Supernovae

Inspired by my daughter this week, I think about whether we can learn from supernovae research to assess the current macro environment.

This week I had the pleasure of watching my daughter present her research to a standing room only crowd of undergraduate students. She spent the summer studying near-Earth supernovae. By near, she meant anything within 200 parsecs which is within 652 light years. For reference, the Milky Way is about 100, 000 light years across. So we are talking things that are close though it is still hard to fathom. This is considered the Local Bubble, the hot, low-density pocket we live in.

She also focused on supernovae that are considered recent, which means within the last 10 million years, which is when we have moved into this Local Bubble. Current research already knows we have been hit by two waves of supernovae in this time. Her goal was to build on this research.

In summary, her research determined that: 1. We have evidence that supernovae have occurred near Earth by observing the layers of Iron 60 found in the oceans 2. We can look not only at star clusters, which previous research did, but also by observing all massive stars near Earth, and determine that there may be almost twice as many supernovae as previously thought and 3. This research potentially impacts some of our previous astrophysics research, such as the number of black holes that we may expect to see.

While this many mean little to many of us, I think there are many things we can learn and apply to what we are seeing in the markets. Don’t think so? Humor me a bit.

1. We have data that tells us what may actually be happening in the world right now

2. This data may disagree with previously strongly held views may not be accurate

3. These findings may cause us to think differently about how things play out going forward

We have data that tells us what may actually be happening in the world right now:

The news of late has started to corroborate the soft-landing hypothesis. We have not only seen the ISM move higher for the second straight month, but we have also seen the new order to inventories ratio consistently move higher as it has all year. This ratio, which intuitively indicates strength in the economy, as purchasing managers are adding more new orders with inventories, on a relative basis, being drawn down. This ratio of new orders to inventories has consistently been able to anticipate the ISM, which itself is coincident with the stock market, both of which lead the economy.

With two consecutive readings moving higher at this point, we are now seemingly in the range of below 50 but rising in the ISM. Recall the graph I have shown many times. If we are below 50 and falling, it is the ONLY time stock returns are negative. However, if we are below 50 and rising, it is the BEST time to own stocks. This is the inflection that fund managers have to navigate. As they are coming back from summer vacation ,they are faced with the idea that they need to start buying the market.

That is the growth metric. What about inflation? On this front, we might be getting a different story. Lately, we have seen crude oil prices heading higher, as demand has remained strong with supply being restricted. This has led to a move back higher in inflation expectations. We have started to see evidence of this in the ISM price index which has also inflected higher. However, there are still expectations that CPI inflation will fall.

This data may disagree with previously strongly held views may not be accurate:

Coming into the year, many in the market expected us to see a recession this year. I firmly admit to being in this frame of mind as well, as I thought at the end of Q1 but most likely into Q2, we would see a recession. If we look at the NY Fed recession index in blue, this is very much consistent with the consensus view coming into the year, that we would see a recession this year. In fact, as we look at this now, it is still the highest we have seen this century. Clearly, the yield curve being inverted is a big driver of this view. Shockingly, the SPX has ignored all of this information and has surged higher this year.

The other part of the consensus view is that this slowdown in the economy would bring down inflation and take the Fed out of the picture. We can see that the headline measures of CPI, PPI and PCE falling, consistent with the beliefs of the market. However, there is some evidence that these measures may be bottoming at this point.

These findings may cause us to think differently about how things play out going forward:

How do we think of the world? ISM is coincident with stock performance Ditto for leading economic indicators. These all tend to move together and all lead the economy as measured by GDP. This year, it is the relative performance of stocks vs. bonds that has ticked higher before ISM and LEI while these have historically moved together. We are starting to see ISM move higher, but still do not see this in the LEI. The market is ahead of the surveys and the data at this point.

Recall the H.O.P.E acronym which highlights housing → orders → profits → employment. This is how money and stimulus flows into and out of the economy. We have seen this in cycle after cycle. In 2022, housing fell first, which dragged down new orders. Profits are only now falling and we have not really seen employment fall yet. However, given the bounce in some housing measures, and the small uptick in new orders, many in the market are still to expect earnings to inflect higher and employment to never weaken.

If this is the case, and the economy and earnings never really weaken, what does that mean for inflation? If inflation continues higher, what do we think that means for Fed policy? This is what I wrote about on Linked In this week:

Chart of the Day - paradigm shift

Last night was the start of the National Football League season. In a game that was watched by fans of all teams, the defending champion KC Chiefs took on the upstart Detroit Lions

The Chiefs have won 2 of the last 4 Super Bowls & have the best player in the league on their team. They are a perennial favorite & are once again favored to win it all

The Lions have been bad for a very long time (decades) but ended last year very strongly & are a darling among the betting public to be relevant this year. However, there are some long-time fans that just aren't believers

Yet, the Lions shocked most people, except their own fan. The Lions entered the game aiming to convince scores of unbelievers that they should be taken seriously. Perhaps we are witnessing a paradigm shift in the NFL

This is somewhat akin to what the Fed tried to accomplish after the Great Fincl Crisis & what it is trying to accomplish now. The Fed was/is trying to convince scores of unbelievers that its message should be taken seriously

After the GFC, the Fed was urging consumers & companies to take more risk. It said rates would stay low forever so we should feel comfortable to do so. It lowered real rates (in white) into negative territory. It was urging us to take risk.

Yet you can see in that circle, which includes the earnings yield on stocks & the BAA corp bond yield, that it took years for people to believe the Fed. People burned by the past were reluctant to buy in. Perhaps they were anchored onto what had happened

Eventually they bought in & yields for risky asset fell by 2013. After that these yields followed real yields. During Covid, when the Fed quickly took real rates negative, the markets rapidly responded. They knew the Fed was serious

Now, The Fed is giving us the opposite message. It is saying rates are going to stay higher for longer. It is saying we should beware of taking risk. However, no one is listening. The market is anchored on the lower for longer message of the the post GFC Fed

You can see in the circle on the right, the real yield is sharply higher yet the earnings yield in blue is back near its lows. Even corp bonds are ignoring the message. None of the risky assets are taking the Fed seriously

In some ways, the mkt is still al in on the post GFC story (Chiefs) & not paying attention to the new paradigm rate hike regime (Lions). The story is changing before our eyes yet the mkt doesn't want to believe. How long can this persist?

Stay Vigilant

There is often much we can learn from other research that helps us frame the debate in our own world view. I appreciate my daughter’s research helping me stay consistent with how I think about my small corner of the world, while she focuses on her small corner of the universe.

Stay vigilant.