Two Sides To A Story
What a move we had in asset prices following last week’s Fed meeting (more on this below). The Russell 2000 small cap index stole the show ripping higher by 5.55% on the week and is now up more than 22% since the October 27th low. The Dow rallied +2.9%, the Nasdaq Composite gained +2.85%, and the S&P 500 rose by +2.5% (seven straight weeks of gains which is the longest stretch in four years). As a result, the Dow set a new all-time high with the S&P 500 and Nasdaq within a whisker of doing the same – goodbye 2022 downdraft, we hardly knew ya.
Before we all get too carried away as we wade back into investor’s favorite pastime of watching ‘number go up’, we need to acknowledge that things are getting a little stretched of late. Complacency is bound to set in with the VIX hoovering around the 12 level and the P/E multiple on the S&P 500 pushing back up near 20x. Not to mention sentiment measures that have moved emphatically back into the bull camp:
As of last Thursday, a whopping 49% of the SPX is overbought based on 14D RSIs. Cracking 50% has only happened one time going back to 1990, so this is about as rare a market move as it gets.
Investors Intelligence poll shows 55.6% of respondents bullish vs. bears all the way down to 19.4%
AAII poll of retail investors has the bullish contingent up to 51.3% (near April 2021 highs) and the bear share getting quite lonely down at 19.3% (lowest since January 2018). See below chart of prior spikes in the bull/bear spread (orange) versus the S&P 500 (pink)
The CNN Fear-Greed index has tipped in ‘extreme greed’ territory at 77 versus 67 a week ago and 58 a month ago.
Beyond sentiment we are seeing positioning metrics showing investors are tripping over themselves to add to their equity exposure. Inflows into equities registered their largest weekly inflow of the year last week (the SPY ETF that tracks the S&P 500 saw the highest weekly inflow going back to the turn of the century).
Meanwhile, analysts tracking CTA flows, show trend followers are now at max long equity exposure, so very little buying support coming down the pike from this crowd.
In a nutshell, risk assets and equities in particular have made quite a move over the past seven weeks and at a minimum are in need of a breather if not a little bit of giveback in the near term. With year-end right around the corner, the Santa Claus rally window a little over a week away, and a lot of investors forced to chase performance, I’m not sure we’ll get a breather, but fear if we don’t, that we’re due for a hangover come the second half of January. Consider that we have not seen a 1% pullback in the S&P 500 in nearly two months and according to Bloomberg, Wednesday’ reaction to the Fed’s pivot was the best financial market rally (inclusive of equities, commodities, and fixed income) on any Fed meeting day since 2009.
One last thought I’d like to share on the near-term outlook is that while the move in equities looks stretched to the upside at the moment, the broadening out of this rally as viewed through the breakout in new 52-week highs is not a bearish signal for stocks to continue to move higher beyond this rally. Sure, I may be wired with a cautionary bias and still retain doubts on the economic ‘soft landing’ outcome, but I’ve learned through experience to not ignore what Mr. Market is telling you – and this message is not a bearish one.
As for last week’s Fed meeting, the FOMC kept the fed funds rate unchanged at 5.25% - 5.50% and strongly hinted that this hiking cycle is over. The real fireworks occurred at Chair Powell’s post-meeting press conference where he gave markets the impression that the committee is starting to consider the timing of rate cuts in 2024. Keep in mind these comments were made with the typical caveats of “data dependence” and monitoring progress on “achieving policy objectives”, but by in large it was delivered with a ‘mission accomplished’ undertone. The concern among investors going into the meeting was by how much would the committee try and push back against the dramatic loosening in financial conditions since late-October (see chart below from Kevin Muir at the MacroTourist). One of the main catalysts for the raging rally in stocks and bonds over the past seven weeks has been the markets pricing in not only the end of the rate hiking cycle, but the start of a rate cutting cycle.
