that index since mid-May. Small and mid-cap growth have largely underperformed as breadth narrows to a few stocks.

The second chart below illustrates the level to which the relationship of outperformance between MGK and VYM is currently stretched. The pair is trading in the 72nd percentile of the 3-month average daily excess return relationship- a level that has commonly seen a reversal over the past year. The short-term relationship is even more protracted, trading in the 95th percentile. Given the simultaneous overbought level in the market, this relationship could face slight normalization in the short term.

Mega Cap Growth is Stretched
High Dividend Yield is Due for Outperformance

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Consumer Survey Shows Rising Bullishness

The latest consumer survey data from the New York Federal Reserve had interesting data.

“The New York Fed’s latest consumer survey found that expectations that stocks will be higher in the next 12 months rose from 39% to 41% since last month’s reading. At the same time, inflation expectations dropped slightly. Consumer sentiment numbers have recently highlighted how certain demographics are thriving while others aren’t, but with the market near all-time highs, it’s no surprise that those who own stocks are feeling good.” – Yahoo Finance

The chart below shows the annual change in consumer surveys of higher stock prices. Unsurprisingly, investors have become increasingly exuberant about stock prices in conjunction with the market rally that began in 2022.

However, Yahoo suggests that the rising bullish sentiment in the consumer survey reflects the “haves and have-nots.” That statement is understandable when considering the breakdown of household equity ownership and the finding that the top 10% of households hold 85% of the equities.

However, consumer survey data shows rising stock market prices lifted confidence across age and income brackets. That should be unsurprising given the daily drumbeat of social and mainstream media highlights of the current bullish market.

Furthermore, when looking at the consumer survey data by income bracket, we see that the lowest and middle-income brackets have seen the most prominent advances in confidence.

Given the popularization of the financial markets through trading apps like Robinhood combined with a rising tide of social media commentary, it is unsurprising that lower income brackets have joined the fray hoping to “get rich quick.”

However, a warning is buried in the rising tide of bullish sentiment.

Market Warning In Bullishness

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

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

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

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

(1.02)*(1.2/1.5)^(1/10)-1+.02 = -(1.08%)

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

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

If economic growth reverses, the valuation reduction will be quite detrimental. Again, this has been the case at previous peaks when expectations exceeded economic realities.

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

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

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

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

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

The only question is what eventually reverses that psychology.

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Exuberance Fails With Reality

Unsurprisingly, equity markets are rising currently. Such is particularly the case as expectations for earnings growth have surged, with analysts expecting near 20% annualized growth rates over the next 18 months.

At the same time, corporations have engaged in massive share buyback programs, which have elevated prices and reported earnings per share by lowering the number of shares outstanding.

However, as economic growth slows, profit margins will begin to revert, and disinflation eats into earnings. Profit margins are tied to economic activity.

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

Historically, when the market trades well above actual profits, there has always been a mean-reverting event to realign expectations with economic realities.

Many things can go wrong in the months and quarters ahead. This is particularly true when economic growth and unemployment are slowing.

While the consumer survey is very bullish on the outlook for continuing asset price increases, that sentiment is based on the “hope” that the Fed has everything under control. History suggests there is more than a reasonable chance they don’t.

Mega Cap Valuations are Dwarfed by Tesla

Tesla investors are betting on the EV maker’s path to tech-caliber profitability. However, the manifestation of that investment thesis is still a pretty long way off, as shown by the degree to which Tesla dwarfs other mega cap valuations in the chart below, courtesy of Bloomberg.

Increasing competition amid a declining consumer appetite for EV purchases is culminating in price cuts and declining margins this year. At a valuation that towers over other mega cap peers, it’s increasingly evident that the investment thesis entirely relies on Tesla’s ability to develop AI capabilities into Full Self-Driving Software. If Tesla can execute its transformation into a software-first robotaxi business, then these valuations may not be all that crazy. Yet, this is a bold assumption to make, as was noted by JP Morgan analysts.

J.P. Morgan warned that consensus expectations and valuation demands around the robotaxi business imply it will be a home run, which is considered far from certain. Notably, the firm thinks the timeframe for any company to generate material revenue from robotaxi operations is years out. That plays into its view that investors in Tesla (TSLA) may have gotten ahead of themselves in terms of baking in a robotaxi premium.

Tesla Dwarfs Other Mega Cap Valuations

What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, the market breadth has become very narrow. Combined with near-term overbought conditions and a decent deviation from the 50-DMA, the market needs a catalyst for a short-term correction. Today, there are five speeches from Federal Reserve members and retail sales. The markets will be parsing the speeches and retail sales data for further clues as to the Fed’s next actions of cutting rates. A very weak retail sales report will lift expectations for cuts sooner rather than later. A strong retail sales number could see a fairly negative market reaction given the current overbought conditions.

This is likely a good time if you haven’t taken any actions to rebalance portfolio risk. While the downside risk isn’t significant, it would take a 4% decline to reconnect with the 50-DMA. Such would provide a much better point to add exposure if needed.

Market Breadth is Narrowing Further

Breadth has narrowed even further over the past week. Technology remains the only overbought sector versus the index, notching its highest relative score in the past year. The sector is also highly overbought in absolute terms- reaching its highest absolute score since the beginning of this year. Such narrow performance argues for a minor correction given the short-term overbought condition in the market mentioned above.

The usual mega cap suspects (Apple, Microsoft, and Nvidia) drove the action last week as the market advanced 1.9%. The second chart below highlights the ten largest stocks in the technology sector. Given their recent performance, it wouldn’t be surprising to see a short-term pullback in NVDA, AAPL, and AVGO. On the other hand, AMD and CRM could be the beneficiaries of a rotation out of those stocks and into the second-string AI trade.

Market Absolute and Relative Analysis
Technology Absolute and Relative Analysis

Freeport McMoran Looks to Innovation to Expand Production

The Copper mining industry has faced a troubling problem for years. It faces a looming Copper shortage related to the electrification demands from the energy transition. Supply is tight, and new mines are hard to find and getting more expensive to build. Luckily, there’s a potential solution to the conundrum. A type of copper ore that’s in large supply but has been too difficult and costly to extract copper from in the past. Instead, it ended up either not being extracted from mines or sitting in waste piles. However, Freeport McMoran may be able to circumvent these challenges with complex new mining technology. The technology will allow the company to further exploit its existing mines in addition to waste piles that have built up over the years, which still hold viable copper. It could allow the company to grow its copper production by the equivalent of a large new mine.

During the next three to five years, Quirk said the company hopes to generate annual production of as much as 800 million pounds of copper through that kind of processing technology — equal to one-fifth of its current total production.

Freeport has already extracted an additional 200 million pounds of copper through the recovery process, and is targeting another 200 million pounds in the next two years. Developing the complex technology has stalled the firm’s push to hit 800 million pounds, but Quirk said the company is making progress.

“We think we’re going to get there — it’s just a matter of time,” said Quirk, who stepped into the top job Tuesday to become the only female CEO of a major mining company.


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Michigan Survey Shows Consumer Concerns

Over the past few months, we have witnessed a decided deterioration in consumer spending. For instance, first-quarter sales from many large retailers showed little to no growth. Economic data like Q1 GDP and the recent retail sales report further confirm that personal consumption is slowing. Last Friday, the University of Michigan Consumer Sentiment Survey followed suit as it was much weaker than expected. In particular, as shown below, the University of Michigan’s current economic conditions survey fell sharply and is not far from record lows. Current conditions are 62.5. That compares to a prior reading of 69.6. Furthermore, the expectation was for the index to increase to 72.2. According to the University of Michigan, the average since 1951 has been 95.31.

With the boost in pandemic-related savings largely depleted, credit usage soaring, and irregular post-pandemic consumption behaviors finally normalizing, consumers no longer have the means or desire to overspend. While one’s financial situation plays a vital role in spending, sentiment is also a function of politics and inflation. The rate of inflation has come down, but the price of goods is still rising—and, importantly, they remain well above what consumers are used to. Regarding politics, other surveys have shown significant differences between what Republicans and Democrats think on economic issues. Because the election is nearing, some of those surveyed by the University of Michigan may be swayed by their politics.

university of michigan consumer sentiment

What To Watch Today

Earnings

Earnings Calendar

Economy

Market Trading Update

As noted on Friday, market breadth remains weak even as the market continues to push higher. Furthermore, investors are now primarily going “all in” on Technology and selling everything else. This kind of behavior has historically ended poorly, but irrational behavior can last much longer than logic predicts.

The economic data shows signs of weakness, which will likely feed into the Fed’s outlook for rate cuts over the next few months. While the market remains oblivious to the diversion between economic realities and Wall Street exuberance, such will eventually reconnect. However, for now, as we enter a new trading week, there is little standing in the way of the bulls momentarily. The market remains on a buy signal, and while short-term overbought, corrections should be contained by the 20-DMA. For investors, adding risk exposure on dips remains a logical strategy. However, that will eventually change.

Market Trading Update

The Week Ahead

Retail sales kick off the economic calendar on Tuesday. As we led this commentary, will it show that consumers are retrenching? The current estimate is for a gain of 0.3% versus 0.0% last month. Building permits and housing starts will likely show that new construction of homes and multifamily properties is slowing rapidly. The graph below shows that housing starts have been trending lower for two years and are back to the peak of the pre-pandemic era. Building permits are now slightly below the 2019 highs.

With the FOMC meeting past, Fed members will be on the speaking circuit. It will be interesting to hear their views on recent data and if they are reconsidering the potential for a rate cut in July.

Many companies will enter buyback blackout windows as we are about a month away from Q2 earnings reports.

housing starts

Macron’s Gamble Is Blowing Up Alongside French Markets

After Marine Le Pen and other right-wing parties pulled off stunning and decisive victories in the European Union elections a week ago, French President Emmanuel Macron made a bold political gamble. He dissolved France’s National Assembly and held snap elections. With the first round of voting occurring in only three weeks, he didn’t think there was enough time for his opponents to form alliances. Hence, they would struggle to win enough votes to advance to the July 7th runoff election. His plan, if successful, helps him secure the backing of a large block of voters in the National Assembly. It appears his plan is backfiring.

The most recent polls show Le Pen could garner about 270 seats in the 577-seat National Assembly. That would make Le Pen’s party, the National Rally, the biggest party in the lower chamber. Furthermore, it gives Le Pen a decent chance to become the next President in 2027 when Macron’s term ends and term limits preclude him from running again. Markets are uneasy with Le Pen’s victory. While Macron vows to hold on to his seat, markets are betting that his powers will be much more limited.

The first graph below, courtesy of SimpleVisor, shares information on EWQ, the U.S. ETF representing the primary French stock index, the CAC 40. It has fallen by about 8% in the last week while the S&P 500 continues to rally. The second graph shows that the yield on French bonds recently rose about 30bps versus German bonds. Lastly, as a result of right-wing gains in France and Germany, volatility in many European stock markets is increasing.

french cac40 EWQ simplevisor

german vs french bond yield spreads
euro vs us volatility france

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Sentimentrader Highlights Bad Market Breadth

Bad market breadth seems to be a hallmark of the rally off of the 2022 lows. Simply, very few stocks are leading markets higher, while many stocks languish. Consider that the equal-weighted S&P 500 index (RSP) is up 3.70% since the start of the year. Over the same period, the market-weighted S&P 500 (SPY) is up over 14%. Just Nvidia has contributed more to the market-weighted S&P 500 than the entire RSP gain for the year. With that in mind, consider the graph below from Sentimentrader. It shows the S&P 500 is hitting new highs, but three important breadth indicators are troublesome.

Per Sentimentrader:

  • More NYSE issues are hitting 52-week lows than highs
  • More NYSE issues are declining than advancing
  • and More NYSE volume is flowing into losers than winners

This confluence of negative indicators with the market at new highs is rare. Per Sentimentrader’s graph, it has occurred four times, including today, since 1965. In 1995, the market surged despite the warning. It was again triggered multiple times in 1999, which was followed by a significant decline. Similarly, the signal in late 2021 was followed by a moderate drawdown in 2022. The new Sentimentrader signal could be a false alarm like in 1995. However, it might be a more immediate warning that the market is heading lower. Given the market breadth and large deviations from key moving averages, we are paying close attention to our technical indicators and will act if necessary. For more information on Sentimentrader’s services, please click HERE.

sentimentrader bad breadth

What To Watch Today

Earnings

  • No notable earnings reports

Economy

Earnings Calendar

Market Trading Update

In yesterday’s market update, we touched on the negative divergences in the market and the poor breadth of the advance. Due to that lack of breadth, combined with a more overbought condition, we noted that the upside may be somewhat limited in the near term until a correction or consolidation occurs. Yesterday, despite a much cooler PPI report, stocks sold off mid-day, although they recovered somewhat into the afternoon. Furthermore, as shown in the heat map below, winners were sparse, with Nvidia and Tesla doing most of the work on the market capitalization-weighted index.

Furthermore, the weaker-than-expected inflation reports and strong bond auctions sent bonds higher. Bond prices have cleared all the major moving averages, are on a buy signal, and successfully retested the breakout of the downtrend from the beginning of the year.

From a technical perspective, bonds appear to have gained some traction on several fronts, and a retracement to the highs from the beginning of the year seems reasonable. While rates are set up for a decent trade, we have not reached the point where the fundamentals support a substantial move higher. For that, it will likely take weaker economic growth into the 2nd half of this year, a further decline in inflation, and the Fed cutting rates.

We will get there. It will most likely be later this year or early next year.

Helping Powell Appreciate Poor Consumer Sentiment

At the FOMC press conference on Wednesday, Jerome Powell stated:

“I don’t think anyone…has a definitive answer why people are not as happy about the economy as they might be.”

He went on to say that the unemployment rate is near record lows. Essentially, he presumes that because most people have jobs, they should be happy with the economy. Apparently, Jerome Powell doesn’t go shopping. The graph below shows the CPI price index for white bread and the annual percentage price change for white bread. In Jerome Powell’s economist mindset, he will tell you that the price of white bread per pound has risen 1.03% over the last year. In his mind, that is a reason for optimism, as white bread inflation is below his 2% inflation objective.

On the other hand, the consumer sees that white bread now costs $1.97 a pound, much higher than the $1.37 a pound before the pandemic. The data in the graph is the same, but the way of looking at it is starkly different. This explains why people have a very different opinion of the economy than Powell expects they should have.

cpi white bread powell

Furthermore

The Rise of Technology

The chart below shows how the mix of sectors within the S&P 500 and the economy as a whole has changed drastically since 1980. When comparing today to 1980, the most notable change is the decline of manufacturing and the increase in innovation. Appreciating this massive shift in the economic structure of the market and the economy helps us understand why valuations have increased over the last forty years. Innovation stocks, predominately residing in the technology sector, tend to be in high-growth situations. As such, they trade with high valuations as investors, and the companies will grow at above-market rates. Manufacturing tends to grow more in line with the economy. Therefore, many of these companies have lower valuations. More innovation and less manufacturing equals higher valuations.

s&p 500 sectors innovation technology manufacturing

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Grant: Rates Are Going Much Higher. Is He Right?

Recently, James Grant, editor of the Interest Rate Observer, was asked about his outlook for interest rates. He sees interest rates moving in a cyclical pattern, potentially rising for another multi-decade period. Grant bases his view on historical observations rather than a mystical belief in cycles. He states that finance has shown a cyclical nature, moving from extremes of euphoria to revulsion in various asset classes. Therefore, he proposes that persistent inflation, increased military spending, and significant fiscal deficits could drive rates higher. The Fed’s target of a 2% inflation rate and the electorate’s preference for policies that lead to inflation also contribute to this trend.

Let me state that I have a tremendous amount of respect for Grant and his work. However, I can’t entirely agree with his view. I will focus today’s discussion on the outlook for interest rates based on the two bolded sentences above.

The chart below shows the long-term view of short and long-bond interest rates, inflation, and GDP. As Grant notes, there is a cycle to interest rates previously.

Interest rates rose during three previous periods in history.

  1. During the economic/inflationary spike in the early 1860s
  2. The “Golden Age” from 1900-1929 saw inflation rise as economic growth resulted from the Industrial Revolution.
  3. The most recent period was the prolonged manufacturing cycle in the 1950s and 1960s. That cycle followed the end of WWII when the U.S. was the global manufacturing epicenter.

