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Thinking About Opportunities In A Dollar Bear Market

U.S. equities are mired in the tightest trading range in the past six years with the S&P gaining 0.82% last week, the Dow rising by 1.20%, and the Nasdaq Composite limping along with a 0.30% bump.  Yields rose on the week, which pressured bond prices across the credit and maturity spectrum lower.  Morgan Stanley’s Chief Strategist Mike Wilson put out a note this morning highlighting just how narrow the recent price action in the equity market has been.  His data shows that the share of S&P 500 stocks outperforming the index on a three-month rolling basis is at its lowest level going back to 2005.  This divergence is underlined by the fact that since February 2nd, the S&P 500 is down -1.0% while the equal-weight composite is down -6.6% (the RSI is flirting with 12-month lows). 

On Friday we got solid results from the big banks (JP Morgan, Wells Fargo, and Citi), but we already knew they were the beneficiaries of the SVB default and subsequent deposit flight out of smaller regional banks.  What is more interesting to my eye is that fact that you see little to no recovery in the stock prices of regional banks as they continue to languish at the lows.  At the close of last week, the regional bank index is down 35% from where they were in early February and down a massive 47% from their cycle high in early 2022. 

On the data front last week, we got a disappointing retail sales report where real retail sales are now down 2.0% year-over-year.  The industrial production print matched consensus expectations, but like retail sales, on an inflation adjusted basis it is down 1.1% year over year.  David Rosenberg pointed out that according to data back to 1968, only 0.3% of the time in the past has the economy managed to avert a recession when both metrics contracted on a year-over-year basis (that’s a 1 in 333 event).  The research staff at the Fed is on the same page as that data suggests, as it is now openly acknowledging the elevated probability of recession.  They stated such in last week’s release of the minutes from the March FOMC meeting where they forecasted a “mild recession” on the horizon.

The macro data over the past two weeks was not at all supportive for those residing in the “soft landing” camp.  Job openings slid to a two-year low and new hiring data is now weakening.  Challenger data is showing a marked acceleration in layoff announcements and deceleration in hiring announcements.  The story in the March jobs report was the weakness below the surface in the cyclical areas of the economy like banks, manufacturing, real estate, construction, and retailing.  While its well-known at this point that the manufacturing side of the economy in the U.S. is small (less than 15% of GDP), it punches well above its weight in terms of measuring economic turning points. 

I hear talking head after talking head on CNBC using the resilience in the stock market (“rolling recession” is the new catch phrase) as their rationale for a bullish stance.  I would submit that a half dozen Mega Cap companies lifting the overall market is masking the true reality.  No, that reality isn’t that everything is terrible, and a crash is coming.  Nor is it all puppy dogs and rainbows.  It’s stagnation at best and fragility at worst.  But in any case, it’s inconclusive at this moment.  A setup that more than anything requires a folding chair with a side of patience to sit back, wait, and watch.  Afterall, we’re talking about an S&P 500 that is at the same level it first reached two years ago.  Sure, two years of consolidation after the massive surge following the two-month Covid recession is an acceptable outcome for most investors, but it certainly isn’t being framed that way by the talking heads.  No, it’s more of the same where the rose-colored glasses crowd is making it a point to ignore the recession risk or look past it as if denying such an outcome will stop it from happening.

It brings to mind the “don’t fight the Fed” mantra that worked so well over the past fourteen years.  No doubt, that was the right strategy to succeed during that period, but yet here we are thirteen months into the most intense monetary tightening in the past four decades and “fighting the Fed’ is exactly what the bulls are doing today.  Take a minute to truly understand the context of the data in the below chart from Tier1Alpha where they plot the expansion (green bars) / contraction (orange bars) of the Federal Reserve Balance sheet against the NYSE index.  Notice what the NYSE index does during prolonged periods of balance sheet expansion (green bars) – it trends higher.  Conversely during sustained periods of balance sheet contraction (orange bars), notably in 2018 – 2019 and again starting in 2022 – the stock market trends lower.                 

