I’ll get to the title part of this missive a little further down, but before then, let's hit on last week's market action.  On the headline front, it was a wild week (the yen carry trade started to unwind, the dispersion trade blew up, and U.S. polls suggest Harris as the frontrunner), but when all was said and done, the S&P 500 finished just about where it started.  Investors once again fell back on the ‘buy the dip’ default setting, which has been programmed into them in this post-GFC world.  That said, the S&P 500 is trading in a bit of no man's land – 2% below its 50-day trendline, 6% above the 200-day moving average, and just over 5% off its all-time highs.  Let the chart below serve as a frequent reminder that no matter how much fundamental, technical, and/or macro analysis an investor does, there is a major force that at times can/will override all other variables: the automated structural flows of employment contributions and all the variants of passive investing. It's not hard to see that weekly outflows are both less frequent and smaller in magnitude.   

As always, there are positives and negatives for investors to focus on: 

• Q2 earnings season is winding down where, overall, they didn’t disappoint – 78% of companies that reported beat their estimates, with EPS growth clocking in at +10.8% year-over-year (best since Q4 2021, according to earnings analyst John Butters over at Factset).  However, valuations remain a constraint to continued price appreciation, with the S&P 500 trading at a forward P/E multiple of a little over 20x – it’s 28x for the Mag7 group of companies. 

• Another plus is the reset we’ve seen in both positioning and sentiment data. Hedge funds, Volatility-Control trading strategies, and CTAs have all meaningfully reduced their long exposure in equities in the last several weeks. Sentiment surveys such as the CNN Fear and Greed Index, AAII, and Investors Intelligence have seen bullish sentiment plunge while bearish sentiment has spiked higher. We needed a good cleansing of all these metrics as they were all near historically bullish extremes heading into the mid-July peak in the S&P 500.   

• Fed rate cut expectations have been jumping around with all the equity market volatility.  A week ago, markets were pricing in a 50bps cut at the September 18th FOMC meeting as a near certainty, but those probabilities have since backed off to just over a coin flip.  Recall that it was just a month ago when the odds were in the single digits that we would get any cut at the September meeting.  Without question, lower rates will be welcome and necessary (in my opinion) in order to bring relief to the small business community that is borrowing via a prime rate that, in real terms is the highest it has been in a century (6.5% - see Michael Hartnett’s chart below from his weekly Flow Show report). 

 For the Fed to stick the ‘soft landing’, it's going to be contingent on lower interest rates in the second half boosting animal spirits and spending activity.  Not to mention kicking starting a housing market where mortgage purchase applications are close to their lowest levels since 1995 and refi’s at their lowest levels since 2000.

Before we get too carried away that rate hikes will be a panacea, keep in mind that nearly 75% of Fed rate-cutting cycles in the post-WWII era ended up seeing the economy slip into recession.  Without question, economic growth is slowing, so is the labor market, and inflation is no longer a problem – all of which suggests that the Fed has the support from the data it needs to justify getting started on normalizing interest rates.  The longer they wait to get going while the data continues to trend in the direction it is, the bigger the risk becomes for them to do more later because they are behind the curve once again.  The last two times the Fed kicked off a rate-cutting cycle with jumbo cuts (more than 25bps) were January 3rd, 2001, and September 18th, 2007.  Unfortunately for investors, those two cuts were just the first of many as the economy slipped into a recession. 

The one thing we do know is that in the year following the first rate cut, when the economy does not slip into a recession, it is constructive for the equity market, with the S&P 500 higher by 18% a year later.  But it’s a different story for equity markets when the Fed cuts rates and the economy slips into recession, with the S&P 500 on average down -9% a year later and down even further beyond one year.   

Let’s walk through some history on rate cuts and the Fed.  Looking at rate-cutting cycles over the past seven decades, I’ve found that, on average, when the Fed gets into an interest rate easing cycle, it unwinds more than 80% of the prior hikes implemented during the tightening cycle.  If history holds to form, that would imply Fed Funds slips below 1.00% in this cutting cycle – not a prediction, just a bit of math and history.  Of all the thirteen easing cycles back to 1955, seven saw the Fed unwind all or more of the prior hikes, with the lowest retracement being just 42% of the prior hikes (this would imply an ending Fed funds rate of roughly 2.5% when applied to this current hiking cycle).  Just some food for thought as we all get charged with analyzing in real-time what’s to come over the next 6 – 12 months. 

Looking ahead, we have a busy week ahead of us, with the real action getting underway on Tuesday with the July PPI report and continuing on Wednesday with the CPI print.  Consensus is at +0.2% month-over-month for both the headline and core-CPI indices.  No doubt, a big surprise in either direction will move markets as it will have implications on the Fed's optionality for both the timing and magnitude of its next move.  Should the numbers come in as expected, I anticipate the equity market to rally and perhaps kick off a sizable one given the options market is showing investors well hedged going into this data release – these hedges will be capitalized on and unwound post the print.  One thing to keep an eye on is this bit of bid we're seeing come back to the commodity markets over the past week.  Copper is bouncing off of five-month lows and oil prices appear unwilling to slip much below $75/bbl – these have been sources of disinflation feeding through the CPI prints the last several quarters, but that won’t remain the case beyond September when base effects get more difficult.   

On Thursday, we get our latest look at the health of the U.S. consumer with the July retail sales report (consensus is looking for a print of +0.4% month-over-month and a tepid +0.1% reading for the ex-auto and “core control” segments which tend to garner more investor attention).  Although the earnings reports coming out this week from Walmart and Home Depot will be just as telling as what retail sales show us.  Also, on Thursday, we’ll get jobless claims, which has become a must-watch number given the focus on the labor market and industrial production at 10:00 am.  We close up the week with housing starts and the August preliminary reading on the University of Michigan Consumer Sentiment Index (consensus is at 66.9 vs. 66.4 in July and a long way down from the 79.4 number we got at the end of the first quarter).