Remembering History

However, while interest rates fell during the Depression, economic growth and inflationary pressures remained robust. Such was due to the very lopsided nature of the economy at that time. Like the current economic cycle, the wealthy prospered while the middle class suffered. Therefore, money did not flow through the system, leading to a decline in monetary velocity.

The 1950s and 60s are the most important.

Following World War II, America became the “last man standing.” France, England, Russia, Germany, Poland, Japan, and others were devastated, with little ability to produce for themselves. America found its most substantial economic growth as the “boys of war” returned home to start rebuilding a war-ravaged globe.

But that was just the start of it.

In the late ’50s, America stepped into the abyss as humankind took its first steps into space. The space race, which lasted nearly two decades, led to leaps in innovation and technology that paved the way for America’s future.

These advances, combined with the industrial and manufacturing backdrop, fostered high levels of economic growth, increased savings rates, and capital investment, which supported higher interest rates.

Furthermore, the Government ran NO deficit, and household debt to net worth was about 60%. So, while inflation increased and interest rates rose in tandem, the average household could sustain its living standard. 

So, why is this bit of history so important to the outlook of interest rates,

What Drives Interest Rates

Grant suggests that interest rates will rise because they have been low for so long. That is akin to saying that since the Atlanta Falcons have not won a Super Bowl in the last 58 years, they should now win it every year for the next 58 years. What drives the Atlanta Falcons to win a Super Bowl are the ingredients to lead to a great team, not just the fact that they have never won one. The same goes for interest rates.

Interest rates are a function of the general trend of economic growth and inflation. More robust growth and inflation rates allow lenders to charge higher borrowing costs within the economy. Such is also why bonds can’t be overvalued. To wit:

“Unlike stocks, bonds have a finite value. The principal and final interest payments are returned to the lender at maturity. Therefore, bond buyers know the price they pay today for the return they will get tomorrow. Unlike an equity buyer taking on investment risk, a bond buyer loans money to another entity for a specific period. Therefore, the interest rate takes into account several substantial risks:”

  • Default risk
  • Rate risk
  • Inflation risk
  • Opportunity risk
  • Economic growth risk

Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer will not pay a price that yields a negative return in the future. (This assumes a holding period until maturity. One might purchase a negative yield on a trading basis if expectations are benchmark rates will decline further.) “

The chart below shows the correlation between economic growth, inflation, and interest rates. Unsurprisingly, interest rates rise when economic growth increases, leading to more demand for credit. Inflation rises with economic activity as the supply/demand imbalance increases prices. That is basic economics.

The chart above shows a lot going on, so let’s create a composite index of wages (which provides consumer purchasing power, aka demand), economic growth (the result of production and consumption), and inflation (the byproduct of increased demand from rising economic activity). We then compare that composite index to interest rates. Unsurprisingly, there is a high correlation between economic activity, inflation, and interest rates as rates respond to the drivers of inflation.

Grant further suggests that interest rates will be higher due to increased debt and deficits. Unfortunately, there is no evidence supporting that hypothesis.

The Deficit Fallacy

As shown below, the 10-year economic growth average correlates with interest rates. When economic growth rises, lenders can charge higher interest rates.

What should immediately jump out at you is that the 10-year average economic growth rate was around 8%, except for the Great Depression era, from 1900 through 1980. However, there has been a marked decline in economic growth since then. (The current spike in interest rates is a function of the artificial stimulus injected into the economy, which is now reversing.)

Increases in the national debt squandered on non-productive investments and rising debt service results in a negative return on investment. Therefore, the larger the debt balance, the more economically destructive it is by diverting increasing amounts of dollars from productive assets to debt service.

Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. What should be evident is that increases in debt and deficits continue to divert more tax dollars away from productive investments into the service of debt and social welfare. The result is lower, not higher, economic growth, inflation, and, ultimately, interest rates.

When put into perspective, one can understand the more significant problem plaguing economic growth. A long look at history clearly shows the negative impact of debt on economic growth.

Furthermore, changes in structural employment, demographics, and deflationary pressures derived from changes in productivity will magnify these problems.

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Inflation Wasn’t Just The 1970s

While many focus on the inflation surge during the late 1970s, as noted above, the entire period from the 1950s through 1980 was marked by rising interest rates and inflation due to a more robust economic growth cycle.

Like today, the Fed was hiking rates to quell inflationary pressures from exogenous factors. In the late 70s, the oil crisis led to inflationary pressures as oil prices fed through a manufacturing-intensive economy. Today, inflation resulted from monetary interventions that created demand against a supply-constrained economy.

Such is a critical point.

During “That 70s Show,” the economy was primarily manufacturing-based, providing a high multiplier effect on economic growth. Today, the mix has reversed, with services making up the bulk of economic activity. While services are essential, they have an extremely low multiplier effect on economic activity.

One primary reason is that services require lower wage growth than manufacturing. Inflation rose in the 1970s due to a steady trend of increasing wages, which created more economic demand. Outside of the artificial spike in demand from government stimulus in 2020, the longer-term trend of wage growth, and ultimately inflation, is lower as wage growth remains suppressed.

Wages come from the type of employment. Full-time employment provides higher salaries to support economic growth. Unfortunately, full-time employment as a percentage of the working-age population has declined since the turn of the century. Such is due to increased productivity levels through technology, offshoring, and immigration. The byproduct of fewer full-time employees is lower consumption and lower rates of economic growth.

Today’s economic environment vastly differs from the economic boom years of the 1970s. Rising debt levels, increased deficits, productivity, and wage suppression erode economic growth, not support it. Therefore, while Grant makes the case for higher interest rates for “much, much longer,” the economic evidence does not support that thesis.

Conclusion

However, even if Grant is correct and increasing debt levels and deficits do cause higher rates, central banks will take actions to artificially lower rates.

At 4% on 10-year Treasury bonds, borrowing costs remain relatively low from a historical perspective. However, we still see signs of economic deterioration and negative consumer impacts even at that rate. When the economy’s leverage ratio is nearly 5:1, 5% to 6% rates are an entirely different matter.

  • Interest payments on the Government debt increase, requiring further deficit spending.
  • The housing market will decline. People buy payments, not houses, and rising rates mean higher payments.
  • Higher interest rates will increase borrowing costs, which leads to lower profit margins for corporations. 
  • There is a negative impact on the massive derivatives market, leading to another potential credit crisis as interest rate spread derivatives go bust.
  • As rates increase, so do the variable interest payments on credit cards. Such will lead to a contraction in disposable income and rising defaults. 
  • Rising rates negatively impact banks, as higher rates impair the banks’ collateral, leading to bank failures.

I could go on, but you get the idea.

Therefore, as debt and deficits increase, Central Banks are forced to suppress interest rates to keep borrowing costs down and sustain weak economic growth rates.

The problem with Grant’s assumption that rates MUST go higher is three-fold:

  1. All interest rates are relative. The assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields on U.S. debt attract flows of capital from countries with low to negative yields, pushing rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
  2. The budget deficit balloon. Given Washington’s lack of fiscal policy controls and promises of continued largesse, the budget deficit is set to swell above $2 Trillion in coming years. This will require more government bond issuance to fund future expenditures, which will be magnified during the next recessionary spat as tax revenue falls.
  3. Central Banks will continue to buy bonds to maintain the current status quo but will become more aggressive buyers during the next recession. The Fed’s next QE program to offset the next economic downturn will likely be $4 trillion or more, pushing the 10-year yield toward zero.

If you need a road map of how this ends with lower rates, look at Japan.

Historical evidence suggests that interest rates will be lower, not higher, unless the Government embarks on a massive infrastructure development program. Such would potentially revitalize the American economy and lead to higher rates, stronger wages, and a prosperous society.

However, outside of that, the path of interest rates in the future remains lower.

The CPI Report Supports Rate Cuts Later This Year

The Fed got good news yesterday, with the headline CPI coming in at 0% for the month. More importantly, core CPI rose by +.16% versus expectations of +.30%. That brings the year-over-year core CPI rate to 3.4%, a tenth below expectations. Excluding shelter costs, accounting for 40% of CPI, core CPI, also called “super core,” was down for the month. This is the first decline since September 2021. This is important because CPI shelter costs should decrease in the coming months. Thus, “super core” could push further into deflationary territory. The graph below shows that CPI rents, a large component of shelter costs, lag changes in current rental costs. For almost a year, actual rent cost changes have hovered near zero percent. Inflation will likely approach the Fed’s 2% target when the CPI shelter costs catch up with actual data.

In our opinion, it’s a matter of when, not if, shelter prices normalize. Therefore, it’s likely that when the CPI shelter normalizes, the Fed will be more comfortable with inflation trends, allowing it to cut the Fed Funds rate. The December Fed Funds contract jumped by 12 bps on the CPI number, thus implying that investors added an additional 50% chance of a rate cut by year-end. With the market reaction, Fed Funds futures now imply two rate cuts by year-end. As we share below, the Fed projects only one rate cut by year-end.


What To Watch Today

Earnings

Economy

Market Trading Update

As noted yesterday, the market has been waiting on the inflation data and the Fed meeting. With inflation coming in cooler than expected and the Fed still on track to cut rates, the market closed higher yesterday. Bonds also rallied sharply, and rates fell.

The bullish underpinnings have weakened while the market continues to set new highs. Breadth has narrowed, and the negative divergence of the advance-decline line to the market has previously warned of a potential overshoot by overly zealous investors.

Speaking of negative divergences, the market has also been rising against a decline in the relative strength index and the MACD. As shown, these negative divergences often suggest that the market’s internals are weaker than the index may suggest.

For now, the 20-DMA continues to act as initial support, but the growing divergence between the market and the 50-DMA is reaching levels that have previously preceded a short-term correction. That deviation, combined with the negative divergences, suggests that investors be a little more cautious with risk exposure in the near term. While nothing suggests that a correction of magnitude is in the offing, a pullback to the 20- and 50-DMA is quite likely in the near term.

Trade accordingly.

The FOMC Meeting Recap

The market was not expecting much in the way of surprises from the FOMC minutes, and the Fed lived up to expectations. However, the quarterly economic projections of the Fed members were a little more hawkish than expected. As we circle below, they increased their core PCE inflation forecast from 2.6% to 2.8% for year-end. Accordingly, they reduced the number of Fed Funds rate cuts to one from three last March.

While their projections seem hawkish, a slight tweak in the statement’s language suggests a dovish tilt. The May minutes say, “In recent months, there has been a lack of further progress toward the Committee’s 2% inflation objective.” The latest minutes state, “In recent months, there has been modest further progress toward the Committee’s 2% inflation objective.

fed fomc economic projections

The following comments are from Jerome Powell’s press conference following the release of the minutes and economic projections:

  • The Fed is prepared to respond if unemployment rises quicker than expected or prices fall faster than expected.
  • Two or three more CPI readings like yesterday’s could lead to a September cut.
  • Powell stressed numerous times that their decisions are data-dependent, and they do not confidently hold their projections. “Do we have high confidence in forecasts? No, we don’t.” He also mentioned they made their projections prior to knowing the data within the CPI report.
  • Powell acknowledged the argument that the strength in job creation (non-farm payrolls) “may be a bit overstated.”
  • post-pandemic normalization of the labor market has now run its course.”
  • Rates are less likely to go down to pre-pandemic levels.” But, “we do not know that.”

Market Cap Distortion On Display

On Tuesday, the S&P 500 rose by 0.25% on the back of Apple’s 7% gain, while the equal weight S&P 500 index (RSP) fell by -0.45%. This familiar story of a few stocks driving the market has been happening for over six months. Statistically, as we show below courtesy of Tier1 Alpha, the 3-month rolling correlation between the market cap-weighted and equal-weighted S&P 500 is at a three-decade low.

The second graph shows the price of the two indexes (SPY/RSP). As shown, it has risen by about 30%. In other words, an equal investment in all 500 S&P stocks would have underperformed the index by 30%. How long can such outperformance continue? With 28% of the S&P market cap concentrated in five stocks (MSFT 7.05%, NVDA 6.68%, AAPL 6.21%, GOOG 4.22%, and AMZN 3.79%), the more direct question is how long can those five stocks or a subset of them continue to grossly beat the markets?

s&p 500 and Equal weight rsp correlation, market cap distortion
spy vs rsp

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Energy Prices Drive The Fed Despite What They Say

The Fed often stresses that it prefers core inflation measures, which exclude food and energy prices. They do this for a few reasons. First, food and energy tend to be more volatile than most other goods. Accordingly, they can distort the broader price trends. Second, food and energy prices are affected by many variables, many of which the Fed is unable to manage. Lastly, the Fed believes core inflation is a better predictive measure of inflation.  

So, while the Fed prefers to ignore food and energy prices, they also heavily rely on energy prices, albeit indirectly. Jerome Powell and other Fed members have emphasized that inflation expectations are very important to follow as they influence inflation. The problem with the Fed’s logic is that energy prices greatly sway inflation expectations. The graph on the left shows crude oil and 1-year inflation expectations. As shown, they track each other closely. We share the same data in a scatter plot to the right to highlight the relationship further. The R-squared (.57) is statistically significant.

Bottom line: energy is used to manufacture, produce, and ship a wide range of goods. While the Fed may want to ignore energy prices, they are too important to the economy, the prices of other goods, and our inflation expectations to dismiss.

energy and inflation expectations

What To Watch Today

Earnings

Economy

Market Trading Update

In yesterday’s commentary, we discussed the decline in oil prices and how, from a trading perspective, this sets up a decent opportunity for an energy trade. Adding to that thesis were two other points for why we added to our position in Diamondback Energy (FANG) in our equity portfolio yesterday.

The first is that speculative trading accounts sharply reduced their bets on oil. The recent sharp liquidation of those contracts provides the fuel for a reversal trade.

Secondly, over the last 10 weeks, energy has been corrected from being overbought to being oversold on a relative and absolute performance basis.

While this does not mean that energy stocks are about to explode higher, the data does suggest that a tradable opportunity is present over the next few months. Such is particularly true as we enter peak driving and hurricane season, where potential demand and drilling disruptions could increase prices.

New Fed Dot Plots Today

Part of today’s FOMC announcement will include the revised economic projections, aka dot plots. The table below shows the projections from March. Revisions to the unemployment rate and GDP will shed light on how their views may have changed over the past three months due to some weaker-than-expected economic data. Projections for Core PCE were increased by 0.2% at the March meeting. If they lower it back down, it will infer confidence that inflation is falling again after having stalled.

Lastly, and certainly most important for investors, is the Fed’s outlook on the Fed Funds rate. In March, they thought they could reduce Fed Funds by .75% by year-end. The Fed Funds market implies equal odds of 25 or 50 bps in cuts by year-end. We suspect the Fed will gravitate toward the market’s view. The Fed will probably want to avoid adjusting rates at the September meeting because it’s an election year. Furthermore, July may be too early for a cut unless inflation declines more than expected. If we assume they skip the next two meetings, that only leaves two more meetings before the year’s end.

fed dot plot economic projections

The Bogus Gas Price Narrative

Given our opening paragraphs about the connection between energy prices and inflation expectations and how the Fed may proceed with monetary policy, it’s worth debunking a narrative. As much as you keep hearing, gas prices are not spiking. Yes, they have been up over 10% for the year to date. However, gas prices tend to follow a seasonal pattern, increasing into the summer driving season and then giving up those price increases in the year’s second half.

The graph below charts the average weekly year-to-date change in gas prices from 2005 to 2023 and compares it to the change in gas prices this year. As shown, gas prices rose more than the average in the first fifteen weeks of 2024. However, that reversed sharply. The current year-to-date change is now about 10% less than is typical for this time of the year. Gasoline prices are volatile, so we should be careful not to read too much into this graph. But, the narrative that high gas prices are a reason to suspect inflation is rising is false.

year to date gas price changes

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Golf and Investing: Mastering Long and Short Games For Success

Let’s play a hole of golf to appreciate how two distinct aspects of golf provide valuable lessons for investors.

You tee off with a driver on a 450-yard par four hole. Your drive is perfect. Not only does the ball land in the middle of the fairway, but you only have 200 yards remaining to the pin. Next, you pull out an iron, hit a beautiful shot, and the ball bounces onto the putting green. With only 40 feet between the ball and the pin and over 95% of the hole behind you, you think a birdie is possible, and in the worst case, you can get a par.

