Looking For Roses Among The Thorns
Equity markets put in a strong week with all the major averages gaining more than 1%, but other than the S&P 500 pushing back up against the top end of its trading range (4,200) not much was accomplished. The Nasdaq rallied more than 3% on the back of what looks like a gigantic AI bubble forming (more on this below) and small caps managed to muster up a rare bout of strength with the index gaining 2% on the week. Ongoing negotiations with the debt ceiling will continue to dominate the markets attention until a resolution is reached. The latest projections on the Treasury’s cash balance and incoming receipts make it a real close call on Yellen running out of money before the June 15th windfall. This puts added pressure on getting a deal done in the next week or so because no one wants to find out the implications of a default even if it’s only for a couple days.
I sure wish I had the same level of conviction many of the recent Fed speakers have on the economy remaining resilient and additional policy tightening being necessary. For instance, on the same day that the Conference Board’s Leading Economic Indicator (LEI) showed a thirteenth consecutive month of contraction, Dallas Fed President Logan stated that a case for a pause on interest rate policy in June “is not clear”. I’m with her on the lack of clarity, but what seems evident to me is that none of us know the lagged impact on the economy after 500 basis points of interest rate hikes and $95 billion in ongoing balance sheet contraction over the past fifteen months. And while we can’t know for sure, history provides a pretty clear picture that not once in the past seven decades has the year-over-year decline in the LEI fell below -8% and the U.S. economy not been in or about to slip into a recession.
Bloomberg Finance L.P.
It's not as if it’s just one indicator flagging rising recession risks, but rather a host of them have been popping up and intensifying over the past year. The inversion of the yield curve is another tried and true metric with perhaps the most reliable historical track record at forecasting a recession, but all I continue to hear is talking head after talking head dismissing its signal as not being applicable in this cycle. Instead, it’s the “this time is different” rationalization with the WSJ jumping on the bandwagon last week, Don't Swing At The Yield Curve – “often a reliable harbinger of past recessions, it now could be a reflection of flawed market assumptions.” They could be right, and this could very well end up being a false signal but understand that buying into this thesis is betting against the probabilities. Investors have been coming up with excuses to dispel the yield curve inversion signal going back to the 90’s and yet the fact remains that every single recession in the post-WWII era followed a Fed-induced yield curve inversion. Only on three occasions was a recession averted (mid-1960’s, mid-1980’s, and mid-1990’s) in the context of a Fed rate-hiking cycle and that was in large part because the Fed stopped hiking before inverting the curve. That’s not the case today.
The one missing piece to the recession thesis that the naysayers can ‘rightly’ point to, is the labor market. The labor market just hasn’t corroborated other recessionary signals and quite frankly until it does the recession thesis just doesn’t have much bite. However, we are seeing signs of cracking in the labor market from a broadening list of economic indicators. Job openings in the most recent JOLTS survey are now 2.4 million openings off their peak and at their lowest level in two years. It would be disingenuous to call that stat out without acknowledging that Job Openings at 9.6 million are still nearly 2.5 million above their pre-pandemic pace. However, it’s the change at the margin that is of interest to this economic observer and the pickup we’ve seen in jobless claims from around 200k at the start of the year to +240k since early-March. This is another sign of incremental weakness on the labor front.
Additionally, David Rosenberg brought to my attention the Kansas City Fed Labor market conditions index (based on 24 variables) in a piece he published last week. This index has contracted for six straight months with the April reading at the most negative level since June 2020.
