The S&P 500 index is a critical benchmark for the U.S. equity market, and its performance often dictates investor sentiment and decision-making. Between November 1, 2022, and September 6, 2024, the S&P 500 experienced a significant rally but not without volatility. Currently, investors have very mixed views about where markets are heading next as concerns of a recession linger or what changes to monetary policy will cause.

However, as investors, we must trade the market we have today. Therefore, using technical analysis, we can explore bullish and bearish market dynamics to assist us in managing risk more effectively. This blog will outline three bullish and bearish perspectives using momentum, relative strength, and other key technical indicators. Finally, we will conclude with five actionable steps investors can take today to mitigate risk.

(Note: All data is as of the Friday, September 6 close.)

Bullish Outlook

1. Strong Support at Key Moving Averages

One of the primary bullish signals for the S&P 500 is its tendency to find support at critical moving averages. Throughout the analyzed period, the 50, 100, and 200-day moving averages supported the index significantly, particularly in late 2023 and early 2024. Even though the index faced downward pressure in August, its ability to bounce from the 150-day moving average indicates that buyers continue to find levels to increase equity exposure. Given the market has remained steadily above the 200-DMA and that average is trending higher, it signals that the longer-term bullish trend remains intact.

2. Momentum Indicators Point to Potential Reversal

Momentum indicators such as the Moving Average Convergence Divergence (MACD) have recently triggered a short-term “sell signal,” which coincides with the recent price correction. However, while these signals have coincided with lower prices in the near term, they have consistently bottomed between -25 and -50. Such has provided investors with repeated opportunities to increase equity exposure over the last two years. When the MACD begins to register readings below -50, such has historically indicated when markets are turning from upward trending to lower trending prices.

3. Relative Strength Index (RSI) Near Oversold Levels

The Relative Strength Index (RSI) measures the magnitude of recent price changes. As of Friday’s close, the RSI is approaching more oversold levels near 30. While not there yet, which suggests markets could see additional weakness in the near term, low readings historically signal short-term market bottoms. Readings of 30 or below indicate that the selling pressure is likely overextended, and buyers tend to regain market control. In April and August 2024, the RSI hovered around these oversold levels, providing a strong signal for bullish traders to take advantage of a bounce. While the recent correction likely has further to go, the current low RSI readings suggest a bounce is likely. Investors should use any rally to rebalance portfolio risk.

However, investors should also consider the bearish warnings.

Bearish Outlook

1. A Lower High

From a bearish perspective, the recent lower high of the market is concerning. If the market declines and sets a lower low, that is one of the more telling technical signals indicating a new potential bearish trend. Lower highs suggest buyers are losing conviction, and each new rally is weaker than the previous one. Simultaneously, lower lows suggest that selling pressure is increasing. This pattern, if sustained, could indicate a deeper corrective phase, possibly targeting lower support zones between 4600 and 5200. While the recent lower high is very early, a recent pattern to review is 2022.

If the market rallies in the weeks ahead, setting a new high, that price action will negate the warning from lower highs.

2. Decreasing Volume of Rallies

Another bearish indicator is the declining trading volume during recent rallies. According to technical analysis principles, strong price moves should be accompanied by increasing volume, signaling widespread market participation. However, rallies in the S&P 500 over the last two months coincided with lower volume levels. As discussed previously, these negative divergences warned investors that the upward move lacks conviction. The divergence between price and volume forewarned of this recent correction.

3. Longer-Term MACD Signals Turn Bearish

We regularly publish our longer-term technical analysis and statistics in the weekly Bull Bear Report (Subscribe for FREE). One of those charts is the Weekly Risk Management Analysis. The chart below matches an intermediate and longer-term weekly MACD signal to the markets. When both signals are on “buy signals,” such has coincided with a trending bull market advance. When both signals confirm a “sell,” as in early 2022, the market has gone through correctional phases.

Currently, while early, both the intermediate and longer-term MACD “sell” signals are registered. There are several crucial points to note:

1. The market is trading at the top of its long-term trend channel from the 2009 lows. While it previously traded above that channel in 2021 due to artificial stimulus, the current advance may be near its current cycle peak.
2. These are weekly signals and, therefore, very slow to move. Signals can whip back and forth for a month or so before becoming confirmed by a breakdown in the market.
3. As noted, the market’s price action needs to confirm the “buy” and “sell” signals. If the market enters a deeper corrective phase, a break of the 200-DMA will confirm the end of the bullish advance that started in 2022.

Notably, while bullish and bearish signals exist, the market can remain in flux for quite some time. For example, the market is approaching oversold territory based on RSI, which typically suggests a reversal. However, the bearish price action and weak volume indicate that caution is warranted. Therefore, while some technical indicators provide conflicting signals, investors must manage near-term risk while waiting for markets to confirm their next direction.

5-Actions Investors Can Take Today to Minimize Risk

Given the mixed technical outlook for the S&P 500, investors should focus on managing risk while positioning themselves for potential market swings. Here are five actions to consider:

1. Trim Winning Positions Back to Their Original Portfolio Weightings

This strategy involves reducing your exposure to positions that have grown beyond their initial allocation due to price appreciation. When a particular asset or stock performs well, its weight in the portfolio increases, potentially leading to overexposure and imbalance. Trimming these positions back to their original weight helps lock in profits while maintaining your intended risk profile. It’s a way to ensure that no single asset dominates the portfolio, which could lead to increased risk if that asset faces a downturn.