Your birdie putt misses by 10 feet. You come up just short on the next putt, and your confidence turns to angst. Finally, the third putt rattles into the cup, scoring a disappointing bogey.

Your long and straight 250-yard drive counts precisely as the 3-foot short putt you missed for par. Similarly, an investment idea backed by a well-thought-out macro thesis is only as good as adequately navigating the many short-term factors that can threaten investment performance.  

Investing’s Long Game

The long game involves forming expectations of economic growth and how revenues and earnings for sectors and industries may change with the economy as it cycles through your big-picture thesis. More simply, the long game is investing based on a macroeconomic outlook.

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Macroeconomic Analysis

Macroeconomic analysis studies the behavior and performance of a country’s economy and its interaction with the global economy. It focuses on broad aggregate variables, including existing economic trends, business cycles, productivity, demographics, geopolitics, governments/central banks, credit, and technological change. 

An increasingly important part of macroeconomic analysis is assessing how fiscal and monetary policies might affect economic growth and price trends.

As we have recently witnessed, fiscal spending can have a massive impact on economic activity and inflation. However, as we may find out, it can also be a drag on economic activity in future years. Similarly, a central bank’s monetary policy, including how it manages interest rates and asset holdings, often dictates liquidity and financial conditions, significantly influencing asset markets and the economy.

International trade and finance, including geopolitics, can play noteworthy roles in macroeconomic analysis. This incorporates trade balances and exchange rates, which are predicated on interest rates and inflation. Other factors include competitiveness, foreign relationships, and foreign investor cash flows.

While longer-term views on the factors we note are critically important, we must also appreciate shorter periods in which our long-term thesis may seem out of favor. Importantly, we must assess whether aberrations to longer trends are short-term or new trends being established.

Similar to golf, an excellent long investing game is crucial to understanding the economic path that directly feeds corporate earnings and consumer and government spending behaviors. Think of the long game as a road map, and your goal is to get from point A to point B. Therefore, assessing the most efficient route is your paramount task.

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Investing’s Short Game

As we now discuss, an investor’s short game is equally important. These are the inevitable traffic jams, accidents, and weather conditions that will force you to stray from the long game.

Investing’s short game includes market conditions, narratives, personal biases, behavioral traits, liquidity, and other factors that briefly influence asset prices away from longer-term trends.

Even if you have an outstanding macroeconomic outlook, ignoring the short game, like being a lousy putter in golf, virtually ensures a bogey or worse on your investment performance.  

Biases and Behaviors

We have written numerous articles on our inherent biases and behavioral traits. For example, our latest on the topic, Behavioral Traits That Are Killing Your Portfolio Returns, reviews five traits that often hurt investors’ performance. We share a summary below, along with a bit of advice.

Confirmation Bias: favoring information that affirms your beliefs. Therefore, read investment advice that goes against your views and may be uncomfortable. It will strengthen your convictions or help you appreciate where your thesis may prove wrong.

Gamblers Fallacy: believing that future outcomes will follow prior outcomes. Today’s hot assets are often laggards tomorrow. While tracking and investing in today’s popular stocks is worthy, keep an open mind that some other stock or asset will likely be tomorrow’s winner.

Herd Bias: doing what everyone else is doing. The thought process is rooted in the belief that if “everyone else” is doing something, I must do it to be accepted. As we wrote in Behavioral Traits:

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.

Trading with the “herd” can be profitable at times. However, we must understand the inherent flaws in group logic and always appreciate the contrarian opinion.

The table below provides a few more examples.

bias and behaviors

Technical Analysis

Technical analysis is one of the best clubs in our short-game bag. While it can be inconsistent, as with every other forecasting model, it is the best tool for quantifying investors’ collective behaviors. Historical price and volume data provide a critical context for various price levels likely to motivate buyers and sellers.

Technical analysis helps detect trend changes. Like reading a putt, technical analysis can help us grasp the risks and rewards a market offers. Furthermore, it can provide price levels with which to buy or sell. In turn, limits allow us to separate our trading actions from our behavioral traits.

Liquidity Drivers/Fed

Financial market liquidity is impossible to quantify, even though investors throw the word around like it’s a known commodity. Liquidity refers to the funds available for investors to invest. When liquidity is plentiful, investors tend to take more risk. Conversely, when liquidity is lacking, investors are often risk-averse.

While liquidity is often considered part and parcel with actual investible dollars available, it’s more a function of investors’ cumulative actions. For instance, the Fed supplied the market with ample liquidity in late 2008, but a meaningful fear of significant bank failures crippled many investors. Sellers were plentiful, and buyers were hard to find. Liquidity was poor. The result was a sharp drawdown in equity prices with high volatility.

The Fed supplies monetary liquidity to the banking system through interest rate policy and its balance sheet. Furthermore, as their role seemingly becomes more dominant with time, their actions become more impactful to markets. Consequently, as we see today, the stock market rallies as prospects of the Fed providing more liquidity via lower interest rates.

Domestic and Global Events

War, weather events, terrorism, political instability, and other local or global events can move markets. Quite often, event-driven trends are short-lived. During event-related volatile periods, investors should try to remain cool and calm. It’s easy to sell into a fear-laced narrative. It’s much harder to buy in such an environment. To quote Warren Buffett:

Be fearful when others are greedy and be greedy only when others are fearful.

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Summary

A well-thought-out long-game thesis can stay intact for long periods with slight adjustments when needed. Like a long and straight drive in golf, when your macroeconomic thesis proves correct, a good portion of your investing job is done.

But, like golf, letting your irrational behaviors control your investment acumen, not appreciating that markets are sometimes foolish, or misdiagnosing what the Fed is doing can devastate shorter- and longer-term results.

Do not forget the two-foot putt counts the same as a daunting drive off the tee box.

Degen Traders Are Taking Storm Of The Markets

Degen traders, short for degenerates, are taking storm of the markets. The Wall Street Journal recently published Meet The Degen Traders Fueling The Latest Meme-Stock Mania. The article introduces its readers to a new type of investor creating incredible volatility in a handful of stocks and cryptocurrencies. Per the article: “Degens are gamblers, not traders or investors. Fundamentals are not a concern for Degens. Instead, they seek excitement.

Degens largely day trade. Furthermore, they have become adept at trading same-day expiration options (0DTE – see Tweet of the Day). We believe 0DTE trades are akin to playing roulette or flipping a coin. Similarly, penny stocks are in vogue with the Degen crowd. The seeming leader of the Degen movement is Keith Gill, aka Roaring Kitty. Through tweets and Reddit posts, Roaring Kitty has single-handedly caused stocks to more than double in minutes. His latest foray is in GameStop shares. As the SimpleVisor graphic below shows, its stock (green) has seen massive volatility. In comparison, the S&P 500 (gray) looks like a flat line.

The ending quote from the article summarizes the story well: “It ends up shaping your way of seeing things. You’re not looking at things as financial instruments anymore,” she said. “You’re just absorbed into this micro-culture.” Our take: unlike most investors, Degens’ are not evaluating stocks based on the potential future earnings of the corporation. Instead, they view it like sports gambling. While Degens can warp the value of stocks for short periods, we believe fundamental investors will take advantage of such opportunities to short said stocks and bring them back toward their fair value.

gme gamestop

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday, the markets are in a holding pattern ahead of this week’s CPI inflation report and the June FOMC meeting. However, today, the market will focus on the latest OPEC report to assess the next moves in the oil market. After the post-pandemic run-up, the Ukraine war, and unrest in the Middle East, Wall Street was expecting oil prices to soar above $150/bbl. However, as is almost always the case, those exuberant estimates rarely come to fruition.

Since April 2022, oil prices have steadily declined and are flirting with support around $70/bbl. That level is high enough to encourage producers to drill but not enough to impede the economy grossly.

Unsurprisingly, given the input cost of oil to energy companies, there is a high correlation between the Energy Sector ETF (XLE) and oil prices.

From a trading perspective, we remain long our energy holdings, after having taken profits in them early this year, and are looking for a reversal in oil prices to signal the next entry point. With Hurricane season fast approaching, we may get another short-term trading opportunity in the next couple of months.

Market Breadth Is Poor As Nvdia Drives The S&P 500

Nvidia, up 35% last month, has become the second-largest stock in the S&P 500, overtaking Apple last week. As such, its contribution to the index grows. This week’s SimpleVisor sector analysis shows that while the S&P 500 rose 1% last week and 2.5% over the previous month, the underlying sectors are not keeping up. The absolute scores also confirm this. Other than XLC (.54), SPY is more overbought than every other sector. Simply, Nvidia and a small handful of other stocks are leading the markets.

The energy sector remains the weakest on an absolute and relative basis. The second graphic below highlights the sector’s top ten holdings and their relative scores versus each other and the XLE sector ETF. We circle Williams (WMB) as it is overbought versus every other energy stock and the sector ETF. The third graph shows the price ratio of WMB to XLE is very extended and has just triggered a sell signal on our proprietary model. Mind you, the sell signal is on the price ratio. This implies that XLE will outperform WMB over the coming weeks, but not necessarily that WMB shares will fall.

simplevisor sector analysis
wmb energy sector
wmb vs xle

Japan Takes Another Economic Step Backwards

The good news for Japan is that its GDP has been revised higher. However, the revision brought it from -2% to -1.8%. Interestingly, the negative growth occurs when its central bank (BOJ) is removing stimulus. The BOJ just raised its benchmark rate for the first time since 2007 and is discussing curbing its bond purchases. This comes at a time when the ECB and Bank of Canada cut rates for the first time since the pandemic. Further, the Fed is reducing the amount of monthly QT, and it is widely expected the Fed’s next move will be a rate reduction.

The yen has traded poorly, as its interest rates are much lower than most developed economies. The graph below shows the yen sits at its lowest level in at least 30 years. If the Bank of Japan does indeed reduce bond purchases and allows rates to move higher, the Fed cuts rates later this year, and other banks follow with similar rate cuts, the yen may finally catch a bid. For now, betting on the yen is like trying to catch a falling knife. However, if the BOJ can revive growth and its interest rates become more in line with those of other nations, the yen may be a good investment at some point in the next six months to a year.

jpy rates bank of japan

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It’s Not 2000. But There Are Similarities.

More than a few individuals were active in the markets in 1999-2000, but many participants today were not. I remember looking at charts and writing about the craziness in markets as the fears of “Y2K” and the boom of “internet” filled media headlines. It was quite the dichotomy. On one hand, it was feared that the turn of the century would “break the computer age,” as computers could not handle the date change to 2000. However, at the same moment, the internet would turbocharge the world with massive productivity increases.

Back then, the S&P 500, particularly the Nasdaq, rallied harder each day than the last. Market breadth looked pretty weak, as the big names were soaring, forcing indexers and ETFs to buy them to keep their weightings. The reinforcing positive feedback cycle fueled markets higher day after day.

I remember those days clearly. It was the “gold rush” of the 21st century for investors.

Interestingly, much like then, we are witnessing investors chase anything related to “artificial Intelligence.” Just as the internet had companies adding a “dot.com” address to their corporate name in 1999, today, we are seeing an increasing number of companies announce an “AI” strategy in their corporate outlooks.

“Execs can’t stop talking about AI. The number of companies that have mentioned AI on earnings calls has rocketed since the launch of ChatGPT. The number of times AI has been mentioned on earnings calls has seen a similar rise.” – Accenture Technology Vision 2024 Report

The difference versus today was that companies would advance regardless of actual revenue, earnings, or valuations. It only mattered if they were on the cutting edge of the internet revolution. Today, the companies racing higher on artificial intelligence have actual revenues and income.

But does that difference remove the risk of another disappointing outcome?

A Forced Feeding Frenzy

As noted above, in 1999, as the “Dot.com” bubble swelled, ETF providers and index tracking managers were forced to buy increasing quantities of the largest stocks to remain balanced with the index. As we have discussed previously, given the proliferation of ETFs and investors’ increasing amount of money flows into passive ETFs, there is a forced feeding frenzy in the largest stocks. To wit:

“The top-10 stocks in the S&P 500 index comprise more than 1/3rd of the index. In other words, a 1% gain in the top-10 stocks is the same as a 1% gain in the bottom 90%.

As investors buy shares of a passive ETF, the shares of all the underlying companies must get purchased. Given the massive inflows into ETFs over the last year and subsequent inflows into the top-10 stocks, the mirage of market stability is not surprising.

Unsurprisingly, the forced feeding of dollars into the largest weighted stocks makes market performance appear more robust than it is. As of June 1st, only 30% of stocks were outperforming the index as a whole.

That lack of breadth is far more apparent when comparing the market-capitalization-weighted index to the equal-weighted index.

However, the concentration of flows into the largest market-cap-weighted companies continues to increase the market capitalization of those top stocks to levels well above that of the “Dot.com” bubble.

The forced feeding of the largest companies in the index, while reminiscent of 2000, does not mean there will be an immediate reversal. If this is indeed a bubble in the market, it can last far longer than logic would suggest.

Just as it was in 2000, what eventually causes the market reversal is when reality fails to live up to expectations. Currently, the sales growth expectations are an exponential growth trend higher.

While it is certainly possible that those expectations will be met, there is also a considerable risk that something will happen.

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Trees Don’t Grow To The Sky

Just as in 2000, the valuations investors paid for companies like Cisco Systems (CSCO), which was the Nvidia (NVDA) of the Dot.com craze, plunged back to reality. The same could be true for Artificial Intelligence in the future. As noted recently by the WSJ:

“AI has had an astounding run since OpenAI unveiled ChatGPT to the world in late 2022, and Nvidia has been the biggest winner as everyone races to buy its microchips. To see what could go wrong, note that this isn’t the usual speculative mania (though there was a mini-AI bubble last year). Nvidia’s profits are rising about as fast as its share price, so if there is a bubble, it’s a bubble in demand for chips, not a pure stock bubble. To the extent there is a mispricing, it’s more like the banks in 2007—when profits were unsustainably high—than it is to the profitless dot-coms of the 2000 bubble.”

It is a good analysis of the four (4) things that could go wrong with AI:

  1. Demand falls because AI is overhyped. (Much like we saw with the Dot.com companies.)
  2. Competition reduces prices.
  3. Suppliers ask for a more significant share of the revenue.
  4. What if the scale doesn’t matter?

As Rober McNamee, a Silicon Valley investing legend, stated:

“There are corporations and journalists that have completely bought into this [the AI hype.] Before investors buy into this we should just ask: How are you going to get paid? How are you going to get a return on something that is effectively a half million dollars each time you do a training set… in a 5% environment.”

As is always the case, the current boom of “artificial intelligence” stocks is just another in a series of “investment themes” over the market’s long term.

“But if we learned nothing else during the SPACs, the crypto, the meme stocks, and whatever else fueled the market’s last run – you know, the one when stocks were the only place to put your money because rates were so low – it’s that when this stuff reverses, it’s always brutal.”Herb Greenberg

And, as we noted previously:

“These booms provided great opportunities as the innovations offered great investment opportunities to capitalize on the advances. Each phase led to stellar market returns that lasted a decade or more as investors chased emerging opportunities.” 

We are again experiencing another of these speculative “booms,” as anything related to artificial intelligence grips investors’ imaginations. What remains the same is that analysts and investors once again believe that “trees can grow to the sky.” 

Trees don’t grow to the sky is a German proverb that suggests that there are natural limits to growth and improvement.
The proverb is associated with investing and banking where it is used to describe the dangers of maturing companies with a high growth rate. In some cases, a company that has an exponential growth rate will achieve a high valuation based on the unrealistic expectation that growth will continue at the same pace as the company becomes larger. For example, if a company has $10 billion in revenue and a 200% growth rate it’s easy to think that it will achieve 100s of billions in revenue within a few short years.

Generally speaking, the larger a company becomes the more difficult it becomes to achieve a high growth rate. For example, a firm that has a 1% market share might easily achieve 2%. However, when a firm has an 80% market share, doubling sales requires growing the market or entering new markets where it isn’t as strong. Firms also tend to become less
efficient and innovative as they grow due to diseconomies of scale.

