Charades, Distractions and Illusions
My news feed over the weekend was inundated with opinions on the potential coup transpiring in Russia by the Wagner Group (a private military outlet) who was allegedly attempting to challenge President Putin’s authority. To be honest, that’s about as deep as my understanding goes as it pertains to this issue. In this era of instantaneous access to information and the ability to spread information (accurate or not) in the interest of illustrating one’s expertise (worthy of such acclaim or not) it is easy to be dragged down a rabbit hole that ends up being much ado about nothing. I’m not saying there is no ‘there’ ‘there’, but the vast majority of us lack the access to the right information that would actually allow us to come to such a conclusion. Even then any conclusion would be subjective or at best an informed guess. Nevertheless, I found the below tweet posted by Jawad Mian (a Macro Strategist for Stray Reflections and brilliant mind) to be the most saliant thing I read on the issue.
Could this coup attempt have major geopolitical and market implications? Yes. Could it be nothing but theater? Yes. At this point, it’s nothing more than a news event that captured individuals’ attention and in my opinion most geopolitical events are just that, newsworthy but useless as it pertains to capital markets or everyday life. I say everyday life with the utmost humility as I sit in a cozy room while on visiting family and mixing in some work in San Diego, California with little threat or disruption to my life. Many in this world are not so lucky, so I want to be very clear in recognizing how easy it is for someone like myself to take for granted just how fortunate I am to be born in the U.S., how lucky I am to have the life I have, and recognize that my hardships are a mere speck of dust compared to the trials and tribulations many individuals face in much more challenging parts of the world. As frustrating as U.S. politics are at times, many citizens of other regions around the world only wish they were so lucky.
Moving off the soap box and on to markets, equities lost ground last week with all three major averages closing lower – the Nasdaq ended an eight-week winning streak and the S&P 500 streak ended at five. Within the tech sector, the PHLX Semiconductor sector declined the hardest (-4.5%) with the Nasdaq slipping 1.4%, the Dow falling 1.7%, and the S&P 500 gave back 1.4%. The first six months of the year are still stacking up to be quite a run with the Nasdaq up +36% ytd and the S&P 500 up +13%. I would argue this is in large part due to an unwinding of overly bearish positioning and sentiment coming into the year, where the consensus view was that an economic recession would commence sometime in the first half. The fundamentals that would support such an outcome just haven’t materialized and as a result investors have been pulled kicking and screaming back into the fray.
Equity market breadth had been on the mend but that reversed last week as illustrated by the S&P 500 equal weight index falling -2.7% and the Nasdaq equal weighted index sliding -2.8%, both meaningfully underperforming their market cap weighted compadres. The relative strength line for the S&P 500 equal weight index continues to weaken, deteriorating to its worst level since late 2020. Not just that, but the stock market’s overall advance-decline line weakened significantly this past week, with decliners outnumbering advancers by 2-to-1 on both the NYSE and Nasdaq.
Irrespective of one’s view of whether we’re still in a bear market, in a new bull market, about to slip into recession, or engineer the illusive soft landing, the S&P 500 is trading at a rich 19x expected 12-month earnings, well above the historic average of 15.6x. The Nasdaq 100 trades at an even more extreme 27x forward P/E relative to its historical norm of roughly 19x. Last week’s price action flipped some technical and momentum indicators on the S&P 500 from tailwinds to headwinds for the first time in several months and puts the major index on the verge of triggering a MACD sell signal. Additionally, positioning as measured by the NAAIM data is hovering in the 80% - 90% range over the past three weeks and has moved up to its most stretched positioning since January 2022 – clearly illustrating that the underexposed positioning coming into the year has been unwound.
Let me be succinct with some closing thoughts on this week’s missive as I have to traverse the nightmarish traffic on a drive up to LA from San Diego for some meetings.
Markets and the economy at times are fraught with charades and misdirection, just as we so often see play out in the machinations of politics. Sometimes things are not always as they seem, and almost all investment actions involve a great deal of uncertainty/risk. The rally in equity markets this year may be a legitimate start to a new bull market or it could very be an illusion of such grandeur that sucks everyone before toppling once again. Without question it has shifted the mindset of many investors away from rising recession risks to a belief that a new economic expansion is underway. Possible and a scenario I am openminded to embracing, but according to our work it is still a lower probability outcome than an economic recession.
