The 12 Charts of Christmas

A chart a day during the Christmas season

My investment process is the result of working in different markets and in different time zones. Each of these areas of the world come at markets with their own flair. Some focus on money flows, others on business cycle investing, still others on relative value. Traders may focus on hourly or daily moves with investors looking at quarterly trends. The one thing I have learned is that there are a lot of ways to be successful in the market, you just need to find your own and stick to the discipline.

Regardless of where I have worked, I have found that a process that focuses on Fundamental Drivers, Behavioral supply & demand, and Catalysts to get people to change their mind has always worked for me. Perhaps the various elements in each category are different, but the construct does work.

With that in mind, I have 12 charts across the 3 categories to give you something to consider as we end 2024. In the spirit of the 12 days of Christmas, I give you the 12 charts of Christmas.

Thank you for reading Stay Vigilant this year. I hope everyone has a joyous holiday season and a prosperous New Year.

See you in 2025 and until then … Stay Vigilant

FUNDAMENTAL

Whether a trader or an investor, you have some sense of the fundamental drivers of a stock, a commodity, or a bond. When involved in asset allocation, you look at the long-term fundamental drivers of each asset class, country, sector and style. Trying to get a sense of how markets are trending will set the road map for how we should navigate.

Relative Valuation

There is no shortage of posts on social media telling all of us how expensive stocks are. The problem is: valuation is a horrible market-timing indicator. In fact, on a 12-month horizon, it has no statistical significance. If you are investing over the long-run, it matters a lot. In fact, it is the only significant variable on a 10-year horizon. Your returns will be strongly dictated by the price you pay. I myself have shown charts throughout the year showing there is little margin of safety in equities when you compare to Treasuries or to cash. It is good to keep this in mind. For many investors, particularly institutional investors, this is less relevant. Sure, they may keep higher cash cushions at times (they are not right now), but they are paid to take risk, to invest in the markets. Where are they choosing to invest? I think the relevant question is where investors choose to get their ‘beta’ exposure. Do they prefer equities or corporate credit? How far up the capital stack do they want to be? Are they feeling like investing for growth and prefer equities, or investing for safety and prefer credit? I compare here the earnings yield of the SPX to the corporate bond yield of Baa companies. We can see a strong preference for stocks in the 90s as this difference was negative. Then post Great Financial Crisis, really until the end of 2022, there was a preference for credit. Right now, equities are strongly preferred. Could this difference widen? Sure. Could this discount persist? Absolutely. It does suggest that even at some of the tightest credit spreads in decades, credit may be more attractive than stocks. Will investors see this and rotate in the New Year? We shall see. This relative valuation is stretched, but not at an extreme yet, so it is more likely to persist absent some catalyst.

Economic Trend

One thing we must all remind ourselves - earnings drive stocks and the economy drives earnings. Sure, there are times when multiples expand in anticipation of economic growth, but at some point, the rubber must hit the road. For this reason, it is always important to be mindful of the economic trend. For this, I prefer the ISM. Why? The GDP data is horrible lagging and subject to multiple revisions. Lately, the GDI data has been more accurate than the GDP even. ISM is timely and coincident with markets, which themselves are leading indicators. Why do I use manufacturing ISM instead of services? Manufacturing has a higher multiplier. For this reason, we see ISM does a very good job of leading earnings revisions, bond yields etc. The chart here shows the year over year of the S&P 1500, including large, mid and small cap stocks. I show you the headline ISM but also the new orders to inventory ratio of ISM, which itself has leading properties. It is clear that stocks have disconnected from the economy, in one of those periods where multiples expand in anticipation of economic growth. How does the economy look? Right now, the ISM is below 50 and rising. I have shown the chart before that suggests this is the best time to own stocks. In addition, the new order to inventory is suggesting the ISM should continue to rise. So, while stocks may have anticipated the economy and are expensive, there is every reason to believe the economic trend in early 2025 will support earnings and allow stocks to grow into their valuation.