2. Sell Those Positions That Aren’t Working

Selling underperforming assets is essential for managing risk and avoiding unnecessary losses. Suppose a stock or asset consistently underperforms relative to its peers or the market. In that case, it may be a sign that the investment thesis has failed or external factors negatively affect the position. Selling these positions frees up capital investors can reallocate to better-performing or more stable assets. It’s a proactive step to cut losses and prevent further erosion of your portfolio value.

3. Move Trailing Stop Losses Up to New Levels

A trailing stop loss is a risk management tool that automatically adjusts as a stock price rises, locking in profits and protecting against downside risk. Moving these stop-loss levels up as the price of an asset increases ensures that if the market reverses, you can capture gains without manually monitoring and selling the position. This strategy helps protect profits while allowing for further upside potential. It’s advantageous in volatile markets where prices can fluctuate significantly.

4. Review Your Portfolio Allocation Relative to Your Risk Tolerance

You should always align your investment portfolio with your risk tolerance, which may change over time due to market conditions or personal factors such as age, income, or financial goals. Reviewing your portfolio allocation means assessing how much your portfolio is invested in different asset classes (e.g., stocks, bonds, cash) and ensuring the risk level matches your current comfort level. For instance, if your portfolio has become more aggressive (higher exposure to stocks or growth assets), you may need to rebalance to reflect a more conservative risk profile, particularly as market conditions change.

5. Raise Cash Levels And Add Treasury Bonds to Reduce Portfolio Volatility

Increasing your cash allocation is a simple but effective way to reduce portfolio volatility. In times of uncertainty or market downturns, holding more cash can help minimize losses and provide liquidity for future opportunities. Cash is a low-risk asset that doesn’t fluctuate with the market, so increasing your cash position can help stabilize the overall portfolio and provide peace of mind during volatile periods.

Furthermore, investors consider Treasury bonds safer investments than stocks, providing stability and predictable income through interest payments. Adding bonds to a portfolio can help reduce volatility, particularly during economic uncertainty or stock market corrections. Bonds tend to have an inverse relationship with stocks, meaning they can perform well when equities struggle, particularly during Fed rate-cutting cycles.

Conclusion

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

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

Could I be wrong? Absolutely.

But what is worse:

1. Missing out temporarily on some additional short-term gains or
2. Spending time getting back to even, which is not the same as making money.

“Opportunities are made up far easier than lost capital.” – Todd Harrison

Trade accordingly.

It certainly seems that technological advances make our lives better. Instead of writing a letter, stamping it, and mailing it (which was vastly more personal), we now send emails. Rather than driving to a local retailer or manufacturer, we order it online. Of course, we mustn’t dismiss the rise of social media, which connects us to everyone and everything more than ever.

Economists and experts have long argued that technological advances drive U.S. economic growth and productivity. As innovations emerge, they play a crucial role in shaping the economy, improving efficiency, and enhancing productivity across various sectors. From artificial intelligence to automation, the benefits of technological progress are widespread and profound.

For example, automation and artificial intelligence have streamlined manufacturing processes, reducing the need for manual labor and minimizing human error. This efficiency boost leads to faster production times and reduced costs, lowering prices while improving profit margins. Higher productivity levels contribute to overall economic growth, as businesses can produce more goods and services with the same resources.

Another significant benefit is the creation of new industries and job opportunities. As technology evolves, it creates demand for new skills and expertise, leading to the development of entirely new sectors. For example, the rise of the technology industry gave birth to jobs in software, data analysis, and cybersecurity, among others. These high-paying jobs contribute to economic growth by increasing consumer spending and driving innovation.

Ray Kurzweil’s 1999 book, “The Age of Spiritual Machines,” introduced the concept of “The Law of Accelerating Returns.“ Ray predicted that the rate of technological advances is exponential rather than linear. That means that technology builds on itself in a positive feedback loop, allowing each generation to advance at an increasing rate.

Kurzweil’s predictions related to this theory have proven remarkably accurate. He predicted technologies such as the internet and the growth in mobile computing power years before they emerged. Out of 147 predictions he made in the 1990s about the future up to 2009, 115 (78%) were correct.

However, were economists’ predictions about the benefit of technology as accurate as Kurzweil’s?

The Dark Side Of Technological Advancement

While technological advances seem to produce an enormous benefit, a dark side gets hidden from public discourse.

One primary concern is job displacement. Automation and artificial intelligence, while improving efficiency, often replace jobs traditionally performed by humans. This displacement mainly affects low-skilled workers in industries like manufacturing and retail, leading to unemployment and underemployment. As machines take over routine tasks, the workforce faces the challenge of reskilling to meet the demands of a more technologically advanced economy. That transition period can lead to economic slowdowns and increased inequality, as not all workers have the means or opportunity to adapt quickly.

The chart below shows the trend of employment versus actual employment. Since 1947, employment has grown with the economy, as expected. However, employment changed in the late 90s as employment fell below the previous growth trend, coinciding with the Internet adoption. The need for employees eroded as the internet fostered technological advances in everything from manufacturing automation to online sales, social media, advertising, and business management. Today, the deviation in employment from the long-term growth trend is the largest in history outside of the pandemic-driven economic shutdown.