Modeling how quickly a growth rate will slow as a firm becomes larger is amongst the most difficult elements of equity valuation.”Simplicable

The internet craze in 1999 sucked in retail and professionals alike. Then, Jim Cramer published his famous list of “winners” for the decade in March 2000.

Jim Cramer's Dot.com Winners For The Next Decade

Such is unsurprising, as endless possibilities existed of how the internet would change our lives, the workplace, and futures. While the internet did indeed change our world, the reality of valuations and earnings growth eventually collided with the fantasy.

No, today is not like 2000, but there are similarities. Is this time different, or will trees again fail to reach the sky? Unfortunately, we won’t know for certain until we can look back through the lens of history.

A Great Jobs Report With Ugly Underpinings

The BLS jobs report showed the economy added 272k jobs, well above expectations of 175k, and the 152k jobs reported by ADP. Also pointing to a strong labor market, average hourly earnings were 0.1% above expectations at +0.4%. While the jobs data seems strong, there is a lot of other data within the report, leading us to question its veracity. For starters, the unemployment rose from 3.9% to 4.0%. While the economy did add jobs per the establishment survey, the unemployment rate calculation uses the household survey. That shows the number of employed people fell by 408k. Further, the participation rate dropped from 62.7% to 62.5%. The graph below shows that over the last six months, the headline-garnering establishment survey has added 2.3 million more jobs than the household survey. Such dwarfs any divergence since the pandemic.

The quality of jobs also has a lot to be desired. The number of full-time jobs fell by 625k while part-time jobs rose by 286k. Such is the biggest drop in full-time employment since last December. Furthermore, the number of people with multiple jobs is now 8.4 million, which is just below a record high. The report also highlights why economic survey results, including Democrats, show dismay at Biden’s economic performance. In just May alone, 414k legal and illegal immigrants gained a job. Meanwhile, 663k native-born Americans lost their jobs. Since the pandemic, native-born workers have lost around 2 million jobs.

The bond market’s initial reaction was very negative due to the strong headline job growth and hourly earnings beat. However, we think that over the next few days, as the market digests the complete set of jobs data, it may feel otherwise. Remember that the coming CPI, FOMC meetings, and Treasury bond auctions also weigh on bonds.

jobs establishment survey vs household suvery

What To Watch Today

Earnings

  • There are no notable earnings reports today.

Economy

  • There are no notable economic reports today.

Market Trading Update

Last week, we noted that the market remains range-bound within the recent consolidation. To wit:

“Crucially, the market has now registered a ‘sell signal,’ which will limit any rallies in the near term. Therefore, investors should continue to use bounces to reduce exposure and rebalance portfolios as needed. The upside to the market is likely constrained to recent highs.

While the market set marginal new all-time highs this past week, the upside likely remains somewhat limited in the near term, given the more overbought conditions. On Friday, the market flipped back onto a MACD “buy signal,” suggesting that the rally remains firmly intact, with the 20-DMA continuing to act as the primary support. Furthermore, volatility remains very suppressed, suggesting that traders are not worried about a significant decline anytime soon. However, with that said, the FOMC meeting and inflation reports are next week, which will have an outsized impact on the broader market. Therefore, continue to manage risk accordingly.

While the market did sell off early on Friday with the strong headline report, the underlying data strongly suggests that employment is much weaker than headlines suggest. For the Federal Reserve and the upcoming FOMC meeting next week, the 4% unemployment rate will likely keep them focused on the risk to the economy and on track to cut rates this year.

Such should continue to a bid under the market for now.

The Week Ahead

This will be a very busy week with lots of information for investors to digest. Wednesday, in particular, could be volatile, with CPI being released at 8:30 am ET, followed by the FOMC at 2:00 pm ET. The market expects CPI to be 0.3% on a monthly basis. Little is expected of the Fed, although it will be interesting to see if they shift their view on the economy to a slightly weaker outlook based on recent data. Jerome Powell may share his thoughts on Friday’s employment report. Given that the Philadelphia Fed expects a significant downward revision of employment figures, he may offer that the jobs market is not as strong as the headlines portray. We look forward to hearing his thoughts on the recent rate cuts by the ECB and Bank of Canada.

Also, this week, the 10-year UST auction will be held on Tuesday, and the 30-year auction will be held on Thursday. Like CPI, PPI on Thursday is expected to rise +0.3%.

Housing Struggles

Not surprisingly, with almost two years of mortgage rates north of 7%, the existing home market has been struggling. Buyers are few and far between as high prices and mortgage rates make home-buying difficult. Further, for many homeowners with sub-4 % mortgages, selling a home and buying a new home with much higher mortgage rates is not appealing. Sales for new homes have performed much better than those for existing homes as homebuilders have been offering customers reduced-rate mortgages. The graphs below show us that both the new and existing markets are essentially shut down.

The first graph shows pending home sales. They are homes under contract but have yet to go to settlement. Last month, they declined 7.7% compared to the prior month. Furthermore, they are down 7.4% versus one year ago. Most stunning, the index is at the same level as in April of 2020, when COVID essentially closed the real estate market. Home sales track very closely with pending home sales.

The second graph shows that the supply of new homes is rising and approaching the 2008 highs. The lower graph measures the supply slightly differently.

The final graph is important as it shows that the balance between supply and demand for homes may be shifting. Before recently, home prices have remained relatively stable despite high mortgage rates. This is largely a function of the small number of sellers in the market. However, as the third graph shows, price cuts to entice borrowers are becoming more popular. In fact, the percentage of listings with a price cut is back to pre-pandemic levels.

pending home sales
new home inventory rising
price cuts housing market

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The Texas Stock Exchange

Yes, you read that right: Texas will host a stock exchange. BlackRock and Citadel are lead investors in a new national stock exchange that plans on calling Texas its headquarters. The Texas Stock Exchange will file for registration with the SEC later this year and hopes to be operational in 2026. The exchange will be 100% electronic, meaning there will not be an iconic trading floor like the New York Stock Exchange (NYSE) or the commodity and futures exchanges in Chicago.

Many upstart exchanges have recently failed. Furthermore, older regional exchanges, like Boston and Philadelphia, which were bought out by the NYSE, no longer exist. However, the odds of success are better for the Texas Stock Exchange due to its backing by Citadel and BlackRock. Blackrock is the world’s largest money management firm, and, therefore, it can shift business toward the new exchange. Citadel is one of the largest electronic trading firms. Ergo, it can also force some of its trades to the new exchange. While the Texas Stock Exchange has financially strong supporters, the Exchange has stiff competition. The graphic below, courtesy of the Visual Capitalist, shows that the NYSE and NASDAQ are the largest stock exchanges in America and the world.

worlds top stock exchanges

What To Watch Today

Earnings

  • No notable earnings releases.

Economy

Market Trading Update

In yesterday’s commentary, we discussed how the mega-cap stocks continue to drive the market. This has left a widening gap between the S&P market-cap weighted index, the equal-weight index, and mid-cap and small-cap stocks.

This bifurcation of performance should not be overly surprising. The reason is that 100% of the entire market’s earnings growth comes from the top-7 stocks in the index. In other words, those improving earnings of the S&P index are non-existent if you strip out the “Magnificent 7.”

The problem with this, of course, is that it leaves very little room for error in Wall Street expectations. Eventually, when the economy slows, earnings will slow even for those magnificent companies, and the market will need to reprice accordingly.

Trade accordingly.

The ECB Cuts Rates

We shared news of the Bank of Canada cutting its interest rates two days ago. Yesterday, the European Central Bank (ECB) cut its interest rates for the first time since it began tightening rates two years ago. It lowered interest rates by 25 basis points on its three key monetary facilities as follows: Deposit (to +3.75%), Marginal Lending (to +4.50%), and Main Refi (to +4.25%).

ECB President Lagarde said they would now wait and see what other central bankers do. Clearly, this is a reference to the Fed. The U.S. economy has been much more robust than most other economies. Therefore, there is less need for the Fed to cut rates. The problem facing the ECB and other central banks that cut rates is the potential for dollar strength, which would increase inflationary pressures.

World central banks often coordinate their efforts. Assuming the next couple of rounds of employment and inflation data are weak, the Fed could ease rates as soon as the July 31st meeting, although the market only implies a 16% chance they will do so at that meeting.

ecb rates

Lower For Longest

The chart below from Charlie Bilello shows the current yield curve inversion is the longest in at least 60 years. This means monetary policy has been restrictive for a long time. What the graph doesn’t tell you is whether it’s restrictive enough. The massive stimulus from the pandemic caused a surge in economic activity and inflation. Restrictive policy is needed to help balance the economy. Even with the yield curve inversion, which limits profits on bank lending and thus disincentivizes lending, the economy has done well. However, with the stimulus having primarily left the system, restrictive policy will weigh on the economy. Once the Fed starts to cut rates, which could come as early as July, the yield curve will start to uninvert, and Fed policies will become less restrictive.

us treasury yield curve fed

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Commodities And The Boom-Bust Cycle

It is always interesting when commodity prices rise. The market produces various narratives to suggest why prices will keep growing indefinitely. Such applies to all commodities, from oil to orange juice or cocoa beans. For example, Michael Hartnett of BofA recently noted:

The 40-year period from 1980 to 2020 was the era of disinflation: thanks to fiscal discipline, globalization, and peace, markets saw ‘deflation assets’ (government and corporate bonds, S&P, growth stocks) outperform ‘inflation assets’ (cash, commodities, TIPS, EAFE, banks, value). As shown below, ‘deflation’ annualized 10% vs. 8% for ‘inflation’ over the 40-year period.

But the regime change of the past 4 years has roles reversed, and now ‘magnificent’ inflation assets are annualizing 11% returns vs 7% for deflation assets.”

Mind you, this is not the first time that markets have gone “cuckoo for commodities.” The most recent episode in 2007 was “Peak Oil.” However, crucially, this time is never different. As shown below, commodities regularly have surges in performance and are the best-performing asset class in a given year or two. Then, that performance reverses sharply to the worst-performing asset class.

That performance “boom and bust” has remained since the 1970s. The chart below shows the Commodities Index’s performance over the last 50 years. On a buy-and-hold basis, investors received a 40% total return on their investment. This is because, along the way, there were fantastic rallies in commodities followed by huge busts.

Such brings us to the big question? Why do commodities regularly boom and bust?

Why Do Commodities Boom And Bust

The problem with the idea of a structural shift to commodities in the future and why it hasn’t happened in the past is due to the drivers of commodity prices.

Here is a simplistic example.

  • During a commodity cycle, the initial phase of a commodity price increase is due to rising demand exceeding existing supply. This is often seen in orange juice, where a drought or infestation wipes out a season’s crops. Suddenly, the existing demand for orange juice massively outweighs the supply of oranges.
  • As orange juice prices rise, Wall Street speculators start bidding up the price of orange juice futures contracts. As orange juice prices increase, more speculators buy futures contracts driving the price of orange juice higher.
  • Farmers scrap plans to produce lemons and increase the orange supply in response to higher orange juice prices. As more oranges are produced, the supply of oranges begins to outstrip the demand for orange juice, leading to an inventory glut of oranges. The excess supply of oranges requires producers to sell them at a cheaper price; otherwise, they will rot in the warehouses.
  • Wall Street speculators begin to sell their futures contracts as prices decline, pushing the price lower. As prices fall, more speculators dump their contracts and sell short orange futures contracts, causing prices to fall further.
  • With the price of oranges crashing, farmers stop planting orange trees and start growing lemons again.
  • The cycle then repeats.

Furthermore, high commodity prices threaten themselves. As always, “high prices are a cure for high prices.” If orange juice prices become too expensive, consumers will consume less, leading to declining demand and supply buildup. The following chart of commodities compared to nominal GDP shows the same. Whenever there was a sharp rise in commodity prices, it slowed economic growth rates. Such is unsurprising since consumption drives ~70% of GDP.

There is also a high correlation between commodities and inflation. It should be self-evident that when commodity prices rise, the cost of goods and services also rises due to higher input costs. However, the price increase is constrained as consumers are unable to purchase those goods and services. As noted, the consequence of higher prices is less demand. Less demand leads to lower prices or disinflation.

Such is why hard asset trades repeatedly end badly despite the more ebullient media coverage.

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Hard Asset Trades Tend To End Badly

Commodities, and hard assets in general, can be an exhilarating and profitable ride on the way up. However, as shown in the long-term chart above, that trade tends to end badly. Commodities have repeatedly led market downturns and recessions.

Will this time be different? Such is unlikely to be the case for two reasons.

As discussed, high prices (inflation) are the cure for high prices as it reduces demand. As shown above, as the consumer retrenches, demand will fall, leading to lower inflation in the future.

Secondly, as the country moves toward a more socialistic profile, economic growth will remain constrained to 2% or less, with deflation remaining a consistent long-term threat. Dr. Lacy Hunt suggests the same.

Contrary to conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year-end and undershoot the Fed Reserve’s target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation.

As he concludes:

The two main structural impediments to traditional U.S. and global economic growth are massive debt overhang and deteriorating demographics both having worsened as a consequence of 2020.

The last point is crucial. As liquidity drains from the system, the debt overhang weighs on consumption as incomes are diverted from productive activity to debt service. As such, the demand for commodities will weaken.

While the commodity trade is certainly “in bloom” with the surge in liquidity, be careful of its eventual reversal.

For investors, deflation remains a “trap in the making” for hard assets.

There is nothing wrong with owning commodities; just don’t forget to take profits.

Zero Down Mortgages Are Back

Here we go again. At the peak of the mortgage bubble, leading to the Great Financial Crisis (GFC), lenders were offering zero down mortgages. As you may remember, that ended poorly. Accordingly, we presumed that the mistake would not be repeated. We are proven wrong. Per CNN, United Wholesale Mortgage (UWM) is offering mortgage borrowers a traditional 30-year mortgage for 97% of the purchase price and a 3% interest-free loan for the remaining 3%. The 3% interest-free loan does not accrue interest, but the loan must be paid back if you sell the home or refinance the mortgage. In other words, a borrower does not come to the settlement table with cash and thus has zero home equity on day one. Compare that to data from ATTOM below, which shows that the median down payment across the United States is 15%.

UWM claims their robust underwriting process will help ensure this is a profitable business for them. Per the article:

“People who make these claims are uneducated about the current state of the industry,” Alex Elezaj, UWM’s chief strategy officer, told CNN. “In today’s environment, UWM is responsible for underwriting the loan, which gives us confidence that these are high quality loans.”

They may have excellent underwriting, but zero-down mortgages are a recipe for problems. Without sufficient equity in a house, zero down borrowers will have trouble refinancing into a new mortgage when mortgage rates fall. Further, if home prices decline, the lender has no equity to cushion a default. As we saw in 2008, some borrowers will mail in the keys to the bank and make the loss the bank’s problem. It will be interesting to see if zero down mortgages are a one-off offering from UWM or a product their competitors will soon offer.

zero down mortgages average down payments

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday’s commentary noted that the market continues to hold support along the bullishly trending moving averages. However, the internal breadth of the market remains a non-confirmation of the current bullish views. The market rallied strongly yesterday, with many familiar names leading the charge, with Semiconductors at the head of the pack. Such remains a familiar rally theme over the last several months, where a brief rotation into defensive stocks quickly returns to the “Magnificent 7.”

Market Heat Map

While it seems unlikely, Danny and I discussed what a potential market reversal would look like on yesterday’s Real Investment Show. I got a few emails asking if I could reproduce the chart I quickly threw together during the broadcast. I used a simple 50- and 200-month moving average during the show. However, the following chart uses a 24, 48, and 96-month moving average, which are better trend lines for the market. The 48-month moving average was the trend line support for the “Dot.com” crash. That moving average was taken out during the “Financial Crisis,” which bottomed at the 96-month moving average. Since the onset of the liquidity-driven, zero-interest rate cycle in 2009, the 24-month moving average has supported the bull market.

Using a Fibonacci retracement sequence, a correction back to the 96-month moving average would be a roughly 50% decline from current levels and would equate to the previous two bear market cycles. However, such a decline would require a 61.8% retracement of the market from current levels, suggesting a really deep economic recession/credit cycle has unfolded. The most likely corrective levels for a more normal economic recession will be a retest of the 24- or 48-month moving averages with a maximum drawdown of a 38.2% retracement, which would align with the 2022 corrective lows.