But Powell and the brass at the Fed chose to steer clear of pushing back against market expectations of cuts starting as early as March. Time will tell whether markets must reprice for what is know nearly six rate cuts in 2024, but for the time being this is where we are. Without question there will be some jostling around with any surprise in incoming data (in particular if its better than expected as that would push rate cuts further out the calendar or eliminate them completely).
I found it interesting that a day before the Fed policy meeting, Treasury Secretary Janet Yellen made the following comments in regard to Fed policy and inflation at a Wall Street Journal CEO summit:
“It’s certainly meaningfully coming down. And I see no reason, on the path that we’re currently on, why inflation shouldn’t gradually decline to levels that are consistent with the Fed’s mandate and targets.”
“I personally don’t see any good reason to think that the last mile is going to be especially difficult.”
“Of course, as inflation comes down, other things equal, real interest rates tend to rise, which causes a tightening of monetary policy in a sense. So that’s one factor that could weigh in a decision that the Fed makes about the path of interest rates.”
Look, think what you will about Janet Yellen but her acumen in economics, the labor market, and policy is up there with the smartest in the world (former Fed chair and 18 years of her career were at the Fed). For her to say something like this as Treasury Secretary makes you wonder just how hard the administration is leaning on the Fed given Biden’s low approval rating going into an election year. I know, “stay out of the conspiracy gutter” Corey, but then I’d never be able to have any fun with my daily grind of mental gymnastics.
Looking ahead, given that we now know the peak of this rate hiking cycle is behind us the focus for markets in 2024 is skewed towards the impact higher rates will have on growth and labor markets, not necessarily inflation. That said, the past two years have shown that inflation can come down even with tight labor markets and above trend growth, and should that dynamic continue into next year, a less restrictive monetary policy stance should allow for a soft landing in the U.S. economy.
Irrespective of how much or how little an impact monetary policy has had on this post-Covid cycle it is time for the Fed to step aside and monitor how things progress. This is a view that was summarized well on X by former Fed economists Claudia Sahm who has been pretty spot on in calling the ebbs and flows of the economy following the 2020 pandemic trough. Moreover, I’m inclined to think that this is probably the right take:
But before we all get overcome with glee as the holiday season rolls in, it would be professionally irresponsible not to consider the other side of the story to the ‘no landing’ / ‘soft landing’ nirvana being priced into markets. On the other end of the spectrum is the ‘hard landing’ scenario that markets are assigning a very low probability to at the moment. However, in the interest of intellectual curiosity and professional prudence let’s ponder such a possibility.
One could make the argument that the Fed intentionally chose not to push back on the aggressive rate cutting cycle markets are pricing in for next year because it sees troubles ahead. Perhaps the Fed is looking beyond the incoming data and focusing much more on what it’s hearing from the business contacts within its respective Fed districts. In the most recent Fed Beige book, nearly 70% of the country (as tabulated by Fed districts) reported that activity is either flatlining or contracting and not one district reported that activity was accelerating. This is a higher share than we saw leading up to the recessions in 2001 and 2008.
Beyond the Beige Book, the Fed is well aware of its inability to quantify the ‘long and variable’ lags of monetary policy, but understands history is littered with examples illustrating its existence. Therefore, when the Fed sees monetary aggregates like M2 contracting, bank lending standards tightening, and excess savings levels depleting it knows that demand is being curtailed. Furthermore, we have an ISM manufacturing index that has been in contraction for thirteen consecutive months, a yield curve inverted (2s/10s) for nearly 17 straight months, LEI’s contracting for nineteen consecutive months, and parts of Europe already in recession while Chinese economic growth is a shadow of its former self.
As for market pricing, let me reiterate that historical analogs are a road map of the past and not a predictor of the future, but they are useful in contextualizing how investors and policymakers reacted to similar setups in the past. Historically Fed pauses last on average 10 months (period between last hike and first cut) and always is accompanied by a rally in both stocks and bonds. That’s exactly what we are seeing right now. However, it’s the next phase of this policy pivot where things get more interesting (divergent). Typically, what comes next is Fed cuts and in this stage of the cycle the stock market and bond yields (bond prices move opposite of yields) end up going down in tandem if an economic ‘hard landing’ (recession) is underway. It’s not until about two-thirds of the way through the recession that yields, and stock prices bottom in anticipation of the oncoming expansion.
