Summer Chop
Odds-making and probability analysis have taken over capital market functioning:
With President Biden stepping aside, who will be the candidate to emerge and face down Trump at the ballot box in November?
How will he or she and the unknowns they bring stack up against a known candidate like Trump?
Watch what they do, not what they say – how much of the campaign platform from either candidate will be enacted?
How will foreign leaders and policy react/adjust to the November election outcome? The rest of the world tends to take their cue from the U.S., but don’t confuse that with ineptitude or a lack of incentive to adapt.
When will the Fed hike, and at what pace?
Is the ongoing slowing in economic growth troughing, or is the deceleration set to continue and, therefore, create a serious threat of recession in late 2024 / 2025?
Can the passive bid, increased concentration, and unrelenting dominance of Mega-Cap Tech continue to carry the equity market at the expense of everyone else?
This is just a short list of what markets are attempting to handicap and price today. Such pricing will continuously shift over the next several months, so we find ourselves in a perpetual state of chop from now through the November election. There are just too many unknowns for uncertainty levels not to be on the rise. And we all know the one thing markets struggle with more than anything is uncertainty.
As for equity markets, they largely struggled last week at the hands of the Mag7, finishing the week with a -5% loss (Nvidia was the biggest decliner -8.75%). The S&P 500 index experienced a rare weekly slide (-2%), the Nasdaq tumbled -3.65%, and the Dow managed to eke out a gain of +0.72%. The rotation that started following the June CPI report into small caps lost steam as we closed out the week, but that didn’t stop the Russell 2000 from gaining +1.74% on the week (it was up as much as +5% on the week into Wednesday’s high).
With the increasing odds of Trump regaining the White House and a GOP sweep, investors have revived the narrative of a ‘Trump trade’ and what it means for markets. The WSJ published a piece over the weekend, “The Trump Trade is Back. But Did It Ever Work?” the flies in the face of public perception:
“It is doubtful that the Trump trade worked out for investors the first time around. The tax cuts did goose the stock market in 2018, but most net income gains accrued to the biggest companies, with the tech sector among the top beneficiaries.
The Russell 2000’s outperformance in the month after the 2016 election Despite a brief revival in 2018, small-caps performed badly under Trump’s four-year watch. Industrials, energy and banks all fared worse than the S& P 500, whereas the dollar and Treasury yields ended up lower. In the end, the best Trump trade was, yes, tech.
The lesson here is that making money from elections is hard, not least because secular forces often override political agendas. Savvy investors may be able to ride the coattails of what has become a well-known Trump trade, but a trade and a strategy are different things.”
I couldn’t agree more with the last sentence: “a trade and a strategy are different things.” Today's backdrop compared to when Trump was first elected in 2016 is drastically different; back then, US ISM and global PMIs were around 60, China's GDP was near 7%, and the Fed Funds rate was a lowly 1.25%. Compared to today, US ISM is sub-50, global PMIs are around 50, China's GDP is under +5.0%, and the Fed Funds rate is 5.375%. In November 2016, the federal deficit was running at 3% year-over-year compared to almost 7% at present, and the debt-to-GDP ratio was 86% compared to over 110% now. It raises the question of how effective more fiscal stimulus will be if we get it.
As for the capital markets, valuations across the spectrum are far more stretched today versus then: forward P/E 22x today vs. 17x then, P/B 4.77 today vs. 2.94x then, dividend yield 1.3% today vs. 2.0% then, P/S is 2.88x vs. 1.95x then, and over the past twelve months the S&P 500 is up +25% vs. +4% then. Oh, did I mention that growth crushed value by more than 70 percentage points, and large caps beat small caps by more than 20% - so much for that narrative. As for interest rates, the yield on the 10-year T-note was 2.1% back in November 2016 and is double that today at 4.2%. Not to mention real yields were a meaningful tailwind back then at +0.3% versus +2.1% today.
I guess what I’m trying to illustrate is that while we can try analyze the policy mix that might be legislated we must do so within the context of a drastically different setup; valuations far more stretched, fiscal policy facing diminishing marginal returns, and economic momentum decelerating.
TD Securities published the below checklist today which I think is a thorough overview of the key variables to watch and the potential impacts depending on election outcomes:
As for what’s ahead, its all about earnings with nearly 25% of the S&P 500 set to report this week (highlighted by Alphabet, Tesla, Visa, General Electric, Thermo Fisher Scientific, Union Pacific, Honeywell, Raytheon…) and another 35% next week. Expectations are sky-high at +9.7%, double the trend in nominal GDP growth. Not to mention how skewed Q2 earnings will remain towards Mega-Cap Tech, Goldman Sachs Chief Equity Strategist David Kostin highlighted this in his weekend note:
"AMZN, GOOGL, META, MSFT, and NVDA are collectively expected to grow 2024 profits by 37% compared with 5% for the median S&P 500 stock. But we have previously noted that consensus estimates of sales growth for the five stocks is forecast to slow from 22% year/year in 1Q 2024 to 17% in 2Q, and further decelerate to 16% in 3Q and 14% in 4Q. NVDA sales growth is expected to slow from 262% year/year in 1Q to 111% in 2Q, 73% in 3Q, and 56% in 4Q. In contrast, sales growth for the median S&P 500 stock will be accelerating, albeit from a slower pace (year/year growth of 2%, 3%, 4% and 5%)."
It will be interesting to see if these companies can deliver and how investors treat the results. What I’m most intrigued about is that Q2 is expected to be the first quarter since the end of 2022 where the ‘other 493’ companies that make up the S&P 500 will deliver positive earnings growth.
Let me summarize my thoughts and how I’m thinking about the current setup. First off, I can eliminate the extremes of both the bull case and bear case – anything is possible, but I think the risk of recession starting to get priced in 90-120 days out is just as unlikely as a 15-20% rip to the upside. Keep in mind the time frame for which I’m thinking about this is into election night. Post-election, we all will be forced to reassess once the outcomes are known. But in the meantime, I expect the equity market to meander within 5-7% up or down from the 5,500 level the S&P 500 currently trades at.
I think the bond market is in a similar position where interest rates have come down to account for slowing growth (but not too sluggish to raise concerns of contraction) and falling inflation. All of which feeds into the Fed's evolving policy view that rate cuts are warranted starting in September (July would be a surprise to the market, but I think the Fed would be justifiable if they cut next week). Three to four cuts over the next twelve months are currently priced into the futures curve, and any further repricing will be predicated on incoming data. Industrial commodities (copper, aluminum, iron ore, and oil) have been sluggish and do not act like global economic growth is set to take off. Gold acts independently of other commodities, as it should, given that it is viewed globally more as a currency than an actual commodity.
In a nutshell, I think most markets will be range-bound (low ceiling and high floor) through the election or until an unexpected catalyst emerges that shocks us out of the summer chop we’ve slipped into. The directional trend has me leaning more toward the bullish camp than the bearish camp. Still, I think a well-balanced portfolio, bar-belled by high-quality equities on one side and short-duration Treasuries on the other with a decent weighting in gold, should have you in a good position no matter what transpires in the near term.
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