This is strictly a hypothetical exercise but does provide some reasonable risk/reward analysis for the future.

ADP and ISM Services

The ADP reported the economy added 152k jobs last month, below the 175k expected jobs. The quote below from ADP’s Chief Economist, Nela Richardson, summarizes the report well.

Job gains and pay growth are slowing going into the second half of the year. The labor market is solid, but we’re monitoring notable pockets of weakness tied to both producers and consumers.

The graph below charts the monthly change in ADP employment (orange). The dotted line represents the 2012-2019 average. As shown, job growth has been below the pre-pandemic average for nearly a year. The green and red bars highlight the six-month moving average of the difference between BLS job growth and ADP. Thus far, in 2024, the average difference is nearly 100k jobs. The average was only 16k between 2012 and 2019. Based solely on this data, it appears the BLS jobs data is due for a “catch-down” with ADP.

adp vs bls employment data

On the heels of an unexpectedly weak ISM manufacturing survey, the ISM services sector survey was stronger than expected at 53.8, well above estimates of 50.8 and last month’s 49.4. Given that the service sector represents over three-quarters of the U.S. economy, this survey indicates continued economic growth. The employment sub-component was 47.1, below expectations and 50. Such points to a contraction in service sector jobs. The price index was 58.1, a relatively high number but below the previous reading of 59.2 and expectations of 60.0. The graph below shows that ISM services have fluctuated between 50 and 55 for the last year and a half. Before the pandemic, the range was 55 to 60

ISM services

The Bank Of Canada Cuts Rates

On Wednesday, the Bank of Canada (BOC) cut its overnight borrowing rate from 5.25% to 5.00%. Similar to the Fed, the BOC is making interest rate decisions one meeting at a time. However, they expect further cuts if inflation continues to ease.

The graph below shows that central bank rates between the U.S. and Canada are often very similar. Hence, might this be a precursor to the Fed cutting rates?

Canada borrowing rate vs fed funds

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Why is Crude Oil Tumbling?

Crude oil prices have fallen by 10% over the last five days and nearly 20% since early April. As we will share, a few factors are negatively impacting the price of crude oil. First, OPEC surprised the markets this past weekend. They agreed to extend most of its production cuts to next year but are phasing out voluntary cuts. The deal appears to be an underhanded way of increasing production. Further pushing crude oil lower is a growing likelihood of a cease-fire agreement in Gaza. Importantly, an agreement could include broader peace agreements extending through the Middle East. Lastly, the recent slowing of economic activity in the U.S. and continued poor economic growth in China are weakening the demand for crude oil. Along those lines, the EIA recently shared that U.S. demand for diesel fell to its lowest seasonal level in over 25 years. Per Reuters:

Products supplied of distillate, EIA’s measure of demand, fell over 6% from February to 3.67 million barrels per day (bpd) in March, lowest for the month since 1998.

The long-term crude oil graph below, using a log scale y-axis, shows that the price of crude oil has formed a wedge pattern over the last two years. Typically, the price breaks out of wedge patterns with a sharp move higher or lower. A break lower would be troublesome, as the blue dotted support line has been dependable support for nearly ten years, except for the early days of the pandemic. Further, a break lower could result in the 50-week moving average crossing below the 200-week moving average. The price of crude oil sits on its 200-week moving average, which has been good support for the last year. On the bullish side, the trend has been upward for eight years, and a break above the dotted blue resistance line could propel crude oil prices back closer to $100.

crude oil prices

What To Watch Today

Earnings

Economy

Market Trading Update

As we have noted over the last few days, there is nothing seemingly “wrong” with the market that would require investors to take a more defensive posture. However, with that said, since we tend to be more “risk averse” by nature, we do pay attention to internal signals that could suggest that risk is rising.

One thing that we do pay attention to is market breadth. When the stock market rises, it should be accompanied by a rising number of stocks trading above their respective 50- and 200-DMAs. The opposite is true during declining markets. However, there are times when breadth does not confirm the market’s current bullish or bearish trend. These “negative divergences” are often worth paying attention to as they suggest that underlying weaknesses or strengths in the market may exist.

While the market has rallied fairly sharply from the April lows, the number of stocks trading above their respective 50 and 200-DMA is mostly unchanged. There are periods when the market has rallied despite weak participation, but more often than not, this is a sign worth paying attention to. If the current market rally will continue higher over the next few months, we need to see broader participation in the market to support that rise. Otherwise, if that breadth continues to narrow, any upside is likely going to be very limited.

As Bob Farrell once wrote:

Rule #7. “Markets are strongest when they are broad, and weakest when they narrow to a handful of blue-chip names”

Small Caps And Bonds Are Well-correlated

The graph below shows that bond prices and the Russell 2000 small-cap index have been well-correlated since bond yields started rising in 2022. Small-cap stock earnings tend to be more sensitive to debt costs and have less access to the capital markets to meet their borrowing needs. Furthermore, banks have been running conservative lending policies, disproportionately affecting smaller companies more than larger ones. If the recent downtick in yields due to weakening economic activity holds, we might expect the small-cap sector to lead the market. Mind you, it is too early, and there is insufficient data to make such an economic claim at this point.

small cap and bonds well correlated

JOLTs

In the latest JOLTs report, the number of job openings fell below 8.1 million to its lowest level since February 2021. Expectations were for 8.4 million. The graph below further indicates that the jobs market is normalizing. It shows the ratio of job openings to the number of unemployed is back to its pre-pandemic peak. The quits rate and hires rate are also back to pre-pandemic levels. We suspect that expectations for Friday’s employment figures will decline slightly on the JOLTs data.

ratio of job openings to unemployed

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Investments For The Coming Power Grid Expansion- Part 3

We continue with our discussion of investment ideas that could benefit from upgrading and expanding the power grid to accommodate surging demand from AI data centers and EVs.

This third and final part of this series focuses on alternative energy sources, utility companies, and other companies related to the power grid infrastructure.

If you haven’t read Parts ONE or TWO we recommend reading them before continuing.

Alternative/Renewable Energy Sources

In 2022, the Department of Energy calculated that renewable energy from solar, wind, hydro, geothermal, and biomass accounted for a fifth of all electricity generation. By 2028, the IEA thinks the percentage will double to 42%. Solar and wind power are expected to be the primary alternative energy sources.

renewable energy

Investments in solar, wind, and other alternative energy sources, along with natural gas, coal, and nuclear, will be increasingly vital to power our utility plants. Furthermore, suppose the US and other nations continue to strive for net zero emissions by 2050 and other environmental goals. The demand for existing and new alternative energy sources will surge in that case.   

net zero emissions
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Renewable energy has benefits and flaws compared to natural gas. The significant advantage of renewable energy is it produces minimal greenhouse gas emissions, as shown below. Second, and equally important, according to the IEA World Energy Outlook, solar and wind energy are the cheapest renewable energy sources and cost much less than carbon-based ones.

safest and cleanest energy sources

However, they have considerable flaws that need to be overcome. Consider the following from Green Solutions.

Relies heavily on weather conditions. When adverse weather conditions occur, renewable energy technologies like solar cells may not be as effective. For example, during periods of rain, PV panels cannot generate electricity, necessitating a shift back to traditional power sources.

Lower efficiency. Regrettably, renewable technologies generally exhibit lower efficiency compared to traditional energy conversion devices. For example, commercially available solar panels have an efficiency of about 15% to 20%. In contrast, traditional technologies utilizing coal or natural gas can achieve efficiency levels of up to 40% and 60%, respectively.

High upfront cost. The manufacturing and installation processes for renewable energy devices, such as PV panels, can be relatively expensive. Only for installation, solar panels cost about $17,430 to $23,870 on average.

Limited geographical region. The availability of high-quality land is limited, leading developers to urgently search for new sites. For example, in Germany, regulatory, environmental, and technical limitations significantly reduce the potentially suitable for onshore wind farms to just 2%.

Shortages of key raw materials. This includes essential metals like nickel, copper, and rare earth metals, such as neodymium and praseodymium, which are vital for the creation of magnets used in wind turbine generators.

Renewable Stocks Are Not Following the Narrative

With time, we believe renewable energy will become much more efficient and hopefully be in a better position to help meet the surging needs of the nation’s utility plants. Investors do not seem as hopeful. 

The recent narrative pushing investors to power grid-related investments has skipped past renewable stocks. The graph below shows two popular alternative energy ETFs, Invesco’s Solar ETF (TAN) and iShares Global Clean Energy ETF (ICLN). Both ETFs are well off their 2008 highs and recent peaks in late 2020. 

alternative energy etfs

Alternative energy stocks and diversified ETFs may be excellent investments for longer-term investors as renewable energy will be relied upon heavily. Furthermore, their stocks have not benefited from the power grid expansion narrative.

Batteries Technology Is Vital To Renewable Energy

Solar and wind energy are not dependable due to weather conditions. For example, the following quote from OilPrice.com:

But while solar power has made the U.S. power-generating system greener, it has also made it more volatile, especially in the top solar market, California. 

There, peak solar power generation coincides with the lowest residential electricity demand during the midday. When power demand begins to surge after 6 p.m., solar output begins to fade.  

In California, for example, “on sunny spring days when there is not as much demand, electricity prices go negative and solar generation must be ‘curtailed’ or essentially, thrown away,” says the Institute for Energy Research (IER).

Accordingly, utilities need more efficient batteries to store excess renewable energy for use during peak demand periods and when the weather isn’t conducive for electricity generation. Without more efficient batteries, undependable alternative energy sources cannot be relied upon as much as the environmental goals demand.

Companies involved in energy storage, especially those at the forefront of producing more efficient batteries, may have significant upside. But, with unproven technology come substantial risks for investors. For instance, many new types of battery technology are in development.

  • Solid-state batteries
  • Lithium-sulfur batteries
  • Cobalt-free lithium-ion batteries
  • Sodium-ion batteries
  • Iron-air batteries
  • Zinc-based batteries
  • Graphene batteries

Battery Diversification May Be Critical

Even if you know which type of battery will be the winner, so to speak, you also have the arduous task of figuring out which company will be a primary producer of the battery. Unless you believe you have good insight into battery technology and the key players in the industry, we think a diversified battery ETF may provide the best investment results. Further, the large battery ETFs are also diversified, with investments in lithium and other metal producers. Unfortunately, ETFs in this space are limited.

Global X Lithium & Battery Tech (LIT) is far and away the largest, with nearly $1.5 billion AUM. While it invests in companies with new battery technology, it also “invests in the full lithium cycle, from mining and refining the metal, through battery production.” Its top three holdings are lithium producers.

Amplify Lithium and Battery Technology (BATT) is the second largest ETF with a mere $89 million in AUM. Like LIT, they invest in lithium producers like BHP and Albemarle.

If you want to make investments in individual companies, Tesla (battery technologies), LG Chem, and Samsung SDI are well-positioned in the industry.

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Lithium Miners

Assuming lithium remains a crucial component in electricity storage batteries, its miners should do well, especially given the recent decline in lithium prices and the related stocks.

North Carolina-based Albemarle (ALB) is the world’s top lithium producer and the largest producer by market cap. It is the only lithium producer of size based in the US. Like the rest of the alternative energy sector, its stock has traded poorly recently. However, with a forward P/E of 16, there is value if its revenues continue upward at their recent pace.

albermarle lithium revenues

We caution you that lithium deposits are being actively explored. Assuming success, the lithium supply may limit the price appreciation of lithium. As an example from The Hill- Researchers make massive lithium discovery in Pennsylvania.

Utility and Grid Operators

Utilities will generate more power, thus increasing their revenue. However, they must invest significant capital to modernize, expand, and reduce greenhouse emissions.

AI data center locations are partially chosen based on their ability to source cheap electricity. Thus, utility companies in the Southeast and Midwest, with access to cheaper natural gas and more reliable alternative energy generation, will be the most cost-effective locations for data centers. The map below shows that Virginia hosts the greatest number of data centers, followed by California and Texas.

ai data centers

Dominion Energy (D) in Virginia and Entergy (ETR) in Texas are the two utility companies that may be the biggest beneficiaries of the growth of AI data centers. Both stocks have relatively low forward P/E’s of approximately 14 and dividend yields of 4.25% for D and 5.50% for ETR. It will be crucial to follow their margins to see how effectively they offset the expansion costs with rising revenue.

Constellation Energy (CEG) and NextEra Energy (NEE) are also worth tracking as they invest heavily in renewable energy infrastructure and will benefit from increased demand. We would add Duke (DUK) and Southern Company (SO) to the list of companies to follow.

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Additional Investment Ideas

We now present an assortment of industries and firms that can benefit.

Technology and AI Firms

Companies specializing in AI software for energy efficiency and management will find opportunities in this evolving landscape. Some of the more prominent names in this sector include IBM, Google, Microsoft, Oracle, and GE Vernova.

Physical Plant Expansion

Companies that supply utility plants with generators, transformers, circuit breakers, and switchboards, among many other parts, will undoubtedly benefit from power grid expansion.

GE Vernova, Eaton, Quanta Services, Emerson Electric, and Siemens

Water/Cooling

The average data center uses 300,000 gallons of water a day to cool its equipment. That is the equivalent of the water used by 100,000 homes. Therefore, companies that can develop cheap cooling solutions for data centers will be in high demand.

Vertiv Holdings (VRT) is a leader in this segment. Its shares have risen tenfold since it went public in 2019 and now trades at a P/E of 100. It’s a high-risk, high-reward stock, not for the faint of heart.

Infrastructure ETFs

There are many other businesses set to profit from the coming infrastructure boom.

Those looking for a diversified investment approach in the power grid may want to explore thematic ETFs.

For example, the First Trust Clean Edge Smart Grid Infrastructure Fund (GRID) holds 103 positions. Beyond diversification and portfolio manager expertise, the fund can buy stocks in foreign markets, which many US investors do not have access to or are uncomfortable with.

iShares (IFRA) is a similar fund with a different basket of stocks and approach toward investing in the industry.

The bottom line is we are confident the expansion and modernization of the power grid will be highly profitable for some companies. However, many companies involved, especially smaller companies with limited product offerings, offer massive rewards but substantial risks. Diversification will prove to be essential for investors.   

Summary

The more we researched the power grid expansion, the more industries, and companies we exposed that could benefit from it. While this article stops here, we will continue investigating the topic and share any exciting findings in the future. The number of rabbit holes is seemingly endless. We encourage you to explore the topic and share any findings you may uncover with us.

Like the birth of the internet, some companies like AOL, Yahoo, and Sun Microsystem, which were the supposed internet leaders, fell by the wayside. Other companies, some already large, others virtually unknown, become leaders. The key to investing in this expansion is to remain vigilant for new companies and technologies that can blossom. Do not assume that the companies in charge today will be so tomorrow. Keep your head on a swivel.

For those unable to invest the time and effort to understand industry trends and identify companies likely to profit, a fund(s) with professionals highly focused on the industry may prove an excellent way to take advantage of the potential infrastructure boom.

Roaring Kitty Goes All In On GameStop

GameStop shares traded nearly 100% higher in pre-market trading before Monday’s official 9:30 ET opening. The reason is a Tweet and Reddit post from Roaring Kitty. On Twitter, he shared the picture below of an Uno playing card. Further, on Reddit, Roaring Kitty posted for the first time in three years. It sounds unbelievable because it is. His Reddit message was a disclosure of his GameStop holdings. Assuming he is not lying to prop up shares of GameStop, he now owns 5 million shares of GameStop and 120,000 June 21st call options with a strike of $20. 120,000 options is the equivalent of 120 million shares, or about a third of all outstanding shares. Because the shares have risen so much, the dealers who wrote those calls will have to buy GameStop stock to hedge their positions. Accordingly, dealers are likely to pressure the stock even higher.

If you recall, Roaring Kitty posted an esoteric graphic on Twitter, which was assumed by investors that it was time again to buy GameStop. Accordingly, the stock rose from 17 to 50 in two days. Three days later, it gave up those gains. GameStop executives have been taking advantage of the situation by issuing shares of the stock at inflated prices. On May 24th, they raised almost one billion dollars in much-needed funding. This instance will likely be similar. The stock will surge and ultimately fall. Some, like Roaring Kitty, will likely make boatloads of money. Others who are late to the game could lose significantly. The question in our mind is when, not if, the SEC will get involved.

gamestop roaring kitty unocard

What To Watch Today

Earnings

Economy

Market Trading Update

As discussed yesterday:

“The 20-DMA crossed above the 50-DMA. On Friday, that support level held, with the market bouncing off of it, keeping the current consolidation in process. If the 20-DMA fails, the 50-DMA is the next logical support level. Below that will be the 100-DMA held during the April sell-off.”