T1 Alpha Sit-Rep: Monday,  April 17th

You see that large green bar on the far-right hand side of the chart, that represents March 2023.  Yeah, that was the nearly $350 billion liquidity injection to stave off a larger banking crisis last month, but that momentary spurt of liquidity is now being withdrawn.  That episode gave risk assets a boost, but as is clear with the entire history of this chart – when the liquidity tied is going out its difficult for risk assets to make any upward progress.   

I understand the psychological challenges investors face in balancing the FOMO (fear of missing out) when asset prices are rising versus the panic GMO (get me out) when asset prices are falling.  Add to this the career risk of those like myself that do this for a living in an attempt to keep up with benchmarks on a daily, weekly, quarterly, and/or yearly basis.  Long-term investing has gone the way of the dinosaur with everyone having instantaneous access to price quotes on their smart phone.  But I’m convinced that anyone with a longer-term view at the moment would easily come to the conclusion that now is not the time to be throwing caution to the wind while being loaded up on risk assets.  Economic growth is slowing and at risk of slipping into contraction.  Inflation is elevated but falling – that’s a good outcome for policy makers and consumers on the margin, but not so much for corporate profits.  Liquidity is being withdrawn.  We’re at the tail end of a historically aggressive Fed tightening campaign.  Not to mention, all of this is occurring into the teeth of a dysfunctional political backdrop with a debt ceiling showdown less than ninety days away.  Oh, don’t forget that the level of sovereign, corporate, and household debt in the global financial system has never been higher.   

Yeah, ignore the risks at your peril.  At this point of the cycle it’s not about catching the entirety of every move.  It’s about prudence, preservation, and living to fight another day.  The opportunity to make money will be there in the future.  You don’t have to force things in an environment as daunting as this one.  I say this as a professional that takes a lot of pride in analyzing what to do with other people’s capital, and admittedly even I find the present setup quite confusing.  Don’t forget that for the first time in over fifteen years investors can earn a 4 -5% yield on cash-like instruments.  You’re getting paid to be patient with equity valuations having moved up to what history suggests are rich levels – a 19x forward P/E multiple on the S&P 500.  Mega Cap Tech is closer to 28x, what a bargain! 

We’re two days into Q1 earnings season and because bank results were better than expected many investors are breathing a sigh of relief and extrapolating this through the rest of the results that have yet to be reported.  Keep in mind the history of peak-to-trough S&P 500 EPS declines during the last three recessions: -28% in the Tech Bubble from 2000-2002, -34% in the GFC 2008 – 2009, and -15% during Covid in 2020.  Compare this to analysts currently penciling in estimates for a -4% haircut ($224 to $216) for 2023 and then earnings shoot back up to $242 in 2024.  Could these estimates end up being correct, sure.  I’m pointing them out more so to make anyone reading this aware of where the crowd is.  Knowing that provides a reference point for mapping out different scenarios if these estimates end up being wrong.               

As for the Fed, we are now up to three Fed Presidents who are now openly commenting about pausing rate hikes – Goolsbee (Chicago), Harker (Philadelphia), and Mary Daly (San Francisco). Maybe we get another 25bps hike at the next Fed meeting on May 3rd, but its pretty clear that this tightening cycle is over.  Next comes the pause and then eventually the cuts will come.  BofA Merrill Lynch put out the following chart which I think is a good roadmap for investors to think about as this tightening cycle runs its course and the upcoming cutting cycle gets underway.  You don’t buy the pause or the first cut (although you typically get a rally following these announcements); it’s the last cut and peak in initial jobless claims that serve as signals to plug your nose, close your eyes, and buy.      