Liquidity

When all is said and done, it is the liquidity that drives markets. Without cash circulating, things dry up pretty quickly. Capital also flows to where it is treated the best, and lately, that has been in large cap US stocks. When I try to track liquidity, I look at financial conditions. Financial conditions are influenced by several factors: interest rates, credit availability, asset prices, exchange rates, volatility, leverage and central bank balance sheet. Chairman Powell has referenced financial conditions often in his tenure. In many ways, this is why I have been so surprised that the FOMC is cutting rates. Why? Financial conditions are as easy as they were in 2021 when assets of all kinds were flying higher. I use two measures here - the Bloomberg financial conditions index in blue, which takes the place of the GS measure that Bill Dudley built and took to the Fed, and the Chicago Fed national financial conditions index, inverted here, in green. Both measures suggest financial conditions are very easy, not just 2021 easy, but as easy as they have been all century long. We should not be surprised, then, to see the FOMC take a pause here. There is plenty of liquidity in the markets. You can see how this liquidity serves to support stock prices also included on the graph. Liquidity is abundant, and may be set to get easier even with the FOMC on pause, if credit improves & the dollar strengthens further. Without a trend in the opposite direction, this will still provide support.

Velocity

It is one thing for there to be a lot of money in the system. It is another for this money to be put to productive uses and not just stored under the mattress. A simple example - after the Financial Crisis, central banks grew balance sheets however none of the money went into the system because banks used the reserves to fix their balance sheets, and consumers & companies had no appetite to borrow anyway. Conversely, during Covid, when balance sheets also grew, money supply exploded higher, and inflation followed. The difference? Velocity or the propensity to use that money by companies and consumers. There is a velocity number from the GDP data that we can observe, but it is very slow moving and lagging. It is in red below. For markets purposes, I find there are proxies that give us a better idea of how and where money is flowing - banks willingness to make loans, small business desire to borrow, and consumers interest in mortgages. In the chart today, we can see that banks have become quite willing to lend money as this measure has trended higher since the bottom around the Silicon Valley Bank crisis in early 2023. Small businesses have not caught on yet, but there is reason to think they might. Small business optimism, not shown here, spiked higher after the Trump election, on the hope of lower taxes, less regulation, and government size being cut down. We shall see if that takes hold, but there is reason to give the benefit of the doubt. One thing holding back velocity, though, is the mortgage data. In spite of a very strong demographic trend of Millennials needing homes, affordability is so poor that few are looking to take out mortgages yet. This is exacerbated by the Fed’s QT impacting MBS spreads and leading to higher mortgage rates. It is more impacted by prices, though, and without new supply, this will be tough. Right now, this is more of a mixed bag.

Overall, a mixed to positive picture for risky assets, with the potential to get even better.

BEHAVIORAL

Once a trend is clear, the next step is to determine the supply and demand in a market. Who is buying and who is selling and why? I call this the behavioral section because no one tells us what they are doing and why, but we can often infer this. Also, there are some known biases that investors exhibit, and if we track these, we might have a better idea of what is happening.

Confirmation Bias

This bias is one that I see so many investors of all types making. It suggests that we only look for information that confirms are thesis and do not seek out information that might be in conflict. Perhaps this was the economists all calling for a recession in 2023 that didn’t appreciate the markets. Or stock investors that focused only on the Mag 7 and not the rest of the market that struggled. Ultimately, for this rally to have a third straight 20% year, it will likely have to be driven by a broadening out across sectors and across capitalizations. Tech and AI investors don’t want to hear that, but that is because they are only focused on the data they think is important. The good news is, the data outside that their purview is improving and looks to be supportive of a broadening of the rally. I referenced the small business optimism index above. You can see it in white here. It has been moving higher since August and really spiked after the election. It isn’t just small businesses either. Consumers, using either the Conference Board or the University of Michigan data, are also feeling better about the world. The last time all went higher was 2021. In 2022, they all went lower. Since then it has been more of a mixed bag. Right now all point to a broadening of this rally, which probably upsets both bulls invested in AI and bears who want to see a lower market. That’s because they have confirmation bias.

