Armadillo Day
Everyone knows about the prognostications of Punxsutawney Phil, but what about Bee Cave Bob?
Yesterday was a day of much anticipation. No, it had nothing to do with the non-farm payroll number. It had everything to do with Groundhog Day, the day we hear about whether we will have a longer than normal winter, or an early Spring. However, did you know in Texas there is an Armadillo Day on the same day?
The stock market is much more like the armadillo than the groundhog. You see, the armadillo not only predicts the weather but also politics. The stock market has to do the same thing and this year looks like it will be quite interesting on both fronts. Shelly Natenberg famously said forecasting volatility is like forecasting the weather - there is a serial correlation component and a mean reversion component. Said simply, if it is cold today, it is likely to be cold tomorrow. However, if it is well below normal today, it is also likely to move back toward normal tomorrow.
In addition, I have seen many reports suggesting that politics plays a part in the market discussion. Take, for instance, this one from BAML:
So, the armadillo, like the stock market itself, is trying to predict the weather (volatility) as well as politics. For the record, Bee Cave Bob made his predictions on both fronts. He walked to both the right AND the left of the yellow line in his cage, meaning that the politics are a toss-up right now. He also did not return to his cave and thus predicted an early Spring. From a stock market perspective, does this mean early strength in stocks only to move into sideways volatility as the election heats up?
Punxsutawney Phil was not going to be upstaged by some young upstart in Texas. Think of Bee Cave Bob like the Nasdaq 100 and Punxsutawney Phil as the Dow Jones Industrials. Phil also predicted an early Spring so I guess we should not be surprised that the stock market has completed the hat trick in predicting good days ahead:
This performance looks a lot more like no-landing than soft-landing, but we have some data from Michael Hartnett at BAML that suggests the market overall is solidly in the soft-landing camp, but importantly, basically no one (5%) are looking for bad news ahead. The final stat, to me, is shocking. Look at the combined market cap of the Mag 7. These are the types of stats we read about 2 years after a market top (e.g. 2000) and say “why didn’t people realize how ridiculous things had gotten?” However, in the moment, trying to put money to work, we all know how it happens.
The last week have been filled with quite a bit of data and news. The market’s response to all of it has basically been “that’s bullish”. It is hard to fight this momentum. Speaking of momentum, any idea how it has performed lately? To the moon, as Archie Bunker used to say.
This shouldn’t be surprising, as the Mag 7 are driving the index higher and higher, and delivered on earnings this week as investors had hoped (more on earnings below). Over the last year, you needed to own the Mag 7, as we can see by the performance of the index vs. the performance of the index without the top 7 names. 1300 basis points of outperformance.
According to Morningstar, there is only one game in town. It isn’t even the Mag 7, it is now the Fab 5, which accounted for 98% of index performance in January:
On the earnings front, it makes sense. The Mag 7 stocks have reportedly grown earnings over 50% in the last year, while the rest of the market is -10%. That earnings recession we expected? It is happening; however, the Mag 7 are completely hiding this. If we see where the earnings growth is this quarter, it is in Technology, Consumer Discretionary (read Amazon) and Communications Services (read Meta). This growth number was negative only about a week ago. Interestingly, we can see that the performance of stocks around earnings (lower right) looks much more like a scatter plot, suggesting much of this good news is priced in.
We know the bar is high, but for now, at least the biggest names are hitting this and bringing overall index earnings numbers to levels that justify further investment:
A few other things besides important earnings happened this week. My favorite economic data point came out - the ISM. This survey measure of the economy is coincident with the stock market, 10 year yields, and the % of companies revising earnings up or down. It came in at 49.1, well above the expectations of 47.2. Importantly, within the number, the ratio of new orders to inventories continued to grind higher. We can see this ratio leads the headline index, which itself leads the economy. I ignored this ratio to my detriment last year. I am not ignoring it right now.
Why does this number matter? As I impress upon all my class, for a long only manager, determining when the ISM is rising from the levels below 50 vs. still falling, is the decision that will make or break your year. If it is above 50, whether it is rising or falling only matters to the extent of the difference in positive returns. Below 50 and rising, as it looks like now, is the BEST time to own stocks. Below 50 and falling is the WORST. Caveat emptor, though, as we saw a head fake last September-October. it started to rise, people rushed into stocks, and then the rug was pulled out. Could that happen again? Perhaps, but the new orders to inventories gives some confidence.
Perhaps this is why, in the last bit of big news of the week, Chairman Powell squelched any hope of a rate cut in March. The initial statement read a little dovish, discussing the possibility of rate cuts this year. The market responded in Pavlovian fashion. However, in the presser, a question came around about WHEN the FOMC could start, and JayPo suggested March looks very unlikely. The non-farm payroll number on Friday, combined with the average hourly earnings blowout, gave a strong signal to a data dependent Fed that now may not be the time to ease. The short-term rate market responded by starting to price the rate hike out in March. You can see the odds are down to 22% now.
These odds were 69% just two weeks ago. In addition, 1.2 cuts have been priced out of December. I still think there is more to come, as I have said I am in the soft landing BUT no cuts camp. I think the market is slowly coming around to this view.
I think rate cuts being priced out matters, because it means the 2-year bond has been the place where many macro investors have been long, and it is the expectation of cuts that has led to the compression of the 2-year yield. The compression of the 2-year yield has driven the SPX market, and the market overall has gone up almost entirely because of multiple expansion. If the 2-year starts to move back higher (inverse on tis graph so lower), we could see multiples begin to contract and bring the market lower. To me, this is a major risk factor for those that are buying in the last 3 months because the ISM is below 50 and rising.
It is not the only risk factor that is out there. Commercial real estate, thought to be a major issue starting last year and running for several years, may finally be coming home to roost. I saw this headline in the Chicago rags this week. Sure, Chicago has it’s own idiosyncratic issues, however, major urban areas are all facing this same problem. Look at the discount they had to sell it at to unload the property! It traded at $4 a square foot. Oh. My. Gosh.
It isn’t just Chicago commercial real estate that is the issue. This week saw both NY Community Bank and Aozora Bank both dramatically cut their outlook for office real estate. NYCB was down over 30% and Aozora down over 20%. It is important to me because NYCB was one of the saviors that stepped in last Spring to buy Signature Bank and get us to think the banking crisis was contained.
Barry Knapp from Ironsides Macro (a great read on Substack if you aren’t already). highlights these stresses with the regional banks are coming just as the BTFP, put in place for regional banks to loan their underwater bonds to the Treasury for full value, is expiring on March 11. Watch the news to see if this gets extended.
Perhaps this is all smoothed over as it was last Spring, but if the banking system is again showing signs of stress, are there really only 5% odds of a hard landing as we saw earlier? Maybe we need to ask a sloth or an anteater next week.
Stay Vigilant
Richard - I wanted to share this excellent post by Amrita Roy. I think you and your readers will find it very interesting. Cheers
https://amritaroy.substack.com/p/risk-a-banking-crisis-or-reignite?utm_source=post-email-title&publication_id=1893834&post_id=141432676&utm_campaign=email-post-title&isFreemail=true&r=12ociv&utm_medium=email
Fact check - a reader (hat tip SC) rightly points out that it was Jackie Gleason in the Honeymooners that said 'To the moon!' Not Archie Bunker. I had the wrong pop culture reference. Apologies