Invest Through It

This week’s missive is going to be intentionally short as I just don’t have much to ramble on about.  The S&P 500 has pushed above the upper end of its longstanding trading range (4,200) and the longer it holds above this level the more constructive it is for stocks.  Late last week we witnessed an appreciable broadening of breadth with small caps, industrials, materials, financials and energy (all laggards ytd) firmly pushing the S&P 500 above the 4,200 breakout level.  Time will tell whether this is just the last hooray of this rally that looked to be running out of steam with the narrowing breadth or the historically elusive ‘soft landing’ can be achieved.  If it’s the ladder, then the cyclical laggards year-to-date have a lot of catching up to do and as such represent a much more favorable risk/reward than the now crowded magnificent-seven mega cap Tech names. 

Our view continues to lean in the direction of the bears, but it hasn’t been a steep enough lean that it has constrained us positioning wise from making some hay while the sun is shining.  Consider us, cautious or selective optimists.  There remains a plethora of themes and idiosyncratic investment opportunities for investors to participate in while balancing the need to risk manage an elevated level of uncertainty with the necessity of long-term compounding. 

In my estimation the setup at the moment does not look favorable for investors to deploy fresh cash into the broad equity market.  Sure, on dips you can add to areas where you have a constructive view longer-term (hard assets, small caps, energy transition commodities, Japan, Mexico, India, emerging markets ex-China, semiconductors, healthcare…), but a lot of things not going wrong (yet) have been correctly repriced in the equity market relative to where we were at the start of the year.  Underweighted positioning in the equity markets has reversed and investor sentiment while far from euphoric (excluding mega cap Tech) is no longer expecting Armageddon.    

We’re at a juncture in the equity market where the liquidity tide is going out as the Treasury is forced to drain financial markets of some $1 – $1.5 trillion in the form of new debt issuance to refill its depleted reserves.  Couple this with a VIX below 15 (lowest it’s been since late-2021) and a forward P/E multiple of 19x (rich to a historical average of ~ 16x).  If the S&P 500 EPS end up coming in at current estimates of ~$228 that is equivalent to a 5.25% earnings yield.  That earnings yield now compares unfavorable on a risk/reward basis relative to a risk-free 1-year T-bill yielding 5.25%, 1-3-year investment grade paper yielding 5.5% or for those more risk inclined 15+ year BBB credit yielding 6%.  In addition to these alternatives offering superior risk/return characteristics, they sit in a more secure segment of the capital structure.   

Not to mention an economic growth backdrop where the totality of incoming data shows an economy that is weakening at an accelerating rate – last week’s payroll print notwithstanding.  Last week’s ISM manufacturing index (46.9) is near its weakest print since the COVID trough and in contraction for seven straight months.  This morning’s ISM non-manufacturing index slipped to 50.3 and is just above contractionary levels while sitting at its lowest level since May 2020.  As for last week’s employment data all I have to say is that the internals of the report were not nearly as strong as the +339k headline print suggests.  The workweek contracted, the unemployment rate rose from 3.4% to 3.7%, and aggregate income ticked down.  Sure, the labor market is holding in, but almost every forward-looking metric on the labor market suggests a weaker labor market awaits in the months ahead.  Moreover, I’m seeing retailer after retailer (Costco, Dollar General, Home Depot, Target, Restoration Hardware, Walmart…) all highlighting a weakening consumer backdrop in their recent earnings reports.    

As for inflation, our work suggests that with each passing day, it remains yesterday’s story.  The company “Truflation” puts out an inflation metric that uses 10 million data points and updates daily versus the lagged measurement aspects of the BLS calculation.  According to them U.S. inflation is down to +2.9% versus the CPI index at +4.9% and down significantly from +12% last June (see chart below).       

The Truflation metric isn’t alone in supporting the notion that the inflation dragon has been slayed.  The ISM manufacturing index had twice as many respondents saying prices compared to year ago levels are going down versus up.  Delivery, freight, and shipping costs have crashed from their supply-chain-disruptions-Covid-peak and are now back to pre-Covid levels.  The Goldman Sachs commodity index which includes twenty-four different commodities is down 26% in the last twelve months.  Not to mention that PPI has melted to a +2.3% inflation rate from +11.1% a year ago. 

Bottomline, according to our work the current setup combined with our outlook on the path for growth and inflation data over the next 2-3 quarters suggests fixed income is a better asset class to own in this window of time.  No, that doesn’t mean you abandon your stocks and put it all ‘on black’, but rather that diversification via bonds should act as a reasonable hedge to equity exposure.  Most importantly investors should embrace and respect the uncertainty. 

