Short and sweet

With a late season golf trip this weekend, I am keeping it short and sweet and sending it out early

Sand Valley’s Lido course above

Over the last couple of weeks, we have gotten quite a bit of data. We have gotten leading data - ISM New Orders - and lagging data - unemployment rate. Data on growth - ISM and Empire Manufacturing - and data on inflation - CPI, PPI and U of M inflation expectations.

What are investors to do in trying to sort through all of this? I hope I can give you some help with that this week.

Before I do that, I want to remind you of this chart that I have shown before. It is showing the returns for stocks and bonds and overlaying with the inflation regime. I have highlighted the region from the 70s to late 90s and then the last few years. As we can see in these highlighted years, the returns of stocks and bonds are positively correlated. These are periods when inflation is high. Then, we look at the period from 2000-2020 and we see that when inflation is low, the correlation between stocks and bonds is negative. We can see that in this chart from Cornerstone:

The intuition here makes sense. When the market concern is about inflation, higher inflation prints hurt bonds because of the expectation of higher rates and a tighter Fed. This also hurts stpcks because the concern is that higher yields will negatively impact earnings and also multiples. However, in those periods when inflation is low and growth is the only concern, higher expected growth will hurt bonds for fear of higher rates, but this higher growth will help stocks. Conversely, slower growth leads to views that the Fed will cut so the initial slow data may hurt stocks, but it helps bonds.

The portfolio construction of 60-40 and risk parity is built on the premise that inflation will stay low and growth is the only concern. It is behind Bridgewater’s All-Weather Portfolio. However, if inflation becomes the concern, these portfolios are at risk because they are constructed exactly as they should not be given correlations. This is the message from 2022. Could it be the message for the next year too?

This leads me to the LinkedIn post I wrote on Friday:

Chart of the Day - auto shutdown

So we got to the point that I think most people following the story thought we would get to. The UAW went on strike last night against all three of the big US automakers.

While each union has asked for slightly different concessions, the trend is pretty clear. Real wages for the workers - truckers, pilots, rail workers, dock workers, flight attendants, mechanics - are not keeping up with the rising cost of living.

While economists & central bankers see CPI back down in the 0.2% m-o-m which is 2.4% annualized & think the Fed is doing its job, consumers look at gas prices up 80% in the last 2 years & think it hasn't. Food up 50%. The cost to live has gone up permanently so. Thus, higher wages are sought.

It is only one data point, arguably a large one, but what will the shutdown in auto production mean? US auto production is 3% of GDP but it has a bigger multiplier effect, especially in the local economies where these plants are.

We can see the yearly changes in Seasonally Adjusted Annual Rate of auto sales. It has been quite strong thru all of 2022 & 23. It is set to plummet from here. We can see the impact on the green line when we have seen large spikes or drop offs in SAAR. As GM goes, so goes the USA ...

To me the more interesting story might be inflation. Naturally many would think that a massive exogenous shock to production might see inflation fall. After all, isn't the Fed trying to slow the economy & therefore bring down prices?

However, think back to 2021 when SAAR dropped on the Suez Canal shut down. Recall when we couldn't get parts, mainly semis, and therefore couldn't make new cars? What was impacted?

The price of used cars went thru the roof. Everyone who needed a car in order to get to work was forced to buy a used car. Prices are only finally adjusting from that. As workers are being asked to get back to the office, at the same time there are no new cars, what happens?

What will happen to the cost of auto insurance? As the price of cars went up, the cost of repair went up as there were no parts. Insurance went up because it cost more to fix cars. Only now has insurance been adjusting.

In fact, in the last higher-than-expected CPI report the biggest thing holding CPI down was the fall in used car prices. Auto repair & auto insurance also were not up as much as forecast. So 3 drags on a number that was higher than expected. Those drags are no longer

The economic data are going to get messy from this. People will try to explain it away. Earnings will get messy from this. CEOs will use it as an excuse. However, the facts will still remain

Prices for consumers have gone a lot higher & stayed there. Those that can are asking for more money to compensate. Those high prices? Are about to go higher. This will be a drag on the economy. Call it late expansion or peak or stagflation. It all looks the same to me

Stay Vigilant

CPI started to tick higher. So did the simple CPI forecast that I built. It is the white line & is a simple geometric average of the variables most often used by my students when they build an inflation model in my class (which is going on right now). These variables are CRB prices, money supply, inflation expectations, PPI and financial conditions.