Another issue is the increasing concentration of wealth and market power in the hands of a few technology giants. Companies like Amazon, Google, and Apple dominate their respective markets, creating barriers to entry for smaller firms. As shown, as technological advances increased, there has been a clear shift in corporate earnings and concentration. Again, starting in the late 90s, increased technological advances reduced the number of employees required to produce goods and services. At the same time, the market became increasingly concentrated in a smaller group of companies.

Monopolistic behavior stifles competition, reduces innovation, and limits consumer choice. Furthermore, corporate profitability soared by reducing labor, which is the most costly expense for any business.

The vast wealth accumulation by these companies contributes to economic inequality. That inequality can hamper overall economic growth by reducing the average consumer’s purchasing power. Since 1990, wealth inequality has soared, with those in the top 10% owning a vast majority of economic wealth. The bottom 50%, which comprises a significant portion of employee labor in the manufacturing and services industries, have barely benefitted.

Lastly, the rapid pace of technological change can lead to productivity paradoxes, where the expected gains in productivity from new technologies do not materialize as anticipated. That happens due to the significant time and investment required to integrate new technologies effectively into existing business processes. Additionally, cybersecurity threats, data privacy concerns, and technology-driven stress can undermine productivity and lead to economic inefficiencies.

But there is even a darker side that no one is talking about.

Social Loneliness

While social media and the internet have revolutionized the way we connect and communicate, they have also contributed to several severe societal issues, including increased loneliness, social and political division, and a troubling rise in teenage suicides. Understanding these negative impacts is crucial for addressing the challenges of the digital age.

One significant consequence of social media is the rise in loneliness. Despite the promise of connecting people, social media often leads to superficial interactions, which lack the depth and intimacy of face-to-face communication. As users compare their lives to the seemingly perfect lives of others online, feelings of inadequacy and isolation can increase. That can be particularly damaging for teenagers, as they are at a critical stage of developing their self-identity and sense of belonging. The constant need for validation through likes and comments can lead to feelings of loneliness and anxiety.

Social media also contributes to social and political division. The algorithms that power these platforms often promote content aligning with users’ beliefs, creating echo chambers reinforcing biases. This polarization can deepen societal divisions, making constructive dialogue and mutual understanding more difficult. The spread of misinformation and fake news further exacerbates these divisions, exposing people to misleading content that can shape their perceptions and opinions. With a growing inability to logically and rationally discuss our differences, passing laws and policies that benefit everyone has become impossible.

Lastly, and most unfortunately, the impact of social media on teenage mental health is alarming. Studies have shown a link between heavy social media use and increased rates of depression, anxiety, and suicidal thoughts among teenagers. The pressure to fit in, the prevalence of cyberbullying, and the exposure to unrealistic standards of beauty and success can create a toxic environment that negatively affects teens’ mental well-being. Tragically, this can lead to an increase in teenage suicides (as shown by the CDC) as vulnerable individuals struggle to cope with the pressures of the digital world.

In conclusion, while technology is a powerful driver of economic growth, it also presents challenges that can negatively impact productivity, equality, mental health, and societal cohesion. Addressing these issues ensures that technological advancements promote sustainable and inclusive economic growth.

After all, that was the promise of technology, to begin with.

Since the end of the “Yen Carry Trade” correction in August, bullish positioning has returned with a vengeance, yet two key risks face investors as September begins. While bullish positioning and optimism are ingredients for a rising market, there is more to this story.

It is true that “a rising tide lifts all boats,” meaning that as the market rises, investors begin to chase higher stock prices, leading to a virtual buying spiral. Such leads to an improvement in market breadth and participation, which supports further price increases. Following the August decline, the chart below shows the improvement in the NYSE advance-decline line and the number of stocks trading above their respective 50-day moving averages (DMA).

Given that “for every buyer, there must be a seller,” this data confirms that buyers are increasingly willing to pay higher prices to bring sellers to market. That cycle continues until buyers willing to pay higher prices decline. While prices are rising, we are seeing a dwindling of buyers at current prices, as shown in the chart of trading volume at various price levels. As shown, buyers currently “live lower” between 5440-5480 and the recent correctional lows.

However, despite the diminishing pool of buyers at current levels, investors are becoming increasingly bullish as prices rise. As shown in our composite fear/greed gauge, based on “how investors are positioned” in the market, we are back to more “greed” based levels. While not at extreme levels, investors are becoming increasingly optimistic about higher future prices. Of course, such readings only confirm what market prices are already telling us.

However, two primary risks to the bullish advance are developing as we enter September.

Share Buyback Window Begins To Close

Over the next two months, a primary risk to bullish investors is removing a critical buyer in the market – corporations. For more on the importance of corporate share purchases on the financial markets, read the following:

• 40% Of The Bull Market Is Due To Buybacks
• Stock Buybacks Aren’t Bad, Just Abused
• Why Mega Caps Will Continue Their Dominance

Those articles support that corporations have comprised roughly 100% of net equity purchases since 2000. In other words, the market would be trading closer to 3000 rather than 5600 without corporate share buybacks.

However, these share buybacks also pose risks to the market in the short-term as well. As Michael Lebowitz noted this morning:

“Like the meteorological seasons, share buybacks also follow predictable patterns. Accordingly, as shown below, we are past the peak share buyback season. Following the peak, share buybacks will decline rapidly until early November. Declining share buybacks is not a bearish indicator per se. However, as the number of buybacks declines, the market, specifically the stocks conducting buybacks, will have less demand for their stock. Think of share buybacks as a tailwind.