BofA Research Investment Committee

 On that note, it’s important to understand that the Fed’s estimate of the neutral funds rate is still 2.5%.  That means that when it comes time to ease, the Fed has a lot of room to cut just to eliminate the excessive restraint in place.  That level of cuts will definitely push the yield curve back into a positive slope and my guess is that it happens through a combination of short-rates coming down a lot and long-end yields falling as well, but not as much.  The yield curve is positively sloped 85% of the time and by a “mean” of 120 basis points between the 2’s and 10’s.  As a point of reference, during recessions the Fed typically drops the funds rate 200 basis points below neutral.  That would target around 1% on the 2-year yield and 2.25% - 2.50% on the 10-year T-bill.  Consider these levels as possible jumping off points for anyone holding Treasury bonds.  It’ll take time for this to playout, but I do think these are reasonable targets.   

I’m going to end with a couple thoughts on the upcoming debt ceiling showdown that’s going to garner more attention in the ensuing 60-90 days.  The Treasury General Account (TGA) balance is down to about $100 billion and depending on incoming tax receipts from 2022 tax returns, Secretary Yellen might exhaust her extraordinary measures earlier than expected.  Which would only pull forward the drop-dead date for Treasury running out of money (current estimates are for July 4th) and then rationing protocols take over.  While it’s a forgone conclusion that the debt ceiling will be inevitably raised it’s the drama and circus leading up to that compromise that is likely to stir some volatility in capital markets.  Already we are seeing the price of five-year credit default swaps (the most widely traded form of debt insurance) on U.S. Treasuries hit their highest level since the ratings downgrade in 2011.  Gold and the VIX were the best performing assets during the 2011 period, and I suspect that will also be the case this time. 

Charlie Bilello put out some great charts via twitter last week on the explosion in U.S. Federal spending over the past two decades – up 185% versus a 64% increase in overall inflation (CPI).  Doing the math, we’re talking about spending increasing at a pace of 5.5% per year, which is more than double the 2.5% increase in CPI.         

@charliebilello

Digging into the numbers shows that the bulging deficits are not the result of falling government revenues (taxes) as they have increased 204% over the past two decades (+5.7% per year).  It’s a spending problem, which to be fair, ballooned as a result of the stimulus provided during the GFC and COVID recessions.  But seeing the federal deficit clocking in at $1.8 trillion over the past 12 months with the unemployment rate at five decade lows and at the peak of an economic cycle is unsettling for the long-term viability of U.S. Treasuries as an investment (always subject to yields).    

@charliebilello

Then there are the complications higher interest rates create for both Uncle Sam in terms of interest expense and the Fed in its pursuit of its dual objectives (price stability and full employment).  Interest expense on U.S. public debt outstanding is at an all-time high of $812 trillion and rising – future interest rate hikes notwithstanding. 

@charliebilello

You can’t look at the U.S. debt data and not think about what this potentially means for the U.S. dollar.  For starters the U.S. dollar is the world’s reserve currency and will remain that way for the foreseeable future.  Any notion that it gets displaced is just a hyperbolic talking point.  Is it under threat and are other countries taking steps to hedge their reliance on U.S. dollars?  Yes, but that’s not a present day or even a present decade risk.  Something that is worth monitoring for investment purposes is whether we are on the cusp of a sustained dollar bear market cycle.  As the below chart from BofA shows, dollar bear markets do happen and when they occur, they typically last for about 6-7 years.  You have to go back to 2002 – 2011 for the last one.   

BofA Global Research

As I type the DXY dollar index is trading at 102.13, down almost 15% from its late-September peak, and a sustained fall below 100 would confirm for me that a dollar bear market cycle is underway.  Ultimately, I do think this ends up being the case, but I’m apprehensive about strongly positioning for such an outcome at this moment.  Reason being is that into the trough of a U.S. recession the dollar typically rallies as its viewed by investors as a safe haven and therefore a beneficiary of capital flows.  Whether that precedent plays out in this cycle is yet to be determined, but I do think investors should be thinking about how to position themselves for a weaker dollar period.  Assets you would want to be exposed to include: value stocks versus growth stocks, emerging markets, Japan, commodities, and precious metals. 

BofA Global Research


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. Corey Casilio is a founding partner of Casilio Leitch Investments, a legal business entity. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.


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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