Yesterday, the market tested the 20-DMA again on an intraday basis and then rallied into the close. Over the last two trading days, there has been consistent buying at the end of the day, suggesting that institutions are accumulating stocks. Such tends to be a bullish signal short-term and suggests that while the upside may be somewhat limited momentarily, the downside risk is contained as well. There has been an interesting rotation of money between sectors, with technology lagging and other defensive areas gaining some traction. For now, there is little need to be overly cautious with portfolios. However, it is worth keeping a close eye on the 20- and 50-DMA for any signs of market erosion in the near term.

Discretionary Stocks Weaken With The Consumer

Last week, we noted that personal consumption appears to be slowing. Earnings from many large goods (LINK) and food (LINK) retail outlets are showing poor growth and, in many cases, below the growth rate existing before the pandemic. Government retail sales and consumer spending data further confirm some weaknesses. The SimpleVisor relative and absolute analysis affirm that investors are concerned.

The discretionary sector (XLY) is now tied with the transportation sector (XTN) as the most oversold on a relative basis. The second graphic shows the ratio of XLY/SPY, which has been oversold for most of this year. This is unsurprising given XLY has given up over 11% to the S&P 500 this year.

simplevisor sector analysis
discretionary etf xly vs spy

The Atlanta and New York Fed Point To Slowing Growth

The first graph below shows that the Atlanta Fed’s GDP Now estimate of second-quarter economic growth continues to decline. It peaked at 4.1% and now sits at 1.8%. (Note they have not updated the graph) Such growth is better aligned with Wall Street economists. Similarly, the New York Fed’s Nowcast GDP model forecasts a 1.76% growth rate. This is down about .25% over the last week. The third graphic shows the impact of the last week’s data on the Nowcast GDP estimate.

new york fed nowcast

new york fed nowcast data impact

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Deviations From Long-Term Growth Trends Back To Extremes

In 2022, we discussed the market’s deviations from long-term growth trends. That discussion centered on Jeremy Grantham’s commentary about market bubbles. To wit:

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

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

Are we currently in a market bubble? Maybe. Honestly, I have no idea. The problem is that market bubbles are only evident and acknowledged after they pop. This is because, during the inflation phase of the market bubble, investors rationalize why “this time is different.” 

As we noted then, there are three components of market bubbles:

  1. Price
  2. Valuations
  3. Investor Psychology

When investors bid up asset prices that exceed underlying earnings growth rates, market bubbles were previously present. Since economic activity generates revenues and earnings, valuations can not indefinitely exceed the underlying fundamental realities.

Interestingly, the correction in 2022 started the reversion process of that deviation. However, investor speculation has since pushed that deviation near its previous peak.

As is always the case, valuations are a function of price and earnings; therefore, deviations in price from the long-term exponential growth trend have marked prior peaks. Unsurprisingly, when price momentum increases rapidly, investors rationalize why overpaying for earnings is justified this time. Unfortunately, as shown, such has rarely worked out well.

As the chart shows, and the definition of a market bubble states, “assets typically trade at a price that significantly exceeds the asset’s intrinsic value. Instead, the price does not align with the fundamentals of the asset. “

Crucially, as previously discussed, excess valuations and price deviations from long-term norms are solely a function of investor psychology.

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

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

So, why are we rehashing this topic?

An Optimistic Bunch

While sufficient data suggests that economic growth rates are weakening, investors are again chasing assets with near reckless abandon. For example, investor allocations to equities are rising sharply as chasing asset market returns displaces logic and underlying fundamentals.

The American Association Of Individual Investors (AAII) allocation measures suggest the same, with investors increasing exposure to equities and reducing cash.

Furthermore, extremely low levels of volatility suggest a high level of complacency among investors. Historically, low levels of market volatility tend to reverse suddenly.

Suppose we create a composite index of investor sentiment and volatility (when one is high, the other is low). In that case, current levels align with short- to intermediate-term market peaks and corrections.

Does this mean the market is about to crash? No. However, as Howard Marks previously noted:

We can infer psychology from investor behavior. That allows us to understand how risky the market is, even though the direction in which it will head can never be known for certain. By understanding what’s going on, we can infer the ‘temperature’ of the market. 

We must remember to buy more when attitudes toward the market are cool and less when heated. For example, the ability to do inherently unsafe deals in quantity suggests a dearth of skepticism among investors. Likewise, when every new fund is oversubscribed, you know there’s eagerness.

Currently, there is little denying the more excessive bullish sentiment that abounds. Investors are willing to take on risk, overpay for underlying valuations, and rationalize their actions. Historically, these actions have been the precedents of markets where expectations exceed underlying fundamental realities.

However, while that may indeed be the case, we must never forget the famous words from John Maynard Keynes:

“The markets can remain irrational longer than you can remain solvent.”

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Managing Risk And Reward

Whether you agree that current market deviations are important is mostly irrelevant. Every investor approaches investing differently. We spend much time researching current market environments to reduce the risk of catastrophic losses. Does that guarantee we will be successful in that endeavor? No. However, understanding the risks we are undertaking helps us quantify capital destruction in case something goes wrong.

Managing risk is far more crucial if you are nearing or have entered retirement. The reason is that your investment horizon is shorter than that of those much younger. Therefore, you are less able to recover from short-term market repricings.

There are some simple steps you can take to prepare yourself.

  • Avoid the “herd mentality” of paying increasingly higher prices without sound reasoning.
  • Do your research and avoid “confirmation bias.” 
  • Develop a sound long-term investment strategy that includes “risk management” protocols.
  • Diversify your portfolio allocation model to include “safer assets.”
  • Control your “greed” and resist the temptation to “get rich quick” in speculative investments.
  • Resist getting caught up in “what could have been” or “anchoring” to a past value. Such leads to emotional mistakes. 
  • Realize that price inflation does not last forever. The larger the deviation from the mean, the greater the eventual reversion. Invest accordingly. 

The increase in speculative risks and excess leverage leaves the market vulnerable to a sizable correction. Unfortunately, the only missing ingredient is the catalyst that brings “fear” into an overly complacent marketplace.  

Currently, investors believe “this time IS different.” 

“This time” is different only because the variables are different. The variables always are, but outcomes are always the same.

When the eventual correction comes, the media will tell you, “No one could have seen it coming.”

Of course, hindsight isn’t very useful in protecting your capital.

Orange Juice Is The Next Cocoa

In mid-March, we presented daily Commentary readers with a section entitled, Add Cocoa To The List Of “Mooning” Assets. When we wrote the article, the price of cocoa was up by 70% for the year, in line with year-to-date gains in bitcoin and Nvidia. Since then, cocoa prices have fallen by over 40% but have started rising again. Some of the price volatility is undoubtedly due to weather conditions and its impact on the cocoa harvest. But as we wrote, speculative fever also plays a role. Orange juice futures appear to be following a similar path.

The graph below shows that orange juice futures prices are “mooning.” Citrus greening, a disease affecting Brazil’s trees, is impacting the price of orange juice. Furthermore, draught and above-average temperatures in Brazil also weigh on crop yields. As a result, Brazil’s crop is expected to be 25% less than in average years. Further impacting the supply of orange juice, Florida’s recent hurricanes have damaged orange trees. The outlook for a busy hurricane season is also to blame.

However, similar to our thoughts on cocoa in March, it seems that orange juice prices are also swayed by the more mainstream speculative flows impacting the commodity markets. Commodities have always been a speculative arena, but with more traditional investors trading orange juice and other commodities, the correlation with crypto and hot stocks is rising as well.

orange juice futures prices

What To Watch Today

Earnings

  • No notable earnings releases.

Economy

Market Trading Update

Last week, we discussed that consumer data suggested the economy was weakening. That was confirmed this past week with downward revisions to Q1 GDP and weak personal consumption expenditures (PCE) reports.

The U.S. economy’s growth in the first quarter was revised to an annualized rate of 1.3% from the previously estimated 1.6%, reflecting weaker consumer spending and equipment investment. This slowdown contrasts sharply with the 3.4% growth rate in the final quarter 2023. Inflation for the first quarter was also slightly revised down to 3.3%.

On Friday, PCE, which is roughly 70% of GDP growth, also came in under expectations, adding more concerns to a growing list of economic data that has recently weakened.

In an interesting turn of events, “bad news” seemed to matter to the markets this week. Of course, the reality was that the market was overbought and needed a correction. Wall Street just needed a reason to liquidate some positions.

As noted last week, the 20-DMA crossed above the 50-DMA. On Friday, that support level held, with the market bouncing off of it, keeping the current consolidation in process. If the 20-DMA fails, the 50-DMA is the next logical support level. Below that will be the 100-DMA held during the April sell-off.

Crucially, the market has now registered a “sell signal,” which will limit any rallies in the near term. Therefore, use bounces to reduce exposure and rebalance portfolios as needed. The upside to the market is likely constrained to recent highs.

The Week Ahead

A new monthly cycle of economic data starts this week with the latest jobs data. JOLTs on Tuesday, ADP on Wednesday, and the BLS report on Friday will provide a new round of employment data. The market expects another relatively weak job number, with payrolls rising by 177k. The prior reading was 175k. We say “relatively” because payroll growth averaged approximately 250k a month. Also on the calendar are the ISM manufacturing and service sector reports on Monday and Wednesday, respectively. The jobs and prices sub-components will likely garner the headlines.

We get a reprieve from Fed speakers as they enter the media blackout period before the FOMC meeting on June 12th.

Electricity Demands And Debt

Traditionally, government debt has a negative multiplier. In other words, each dollar of debt ultimately reduces economic growth. While we have little doubt that will change going forward, there is one significant investment the government will be making that has the potential to create lasting economic growth. Following up on our soon-to-be three-part article (Link 1, Link 2) on investing in the coming power grid expansion, we present an article on how the massive upgrade and expansion of the power grid will affect the economy. The following comes from Electricity Demand Cures Debt Concerns.

However, building infrastructure is very labor-intensive, and CapEx is labor—and investment-intensive. Those dynamics change the economic growth dynamic. While corporations increase capital investment to build the power supply, the Government will likely enter the fray with further infrastructure-focused spending bills. This is because AI is a critical component of ensuring the defense and national security of the United States. However, instead of issuing debt to spend on domestic welfare programs, the debt used in infrastructure will create economic growth through labor creation.

Government spending on infrastructure differs from most other government spending because it can create both near-term economic growth in the grid’s buildout and, more importantly, lasting economic growth.

The article shares that Goldman Sachs thinks the infrastructure expansion could add 0.4% to GDP, as shown below.

power grid GDP growth scenarios

Increases in productivity, productive capital investment, and increased labor demand for the infrastructure buildout (which will also result in higher wages) should provide the economic boost needed.


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Lets Knock On Wood

We haven’t written lately on Cathie Wood and her ARKK Innovation ETF. But given the popularity of her funds, their horrendous results over the last three years, and Wood’s preposterous claims, let’s knock on Cathie Wood and ARKK.

Wood started the ARKK fund and others in 2014. The flagship fund, ARKK Innovation Fund, seeks long-term growth through investments in disruptive companies. In the stock market rally of 2020, ARKK flourished. Consequently, its assets (AUM) rose from $2 billion at the start of 2020 to its peak of $28 billion in early 2021. ARKK’s AUM today is $6.2 billion. Her fund was the poster child for the 2020 meme stock rally and has since become one of the worst-performing ETFs. Wood’s promises of outsized returns drove speculation in her fund. To wit is a comment from the fund on December 17, 2021:

“With a five-year investment time horizon, our forecasts for these platforms suggest that our strategies today could deliver a 30-40% compound annual rate of return during the next five years. In other words, if our research is correct – and I believe that our research on innovation is the best in the financial world – then our strategies will triple to quintuple in value over the next five years.” -Cathie Wood

The graph below shows the fund’s poor performance, which is even more troublesome when compared to her claims and the Nasdaq (QQQ). The point of knocking Cathie Wood and ARKK is to highlight that narratives and market actions can be substantial and, in the longer run, damaging to investor returns. As our ARKK example shows, reality always catches up with stocks; it’s just a question of when.

arkk vs QQQ cathie woods

What To Watch Today

Earnings

  • No notable earnings announcements today.

Economy

Market Trading Update

There are many narratives surrounding Bitcoin, from a shield to Government overreach to the future of digital money. However, regardless of your opinion on the cryptocurrency, it is a terrific “risk on” proxy.

From a technical perspective, Bitcoin recently ran to the top of its 2-standard deviation range and has likely started a short-term correction. With a MACD sell signal close to triggering, a reset of $60000 is likely as Bitcoin remains in a fairly wide trading range following the Bitcoin ETF buying frenzy.

Given Bitcoin’s history of being a good “risk on/risk off” proxy, if Bitcoin breaks below critical support, we should likely expect the broader market to follow suit. In such a case, we would likely see momentum trade shifting to a more defensive group of stocks in the index.

Just something we are watching.

The South Park Investment Curse

We stumbled across an interesting article showing an odd correlation between stocks mentioned on the TV show South Park and poor stock performance. Per the article:

Brent Donnelly, president of Spectra Markets, did the leg work and found that once a company or its product is featured prominently on an episode of the animated comedy series, its stock tends to underperform the S&P 500 by 7 percent over the following 12 months.

There may be some logic to the correlation. For instance, if a company’s product is popular but absurd, as is sometimes the case with South Park plot lines, might its market value also be too high? The table below from the article shows stocks featured on the show since 1998. While the average results affirm the author’s theory, the variance of returns is substantial.

south park investment curse

GDP Revised Lower

Monday’s Commentary shared information on the recent spate of economic data revisions lower. First quarter GDP is now included. It fell from 1.6% to 1.3% yesterday. As shown below, the revision was driven by a sizable downward revision of consumer spending. The price indexes also ticked lower by 0.1%. While the first quarter is weak, there are no indications that such weakness will be sustained in the second quarter. Currently, as we share in the second graph, the Atlanta Fed’s GDP Now is running at 3.5% for the second quarter.

q1 gdp revisions contributions
gdp now estimate

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Electricity Demand May Cure Debt Concerns

The future of electricity demand for everything from electric cars to Bitcoin mining to artificial intelligence may also be the cure for our debt concerns.

Before you dismiss that statement, let me explain.

One of the bears’ primary arguments against the financial market and the economy’s health is what is perceived as the surging increase in Government debt. That increase in debt supports their frantic calls for the “end of the dollar,” economic disruption, and essentially the demise of the U.S. as a global power. Looking at the increased Government debt in a vacuum, you can understand the concern.

Of course, the increase in federal debt results from excess government spending, particularly since the pandemic-related shutdown. We see the surge in the federal deficit, the largest since the financial crisis and the most significant deficit outside of a wartime economy.

It is also notable that economic growth has slowed markedly as both debts and deficits have increased. That decrease in economic growth is an essential point of our discussion.

In “40-Years Of Economic Erosion,” we discussed the difference between productive and unproductive debt. To wit:

The problem is that these progressive programs lack an essential component of what is required for ‘deficit’ spending to be beneficial – a ‘return on investment.’ 

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse and waste of it.

John Maynard Keynes’ was correct in his theory that in order for government ‘deficit’ spending to be effective, the ‘payback’ from investments being made through debt must yield a higher rate of return than the debt used to fund it.

Currently, the U.S. is ‘Country A.”

Read that carefully, as electricity demand may provide that needed change to the debt dynamic.

Electricity Demand To Surge

As noted, the United States power grid has lacked sufficient investment to handle the increasing burdens of electricity demand in previous years. It isn’t just a growing population that needs more housing, mobile phones, laptops, and computers. However, adding electric vehicles, bitcoin mining, and artificial intelligence will overwhelm the current electricity supply in the U.S.