Back to the consumer for a moment, I found the comments from Bank of America CEO Brian Moynihan on Face the Nation to be noteworthy as he articulated his concerns over the U.S. consumer spending outlook having “really slowed down”.  Based on the bank’s database of 60 million accounts, spending growth over the past year has been cut in half.  Keep this in your back pocket as 70% of GDP is consumption of some fashion.  Moynihan pointed out that “traffic” data (restaurants, travel, and theme parks) is becoming less reliable because consumers are spending less per visit, and evidence is growing that they are seeking bargains.

Given recent market volatility and increased visibility of the ‘R-word’ (recession) becoming a risk, my mom requested that I be sure and write about something positive in this week's missive.  Well, Mom, here you go, and you should be relieved that I didn’t have to dig too deep into the data to find some constructive crumbs.  M2 is a monetary metric often referenced to measure the nation’s money supply where a contraction in money supply is often viewed as a negative signal for future economic growth, and an expansion is viewed as the inverse.  The good news is that M2 has stopped contracting, with the June data showing it expanded +1.0% year-over-year compared to a decline of -3.8% a year ago.  This is the third month in a row that it has been in positive terrain – that is enough data points to make a trend.  The same goes for bank credit, which has increased on a YoY basis for four months in a row after spending much of the second half of 2023 in negative terrain (currently sitting at a sixteen-month high of +2.5% YoY in July).  In addition to the growth in money supply and bank credit, we are witnessing a net loosening in lending standards in the latest bank lending survey.  For context, I’m not suggesting that lending conditions are loose by any means, but at the margin, we are seeing a thaw on the credit front.       

The last topic I’m going to hit in this week’s missive has as much to do with investor psychology and human behavior as it does with fundamental analysis.  Anyone who has been a client of ours over the past six years or has been following this missive is aware of the constructive investment view I’ve had regarding nuclear energy, an evolving nuclear renaissance, and, as a result, uranium, which is the natural resource used to fuel nuclear reactors.  In a nutshell, nuclear energy is the most efficient, productive, and carbon-friendly form of energy production ever invented.  Some may not share this opinion, and that’s fine by me, but at the root of our investment thesis was that there was a growing disparity between the amount of uranium demand needed over the next decade relative to the amount of uranium that could be supplied.  Below is a slide from our Q3 slide deck summarizing the big picture.   

But my interest in writing about this investment theme in this week’s missive isn’t to dive back into the investment thesis but rather to highlight how difficult it can be to maintain conviction no matter how much you double, triple, and quadruple-check your fundamental analysis.  I first started risking client capital in this space as far back as late 2017.  Back then the math was as intuitive as it was simple.  A pound of uranium was trading at less than $20/lb, and the breakeven cost of new production was estimated to be $35-$45/lb.  As a result, a lot of mines were being shut down, and others were going out of business.  It was just a matter of time before prices had to go up, or the supply-demand imbalance would only continue to grow, and prices would eventually spike because there wasn’t enough uranium being mined to fuel the +430 globally operating reactors.

As obvious as it seemed to me on where the fundamental eventuality of this market was going, my timing was off by nearly three years.  From 2018 into early 2020, this market moved in small fits and starts (it’s a very small segment of the energy market and very volatile), but the general direction was a death-by-papercut downward grind.  In the accompanying chart, I’m using the Global X Uranium ETF (URA) as a proxy to track the price movement in the sector.  Over this +2-year period, this ETF declined nearly 30%, while according to my work, the story did nothing but incrementally improve over this period.  There became a point where I questioned the entire thesis and worked through the mental anguish that I would soon have to acknowledge I was missing something. 

Then COVID hit, the entire equity market got slammed, and the uranium space was right there with it.  So here I am at the depths of the COVID lows, underwater by more than 50% on the client capital invested in the space, pretty much sick to my stomach on a daily basis.  However, the fundamental story continued to strengthen according to my work.  So, through a lot of communication and even more trust and faith in my work on behalf of clients, we stayed the course.  Lo and behold, eventually, the market began to recognize the constructive investment setup I’d been trying to capitalize on three years earlier.  In this business, early is wrong. 

Fast-forward to the present day, and what is easily visible from the chart is that over the past four years, this investment thesis has become broadly recognized and priced into the market (+170% or more than 40% annual returns).  However, the self-congratulatory backslapping isn’t the point I’m trying to make.  The bigger point is the numerous occasions of significant corrections an investor had to endure to realize the totality of those gains.  In the post-COVID period, the URA ETF has had 11 corrections of more than 10%, 6 corrections of more than 25%, and 1 drawdown of more than 40%.  Each of these was challenging to endure, and every one caused me to question my work – including the over 30% drawdown underway since mid-May.  But no way would I have been able to retain this conviction had I not done the level of work I did on understanding the fundamentals of the industry.  Being able to decipher noise from useful information and having the fortitude to understand that volatility was the price of admission for an investment with the risk/reward profile this sector presented.    

Without question, this experience is easier to write about, given that it eventually vindicated my work and that we were ultimately on the right side of it. But if I’m being honest, I’m not sure the ride has been worth the anxiety that came with it. Look at that chart; you're in a state of drawdown more often than you are in a state of appreciation.  That’s grueling, and it wears on you.  You want to hear something funny? I think the setup for this thesis is just as strong today as it was seven years ago when I started kicking the tires.  Fundamentally, it may even be stronger.  However, I think the easy money has been made (isn’t that quite the oxymoron), but I continue to think nuclear energy has a bright future, and uranium prices need to still move higher before the supply-demand imbalance becomes less favorable.     

The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.

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