The pattern is predictable because it directly relates to corporate earnings reports. For three reasons, most companies ban share buybacks about a month before their quarterly earnings report.

• Insider Trading Concerns—Employees have access to non-public information regarding their earnings. Therefore, the ban helps eliminate the perception that the company might be trading its stock on such information.
• Investor Perception– Similarly, investors might be suspicious if the company was actively buying its stock right before the earnings announcements. If the investors were mimicking the company’s purchases, this could create heightened volatility in the stock.
• Regulatory Concerns—While the SEC does not regulate share buybacks before earnings, most companies want to avoid an investigation if the SEC suspects those buying back the shares have inside information.

As shown on Thursday, September 5th, the window for buybacks will begin to close. Corporate buying support will be non-existent by the beginning of October and through the end of the month. In other words, the primary buyer of equities will not be available to bid prices.

If you don’t believe that share buybacks are as crucial as we state, the following chart should answer any questions.

Unfortunately, removing that primary buyer will coincide with a secondary market risk.

Presidential Election Concerns

As we enter September and October, a secondary risk increases. Historically, these months have seen stock market declines, especially in years with a Presidential election. There are three primary reasons for this trend.

1. Uncertainty Surrounding Election Outcomes

Markets dislike uncertainty, and the outcome of a Presidential election is a significant unknown. Investors become cautious during election years, especially when the race is tight. They worry about potential policy changes impacting taxes, regulations, and government spending. That heightened uncertainty increases market volatility and often results in stock market declines as investors move to safer assets.

2. Policy Change Concerns

Depending on the election outcome, significant policy changes can occur. For instance, Harris and Trump have very different approaches to fiscal policy, regulation, and international trade this year. With the polls very tight, Wall Street may look to lock in gains before the election, fearing that new policies might negatively affect corporate profits via higher tax rates and, potentially, changes to capital gains rates.

3. Economic Data Releases

September and October are critical months for economic data releases, particularly since the Federal Reserve expects to cut rates in September. Key indicators from employment, inflation, and housing will potentially move markets over the next two months. Given the approaching election, the markets will scrutinize those releases closely as candidates try to leverage the data. Any negative surprises could result in a sharp pickup in volatility.

Conclusion

As we head into September, which already has a weak performance record, understanding these two risks can help investors navigate a potential pickup in volatility, particularly during election years.

However, the timing of such a consolidation or correction is always tricky. 

We suggest maintaining risk controls, taking profits as needed, rebalancing portfolios, and holding slightly higher cash levels.

While these actions won’t entirely shield portfolios from a near-term decline, they will buffer increased volatility, allowing for more rational and controlled portfolio management decisions.

In a recent discussion with Adam Taggart via Thoughtful Money, we quickly touched on the similarities between the U.S. and Japanese monetary policies around the 11-minute mark. However, that discussion warrants a deeper dive. As we will review, Japan has much to tell us about the future of the U.S. economically.

Let’s start with the deficit. Much angst exists over the rise in interest rates. The concern is whether the government can continue to fund itself, given the post-pandemic surge in fiscal deficits. From a purely “personal finance” perspective, the concern is valid. “Living well beyond one’s means” has always been a recipe for financial disaster.

Notably, excess spending is not just a function of recent events but has been 45 years in the making. The government started spending more in the late 1970s than it brought in tax receipts. However, since the economy recovered through “financial deregulation,” economists deemed excess spending beneficial. Unfortunately, each Administration continued to use increasing debt levels to fund every conceivable pet political project. From increased welfare to “pandemic-related” bailouts to climate change agendas, it was all fair game.

However, while excess spending appeared to provide short-term benefits, primarily the benefit of getting re-elected to office, the impact on economic prosperity has been negative. To economists’ surprise, Increasing debts and deficits have not created more robust economic growth rates.

I am not saying there is no benefit. Yes, “spending like drunken sailors” to create economic growth can work short-term, as we saw post-pandemic. However, once that surge in spending is exhausted, economic growth returns to previous levels. What those programs do is “pull forward” future consumption, leaving a void that detracts from economic growth in the future. That is why economic prosperity continues to decline after decades of deficit spending.

We agree that rising debts and deficits are certainly concerning. However, the argument that the U.S. is about to become bankrupt and fall into economic oblivion is untrue.

For a case study of where the U.S. is headed, a look at Japanese-style monetary policy is beneficial.

The Failure Of Central Banks

“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.” – Keiichiro Kobayashi, 2010

Kobayashi will ultimately be proved correct. However, even he never envisioned the extent to which Central Banks globally would be willing to go. As my partner, Michael Lebowitz pointed out previously:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $24 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

The belief was that driving asset prices higher would lead to economic growth. Unfortunately, this has not been the case, as debt has exploded globally, specifically in the U.S.

“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”

Not surprisingly, the massive surge in debt has led to an explosion in the financial markets as cheap debt and leverage fueled a speculative frenzy in virtually every asset class.

Soaring U.S. debt, rising deficits, and demographics are the culprits behind the economy’s disinflationary push. The complexity of the current environment implies years of sub-par economic growth ahead. The Federal Reserve’s long-term economic projections remain at 2% or less.

The U.S. is not the only country facing such a gloomy public finance outlook. The current economic overlay displays compelling similarities with the Japanese economy.

