Be Weary Of “Bad News” Becoming Bad News
Asset prices across the board ripped last week on the back of some soft economic data which provided the latest validation that the Fed is done with its hiking cycle. No guarantee’s that they are done, but it’s fair to say that the bar is now set pretty high for any additional rate hikes. Fed fund futures for a December rate hike cratered to 5% following Friday’s soft employment report (they were north of 20% on Thursday). Furthermore, markets now anticipate the Fed will cut rates for the first time as early as April with a total of four cuts priced in for 2024 (see table below). Keep in mind that the winds of change can at times blow briskly and at other times be just a subtle breeze. So don’t get too confident that the Fed is going to let go so quickly of the “higher for longer” guidance it expended a considerable amount of energy building up since they last hiked in July.
As for the markets, the S&P 500 ripped higher by nearly 6% last week as it notched its best weekly gain since November 2022. The Nasdaq gained 6.5% on the week and the Dow appreciated by 5.0%. The Russell 2000, which has been a major laggard over the last two years when compared to the larger cap weighted indices, was at the top of the weekly leader board with a gain of 7.6%. Before we get ahead of ourselves in thinking that risk assets are set to take off on their next leg higher, I think a bit of context is in order. It was only a little over two weeks ago when the S&P 500 started to slice below major technical levels. Sentiment proceeded to fall rather quickly where at the recent lows, Investors Intelligence bulls were down to 42.9%, the CNN Fear-Greed Index slipped in deep “Fear” at 18, the AAII polled showed a mere 24.3% in the bull camp, and investor positioning was being aggressively unwound. In a nutshell, we had a lot of the necessary ingredients to create a significant rally if/when a positive catalyst came along.
It’s no surprise that when Powell and weak data opened the ‘pause’ door a little further that investors jumped all over it. It’s typical market behavior for investors to bid up risk assets when the Fed goes on hold, just as risk assets rally on the first cut. And in the blink of an eye equities have gone from deeply oversold conditions to modestly overbought. A little bit of consolidation after last week’s run would be a good development to keep the seasonal rally in tack – too much at one time would just create a more challenging set up to risk manage on the other side.
But don’t lose sight of the other details in the historical data that show from the time when the Fed pauses to the ultimate low in the S&P 500 is a slide of 25%. The reason for risk asset price weakness is the same reason the Fed decided to pause and then ultimately cut rates – the economic data is weakening and a decline in earnings estimates is soon to follow. I’m not saying this cycle is going to play out identically to the averages of prior cycles (we all know this cycle is unique in and of itself), but there is a rhythm and a rhyme to business cycles and this one will be no different. Fundamental bear market lows typically don’t occur until the Fed is two-thirds of the way into its easing cycle, the 2s/10s yield curve has re-steepened to +140 basis points, and jobless claims start to fall from their cycle highs. None of these are even remotely close to happening just yet. Give it time, stay patient, keep an open mind, and remain flexible with your positioning.
From my perspective it’s the bond market that is acting as the tail wagging the stock market dog. On July 17th the BLS issued the June CPI inflation report which showed inflation falling to its lowest point of the cycle at 3.0% year-over-year. The yield on the 10-year T-note closed the day at 3.80%. From that point yields went on an upward tear, rising more than 100 basis points to 4.84% as of October 27th (they did break above 5.0% intra-day along the way). During that time the S&P endured a 10% correction. However, since October 27th the yield on the 10-year T-note has declined roughly -45 basis points (from the intra day high) and the S&P 500 has rebounded nearly 6%. The recent slide in interest rates is the largest decline since the regional banking crisis in March. Look, its never just one thing when it comes to investing, but it’s the cost of money (interest rates) that have been and will be the most important macro factor to get right for the foreseeable future. At a minimum, stocks need stability in yields (jumping around 50 basis points a week like a yoyo is insane) and they likely need lower yields to make a run at new highs. However, this could be one of those moments where lower yields could be a bad thing in that they are moving lower because the economy is giving way.