For example, bitcoin mining demands an extreme amount of electricity. As noted by Paul Hoffman in Bitcoin Power Dynamics:

“The daily consumption of 145.6 GWh for Bitcoin mining in the U.S. is about 1.34% of the total daily power consumption in the country. Despite the small percentage this is still an enormous amount of electricity, keeping in mind that the U.S. is a heavily-industrialized country consuming a lot. When we extrapolate this daily consumption to a year, we get 53,144 GWh.”

Bitcoin mining is a relatively small industry with a large footprint on electricity demand. However, “generative artificial intelligence (AI)” is a different beast. According to S&P Global Commodity Insights, the electricity needed for AI remains unclear, but the technology will lead to a significant net increase in US power consumption. Medium recently had some charts detailing that growth.

“AI energy demand is projected to surge from approximately $527.4 million in 2022 to a substantial $4,261.4 million by 2032, with a robust compound annual growth rate (CAGR) of 23.9% from 2023 to 2032.”Medium.

“Simultaneously, the Utility Market is expected to experience even more significant expansion, increasing from $534 million in 2022 to a substantial $8,676 million by 2032, driven by a remarkable CAGR of 33.1% from 2023 to 2032.”

As S&P points out:

“Power demand from operational and currently planned datacenters in US power markets is expected to total about 30,694 MW once all the planned datacenters are operational, according to analysis of data from 451 Research, which is part of S&P Global Market Intelligence. Investor-owned utilities are set to supply 20,619 MW of that capacity. To put those numbers into perspective, consider that US Lower 48 power demand is forecast to total about 473 GW in 2023, and rise to about 482 GW in 2027.”

So, what does this have to do with the debt?

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Growing Our Way Out

We have used deficit spending for decades to fund social welfare programs. Those programs have a long-term negative multiplier on economic growth. However, the future requires building an electricity infrastructure, which is a different dynamic. However, using deficit spending for projects with a “return on investment,” such as power production (geothermal, nuclear, tidal) or broadband, which users pay a fee to consume, is valid. This is because the long-term revenue generated by these projects repays the debt over time. Furthermore, these projects are labor intensive, creating demand for jobs, commodities, and capital expenditures.

Since 1980, capital expenditures (CapEx) have dropped as economic growth slowed. The chart shows the 10-year average annual change in CapEx vs. GDP. If economic growth (primarily consumption) is slowing, then the demand to expend CapEx is also reduced. This is because corporations seek out cheaper alternatives such as offshoring, productivity increases, and wage suppression.

However, building infrastructure is very labor-intensive, and CapEx is labor—and investment-intensive. Those dynamics change the economic growth dynamic.

While corporations increase capital investment to build the power supply, the Government will likely enter the fray with further infrastructure-focused spending bills. This is because AI is a critical component of ensuring the defense and national security of the United States. However, instead of issuing debt to spend on domestic welfare programs, the debt used in infrastructure will create economic growth through labor creation.

The chart below assumes we will continue to issue debt at the average quarterly pace since 2021. However, instead of wasting money, we focus on productive investments while maintaining all current spending programs and obligations. Assuming some conservative growth estimates resulting from the investments, the “debt to GDP” ratio will begin declining in 2026 and revert to more sustainable levels by 2030.

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Conclusion

While the bears constantly ring the alarm bell about the current level of debt and deficits, the more dire economic consequences they forecast may fail to come to fruition.

As noted by Goldman Sachs:

“Generative artificial intelligence has the potential to automate many work tasks and eventually boost global economic growth. AI will start having a measurable impact on US GDP in 2027 and begin affecting growth in other economies worldwide in the following years. The foundation of the forecast is the finding that AI could ultimately automate around 25% of labor tasks in advanced economies and 10-20% of work in emerging economies.”

They currently estimate a growth boost to GDP from AI of 0.4 percentage points in the US.

Increases in productivity, productive capital investment, and increased labor demand for the infrastructure buildout (which will also result in higher wages) should provide the economic boost needed.

Will it solve all of the current socio-economic ills facing the U.S.? No. However, it may provide the growth boost necessary to revitalize economic growth and prosperity in the U.S., which we have not seen since the 1970s.

It may also just be enough to keep the demise of the U.S. from occurring any time soon.

ETF Fund Flows Confirm What We Knew

The graph on the left below, courtesy of Arbor Data Science, shows that $8 billion of funds flowed into U.S. large-cap ETFs, leaving every other broad ETF sector in the dust. Not surprisingly, U.S. large-cap stocks, consisting of the S&P 500 and, importantly, Nvidia, outperformed the market. The other ETF factors, such as small and mid-cap, staples and discretionary, and thematic, all saw flat to negative fund flows.

Every Tuesday, we give readers a glimpse of our proprietary relative and absolute analysis on SimpleVisor. The analysis helps us appreciate which sectors and stock factors are moving into and out of favor. For instance, the graphic on the right below shows ETF factor performance. The relative score is based on a series of technical readings of the price ratio of the specific factor ETF to the S&P 500 (SPY). The absolute score uses the same technical readings but only on the price of the ETF.

The factors in the table are sorted from most overbought (red) to most oversold (green). As we share, the two highest scores are variations of U.S. large-cap ETFs. While the fund flows recently shifted toward large caps, our analysis has pointed us to increasingly better relative and absolute performance of large caps for the last few weeks. The “spaghetti” graph on the right charts the intersection of the daily absolute and relative scores for S&P 500 Growth (IVW). The movement from the lower left quadrant to the upper right shows that its relative and absolute scores have steadily improved. Furthermore, IVW is now overbought using both metrics. Consequently, the analysis leads us to believe the sector may take a breather in the weeks ahead.

etf fund flows and simplevisor absolute and relative analysis

What To Watch Today

Earnings

Economy

Market Trading Update

The market has been quiet this week ahead of today’s earnings report from retailers, which will give us another look at the strength, or not, of the consumer. Furthermore, today’s and tomorrow’s economic reports will give the markets another reason to wrestle with the inflation/deflation debate and how much the Fed will cut rates. The markets will focus on the PCE (Personal Consumption Expenditures Index) price report and expenditures for clues on upcoming Fed policy.

As we have discussed, with the market back to more overbought levels, further price appreciation was going to be difficult. Such has been the case over the last couple of weeks, with the market consolidating near recent highs. The good news is that consolidation has allowed the 20-DMA to catch up with the market, providing some near-term support. The bad news is that the consolidation has caused the MACD signal to get close to crossing back into a “sell.” That sell signal does NOT mean a significant correction is underway, but it does suggest if it occurs, that market appreciation will be limited for a period.

There is certainly potential for the market to correct towards the 50- or 100-DMA, and any report suggesting a higher inflation read could catalyze a larger decline. However, I would expect the 100-DMA (blue line) to contain any decline near term. However, as is always the case, “something else” could happen so it is always prudent to manage risks accordingly.

  • Resize positions back to target weights
  • Add defensive positions
  • Raise cash levels
  • Sell underperforming positions as needed.

Corporate Bonds Send Unheeded Warnings

As we have noted on occasion, the credit spread, or difference between corporate bond yields and comparable maturity U.S. Treasury yields, is the tightest (smallest) in 25+ years, as shown in the first graph. Hence, the graph alludes that bond investors have minimal credit concerns. Should they? The second graph argues yes. The Financial Times graph highlights that the percentage of low BBB bonds moving to a negative outlook is increasing. A negative outlook is a warning by the rating agencies that the bond is at risk of downgrade. Assuming the bonds in the graph are rated BBB-, a downgrade would move them to junk status. Further, note the number of bonds on the positive watch is declining.

Typically, bond spreads move with potential changes in credit ratings and general economic trends. While economic trends remain solid, higher interest rates are slowly catching up with companies. Therefore, higher interest expenses will weigh on profitability and credit ratings. Consequently we must ask, might the bond market be ignoring a gasping canary in the coal mine?

bbb bonds credit spreads oas
bbb bonds on negative and positive watch

Auto Inventories Normalize Leading Car Prices Lower

The graph below from Wards Auto and Bank of America plots auto inventories for car dealers. The dark blue line tells us the dealers are now holding 52 days’ worth of sales in inventory. Such is still a little below the pre-pandemic levels. However, the amount of inventory is rising steadily, which points to a more normal supply-demand curve for cars. Not surprisingly, with rising inventories, dealers are losing pricing power. The second graph shows that CPI for new autos looks like a mirror image of the inventory graph. With CPI for new autos slightly below zero, further increases in inventories could lead to deflation in the sector.

auto inventories rising
cpi new autos

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The Power Grid Expansion – Part Two

This article follows Part One, which discusses the massive investment dollars that will be spent expanding and modernizing the power grid to facilitate demand from AI data centers and EV users. With the macro investment theory laid out, we explore which industries and companies may benefit from the power grid expansion. Part Two focuses on the traditional energy suppliers that will fuel the power grid. We do not present the industries and companies in any particular order.

As you read, please consider that picking the “right” power grid stocks is difficult. In the short run, money flows into and from stocks and sectors align with the popular narratives of the day, regardless of whether they prove correct. Narratives and the sentiment they spur can grossly distort a stock or industry’s valuations and create overbought or oversold conditions. However, over the long term, profits supersede narratives.

This article presents a longer-term view.

Before starting, we address a reader’s question regarding the electricity Bitcoin miners require.  

Bitcoin Mining

After reading Part One, a reader asked if Bitcoin mining contributes to the need to expand the power grid. The answer is mixed. Bitcoin mining requires a lot of electricity. However, as a percentage of total power usage, it’s not nearly as much as AI data centers and EVs will consume.

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.

From his report, the first pie chart below shows that the US accounts for over a third of the global power consumption used to mine for Bitcoin. While we are the most significant power user for mining, it is a relatively minor percentage of our total power consumption. To wit, Bitcoin miners use 1.34% of domestic electricity. While a small percentage, it is still a tremendous amount of electricity, as the second graphic shows. However, it is not single-handed enough to warrant the mass expansion of the grid.

bitcoin energy consumption by country
bitcoin energy consumption
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Natural Gas- “The Fuel That Keeps The Lights On

Per the EIA, natural gas accounted for 43.1% of domestic utility-scale electricity generation in 2023. No wonder they call it “the fuel that keeps the lights on.”

Natural gas is abundant in the US. As a result, its price is near 30-year lows, as shown below. In addition to being cheap, burning natural gas is cleaner than burning coal or petroleum products. It’s a win-win energy source for utility companies.

natural gas futures

The increase in natural gas reserves over the last fifteen years is primarily the result of shale oil fracking. About three-quarters of the nation’s natural gas comes from shale wells.

According to Wells Fargo analyst Roger Read, the demand for natural gas could increase by 10 billion cubic feet daily by 2030. If correct, that is a nearly 30% increase from what is currently used for electricity generation in the US.

natural gas reserves

The graphic below, courtesy of the Williams Company, illustrates the roles of the upstream and midstream participants who get natural gas downstream to our homes, schools, and businesses. 

upstream midstream downstream graphic

Upstream Producers

The largest US natural gas producers, aka upstream, are listed below. Of these, EQT, SWN, AR, and CNX predominantly drill for natural gas. The remaining companies have significant interests in other types of fuels as well as natural gas.

EQT, SWN, AR, and CNX share prices correlate highly with natural gas prices. Conversely, the other stocks are not nearly as connected to natural gas prices. Given the high correlation, EQT, SWN, AR, and CNX will benefit the most if natural gas prices rise. However, natural gas is plentiful in the US. Accordingly, prices could stagnate near current levels if the supply keeps pace with growing demand.

Unless they are estimating the supply of natural gas, we do not think this sector will benefit overly from the increased use of natural gas to fuel our growing power grid.

natural gas producers

Midstream

Natural gas distributors, referred to as midstream, will benefit proportionately from the increased demand. These companies transport natural gas via pipelines from the wells (upstream) to the end users (downstream).

Think of these companies as toll-takers on the energy highway. The more natural gas moves through their pipelines, the more revenue they make. Unlike producers, midstream stock prices are less correlated with natural gas prices and more so by the volume of energy transported.

Many midstream companies pay high dividends, which can fluctuate with profits. Some are organized as limited partnerships with unique tax reporting obligations.

Kinder Morgan (KMI) owns the nation’s largest natural gas network, accounting for approximately 40% of the natural gas consumed. Other large companies include Cheniere Energy (LNG), The Williams Companies (WMB), Energy Transfer LP (ET), Enterprise Products Partners LP (EPD), and Enbridge (ENB). Other than KMI, these companies also derive revenue from different energy sources.

Kinder Morgan (KMI), ONEOK (OKE), and Targa Resources (TRGP) are principally natural gas and liquid gas transporters.

Since midstream company profits depend more on the volume of gas being transported versus upstream producers who rely more on natural gas prices, we prefer midstream. The graph below compares the correlations of the four upstream and three midstream natural gas stocks versus the price of natural gas over the last two years.

upstream downstream correlation to natural gas
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Nuclear Energy

Nuclear energy is back in vogue. After being out of favor following Chernobyl and, more recently, Fukushima, countries are rediscovering its benefits. As the graph below from Our World in Data shows, nuclear energy is not only one of the safest energy sources but the cleanest.

nuclear energy is safe and clean

The graph below, courtesy of Statista, shows that nuclear power production has stagnated for over 20 years.

nuclear electricity generation

There are three main ways to invest in nuclear energy: uranium miners, constructing and maintaining nuclear power plants, and the utilities engaged in generating nuclear power.

According to the World Nuclear Association (WNA), 60 reactors are under construction, and another 110 are planned, 13 of which are in the US. For context, there are about 440 nuclear reactors in the world. Notably, some of the growth will replace old plants being retired. If the world truly embraces nuclear power, the number of new reactors will likely grow substantially.

While natural gas is now being liquified and shipped internationally, most natural gas is and will be distributed within the US. On the contrary, uranium miners and nuclear construction companies can benefit more from expanding power grids globally.

Uranium Producers

The graph below from Cameco shows that the price of uranium has tripled in the last few years but is still below its record highs.

uranium prices

Uranium production peaked in the US about forty years ago. Per the EIA, Canada and Kazakhstan now account for over half of our imports.

The four biggest uranium producers trading on US exchanges are BHP (BHP), Cameco (CCJ), NexGen Energy (NXE), and Uranium Energy (UEC). CCJ, UEC, and NXE primarily produce uranium. BHP, on the other hand, produces a wide variety of commodities.

Since 2021, when uranium prices started to increase aggressively, shares of the three pure uranium producers have grossly outperformed BHP. Given these significant returns, investors should exercise caution in the short run despite optimistic long-term predictions for more nuclear facilities.

uranium producer stocks

Nuclear Reactor Construction and Maintenance

Coming online later this year, Unit four of the Nuclear Plant Vogtle in Georgia expects to generate more than 1,100 megawatts of energy. This follows unit three, which went online in 2023. Construction of both units started in 2009. The total cost of the two units will exceed $34 billion. In the construction process, the lead contractor, Westinghouse, went bankrupt.

We share this because building a new reactor is time-consuming and very expensive, and as Westinghouse investors found out, it can be risky. Further, the permitting and approval process can take years. But if done correctly, it can be very profitable.

Brookfield Renewable Partners (BEP) and Cameco (CCJ) now own Westinghouse. 

In addition to Brookfield, other companies can profit from constructing new plants. One such company is GE Vernova (GEV), which owns GE Hitachi Nuclear Energy (GEH). Per their website:

GEH combines GE’s design expertise and history of delivering reactors, fuels, and services globally with Hitachi’s proven experience in advanced modular construction to offer customers around the world the technological leadership required to effectively enhance reactor performance, power output, and safety.

Quanta Services (PWR) is another beneficiary of the growth in the number of nuclear plants. They are certified by the NRC to repair nuclear plant substations and switchyards.

We think GEV and PWR potentially offer investors promising long-term returns, as they are involved in nuclear facilities and a wide range of traditional power generation operations.

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Nuclear Power Generation

Many utilities source electricity from nuclear plants. Some of the largest include Duke, Dominion, NRG, Southern Company, and Constellation. While their expenditures to build and service nuclear facilities are extensive, the benefits of this clean and safe energy will pay future dividends. Investors must carefully weigh the initial capital expenditure of building a nuclear facility versus its long-term benefits.

The graph below from the Nuclear Energy Institute (NEI) shows the US has 93 nuclear reactors of which the large majority are in the eastern half of the nation.

nuclear power across the us

Summary

Part Three will cover alternative energy sources and summaries of other industries and companies that may benefit from the expansion and modernization of the power grid. 