Too many market indicators and trending economic data are flagging amber signals for us to abandon the ‘invest through it, but with caution’ philosophy. For starters, the magnitude and duration of the fourteen month slide in the Conference Board’s LEI indicates that the start of a recession is one or at most two quarters away. The depth, dispersion, and duration of the current yield curve inversion is another indicator that pegs the recession odds at 100%. I know, I know, so many investors are downplaying the inversion of the yield curve this cycle as being a false flag, but the 2s/10s is at -101 basis points this morning and this is its most inverted level since 1981. Never have we experienced an inversion this steep, let alone being inverted for going on twelve months now, and the U.S. not tipped into recession.
Then there are the back-to-back contractions in real-GDI which has always coincided with an economic recession. This downturn in real-GDI is corroborated by the fact that total business sales volumes, the index of aggregate hours worked, industrial production, and real personal incomes have all peaked at some point in the last several quarters. The GDI data are key because it suggests that we could be in for some hefty downward revisions to payroll and wage data ahead and it is the inevitability of revised data that causes the NBER to always be so late in making the official recession call – typically publishing the announcement 8 months after the recession has already taken hold!
The last data point I’ll throw out there for now is the rise in the four-week moving average in initial jobless claims, which just popped to +65k above the cycle lows. Historically, the month that jobless claims reach a +65k increase from the trough, job growth in the nonfarm payroll report practically evaporates. So, we’ll have to see what the next several employment reports come in at, but a move up in jobless claims to this level is not something that should be ignored as the economic archives indicate it leads recessions by one to two months.
It must be said, no two economic cycles are the same and without question this post-pandemic recovery is one of the most unique backdrops many of us have ever analyzed. So, anything I write or expectations I have, I’m doing with a great deal of flexibility and open mindedness. For instance, while we have a cautious and defensive investment bias based upon our analysis it hasn’t constrained us from investing in areas where we see opportunity. There are many areas we like and express through an array of exposures in portfolios. However, outside of a couple specific areas we don’t feel compelled to have the full weighting of the exposure expressed right here right now. If, as we suspect, we get some downside volatility or an economic downturn over the next couple quarters we intend to build out these exposures further and/or introduce new ideas that come through our work.
I still find it surreal that investors bought into the “don’t fight the Fed” mantra so adamantly in the post-GFC era, and for good reason, because it was validated time and again. Yet, here we are today moving into the peak of the most aggressive tightening cycle in four decades and investors have little fear in ‘fighting the Fed’. Go figure. Without question the forward outlook is unclear for all scenarios; no landing, soft landing, or hard landing which renders anyone exulting a view with unabashed confidence as dangerous.
I’ll use housing as an example to illustrate the confusion and complexity permeating a lot of economic data sets. Without question housing prices across the nation are elevated, near all-time highs, and to this point have shown very little impact from a near tripling in mortgage rates since early 2022. How can this be? Afterall, housing is one of the most interest rates sensitive sectors of the economy and even a neanderthal would expect house prices to come under pressure with this spike in mortgage rates. Well, digging into the data reveals that household formation, aided, and abetted by the millennial generation, is expanding at its most robust pace in decades. This is underpinning demand.
The supply side of the equation is even more interesting, in that the past five years have been the first five-year period in U.S. history where new housing construction has not kept pace with the change in full-time occupied housing (both owned and rented). This is fascinating, especially when you consider that a home (the actual structure) is a depreciating asset that needs to be replaced every 75 years or so. The outstanding stock of housing units in the U.S. stands at 129 million and the math suggests that roughly 1.7 million new homes must be built each year simply to replace depreciated structures. The current pace of new home construction is just under this at 1.65 million.
So, while many of us look at the price tag on houses today and scratch our head, mumbling to ourselves something, something, this is the mid-2000’s housing bubble part deux. The economics of the situation suggests that the underlying fundamentals are constructive. Furthermore, that the Fed is pursuing the wrong path to fight inflation – hike rates higher and higher until something breaks while failing to acknowledge their blunt tool of interest rate hikes isn’t the right remedy for supply constraints in certain industries. Higher interest rates don’t incentivize new supply, it constrains it which only further exacerbates the problem. Ahh, you thought I was going to go a full missive without saying something about the Fed – you’re not so lucky.
Bottomline, stay disciplined, vigilant, and patient with your capital. That doesn’t mean you don’t play the game, but rather don’t force the issue. This is one of the more fruitful investment backdrops any of us have experienced in several decades with all markets (bonds, stocks, foreign, commodities, and precious metals) providing opportunities, but not all at the same time.
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