Haver Analytics, Rosenberg Research
As I said, cracks, but that is all as of now. To summarize, the economic backdrop is bending but hasn’t broken. I lean in the direction that it will eventually break and based on our work, said break will occur in Q2 or Q3 this year, but this view is by no means assured. The depth, dispersion, and duration of the yield curve inversion suggests that a recession is inevitable. The most aggressive interest rate tightening cycle in four decades, M2 at its most negative year-over-year change since the 1930’s, the depth and duration of the decline in the LEI’s, and retrenchment in bank lending data all point to an upcoming window of vulnerability for the economy. Timing it is the challenge, but I do think we’re entering that window now. The most fascinating thing about this setup is that few asset classes from the S&P 500 to corporate credit to even Treasuries are priced for such an outcome. Now, this could mean that our analysis is completely off base relative to market pricing, but the yield on the 10-year Treasury Note at 3.66% is priced for 50/50 odds of a recession in our estimation. Parts of the equity market like commodities, cyclicals, small caps, and financials are priced 60 – 65% odds of a recession while the likes of Technology (led by seven dominate mega-cap industry monopolies) have barely flinched at the thought of an economic downturn impacting their businesses.
When you peel back the onion on the recent performance for the S&P 500 it’s been dominated by short-term momentum at the hands of big-Tech. Consider this, from January 1st through February 1st the S&P 500 was up a little over 7%. Then from February 2nd through May 19th the S&P 500 is flat (as in 0% return). Year-to-date the Top 10 largest stocks are up roughly 30% compared to the bottom 490 stocks generating a collective return of 0%. If you’re frustrated as an investor this year, this is why. If you missed the early-year rally or were underweight the largest stocks, this market has been much more difficult than advertised.
Tier1Alpha published some work last week attesting to the dichotomy in market internals. The number of S&P 500 components outperforming the index itself has fallen to a two-year low (teal line in chart) while tech dominance has driven the year-to-date performance. This is in stark contrast to the second half of last year where tech was lagging while the broader market remained relatively robust. In market regimes like the present, passive investors are able to benefit from market-cap weighted indexes like the S&P 500, although such a concentrated level of risk rarely ends on a positive note.
Tier1ALPHA.com
This brings me to a thought on the current AI craze causing investors to chase any company mentioning AI as if it were a meme stock. Nvidia is the poster child for this latest market euphoria as investors have pushed its shares to 28x sales. It is difficult to contextualize just how rich a valuation 28x sales is for a company. Especially one with a market cap of $780 billion. Below is an excerpt of a letter from Sun Microsystems CEO Scott McNealy in April 2002 after the popping of the Tech Bubble. This is the best example I can think of to provide useful perspective. Keep in mind, Sun Microsystems stock price went from $10/share at the start of 1999 to $65/share in late-2000 and round tripped back to below $10/share in 2002. Oracle would eventually acquire the company for $9.50/share in 2009, but here is what Scott had to say after investors bid up Sun Microsystems stock to more than 10x sales:
Having said all that you would think that an investment analyst like myself that leans bearish at the moment can find nothing to invest in other than cash, high quality credit, and gold. True, I like all those, and while I don’t find the S&P 500 trading at 4,200’sh with a very concentrated and feverish makeup all that interesting, there are some opportunities I find intriguing.
Near the top of the list are a few markets outside of the U.S. – Mexico, India, and Japan. All are beneficiaries of ongoing friend shoring and peak globalization brought about by the Sino-U.S. cold war. Both Mexico and India have the benefits of constructive demographics, strong debt-to-GDP profiles relative to the rest of the world, and labor forces that are very competitive for multinational corporations. The fact that the Mexican peso is one of the strongest currencies in the world this year (+11%) is a testament to capital flowing into the region to take advantage of the opportunity.
Keep in mind that when thinking about allocating capital outside the U.S. you always have to be mindful of where the U.S. dollar is trading and where it could go. Over the last several weeks the dollar has put in what I view to be a countertrend rally as it pushed above 103 and taken out to the upside its 50-day and 100-day trendlines. Before this move is over, we could see the dollar move up to the 105 – 106 level, but should it fail there (as is my suspicion) then the long-term dollar bear market cycle I’ve been waiting for could be underway. So, both commodities and foreign investments could face a stiff headwind at the hands of a rising U.S. dollar in the near-term, but if/when it reverses – a weaker dollar will add another leg to what is already a constructive long-term setup.