As for last week’s data, the headline print of +150k jobs created in the October employment report was nice and yet again here is another report where both bulls and bears can find something they like. Where our work shows we are in the cycle and equities priced more for a ‘soft landing’ than a ‘hard landing’ I’m viewing all incoming data with more of a skeptical lens. If assets were priced for a hard landing, I’d be more focused on looking for light at the end of the tunnel. Nevertheless, what was fairly clear to my lens in last week’s jobs report was the ongoing downtrend in job growth which started back in the summer of 2022 – falling from the mid-300k range to the mid-100k range. Below is a chart from Eric Basmajian at EPB Research confirming as much.
Beyond the headline print the details of the report reflected a considerable weakening in the labor market. There were 101k in downward revisions to prior reports, +127k of the +150k headline print came from the Birth-Death model, and the -0.3% drop in the workweek is equivalent to a decline of 300k jobs. The Household survey showed a decline of -348k jobs with people working part-time for economic reasons and the number of multiple job holders each surging, +218k and +205k respectively. One of the most comprehensive data points in a monthly jobs report is the aggregate hours worked index because it represents total labor input into the economy and that metric declined -0.3% (an occurrence that happens merely 10% of the time). The U3 unemployment rate rose to 3.9% and is now up 0.5% from cycle lows – a level that historically triggers a recession watch signal to investors. One positive in the report (at least from a Fed policy perspective) was the modest rise in wage growth at +0.2% month-over-month. The year-over-year trend is down to +4.1% while the three-month pace is down to a +3.2% annual rate. Should provide some solace to Fed members that the slack in the labor market is helping to curb wage growth.
Last week’s initial jobless claims readings also showed a subtle weakening in the labor market with initial claims rising for the second consecutive week – from 200k on October 14th to 212k on October 21st to 217k on October 28th. Still low for sure as a count of 217k is hardly an employment crisis, but the trend is heading in the wrong direction for the macro bulls. If/when this number starts to approach and breach 300k then we’ll have something to worry about. Until then it’s a trend worth watching to see if further fraying on the edges continues. The other data point in this report is continuing claims which have risen for six consecutive weeks, and by 35k in the week of October 21st, to 1.818 million. This is the highest level of continuing claims since April 15th and suggests that it is becoming increasingly difficult to secure another job once an individual is out of work.
Bottomline, none of the labor market data at this point is setting off alarm bells at current levels, but the trends are a cautionary signal that mandate close scrutiny with each subsequent report over the near-term. I’ve said it before, and I’ll say it again. Given the growth and evolution of passive participation in markets which has come to dominate/explain most of the price movement in markets on any given day it has created this codependent relationship between the labor market and asset prices. Most investors way of participating in markets is through there employer sponsored retirement plan and the only way to have an employee sponsored retirement plan is to have a job. This is why I think the labor market is the most important economic data point to watch as it relates to equity prices. This isn’t a new revelation as the strength of any economy is dependent on a vibrant and expanding labor market. But today this relationship is more important than it ever was.
In particular for the “Magnificent Seven” as they now command roughly 25% of the weighting of the S&P 500. Exclude the performance of these seven companies from the S&P 500 this year and the year-to-date return goes from +13% to 0%. Remove the mindless flow of capital into passive index participation via employer sponsored retirement plan contributions and it’s going to be a lot harder keeping this group of seven companies trading at a P/E multiple of 41x. For crying out load Microsoft and Apple alone make up 14% of the S&P 500 and Apple hasn’t delivered positive year-over-year earnings growth for four consecutive quarters. So much for diversifying through an index fund.
All I’m getting at is that if/when the labor market starts to breakdown in a more material fashion, it likely will represent a considerable headwind to equity market upside as the flow dynamics will change meaningfully. Now take that line of thinking a step further down the path and imagine outright selling by individuals who have lost their jobs and need money to pay their bills. Easy Corey, you’re getting ahead of yourself with this hypothetical (that’s all it is) – I agree, but there is no harm in thinking through scenarios that are plausible.