As you can see, based on these metrics, inflation is heading higher again. The percent change is running at 5% on a yoy basis, above the headline or core CPI rate. Well above the Fed’s desired target.

If inflation is above the Fed’s 2% target, and now starting to turn higher, as investors, we should be prepared for rates that are higher for longer. While the Biden Administration has said it doesn’t think inflation is a problem as long as wages increase, and we are seeing wage demands increase at least, the Fed knows it needs to slow inflation via the economy which means slow jobs. A higher for longer Fed can most clearly be seen by looking at real yields. Here I look at 5-year real yields that are 2.2%. I plot them vs. the earnings yield for stocks. This graph would suggest earnings yield should rise from 4.9% (21 ish P/E) to closer to 6% (17 ish P/E). Even if it doesn’t rise because of investor enthusiasm for AI, we are hard-pressed to see multiples expand (earnings yield fall) from here.

That is fine as long as earnings are growing. Ultimately, the economy leads earnings and earnings lead stocks. Multiples like P/E are the fast-moving sentiment measure that tells us how much investors are expecting. All year investors have told us they expect higher earnings. Here, we can see the extent of this. Investors are looking for double digit earnings growth in each of the next two years. Right now, earnings are running at $220 and in two years these are expected to be $288. This means forward earnings yields look reasonable. However, it means the earnings growth hurdle rate for stocks is very high. As I told my Finance for non-Finance Majors’ class this week, there is very little margin of safety for stocks. It doesn’t mean stocks have to go lower. It does mean that if anything goes wrong, there is little support though.

This is the same table above but in visual form for those who are visual learners. We can see that for this year and the next two years, earnings expectations are either above or well above where they were a year ago. Views have gotten quite bullish.

Is this reasonable? As I said, the economy leads earnings and earnings lead stocks. Here I look at the ISM, the ISM New Orders to Inventories and earnings revisions. New orders lead the ISM itself as we can see below. New orders to inventories has been signaling a bounce in ISM all year long. Earnings revisions have kept up with this forecast. The economy itself may only be turning now. This is the soft landing that is now solidly consensus. Will the turn in the economy be as strong as everyone is expecting?

We are at that phase now where: 1. inflation will be a focus which suggests to me that stocks and bonds will be positively correlated 2. stocks need earnings growth to move higher because multiples should not expand 3. The expectations for earnings and economic growth are already quite high which means there is very little margin of safety for growth investments. This doesn’t mean risky assets must fall, it does mean that the hurdle rate is pretty high though.

One last thing in thinking about higher for longer. Recall something I have mentioned many times before. If we look back to 2020-2021, there was a bubble. Some say it was stocks, some say housing etc. However, for me it is pretty clear the bubble was in duration. Rates had gone to zero if not negative around the world. This forced investors who had to match assets and liabilities, or who were forced by regulation to only own certain assets, to massively increase their demand for fixed income. Remember the chart of the amount of negative yielding debt in the world that hit $18 trillion? Well, what we forget is that all investments have duration. Duration is just a measure of the sensitivity of an investment to interest rates. We typically think of it primarily in regard to fixed income because it is more obvious. However, this chart from Bank of America reminds us that there is duration in the equity market too. Zero eps high growth stocks (typically tech) have the longest duration. Think of your valuation model where all of the value comes from the terminal value in 10 years. Compare that to the boring toothpaste manufacturer that pays a huge dividend each quarter or a regulated utility. These assets cash flow up front (with very little terminal value) and thus have short duration.

With a higher for longer Fed, we have seen bond investors continue to shorten duration. They have sold 10-year bonds (and longer) and moved into 2 year and shorter where the yield is higher, and prices basically pegged. However, we have not seen longer duration equities move accordingly. We are starting to see other long duration assets like crypto start to move. We are seeing investors back off from funding rounds for VC as well, since that is long duration. The one standout in all of this is the NDX as we see below.

Higher for longer means it is time to …

Stay Vigilant