As for Japan, according to our work it is the market with the most compelling risk-adjusted return potential for the next twelve months. For starters, the Yen is cheap on a relative basis in part because of a still-easy Bank of Japan policy stance. Fiscal policy continues to be stimulative and equity valuations are attractive. These are only some of the reasons the Japanese Stock Index hit 33-year highs last week (yes, they are still handily below all-time highs, but you must start somewhere). Perhaps the most constructive aspect of Japanese equities is a push by the corporate sector to return cash to shareholders (nearly 50% of Japanese companies have net cash on their balance sheets versus just over 20% in the U.S.). Roughly 54% of the TOPIX members are trading below book value compared to 7% in the S&P 500 and on an absolute basis the price-to-book ratio in Japan is 1.3x compared to 4.0x in the U.S. and 1.8x in Europe. On valuation metrics alone this puts a firmer floor and higher ceiling on Japanese equities relative to other regions.
Additionally, investors remain under exposed to the improving fundamentals in Japanese equities with the latest BofA survey of global portfolio managers showing in May a net 11% underweight. That hasn’t curtailed Warren Buffett from carrying his largest equity exposure of any region in the world (outside of the U.S.) in Japanese equities. Japanese manufacturers have been retooling, optimizing, and robotizing their facilities for years to contend with deteriorating local demographics. As a result, they’ve made themselves into a low cost, highly efficient, and reliable partner for foreign investment around the world.
The other area of investment that has been climbing up the actionable list are parts of the commodity markets. Over the past several months base metals, oil, natural gas, and soft commodities have been hit hard. If a recession does play out in the U.S. I would expect commodities still have more downside, but that would present a very compelling opportunity for investors to build out the largest exposure their investment policy will allow in this space.
As illustrated in the below graphic, the value of the Goldman Sachs Commodity Index (GSCI) relative to the S&P 500 is at its lowest level in the past seven decades. This by itself isn’t enough of a reason to warrant a meaningful investment, after all this has been the case for the better part of the last decade.
Incrementum AG, Crescat Capital LLC, Tavi Costa, Bank of England
But given the lack of investment in resource extraction over the past ten years and the policy focus on a greener and more climate friendly energy strategy going forward, these industries are likely to remain capital starved until prices rise to a level that entices additional capex investment. This is a process we’re in the midst of observing playing out firsthand in the uranium market over the past five years (a place we’ve dedicated a lot of time, energy, and capital). Domestic uranium production in the U.S. in each of the last three years has been near the lowest level in history. Why? Because the current price of $53.50 per pound of uranium (while up nearly 200% since 2016) is too low for most uranium mining companies to breakeven on the cost of production. As a result, the price will continue to rise until the imbalance between supply and demand finds an equilibrium. Moreover, producers would rather sit on the pounds in the ground until a price level is reached that adequately incentivizes and compensates them for their production.
Energy Information Administration
This story is applicable for many other commodities (copper, lithium, rare earth minerals, and even oil) that will be in high demand in order to meet the policy goals mapped out by a more carbon friendly and greener energy strategy. Note, I’m not saying there is a shortage of commodities in the world, but rather a shortage of commodities at an uneconomically viable price of production.
Investing in these areas can be gut wrenching and at times make you question your sanity, but the payoffs from such opportunities are becoming very compelling. I would advocate not getting too impatient right-here-right-now with the elevated risk of an economic recession in front of us, but I would advocate starting to dip a toe and putting into place a plan to build out a position over the ensuing quarters.
In closing, I wouldn’t advise chasing the broad equity market at the 4,200 level. This price is reflective of a lot of things working out in a favorable fashion, i.e.) $220 EPS for the S&P 500, a 19x P/E multiple, nearly 200 bps in interest rate cuts from the Fed, and Washington not mucking anything up. Individually, anyone of these things can occur, but for them all to collectively occur is an ‘as good as it gets’ setup. “I know, I know – Corey we’re so tired of reading about the fundamental bear story. Look at Nvidia. Look at Microsoft. Look at Meta…don’t you get it because it was so obvious, they were going to do what they are doing this year after being detested last year. Right! Obvious.” What was I thinking.
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