Anyone looking at the year-to-date return of 10% on the S&P 500 and concluding it’s been a good year for the stock market is not paying attention to what is really happening.  Carter Braxton Worth has put out some great content all year long on this performance illusion, where he updated the following table through Friday on the Russell 3000 (an index comprising 98% of the investable equity universe in the U.S.).

Yes, the index itself is up 8.88% ytd, but the average company performance for the year is -2.5% and the median is -7.72%.  Less than 40% of the companies in the Russell 3000 are positive on the year with more than 60% in the red.  You can read the rest of the table for yourself, but understand this, without the major gains in the Magnificent 7 this year the overall stock market would be much lower. 

Moreover, it’s not just the equity market that has struggled this year as the rise in interest rates has set the Treasury market on course for its first three year losing streak in history.  Investment grade debt is off nearly 6% on the year and high yield has declined 2%.  Short-term debt, cash, and gold have been a couple areas of a very narrow list of safe harbors for investors this year.  Otherwise, like 2022, the odds favor any investment made outside these areas as likely to have declined in value.  Okay Corey, thanks for the information, but what does one do with it.  Is this bullish in that it indicates potential opportunity?  Is this bearish in that things will get worse from here?  I don’t know is the most forthright answer.  It’s both bullish and bearish is another non-answer answer. 

Like the saying goes, beauty is in the eye of the beholder.  I see opportunities and further pockets of risk in many areas.  The market that I think presents the best risk/reward setup at the moment is the fixed income market where yields across the gambit (Treasuries, investment grade credit, high yield, emerging markets, and TIPS) offer high enough nominal yields to compensate buyers for both future credit and interest rate risk.  I’ve been adding exposure to client portfolios in all these areas over the past several weeks.  Yields may continue to back up, but to turn outright bond bearish now (after the largest bond bear market in history) would be akin to an equity strategist getting or staying bearish in the summer of 1982, fall of 2002 or early winter in 2009. No matter the asset class, all bear markets end.  Something that is likely crossing the mind of Bill Ackman and one of many reasons for him to announce today that he was closing his bond short.

Consider the asymmetry that is setting up across the maturity spectrum of sovereign bonds with a further +50bps or +100bps move up in yields versus a -50bps or -100bps decline – nearly 2.5x upside versus downside in the price of 30-year Treasury bond (remember yields and prices move inversely).

I remain cautious on the broad equity market, but it’s hard for me to be too bearish with the S&P 500 at 4,200 when I think the downside in a recession scenario is around 3,700 (12% lower).  Yeah, I’d like to sidestep such a downside as much as possible, but as Carter Worth’s table laid out above – a lot of companies are already discounted for poor results or the expectation of poor results coming down the pike. 

Bottomline, the current investment backdrop is perhaps the best setup investors have seen in the last fifteen years depending on how one wants to look at it.  You can sit in cash or short-term T-bills with no risk and earn 5%.  You can take on some duration and/or credit risk and earn anywhere from 6 – 12% if you’re so inclined.  These options all represent a fairly reasonable hurdle rate and competition for investors to consider in lieu of putting capital at risk in equities.  The below chart puts into context how high rates have risen for small cap companies and goes a long way in explaining why the Russell 2000 has been the worst performing segment of the equity market (-31% from its November 2021 high) over the past two years. Companies, households, governments… anyone that has to roll over maturing debt at current interest rates is doing so at the highest levels in the past fifteen years.  It makes sense that their equity values would reflect such a negative fundamental hit.

As for the stock market, it is no longer ignoring the challenges posed by the most aggressive Fed tightening cycle in four decades, a higher cost of capital, softening of economic growth, inflation pressuring profit margins, broadening geopolitical tension, and weakening consumer pocketbooks.  Some degree of these risks are priced into an S&P 500 at 4,200, very little risk was priced in with an S&P 500 at 4,600 and much of it would be priced in with an S&P 500 down at 3,700.  My advice is not much different than it’s been in the last eighteen months – be patient, be disciplined, be flexible, and don’t be afraid to change your mind as the cycle evolves.  I would not classify my views as either bearish or bullish at this moment and admittedly I could lean either way depending on how certain things unfold in the weeks ahead (accept and appreciate the nuance of things).  Makes me think of the following quote from Morgan Housel which I find quite fitting for the moment:

“Angry people look for problems and find them everywhere, happy people seek out smiles and find them everywhere, pessimists look for trouble and find it everywhere.  Brains are good at filtering inputs to focus on what you want to believe.”

This is a big week for corporate earnings with several of the Magnificent 7 reporting (Microsoft, Alphabet, Meta, and Amazon), some important industrial bellwethers (General Electric, Boeing, 3M, Texas Instruments, Ford, and UPS), and the major integrated oil companies closing out the week (Exxon and Chevron).  We’ll also get the first iteration of Q3 GDP (Atlanta Fed is at 5.4%) which is expected to be strong.  This should filter through to Q3 earnings and likely present a stiff headwind to the bearish view where overall earnings results should be fine – Q4 and Q1 will be a different story, but those won’t get reported until next year. 