And it’s typically yields that lead equities both on the way into an economic downturn and on the way out. Keep this in mind when considering the message being conveyed by the bond market with the yield on the 10-year T-note falling by nearly 110 basis points over the past two months. Sure, this could be the bond market taking back some of the overshoot to the upside on what was the most aggressive interest rate hiking cycle in the last four decades, but it could also be the bond market’s way of discounting the onset of an economic contraction. To be fair, neither I nor anyone else knows the answer to this riddle at this point, but ignoring the possibility of the left tail of the distribution is imprudent. I’m not saying one should have a recession probability much above 40%, but it sure as heck should not be discounted at less than a 10% probability which what is being assigned by an S&P 500 trading at a 20x P/E multiple and just shy of all-time highs.
David Rosenberg, in his ‘Breakfast with Dave’ publication crunched the historical numbers for all of us to ponder.
In the cycle leading up to the GFC, bond yields peaked in July 2007. The stock market peaked in October 2007.
Leading up to the popping of the Tech bubble, bond yields peaked in February 2000. The stock market peaked in September 2007.
Leading up to the recession in 1990, bond yields peaked in May 1990. The stock market peaked in July 1990.
In February 1980, bond yields peaked in February 1980. The stock market peaked in November 1980.
How about the recession in 1974, bond yields peaked in August 1973. The stock market peaked in October 1973.
You get the point. A recession is not a forgone conclusion because yields have fallen, but rather a breadcrumb to follow as we sift through the cacophony of information that informs our decision-making process. I’ve said it before, but I’ll say it again – drawing parallels to historical data in this post-covid era is rife with inconsistency given there is a limited sample size of post once in a century epidemic work out periods. But I still think it’s a worthwhile exercise if for nothing else than to appease one’s curiosity.
Back to markets for a moment as I look to close up this week’s missive. The bond market has come a long way with yields falling across the maturity spectrum. The 10-year yield slipping below the 4.0% level was a major break in trend and puts a target on it drifting lower over the next several quarters. The technical picture suggests a move down to 3% is plausible and that won’t be a stretch if growth and inflation continue lower (as expected) over the next six months.
As for the dollar, it continues to melt lower – not by much but directionally lower, nonetheless. This is largely a result of the increasing possibility of rate cuts next year (nearly six cuts priced in for 2024). Gold has been a beneficiary of the fall in yields and a weaker dollar, but not nearly as much as stocks and bonds. However, I must admit I’m impressed that gold is up +11% on the year given the pressure from higher yields and a strong dollar up until the end of October. I continue to think all investors should own some of the yellow metal in their portfolio as an insurance hedge to all kinds of bad outcomes.
I’m not sure if I’ll pen another missive this year or not with the upcoming holiday schedule, but if not I’m fine with this being my final thought going into 2024. In a ‘soft landing’ outcome the yield on the 10-year T-note can trade around +/- 4% (even with a couple rate cuts) while earnings, economic growth, and stocks perform well. If the Fed cuts and the yield on the 10-year T-note slips to the low 3’s or below, I suspect we are careening towards a ‘hard landing’ where stocks get hurt while Treasuries and Gold perform well. If by chance we get the ‘no landing’ then yields rise with the 10-year drifting back up to 5% (or higher), stocks are mixed bag with energy/commodities performing best and the dollar taking another leg higher.
From my family to yours, Happy Holidays, Merry Christmas, and Happy New Year. I hope you feel as blessed and fortunate as we do. That’s not to say life in the Casilio household is all ‘puppy dogs and rainbows’, but I do have a wonderful wife, three perfectly imperfect children, and good health – if would be unfair to ask for anything more.
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