Many believe that more spending will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity. However, one should at least question the logic given that more spending, as represented in the debt chart above, had ZERO lasting impact on economic growth. As I have written previously, debt is a retardant to organic economic development as it diverts dollars from productive investment to debt service.

Japanese Policy And Economic Outcomes

One only needs to look at the Japanese economy to understand that Q.E., low-interest rate policies, and debt expansion have done little economically. The chart below shows the expansion of BOJ assets versus the growth of GDP and interest rate levels.

Notice that since 1998, Japan has been unable to sustain a 2% economic growth rate. While massive bank interventions by the Japanese Central Bank have absorbed most of the ETF and Government Bond market, spurts of economic activity repeatedly fall into recession. Even with interest rates near zero, economic growth remains weak, and attempts to create inflation or increase interest rates have immediate negative impacts. Japan’s 40-year experiment provides little support for the idea that inflating asset prices by buying assets leads to more substantial economic outcomes.

However, the current Administration believes our outcome will be different.

With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the subsequent economic decline when it occurs.

That is the same problem Japan has wrestled with for the last 25 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size), there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 40-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

• A decline in savings rates to extremely low levels which depletes productive investments
• An aging demographic that is top-heavy and drawing on social benefits at an advancing rate.
• A heavily indebted economy with debt/GDP ratios above 100%.
• A decline in exports due to a weak global economic environment.
• Slowing domestic economic growth rates.
• An underemployed younger demographic.
• An inelastic supply-demand curve
• Weak industrial production
• Dependence on productivity increases to offset reduced employment

The lynchpin to Japan and the U.S. remains demographics and interest rates. As the aging population grows and becomes a net drag on “savings,” dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

Conclusion

Like the U.S., Japan is caught in an ongoing “liquidity trap” where maintaining ultra-low interest rates is the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go, the less economic return that is generated. Contrary to mainstream thought, an ultra-low interest rate environment has a negative impact on making productive investments, and risk begins to outweigh the potential return.

More importantly, while interest rates did rise in the U.S. due to the massive surge in stimulus-induced inflation, rates will return to the long-term downtrend of deflationary pressures. While many expect rates to increase due to the rise in debt and deficits, such is unlikely for two reasons.

1. Interest rates are relative globally. Rates can’t rise in one country, while most global economies push toward lower rates. As has been the case over the last 30 years, so goes Japan, and the U.S. will follow.
2. Increases in rates also kill economic growth, dragging rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges. 

Unfortunately, for the next Administration, attempts to stimulate growth through more spending are unlikely to change the outcome in the U.S. The reason is that monetary interventions and government spending do not create organic, sustainable economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void. Eventually, the void will be too great to fill.

But hey, let’s keep doing the same thing over and over again. While it hasn’t worked for anyone yet, we can always hope for a different result. 

What’s the worst that could happen?  

The latest retail sales report seems to have given Wall Street something to cheer about. Headlines touting resilience in consumer spending increased hopes of a “soft landing” boosting the stock market. However, as is often the case, the devil is in the details. We uncover a more troubling picture when we peel back the layers of this seemingly positive data. Seasonal adjustments, downward revisions, and rising delinquency rates on credit cards and auto loans suggest a more cautious view. The consumer—the backbone of the U.S. economy—may be in more trouble than the headline numbers indicate.

The Mirage of Seasonal Adjustments

The July retail sales report showed a sharp increase of 1.0% month-over-month, surpassing expectations. However, while that number supports the idea of a resilient consumer, these spikes have been more anomalous than not. Since 2021, real retail sales have virtually flatlined. Such is unsurprising as consumers run out of savings to sustain their standard of living.

The following chart of real retail sales clearly shows the consumer dilemma. Over the past two years, retail sales have not grown to support more robust economic growth rates. Notably, flat real retail sales growth was pre-recessionary and a “red flag” of weakening economic growth. However, given the massive surge in spending driven by repeated rounds of Government stimulus, the reversion of retail sales to the long-term trend has taken longer than previous periods, leading economists to believe “this time is different.”

But before we break out the champagne, let’s examine how these numbers are calculated. Retail sales data is notoriously volatile. Factors like weather, holidays, and even the day of the week play a significant role. To smooth out these fluctuations, the data is seasonally adjusted. The chart shows the magnitude of these seasonal adjustments since 1992. Interestingly, the magnitude of these adjustments is increasing over time.

But what happens when those adjustments paint an overly rosy picture?

Downward Revisions: A Growing Trend

Seasonal adjustments are a double-edged sword. While they aim to provide a clearer view of underlying trends, they can also distort reality, especially in an economy as dynamic and unpredictable as ours. Unfortunately, these adjustments are often revised in hindsight as more data becomes available. For example, a “red flag” is that eight of the past twelve-monthly retail sales reports were revised significantly lower, making the recent monthly “beat” much less impressive.

Why are retail sales being revised downward so frequently? One possible explanation is that initial estimates are overly optimistic, perhaps due to seasonal adjustments. As more accurate data becomes available, the true picture emerges, and it’s not as pretty as many believe. So, is there potentially a better method?

