So Far, A Healthy Correction
In the first six months of the year, it was all about Mega-cap Tech, while almost everything else in the stock market languished in its wake. However, a shift has taken shape in market character since the June CPI report was reported on July 11th, in addition to more dovish musings out of the Fed and incoming economic data confirming that a recession remains somewhere out on the horizon (but not now). Over the past three weeks, the Russell 2000 (small cap index) has surged +10% while the Nasdaq 100 has plunged -8%. For the month, the Russell 1000 Value index is up more than +4%, while the Russell 1000 Growth Index is down nearly -3%, the Russell 2000 is up +10% while the S&P 500 is flat, and coming into the month, the Russell 2000 was barely up +1% on the year, and yet here we are with three trading days left in July and the small-cap index is up +11.5% year-to-date – just 3 percentage points behind the S&P 500.
Where we are in this summer correction is still yet to be determined, but dip buyers stepped in to close out last week. The buying was insufficient to stop the S&P 500 and Nasdaq from registering weekly declines of -0.8% and -2.6%. At the same time, the Dow, with its more industrial, financial, and healthcare-focused constituents, gained +0.8%. The breathtaking rally in small caps has taken many investors by surprise, and I continue to question the sustainability of this move – seeing it more as just a major trade unwind (short small caps vs. long tech) by long/short managers and hedge funds. After all, these are rather financially unsound companies we’re talking about with highly leveraged balance sheets; roughly a third of them don’t even turn a profit, and those that are profitable have net free cash flow margins substantially below the companies that make up the S&P 500. Keep in mind the P/E multiple for the Russell 2000 at 15.5x now slightly exceeds the long-run norm of 15.2x – so it's not as though this group is cheap relative to its historical metrics.
I want to comment on one other aspect of last week’s price action, in particular, what we saw on Wednesday. Last Wednesday was some of the worst downside price activity we’ve seen in the equity market in quite some time:
Biggest one-day loss (-3.6%) for the Nasdaq since October 7th, 2022
Biggest one-day loss (-2.3%) for the S&P 500 since December 15th, 2022
First down day of -2% or more in the S&P 500 since February 21, 2023 (longest streak since 2007)
Biggest one-day loss (-5.9%) for the Magnificent 7 since September 13th, 2022
The Magnificent Seven flashed a -10% technical correction (intraday)
The NYSE composite lost -1.1% and had dropped in five of the past six sessions
Even the mighty Russell 2000 succumbed to a -2.1% drubbing
Biggest one-day advance in the VIX (+3.5 pts) since March 9th, 2023
Yet, with all the ugliness playing out in the equity market, U.S. treasuries also sold off in tandem, with the long bond down more than 1%. This was another illustration of the change in correlation between stocks and bonds – from inversely correlated since the turn of the century to positively correlated in the aftermath of the aggressive policy enacted to resurrect the economy from the pandemic shutdown in 2020/2021 (see chart below). The last three years have neutered the theory that diversification via stocks and bonds would bring stability to a portfolio. In actuality, they have tended to trade in the same direction, and in particular, during sell-offs in the equity market, long-duration bond holdings have exacerbated the downside of a portfolio by declining as well.
As you can see from the Merrill Lynch chart on rolling 24-month correlations between stocks and bonds, this relationship has and can shift over time, but the last two decades were a stark contrast to the three decades from the late 1960s through the late 1990s. If this positive correlation backdrop persists it requires a rethink for investors and necessitates a change in strategy/risk management for portfolios.
It's a jam-packed week of data, earnings, and policy in front of us – one I’m sure will prove pivotal in setting the tone for the rest of the summer. On Tuesday, we get the JOLTS and Conference Boards’ consumer confidence data for July, ADP for July on Wednesday, along with the second-quarter Employment Cost Index, and, of course, the Fed meeting. ISM manufacturing PMI for July headlines Thursday's data along with Q2 unit labor costs, and we round out the week with the July employment report on Friday morning.
Alan Blinder penned an op-ed in today’s WSJ, joining the chorus of other prominent economists (El Erian & Dudley) arguing the Fed should get started with its rate-cutting cycle at the conclusion of Wednesday’s meeting. It’s unlikely they will, but the overriding argument made by the ‘cut now’ crowd is the restrictiveness of current policy settings. Using the 1-year inflation swap, real rates are at cycle highs of 3.4% (see chart below), which is incongruent with disinflation firmly established, the labor market in better balance, and economic growth downshifting.
All major definitions of the Taylor Rule suggest the Fed funds rate should be closer to 4.0% than 5.375% right now. Why jeopardize trying to achieve the ever-illusive soft landing when such a possibility is within grasp? I’m not saying it will work, and let’s be honest, a 25-basis point cut doesn’t really move the needle, but it does recalibrate expectations and puts the accommodative policy-setting chain of events into action.