It will be quiet on the Fed front as they enter a blackout period prior to next week’s Fed meeting.  Probably a good thing for the market that we won’t have any Fed talk after last week’s confusing delivery from Chair Powell at the NY Economics Club.  Comments he made in his prepared remarks were treated bullishly by both the bond and stock markets.  He emphasized policy lags and tons of tightening in the pipeline and sounded rather encouraged over the downward trajectory in wage and price inflation.  Then came the Q&A session and all of a sudden, hawkish tones emerged.  He left the door open for additional rate hikes if the economy refuses to slow below potential growth.  He seemed to indicate that policy may not be as tight as commonly perceived – in part because he is leaning towards a view that the so-called “neutral” rate may now be on the rise, due to a host of factors, including structurally high deficits.

Powell is also of the mind that given how many homeowners and businesses locked in their debt at or near the cycle-lows in rates, Fed policy is exerting less of a restraint on the economy than used to be the case.  His comment that “it may just be that the rates haven’t been high enough for long enough […] the evidence is not that policy is too tight right now” was a real shot across the bow that the bar is very high indeed when it comes to future rate cuts.  In a nutshell, I consider Powell to be very patient and flexible with his view at this juncture.  It’s refreshing, yet concerning all at the same time.  In a sense, Powell is pulling up just short of acknowledging we’re at the point in this monetary experiment where we aren’t sure if our hypothesis will be proven right or very wrong.  

I remain of the view that the hiking cycle is over, and the Fed is done.  QT will continue to operate in the background, and we’ve heard from several Fed officials that they want to continue to reduce the balance sheet into 2025.  I have my doubts they can make it that long given the way the Treasury market has been acting and especially if the economy slips into recession, but we’ll see how such a view plays out.  Not to mention the pressure higher rates is putting on the fiscal standing of Uncle Sam.  Last week we got the deficit numbers for fiscal 2022 which chalked in at a hefty $1.7 trillion.  If you add back the student loan forgiveness program adjustment, the deficit was actually $2 trillion.  To put this in perspective, the annual U.S. deficit is just shy of the total individual income tax collected.  It also means that the 2023 deficit is nearly 5x as large as corporate income taxes.  The 2023 deficit as reported is approximately 25% larger than total Social Security outlays.  Net interest was $659 billion and should soon pass the national defense budget.  Really gets the mind going when you think about future implications which at some point will matter – when and how, good question?

The significant rise in bond yields since early September and the grinding weakness in the equity market is invigorating the bears to the point where today’s WSJ op-ed had a piece penned by John Greenwood and Steve J. Hanke titled, “Another Black Monday May Be Around the Corner”.  I think the title is overly dramatic (exchanges have circuit breakers in place today to prevent such an outcome), but I can’t say I disagree with what are some very valid points made in the piece.              

To wit:

“The Federal Reserve’s policies are threatening U.S. financial markets and the economy. They are in danger of a steep recession and the risk of a repeat of 1987’s Black Monday […] In that year the key 10-year bond yield rose steeply from January onward (from 7% in January to 10% by Black Monday in October) and the money supply slowed sharply […] A bond market crunch and monetary squeeze together led to a sudden, drastic reassessment of equity-market valuations. The same could happen today, particularly since the current jump in bond yields and monetary squeeze are much more pronounced than in 1987.

Because of the sustained decline in the money supply, the economy is in real danger. So far, only the remaining excess money the Fed created between 2020 and 2021 — the cumulative excess savings from the COVID-19 handouts — has been keeping businesses hiring and consumers spending. The effects of the excess money are still giving the economy a lift, but that extra fuel is almost exhausted. When it dries up, the economy will run on fumes.

In all of this, an appreciation for time lags is critical. The Fed ignored the huge acceleration in the quantity of money and thus failed to anticipate the ensuing inflation. When inflation struck in early 2021, Fed officials tried to argue it was “transitory,” caused by supply-chain disruptions.

The Fed continues to ignore the money supply, and we now face the opposite problem. The money supply has been contracting for 18 months, and soon, after the overhanging extra money from 2020-21 has been used up, spending will plunge and inflation will fall, not simply to 2%, but below — and perhaps even into deflation in 2025.

Since Fed officials pay no attention to either monetary aggregates or their credit counterparts, they are overlooking these signals, and the risks are intensifying each day. Instead, we hear Fed leaders talk about being “data-dependent” — keeping their eyes firmly on lagging economic indicators such as the labor market and the composition of the consumer-price index, not the monetary causes for their movement.

Monetary analysis tells a very different story than the measures the Fed follows. The first effect of a monetary contraction is higher market interest rates for a brief period. Then comes an economic slump. The economy goes into recession and inflation falls. This results in a second and more permanent effect of subpar money growth, namely lower interest rates and a weaker currency.

When the stock market crashes, “higher for longer” will become a thing of the past as the Fed makes an abrupt pivot. Then the 10-year yields and U.S. dollar will come tumbling down.”

One last thing and its uncomfortable thinking about money with the suffering and displacement unfolding in the regions of the world caught up in conflict, but this is my job.  Since the October 6th close, we have seen the gold sector rise +7%, the S&P 500 defense/aerospace sector advance +6% and the energy space rally +6%.  Bonds have failed to be a safe haven, mind you, owing to the amazing strength of the U.S. economy and Fed policy expectations.  But I would advocate all portfolios should have some exposure to these areas in the current environment.

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