As noted, monthly retail sales are volatile due to various events. Christmas, Thanksgiving, Easter, summer travel, back-to-school, and weather all impact consumer spending. Therefore, “seasonally adjusting” the raw data may seem necessary to smooth out these periods of higher volatility. However, such a process introduces substantial human error. Using a simplistic 12-month average of the non-seasonally adjusted data (raw data) provides a smoother and more reliable analysis of consumer strength. Historically, when the 12-month average of the raw data approaches or declines below 2% annualized, it is a “red flag” for the economy. Again, the massive spike in COVID-related stimulus is reversing towards levels that should concern investors.

In other words, if we strip out the seasonal adjustments and apply a smoothing process to volatile data, the issue of consumer strength becomes more questionable.

Another “red flag” is realizing that retail sales should grow as the population grows. If we look at retail sales per capita, we see that before 2010, retail sales grew at a 5% annualized trend. However, that changed after the “financial crisis,” retail sales fell well below the previous trend despite an increasing population. While that gap improved following the Covid-stimulus supports, the gap is once again widening.

As you can see, the data shows a much more subdued picture of consumer spending, which raises a critical question: Are we being lulled into a false sense of security by the headline numbers? The reality is likely far more sobering.

The Debt Bomb: Rising Delinquency Rates

Perhaps the most alarming signal comes from the rising credit card and auto loan delinquency rates. Consumers have been relying heavily on credit to maintain their spending habits in the face of high inflation and stagnant wage growth. The spread between retail sales and consumer credit to disposable personal income rises as COVID-related stimulus runs dry and inflation is outstripping wages, forcing consumers to turn to credit.

But there’s a limit to how much debt consumers can take on before the house of cards tumbles.

According to the latest data, delinquency rates (more than 90 days) on both auto loans and credit cards have reached their highest level since 2012. Notably, delinquency rates are rising the fastest for younger generations that tend to have lower incomes and less savings. (Charts courtesy of Mish Shedlock)

These rising delinquency rates are a warning sign that consumers struggle to keep up with their debt obligations. As more consumers fall behind on their payments, the risk of a broader economic slowdown increases. After all, consumer spending accounts for nearly 70% of U.S. GDP. If the consumer falters, the entire economy is at risk.

The Implications for Future Consumption

Given these “red flags,” it is difficult to see how the current level of consumer spending can be sustained. Rising delinquency rates, downward revisions to retail sales, and questionable seasonal adjustments all suggest the consumer is running out of spending power.

In the near term, we may continue to see headline retail sales numbers that appear healthy, especially if seasonal adjustments continue to provide a tailwind. However, the underlying data tells a different story. As more consumers reach their debt limits and delinquency rates continue to rise, we could see a significant spending slowdown later this year.

That slowdown would have far-reaching implications for the broader economy. Retailers could see further revenue declines, leading to potential layoffs and further weakening of consumer spending. Banks and financial institutions could also face higher loan losses, particularly in the credit card and auto loan sectors.

In summary, while the latest retail sales report may have given the market a short-term boost, suggesting a “soft landing” economically, the underlying data suggests we should be cautious. Seasonal adjustments and downward revisions are masking the actual state of consumer spending, while rising delinquency rates are a clear sign of trouble ahead.

Investors and policymakers would do well to look beyond the headlines and focus on the economy’s real risks. The consumer may be hanging on for now, but the cracks are starting to show. Ignoring these red flags could lead to a rude awakening in the months ahead.

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

In “The Fed’s Real Target” it was explained that the Fed’s interest rate manipulations are intended to influence the behavior of borrowers, not investors.  Fed Chairman Powell agrees.  In his most recent press conference, Powell reiterated that the Fed Funds rate continues to be the Fed’s primary tool to influence the U.S. economy.  Based on the Fed’s analytical framework, the economy is slowed by a series of interest rates increases because the behavior of borrowers is constrained.  Using similar logic, the economy is stimulated by a series of interest rates declines because borrowers use the reduction in interest expense for other purposes that promote economic growth.

But the Fed also bought a non-trivial amount ($3.6 trillion) of government obligations during the Quantitative Easing (QE) experiment, in the belief that QE would also boost the U.S. economy. Unlike interest rate manipulations, QE is direct manipulation of bond prices and yields and is clearly directed at investors, not borrowers. This key difference between who QE and QT targets are incredibly important and often not fully appreciated by investors.

Since November 2017, the Fed has embarked on Quantitative Tightening (QT), a policy that forces investors to refinance trillions of U.S. government obligations that are maturing from the Fed’s portfolio.

Can the movement of asset prices during the QE period give clues about how asset prices might move during QT?  In this article, we show that the Fed’s QE policy produced the counterintuitive result of higher yields on Treasury bonds, not lower yields as implied by supply/demand analysis.  Using symmetrical logic, the Fed’s QT policy should be expected to reverse the effects of QE, and to produce the counterintuitive result of lower yields, not higher yields implied by supply/demand analysis.

QE was launched in 2008 and ended in late 2014 after three rounds of purchases plus Operation Twist which extended the duration of their holdings  Digging through the archives, the following chart shows that the S&P 500 index (SPX) rose 176% during the periods in which QE was operative (colored lines) while SPX declined 32% during non-QE periods (gray).  Since mid-2015, when the chart was created, SPX has risen from 2100 to 2785, a gain of 31% that offset almost all the 32% loss.  Clearly, QE produced an upward bias to stock prices. While the topic for another article, it is worth pointing out that many other central banks continued buying assets after QE ended via their QE programs and this activity played a role directly and indirectly in supporting SPX.