Might GE Vernova Be The Next Nvidia?

Nvidia shares have risen by 600% in the last two years. While some say its shares are now grossly overpriced, its earnings and sales growth argue otherwise. Nvidia’s surging stock prices typify what is happening with many stocks related to the AI boom. While technology sector stocks appear to benefit most from AI, other sectors may do equally well. For instance, as we recently wrote in AI Data Centers and EVs Create Incredible Opportunities, the power grid needs to be modernized and expanded at great expense to facilitate AI. At the forefront of this infrastructure investment is GE Vernova. GE Vernova (GEV) is a recent spin-off from GE. The company is involved in the power grid’s many traditional and alternative energy aspects. They also provide software and financial services to infrastructure projects.

SimpleVisor subscribers have been aware of GE Vernova for three weeks. Our weekly Friday Favorites provides a technical and fundamental summary of a company of interest. On May 10, 2024, we reviewed GE Vernova. We share the following from the article.

GEV is a supplier of industrial goods and services allowing utility companies to keep up with growing energy demand. As such, their upside growth potential is much more significant than most other utilities. GEV should profit as utilities are forced to spend and invest to upgrade and expand their power generation facilities to meet the surge in power needed by data centers and EVs. Consequently, their cash flows should look different than most utility companies. Accordingly, GEV is not only a bet that AI data centers will generate massive power needs, but it is a unique way to seek diversification within the utility sector.

We currently hold a position in GE Vernova in our equity model.

ge vernova gev

What To Watch Today

Earnings

Economy

Market Trading Update

Yesterday, we noted that from a technical perspective, the markets remain on a current MACD “buy signal” and have cleared all previous resistance levels. Furthermore, the 20-DMA crossed above the 50-DMA, providing additional support to any short-term market correction. The 20-DMA will now become running support for the market. As the market consolidates the run from the April lows, the 20-DMA is catching up to the current price, and some overbought conditions are reversing. While the market continues to jump from headline to headline for clues as to the Fed’s next moves, most is just media trying to find something to discuss.

For now, market signals remain bullish, suggesting traders remain exposed to equity risk. That will eventually change, but the “buy/sell” signals will alert us to that.

One Day Settlement

Starting yesterday, stock transactions will settle in one day, not two. Accordingly, if you buy or sell a stock today, the money and shares will move to and from your account tomorrow. As a result, the transaction settlement process will be less risky. According to CNBC, wild trading in the shares of GameStop in 2021 pushed the SEC to make the change. Per CNBC:

The latest change comes after the GameStop mania in 2021 put the settlement process under closer scrutiny. The wild swings in so-called meme stocks meant that the agreed-upon price for trades was significantly different from the market price when the trade was actually settled. There was also increased instances of “failure to deliver,” or trades where settlement did not occur, during that period.

While desired, same-day settlement is unlikely until the advent of digital securities, which is likely years away. For more on what that may look like, check out an article we wrote in 2021 on the topic—Bye Bye Brokers.

FedEx And Transportation Stocks Flounder

For yet another week, the transportation sector, using SimpleVisor’s sector and factor proprietary analysis, has been the weakest sector on a relative and absolute basis. The first graphic below shows the transportation sector is extremely oversold versus the S&P 500. Similarly, on an absolute basis, the transportation and energy sectors are the most oversold. The second graph shows that FedEx is the most oversold in the transportation sector on an absolute and relative basis. The third graphic shows how poorly FedEx stock has traded compared to the market since December. However, as a result, its valuations (on the left side of the graph) are now very reasonable versus the market’s. The last graphic shows that its revenues have been flat since 2020. Despite its poor performance, it is still overpriced, using multiple fair value calculations.

For SimpleVisor subscribers, this coming Friday’s Favorites will provide much more fundamental and technical insight into FedEx.

simplevisor sector analysis

fedex transportation sector simplevisor
fedex valuations stock performance simplevisor
fedex revenue and fair value simplevisor

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No, Corporate Greed Is Not The Cause Of Inflation.

Corporate greed is not causing inflation, despite the claims of many on the political left who failed to understand the very basics of economic supply and demand.

“If you take a look at what people have, they have the money to spend. It angers them and angers me that you have to spend more. It’s like 20% less for the same price. That’s corporate greed. That’s corporate greed. And we have got to deal with it. And that’s what I’m working on.” – President Biden via CNN

Yes, prices have certainly gone up due to inflation. However, that wasn’t the fault of corporations. The surge in inflation directly resulted from the supply-to-demand imbalance caused by shutting down the economy (supply) and increasing household purchasing power by sending them checks (demand).

For the majority of Americans who now get their “news” from social media, the uneducated masses now have a new target of hatred for their financial woes – corporate greed.

A Claim Of Absurdity

The problem, as with many of the narratives ramping up the ire of Americans on social media, is it is patently false.

As Michael Maharrey previously penned:

“One simply has to reason through the claim to uncover the absurdity. If corporations can willy-nilly raise prices and enjoy “excessive” profits, why don’t they do it all the time? Did corporations suddenly get greedy in 2021? And why did the Federal Reserve spend a decade fretting about inflation being ‘too low’ as it struggled to hit its 2% target? Was there not enough corporate greed before coronavirus?”

When you think about it this way, something else apparently happened.

Let’s begin with Powell’s assessment of the cause of inflation.

“The ongoing episode of high inflation initially emerged from a collision between very strong demand and pandemic-constrained supply. By the time the Federal Open Market Committee raised the policy rate in March 2022, it was clear that bringing down inflation would depend on both the unwinding of the unprecedented pandemic-related demand and supply distortions and on our tightening of monetary policy, which would slow the growth of aggregate demand, allowing supply time to catch up.”

It’s crucial to note the complete dismissal of the causes behind the “collision between robust demand and pandemic-constrained supply.” I suspect this was intentional in avoiding placing blame at the feet of the current or previous administrations or themselves. However, it muddies the impact of their actions that created the problem.

The following economic illustration is taught in every “Econ 101” class. Unsurprisingly, inflation is the consequence if supply is restricted and demand increases via monetary interventions.

  • Who had the power to shut down the entire economy and force everyone into their homes using a fear-driven campaign? Was it the war, corporations, or the Government?
  • Who then supplied trillions in stimulus checks directly to households to spend when no supply could be produced? Was that corporations? Russia? Or was it the Government?
  • Who supported the issuance of trillions in debt issuance to fund those stimulus checks and keep interest rates suppressed? Was that the Federal Reserve, Russia, or corporations?
  • Was it corporations that put a moratorium on student loans, rent, and mortgage payments, giving individuals a source of additional funds to spend? Or was it the Government?

Milton Friedman also had much to say on this issue.

Corporate Greed Does Not Cause Inflation

Regarding inflation, many armchair economists are quick to quote Milton Friedman.

“Inflation is always and everywhere a monetary phenomenon.”

The problem is there is much more to Friedman’s statement on the cause of inflation.

As Milton Friedman once stated, corporations don’t cause inflation; governments create inflation by printing money. 

“It is always and everywhere a result of too much money, of a more rapid increase of money, than of output. Moreover, in the modern era, the important next step is to recognize that today the governments control the quantity of money so that, as a result, inflation in the United States is made in Washington and nowhere else. Of course, no government any more than any of us, likes to responsibility for bad things.

All of us are humans. If something bad happens, it wasn’t our fault. And the government is the same way, so it doesn’t accept responsibility for inflation. If you listen to people in Washington talk, they will tell you that inflation is produced by greedy businessmen, or it’s produced by grasping unions, or it’s produced by spendthrift consumers, or maybe its those terrible Arab sheiks who are producing it.”

As he concludes:

“But none of them produce inflation, for the very simple reason that neither the businessmen, not the trade union, nor the housewife have a printing press in their basement on which they can turn out those green pieces of paper we call money. Only Washington has the printing press, and therefore, only Washington can produce inflation.”

The inflation surge has nothing to do with corporate greed taking advantage of consumers but rather the actions of the Federal Reserve and the Government. The cause of inflation was the economic consequence of “too much money chasing too few goods.”

Milton Friedman’s statement is supported by the chart below showing the M2 money supply compared to inflation (with a 16-month lag).

You can watch Milton’s entire speech on “Money and Inflation.”

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Corporations Respond To Inflation

So, if it isn’t corporate greed, why are corporations raising prices so much on everything?

Corporations have a responsibility to their shareholders to remain in business. If the costs to their business increase (i.e., wages, benefits, commodities, utilities, etc.), such must be factored into the selling price to maintain profitability. Crucially, corporations can only pass on higher input costs to consumers if demand remains higher than the available supply of those goods or services.

In 2020 and 2021, corporations could pass on most of the inflationary increase to consumers as they were willing to spend the Government’s money. However, as excess savings run out, inflation declines as consumers decrease spending. Corporate profits weaken as the ability to pass on higher input costs to customers fades. As shown, as inflation declines, the rate of change in corporate profits also weakens.

We see the same if you use a two-year average of corporate profits minus inflation. Again, when inflation surged in 2020, corporations could pass on the bulk of the cost increases to consumers. Today, as inflation slows due to declining demand, corporations must absorb the inflation to sell products or services.

Another way to view this issue is by comparing the spread between the consumer price index (what consumers pay for goods and services) and the producer price index (what corporations pay). When inflation rises, and consumer demand exceeds supply, corporations can pass on higher input costs to consumers. Corporations absorb higher input costs when inflation declines to sell products or services.

Here is the crucial point:

“Corporations don’t create inflation. They merely react to changes in demand and adjust pricing and supply to maintain profitability. When the consumer slows down, corporations cut prices to reduce supply.”

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Who Is Responsible For Inflation?

If there is a “greed factor” in inflation, it is more of a function of political policy and Wall Street. Let’s start with political policies.

Most government policies are passed to appease the masses in one form or another, but mostly to appease those who fund campaigns to keep them in office. We have already addressed the side effects of shuttering the economy and sending checks to households while halting debt payments. That had nothing to do with corporate greed, but the voting base was happy getting “free money.”

There are also policies pushed at the state level that result in higher inflation but keep politicians in office. For example, California’s minimum wage hike to $22/hour is an inflationary policy. Corporations’ obvious response is to raise prices to offset the higher wage costs.

To wit:

“Labor costs are the highest expense to any business. It’s not just the actual wages, but also payroll taxes, benefits, paid vacation, healthcare, etc. Employees are not cheap, and that cost must be covered by the goods or services sold. Therefore, if the consumer refuses to pay more, the costs have to be offset elsewhere.

For example, after Walmart and Target announced higher minimum wages, layoffs occurred and cashiers were replaced with self-checkout counters. Restaurants added surcharges to help cover the costs of higher wages, a “tax” on consumers, and chains like McDonald’s, and Panera Bread, replaced cashiers with apps and ordering kiosks.”

Furthermore, Wall Street itself is a factor. Prices of commodities are controlled by traders on the New York Mercantile Exchange. Those traders look for opportunities to place bets on commodities based on many events that could impact supply, such as weather, transportation disruptions, or geopolitical conflicts. Take a look at the commodity index below.

That surge in commodity prices, which resulted from the economic shutdown, raises the cost of input prices to corporations. That additional cost must be accounted for in the production process and is ultimately passed on to the consumer.

This isn’t corporate greed. The increased cost to consumers is a byproduct of Wall Street raising the price of commodities to gain profit from supply disruptions.

While it is easy to blame corporate greed for higher prices, it is not the fault of corporations. As noted, corporations are responding to higher input costs to maintain profitability for both shareholders and to remain in business.

No, corporate greed is not responsible for inflation.

Yes, it is a nice fantasy that corporations should eat higher costs and be benefactors to consumers.

However, corporations are not charities.

Food Also Points To Slowing Personal Consumption

Thursday’s Commentary led with a discussion of how sales at major retailers were slowing appreciably. The takeaway from the piece is that personal consumption, accounting for two-thirds of GDP, is slowing. A reader emailed us, “Not so fast with your judgment. “You may be right, but you should also look at spending on food for confirmation.” We agree. Grocery stores, restaurants, and beverage and food distributors can provide more clarity about personal consumption trends.

Our food analysis, shown below, is based on sales from the following companies: Albertsons (ACI- data since 2020), Kroger’s (KR), Starbucks (SBUX), McDonald’s (MCD), Coke (KO), Pepsi (PEP), Chipotle (CMG), YUM Brands (YUM), Sysco (SYY), and ADM (ADM). We took the same approach and compared each company’s current annual revenue growth to 2021-2022 and the three years before the pandemic. We also weighted their revenue growth and calculated a weighted aggregate sales growth. Remember that the graphs and the results from the first Commentary do not account for inflation.

The first graph shows that five of the nine food companies have higher sales growth today than in the pre-pandemic period (we exclude ACI as there is no data for the period). However, all ten companies except McDonald’s have lower sales growth than in 2021-2022. The graph on the right shows that the weighted annual sales growth is now the lowest since 2017.  This analysis confirms our prior work that personal consumption growth has slowed considerably. Now, considering inflation is about 2% higher than in the pre-pandemic period, our thesis strengthens.

food sales

What To Watch Today

Earnings

  • No notable earnings announcements

Economy

Market Trading Update

Last week, we discussed that the 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. Over the last few trading days, the markets had to focus on the minutes from the last FOMC meeting and earnings from Nvidia.

The FOMC minutes revealed little new information. Inflation remains stickier than expected, keeping the Fed on pause from cutting rates. However, recent speeches by Fed members did not indicate any real consideration of hiking rates. The market was fairly calm following that release as all eyes focused on Nvidia earnings.

As has been the case over the last few quarters, Nvidia failed to disappoint. It announced earnings and revenue that beat expectations, announcing a 10-1 stock split in the process.

“Nvidia reported revenue for the first quarter ended April 28, 2024, of $26.0 billion, up 18% from the previous quarter and up 262% from a year ago. For the quarter, GAAP earnings per diluted share was $5.98, up 21% from the previous quarter and up 629% from a year ago. Non-GAAP earnings per diluted share was $6.12, up 19% from the previous quarter and up 461% from a year ago.”

Such lifted the stock by 10% on Thursday, but the rest of the market sold off as traders took profits from the FOMC announcement.

From a technical perspective, the markets remain on a current MACD “buy signal” and have cleared all previous resistance levels. Furthermore, the 20-DMA crossed above the 50-DMA, providing additional support to any short-term market correction. The 20-DMA will now become running support for the market. While corrections should be expected, any pullback should be contained by the 20-DMA, which will provide an entry point to add exposure as needed.

When the MACD signal crosses, such will provide the next signal to reduce risk and rebalance exposure as needed. For now, the bulls maintain control of the market narrative. Trade accordingly.

The Week Ahead

The holiday-shortened week should be quiet. The only notable economic release will be the PCE data on Friday. Core PCE, the Fed’s preferred gauge for inflation, is expected to increase by 0.2% monthly and 2.7% annually. Both are 0.1% below last month’s figures. Given the recent slowdown in retail sales and our recent sales analysis of retail and food distributors, it will be interesting to see if the PCE personal spending numbers confirm a weakness in consumption.

Mind The Revisions

At first glance, the March durable goods data was much better than expected, coming at +0.7% versus expectations of -0.8%. While the beat of 1.5% is very impressive, March was revised significantly lower from +2.6% to +0.8%. The graph below, courtesy of Zero Hedge, shows this is not a one-off instance. Per Zero Hedge:

Over the last 14 months, durable goods orders have been revised lower 9 times (and the downward revisions are considerably larger than the upward revisions).

durable goods revisions

It’s not just durable goods that have recently seen revisions lower. The four graphs below show significant downward revisions to the BLS payroll data, manufacturing new orders, industrial production, and new home orders. While not shown, PPI has been revised lower in four of the last seven months by a net -0.8%.

Most economic data is revised, as surveys and limited data make it challenging to furnish the market with both accurate and timely results. While this is widely accepted, we find the preponderance of negative revisions versus positive ones unusual. Some will blame the revisions on politics, and others will say these are clear signals that recession is near. Regardless of whether either or both are correct, it is essential to consider the current data points and the trend of the last three and six months, which capture revisions.

payrolls revisions
new orders revisions
industrial production revisions
new home sales revisions

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