As for the stock market, it continues to chop sideways in its quest to properly price the cornucopia of unknowns coming down the pipe over the next three months. On the economic front, it has become extremely challenging to gauge the health of the labor market accurately. The unemployment rate has quietly crept up to 4.1%, where a rise to 4.2% in Friday's job report would trigger a Sahm Rule recession signal (0.5% rise from the lowest point over the last twelve months). However, if one were just focused on the monthly headline prints, you would conclude the labor market is chugging along just fine. But a deeper dive into less visibly reported data tells a different story.
The Business Employment Dynamics data (BED) were released last week for Q4 (this report covers 9.1 million establishments, is taken from the Census, and is viewed to be far more inclusive than nonfarm payrolls). The BED data showed that there was a net +344k increase in private sector employment in 2023Q4 – however, the monthly reported NFP reports estimated that there was a +451k increase in private employment in 2023Q4 (an overestimation by more than +100k). Employment gains from the birth-death of businesses (gross job gains at opening establishments, compared to gross job losses at closing establishments) were +114k according to BED data. But the birth-death model that factored into NFP was at +346K – more than +200k jobs overestimated by this model.
Here’s the real kicker: when you take Q3 and Q4 together, the BED numbers show that there was only +152k net private-sector job creation in the second half of 2023. However, the massive distortion from the Birth-Death model in the Establishment Survey gave the nonfarm payroll report this false glow of a +972k surge. That is more than an +820k overstatement from the one report that the market trades most heavily on – yeah, who cares about the details in this era of 24-hour news cycles, instantaneous access to information, and individuals having the attention spans of a gnat. To be clear, the employment gain from the birth-death of businesses between July and December 2023 was +95k, according to the BED data. However, the birth-death model that factored into the NFP report was at +666K for the comparable period – more than +571k jobs were overestimated by the model deployed in the nonfarm data: lies, damned lies, and statistics.
Well, since I’ve already started down this rabbit hole, I might also hit on one more thing in the interest of being thorough. In the last few weeks, we got the state employment numbers for June, which showed that 30 states have now seen their unemployment rates rise +0.5% or more from the cycle low. Let me take you on a jaunt down memory lane to show you what the historical data suggests about this data. Prior to the GFC recession that started in December 2007, 35 states registered a rise of 0.5% in their unemployment rates. In the recession before that, which started in March 2001, it was 16 states; in July 1990, it was 25 states before that recession kicked off. On a Sam Rule basis, which is a little more restrictive in its calculation, we were at 12 in December 2007, 13 in March 2001, and 7 in 1990, compared to 12 states triggering that mark currently.
So what, Corey? You’ve repeatedly penned that history rhymes but does not repeat and that each cycle has its nuances. That is true, and that is why if history predicted the future, librarians would likely be some of the best investors ever—but I’m not familiar with many investment books written about them. My point is that there is enough evidence coming through the data that argues for some caution in allocating your capital at this time. We’re deep into a Fed tightening cycle that has meaningfully impacted areas sensitive to interest rates, the direction of fiscal policy is in flux until we get through the election, and the labor market is showing some cracks. The bottom line is that sacrificing some upside return to minimize downside risk is not a bad decision. In my opinion, it’s a tradeoff worth taking and can be done without regret.
The elephant in the room remains what is happening in the commodity markets. Typically, a trade into value, cyclical, and small-cap stocks coincides with a positive thrust in commodity prices. Since the middle of May, CRB metals have declined more than -10%; the same goes for CRB textiles, which are off by over -10% from the nearby high. Agricultural prices have fallen -15% in just the past two months. Oil prices fell nearly -4% last week and are down in each of the past three weeks. The commodity markets, along with the fact that the 10-year Treasury note yield trades nearly -120 basis points below the Fed’s policy rate, are recession signposts even though the recession is only showing up in a handful of economic reports. These really are interesting times.
The last thing I’ll mention is earnings, which are coming in above consensus estimates by 3% in aggregate. This week is the biggest reporting week of Q2, with 167 companies set to report and four of the Mega-Cap Tech contingent hitting the tape (MSFT on Tuesday, META on Wednesday, and APPL and AMZN on Thursday). But the myriad economic numbers, the policy meetings in the U.S. and abroad, and the slate of crucial earnings releases strongly suggest that we will be in store for another hugely volatile week. Keep in mind one of the sharpest moves these past two weeks has been in the VIX, which has surged more than +30%.
Along with everything else mentioned above, remember the calendar: August and September are historically the worst-performing months of the year for the S&P 500. More volatility could be ahead. There is a lot riding on the bond market, too, because futures are priced with near certainty at this point for a Fed rate cut at the September meeting—and a total of -66 basis points of relief by year-end. This, in turn, makes this Friday’s jobs data critical for the Treasury market to sustain its rally.
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