Another key economic data point reported last week was the ISM manufacturing PMI which dropped to 46.7 in October, from a 10-month peak of 48 in September. This was a steeper decline than the anticipated 49, marking the 11th successive month of contraction in the US manufacturing realm. This downturn highlights the ripple effects of the Federal Reserve's increased borrowing rates, further testing the mettle of US goods producers based on other indicators. The contraction in new orders intensified (45.5 versus 49.2 in September), indicating the 14th consecutive decrease. Panelists attributed this to diminished demand from both domestic and international markets. As a result, production decelerated (50.4 vs 52.5), almost reaching a standstill, given the marked drop in backlog orders (42.2 vs 42.4) which countered the reduced demand for new items.
The weakness in the manufacturing sector is not solely a U.S. issue. The German Manufacturing PMI came in at 40.8 (it’s 16th consecutive month of contraction), the French PMI is in its 10th month of contraction at 42.8, and China’s manufacturing PMI remains mired in a slump at 49.5. One troubling detail of the U.S. ISM is that it showed the grand total of 11% of industries (2 out of 18) posted any growth in October – the same depressed level as in the spring of 2020 and the fall of 2008.
Look, I’ve become less interested and even less impressed with headline grabbing market calls or predictions as my time in this profession clicks along. I don’t know what will happen in markets tomorrow, next week, next month, or next year any better than the next guy/girl. However, I do think of myself as becoming fairly proficient at risk managing the range of possibilities and reorienting capital prudently throughout the progression of a business cycle. That being said, I do not see the current set up as one that is favorable for being over exposed to risk. Sure, you could catch a good run, like the one that started last week, and it could carry into year-end (that was how we had capital leaning at the start of last week). But don’t be fooled by these little rallies into thinking that there was a sustainable fundamental improvement that drove last week’s whippy rally. The data got worse, period. It’s not crashing and I’m not clamoring that a crash or a crisis is just around the corner. But the data is weakening enough that the Fed is and should be pausing. There is a signal in that. Moreover, if/when the Fed starts cutting rates to ease policy in an effort to stimulate the economy it is important that you understand they will be doing it at a time of weakness, not strength. So, don’t get overly excited about these wiggles along what is a lengthy progression through the most challenging segment of a business cycle.
At this moment I still don’t know whether we’ll get a ‘soft landing’ or a ‘hard landing’. The data continues to have me leaning in the camp of the latter and the margin of safety in equities with the S&P 500 at just below 4,400 is not favorable enough where I think the pain of being wrong will be acceptable. On the other hand, I think bonds offer a very favorable margin of safety to the risk of a further rise in interest rates while also having the kicker of meaningful upside should the business cycle progress like I suspect.
In closing let me try and synthesize my thoughts on a very complicated analysis with a lot of moving pieces. Where a change in any number of variables has ripples through the entirety of the analysis. But here goes. I don’t think the Fed can relent on its path until it sees meaningful weakness in the labor market. We’re not there yet – at the margin we’re seeing the labor market weaken, but it’s not yet material. Furthermore, I don’t think we see meaningful weakness in the labor market until stock prices are considerably lower. Last week we were getting closer, but executives don’t implement large layoffs when their stock prices are within 10-15% of all-time highs. A fall of 20 – 30% and you’re in the ballpark. So, without lower stock prices yields will remain ‘higher for longer’ and draw out this contractionary stage of the business cycle even longer. Given how financialized the U.S. economy is, the stock market has become the economy. Therefore, the Fed is going to have to break stocks one way or the other to achieve its objective. I don’t have a problem being wrong on this view – I’ll manage client capital through it no matter what twists or turns it takes, but that’s how I’m thinking about things.
On this note, I don’t think we’re going to have to wait too much longer to find out. I think in the next six months we’ll know. The Conference Boards Leading Economic Indicator Index has fallen for 18 consecutive months, the monetary aggregates are contracting (M1 -10.4% YoY and M2 -3.6% YoY), the unemployment rate is up 0.5% from its trough where a couple more months of deterioration will trigger the Sahm rule (100% accuracy in predicting a recession), and the Fed just completed the most aggressive tightening policy in the last four decades. Not to mention QT is still chugging along in the background. Sorry for rolling out the bear parade, but what I saw in last week’s data made me more cautious, not less – even more so with equities rallying 6%.
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