Moving to the market for U.S. Treasury bonds, QE produced quite a different result than many had expected.  The 10-year Treasury yield rose by 184bp during periods of QE and fell by 293bp during non-QE periods.  Despite massive bond purchases by the Fed, sales by other investors overwhelmed the Fed’s actions.  Since mid-2015, when the chart below was created, 10-year Treasury yields have risen from 2.25% to 2.85%, offsetting some of the decline in yields that occurred during non-QE periods since 2008.

Why might yields have risen during periods of QE, when the Fed was buying trillions of dollars of bonds?  The chart below shows that inflation expectations rose by a total of 274bp during periods of QE and fell by 104bp during non-QE periods.  Markets apparently believed that QE would produce a systematic increase in inflation.

Summarizing the results of stock and bond markets post-2008, during QE periods, the Fed bought $3.6 trillion of government obligations, but bond yields rose.  During non-QE periods, bond yields fell.  Almost nobody expected that a multi-trillion program of buying government bonds would result in declining prices (rising yields) for government bonds.  Yet that’s what happened.  Based on the movement in breakeven yields, investors believed QE would result in systematically higher inflation.  During QE periods SPX rose, and during non-QE periods SPX was basically unchanged.

Viewed from the perspective of a portfolio, QE clearly changed the risk tolerance of investors, who sold U.S. Treasury bonds to the Fed and used the proceeds to buy U.S. stocks and a variety of other risky assets that appreciated sharply (real estate, junk bonds, emerging market stocks and bonds, collectibles, etc).  To use technical language, the risk premium fell for risky assets relative to U.S. Treasury bonds.

Transition from QE to QT

Since November 2017, the Fed has been pursuing a policy of QT, allowing a portion of its portfolio of bonds to mature without reinvesting.  If QT is the opposite of QE (essentially, bond-selling instead of bond-buying), it is logical that asset prices will adjust in the opposite direction than what occurred during QE.  That is, bond yields should fall even though the Fed’s actions require investors to now buy $50 billion more of government obligations each month.  Stock markets should fall because investors will sell risky assets to meet the increased supply of Treasury bonds.   But what is the actual pattern of prices in the QT era?

SPX has risen by approximately 5% since November, but more than 100% of that gain occurred in December and January, possibly in anticipation of corporate tax cuts.  Since January, the trend has been downward and much more volatile.  QT began slowly, at $10 billion per month, but starting in July 2018 it has been ramped up to $50 billion per month in maturing bonds.  QT may already be taking a toll on the stock market.

How about the bond market?  The combination of higher deficits, higher short-term interest rates, and the Fed’s QT program means that investors will need to buy more than $1 trillion in newly-issued Treasury notes in each of the next few years.  A simple supply/demand analysis would suggest that bond yields should rise during a period of QT, just as a simple supply/demand analysis would suggest that bond yields should have declined during QE.

As shown below, bond yields have indeed risen since the beginning of QT, from 2.40% to 2.85%.  But just as with the stock market, most of the move occurred in December and January, as markets began to anticipate the stimulative effect of corporate tax cuts.   Since January, bond yields have gone sideways, defying the predictions of those who believed long-term interest rates would inevitably rise because of the Fed’s rate hikes and increased deficit spending, each of which increases the supply of U.S. Treasury bonds.

Are the bond markets expecting a return of inflation?  The chart of inflation expectations below is remarkable because inflation expectations have remained in a narrow range of 1.5-2.5% for most of the past 15 years.  As a result, relatively small changes can appear to be larger than they really are.  During the entire QE era, inflation expectations were also anchored in the 1.5-2.5% range, although as explained previously, inflation expectations rose during QE periods and fell during non-QE periods.  Since QE ended in late 2014, inflation expectations fell from 1.8% to 1.2% as the price of crude oil crashed from $110 to $26 per barrel.  Inflation expectations then rose to the current 2.1% level. That said, QT seems to have put a lid on rising inflation expectations, which have been stuck at 2.1% for the past six months.

Many, including the Fed, fear that inflation will spike higher.  But the ever-flattening yield curve, which is an excellent leading indicator of recessions, suggests that bond markets are beginning to believe that the next move in inflation is down, not up.  The flat yield curve also supports our analysis in “Does Surging Oil Costs Cause a Recession?” which shows that a combination of rising short-term interest rates and a doubling of crude oil prices preceded each recession since 1970, with no false signals.  Those conditions exist in 2018.

Finally, the prices of industrial metals such as copper are nosediving.  Many will attribute the recent weakness in metals to the threats of a trade war.  But it is also possible that the Fed’s combo-platter of QT (aimed at investors) and rising U.S. interest rates (aimed at borrowers) is a primary culprit.  Regardless whether the trade war or Fed actions are responsible, it is clear that commodities investors don’t like what’s on the menu.

Conclusions

The purpose of this article is to estimate the future direction of asset prices based on the logic that QT will have the opposite effect on asset prices then occurred during QE.