As the saying goes, “those who do not learn from history are doomed to repeat”.  I say this because the current setup has much in common to what was transpiring in late-2015 / early-2016.  The U.S. economy was slowing with the manufacturing sector in recession, China was weak, the Fed was tightening (albeit at the doorstep of its tightening cycle), the services sector and labor market were resilient while marginally weakening.  Leading indicators had been falling for months, and I was convinced we were heading into a recession.  As a result, I had the bear market playbook fully engaged in client portfolios.  Long-story short, in early January we got the Shanghai Accord where global policy makers introduced a coordinated strategy to support global growth, the dollar rolled over, and then Fed President Janet Yellen backed off the Fed’s tightening path.  Risk assets started performing better and then in the Fall of 2016 we got the surprise Trump victory with his business-friendly agenda, the economy reaccelerated, and risk assets rallied for another two years.  All the while I remained inflexible in my bearish view which was being proven wrong with each passing day.

The morale of the story is that investors should never marry their forecast.  It’s important to maintain humility, to recognize when you’re wrong, and be open-minded enough to pivot to correct an error.  Trust me when I say this is ‘easier said than done’.  But I take you for this stroll down memory lane because the price action in risk assets is incongruent with weak fundamentals.  It’s as though investors are comfortable looking past this soft patch with a line of sight on improving rate of change metrics a couple quarters down the road.  I’m not convinced this isn’t a Wiley E. Coyote moment, but I’m also not convinced that investors should be positioned for a GFC redux.  I have strong doubts that this move higher in stocks since October is anything more than an extended bear market rally.  Furthermore, if it’s the start of a new bull market it’s one of the most pathetic on record and is kicking off from a market cap / GDP ratio sitting at roughly 150%.  A level that prior to the last 5-years had never been reached, let alone sustained.

The best advice I can give you here and now is the same thing I continue to tell myself day in and day out as I go through my routine – invest through it.  None of us know with any certainty what tomorrow brings, but for those doing the work and putting in the time there are viable longer-term investment themes investors can and should sink their teeth into.  It doesn’t mean you put the entire exposure on right here right now, but some, heck yeah.  Then manage the exposure0 as the cycle evolves.  Should it continue to prove valid, use periods of weakness to add to it, and don’t be bashful about clipping some profits when it’s going handsomely in your favor.  Then dig in and try to find other opportunities and other themes worthy of committing some capital.  In the meantime, there has never been a more lucrative time in the past fifteen years to get paid on the money you have sitting on the sidelines awaiting the next opportunity.  Embrace and appreciate the fact that money markets yield north of 4.5%.  Consider this tradeoff in your investment decision making – such a high secure return establishes a high hurdle to get over in order to put capital at risk of potential loss. 

I can’t end without a comment on the Fed and next week’s FOMC meeting where expectations for a ‘skip’ are getting baked in.  ‘Skip’ as in they don’t hike, retain a tightening bias with optionality to hike at the July meeting, but they don’t want to allow investors to get too confident in pricing in a prolonged ‘pause’.  I’m of the view that this tightening cycle is over where this ‘skip’ ultimately becomes a ‘pause’ and sets the stage for cuts before year-end.  The Fed will continue to talk tough as they always do while believing the economy is heading for a ‘soft landing’.  However, keep in mind that we’ve had 14 tightening cycles in the post-WWII era with only three ending with a ‘soft landing’.  Much of the time when the Fed shifts to a pause economic growth is still expanding and job growth is on the rise (90% of the time).  One unique characteristic of this cycle is that it’s highly likely the inflation peak is already in the rearview, whereas in the past, 70% of the time inflation peaks after the Fed hits the pause button.       

What this boils down to is that monetary policy at this juncture becomes more of an art than a science.  Incoming data becomes contradictory and cross currents aplenty, rendering it very difficult to have a clearcut view on incremental moves.  My read of recent comments by key members within the FOMC is that they’ve done enough (they wanted to get the fed funds rate to 5% and they’ve done that) and they are ready to step aside and assess the lags as they make their way through the system.  Keep in mind this is the most intense tightening cycle in four decades and it’s coming off a period where rates were nailed to the floor for nearly fourteen years. 

Oh, one more thing for you to marinate on as I fail miserably at keeping this missive short and sweet.  Too many investors fail to realize how good Wall St. is at marketing to individuals that are either too busy, too trusting, or flat out lack interest in trying to understand capital markets.  I say this because I’m sure everyone reading this at some point has come across some version of the notion that you can’t time the markets.  Or that you have to be in the markets at all times because if you miss the best days in the market your cumulative returns are drastically inferior to if you had stayed the course.  That assertion is accurate and backed up by the data, but they do shed light on just one side of the equation.  What if an investor managed to miss the worst days?  How do those numbers look?  Rarely do you see this part of the analysis.  Well, hat-tip to David Salem at Hedgeye, who ran the numbers in the below table which tell the whole story.  This isn’t a pitch for market timing, but it does argue that the payoff stream for some success is lucrative.

I’ll let the below table speak for itself.  Since 1926 the S&P 500 is up 226x (for context 2x would be a doubling, 3x a tripling, 4x a quadrupling and so on).  Miss the 10 best days and your return is only 75x.  Add back in the best 10 days, but sidestep the worst 10 days and your return is up 741x.  A very important detail to recognize in the data is that the 10 best days and 10 worst days in market history all occurred during bear markets.  Now you have the full analysis, thank you Mr. Salem. 


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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