Here’s what we know happened during QE:

• QE changed the behavior and preferences of investors, which greatly affected relative prices
• QE produced an expected result of higher stock prices
• QE produced an increase in inflation expectations, which produced the unexpected result of higher Treasury bond yields

If markets respond to QT symmetrically to how they responded during QE, then:

• QT will change the behavior and preferences of investors and change relative prices
• QT will produce lower stock prices
• QT will reduce expectations for inflation, resulting in lower Treasury bond yields

So far, the QT era has not produced lower stock prices and bond yields.  That said, it is too early to make a definitive statement on QT’s ultimate impact.  The full force of QT ($50 billion per month) has just begun, and there are signs that stocks and bonds are beginning to change direction.  Since November when QT began, SPX has risen.  But since the January peak that occurred in the wake of tax cuts, the trend of SPX is downward and more volatile.  Since November, bond yields have also risen.  But as with SPX, since January a change has occurred; bond yields have stopped rising.

It is possible that the trends in effect since January will persist and possibly intensify throughout the QT era, which would be a surprise to the consensus view that interest rates will inevitably rise due to an increasing supply of Treasury bonds.  Other important data points also suggest that Treasury bond yields may continue to fall; inflation expectations have been static since QT was launched in late 2017, the yield curve continues to flatten to levels not seen since 2007, and industrial commodities are in freefall.

“Peter Cook is the author of the ‘Is That True?’ series of articles, which help explain the many statements and theories circulating in the mainstream financial media often presented as “truths.” The motives and psychology of market participants, which drives the difference between truth and partial-truth, are explored.”

The persistent rise in interest rates has become a dominant topic of the financial media. It is now common to read articles on how a rise in the 10-year Treasury bond rate to a specific level will produce some type of sea-change in perception and/or reality. Some of those points are already in the rear-view mirror (2.65%), while another was crossed this week (3.05%), and still others lie ahead (3.22%). Some commentators eschew a specific interest rate and instead specify a range, such as 3.50%-3.75%.

The focus on interest rates is understandable. Rising rates are, by definition, a negative influence on bond prices.  With tens of trillions of dollars of bonds outstanding, a rise in interest rates of, say, 1%, produces market losses of hundreds of billions of dollars. If the Fed’s beloved “wealth effect” ever existed, it is now a movie that is running in reverse, perhaps more quickly than it ever ran in forward.

In addition to negatively influencing bond prices, rising rates are perceived to be a negative influence on most other assets, such as real estate, commodities, or private businesses. Of course, this is also true of stock valuations.  Ever since the peak in interest rates in the early 1980s, falling interest rates have been used as a primary justification for rising stock valuations.

Oddly, investors of the Russell 2000 index (R2K), comprised of small-cap companies, don’t seem to care about the connection between rising interest rates and lower stock prices. Defying the predictions of many, R2K made a new all-time high this week while bond yields rose to 7-year highs. This combination is particularly at odds with financial theory because R2K companies have a greater exposure to rising rates than larger companies.  For example, the maturity of the debt of R2K companies matures earlier and carries a higher interest rate than large companies in the S&P500 index (SPX).

Looking at other influences on stock prices, R2K historically tends to rise when the dollar is strong, but it also tends to be weak when the price of oil is rising. So recent changes in the dollar and oil largely negate each other and don’t explain the R2K’s strength.

Diving further into relative valuations, the Wall Street Journal publishes valuations on a weekly basis, as shown in the table below.

The price/earnings ratio (PE) based on the past year’s earnings is far higher for R2K (88.75) than SPX (24.28) and even the NASDAQ 100 index (24.99), an index dominated by the largest U.S. growth (technology) companies, which should presumably be valued more highly than smaller companies. Looking forward, after waving the magic wand which uses operating earnings instead of GAAP earnings, R2K (26.15) is still valued more highly than the SPX (17.05) and NASDAQ (20.25). It is important to note that the P/E calculation for the R2K throws out the earnings of companies losing money, while SPX includes them. Ergo, the true P/E of R2K is larger than it appears. The following quote was from an article written in 2016 that analyzed R2K valuations:

“As a point of comparison, the widely reported P/E ratio of 46 for the R2K appears to be much lower than our value (237x). Unlike, the market benchmark S&P 500, the reported Russell P/E ratio excludes companies with negative earnings. Our analysis appropriately includes both positive and negative earnings.” – Banks in Drag : The Russell 2000 Exposed 

Historically, the R2K is trading near its all-time high in valuation, as shown below by the red line. Since 2003, the R2K traded at a higher valuation only a few times; during the earnings crash and recession of 2009, briefly during 2015, and again throughout 2017. Although Yardeni.com calculates a slightly different P/E for the R2K (24.1) than the WSJ, it is still higher than both the SPX and NASDAQ, and as noted above likely much higher on an apples-to-apples basis.

R2K companies are more exposed to the U.S. economy than larger companies, because larger companies derive a greater percentage of revenues and profits from overseas.  So one explanation for the higher valuation of R2K companies is that U.S. economic growth will be stronger than global growth.  But it is also true that the Fed is well into a tightening cycle that is designed to restrain growth and inflation, while Europe and Japan still have the monetary petal pushed to the metal, including negative interest rates.  As previously explained HERE, the combination of rising interest rates and energy prices has preceded every U.S. recession of the past 45 years, and that combination is present yet again in 2018.

In conclusion, interest rates are rising, but they have not produced the expected effect on stock prices. R2K companies are trading at an all-time high in price as bond yields are breaking to multi-year highs. R2K companies are trading at a high PE multiple relative to larger, more stable companies that have less exposure to rising interest rates. R2K companies also are trading at a high PE multiple relative to historical norms. Perhaps all of these conditions will continue into the future, but that seems like a low-probability bet, which is a major source of risk for small-cap U.S. stocks.