Representativeness

The representativeness heuristic is used when making judgments about the probability of an event under uncertainty. I find no better measure of uncertainty than the options markets. When investors are nervous, they seek the insurance of put protection. When they feel better about the world, they either speculate buying upside calls or sell upside options to generate income. Either way, the ratio of puts to calls does a good job, on a short-term horizon, of telling us what could happen with markets. I use a 20-day moving average to smooth the noise, and have inverted it here to reflect the same directionality. However, you can see that it does a nice job compared to the yoy change in the SPX. Right now, the options market is still telling us that investors are not worried about markets and are still calling for more upside, this in spite of the panic in markets and explosion of the VIX around the last FOMC meeting. The directional volume, and uncertainty of the market, is still quite supportive.

Cognitive dissonance

Cognitive dissonance means people can’t hold competing thoughts in their head. This is incredibly difficult for just about every trader or investor. They tend to focus on only what they know and what they think. As I tell the students in all of my classes - portfolio management, investment research or derivatives trading - is that what they think matters, but what others think matters just as much. What is your ‘variant view’? Are you viewing the world the same or different than others? This is true for a stock, a commodity or a market overall. To judge this, I like to look at the earnings growth expectations built into the markets. After all, earnings drive stocks. If we know where consensus is, we have an idea of when that consensus will be happy or disappointed. We couple with our view of what we think can happen, and we now have a better idea of the trade to make. As good as the news has been so far, this graph suggests the hurdle rate is a bit high. Consensus expects earnings to have double digit growth each of the next two years. If it happens, stocks aren’t so expensive as we see from the forward multiples. If it doesn’t, there will be disappoint. Some other things to help frame this: NDX expectations are even higher at over 17% growth the next two years, & SPX earnings growth last quarter was 8.5% and was only double digit in one of the 4 quarters this year. The bar is high folks. Not to say it can’t happen as the economy improves, but a lot of good news is priced in.

Loss aversion

Investors hate losses more than they appreciate gains. This is a tried-and-true mantra of markets and all investors. This is particularly true of institutional investors near the end of the year when their bonus is on the line. My gauge for assessing the loss aversion in markets is to look at daily technical charts. We can see the levels where if breached, investors are losing, hating life, and probably panicking. Take for instance the chart below. We can see the ichimoku cloud, where is the area where volume has been accumulating. When it is rising, we are in a market that is trending higher. However, we are also in a market where the average price people are long from is also higher. The recent pullback has us right on the cloud. This should be support levels. If it breaches, the bears will be in control. For now, the bulls still are. The middle panel shows the MACD, which is the moving average convergence/divergence. It suggests a possible change in trend, as short-term moving averages are crossing below long-term ones. The set-up is still positive, but there are risk factors now and we need to be vigilant that these levels need to hold, or there could be a flush into the end of the year. Markets are very thin around the holidays so be careful out there.

Anchoring bias

Anchoring Bias is a cognitive bias that causes us to rely too heavily on the first piece of information we are given about a topic. For many, this is their 401k levels as they look at this information on a monthly or quarterly basis. For others, it may be the long-term trend in the market. Either way, it is helpful to understand what other investors may be anchoring on, so we can assess their frame of mind. Looking at the weekly chart, the trend is very clear and very positive. We can expect more money flowing into stock markets in the new year, as investors see the growth their balance has had the last two years. However, this chart also has some worrying signs. Again, the middle panel on a weekly basis has the MACD crossing lower. This is concerning. Maybe more concerning is that the RSI on the bottom did not confirm the new highs. As prices hit new highs, RSI was heading lower. This divergence is another negative. For now, we can expect the anchoring on trend will be supportive in the near-term, but have to be aware of the negative signs too.

Overconfidence

Overconfidence does in everyone at some point in their careers. I have found no better sign of late than the latest BAML Fund Manager Survey from Michael Hartnett. Investors are pouring into stocks and out of cash at a rate rarely seen in their survey. This has predicted huge tops in risk assets in the past. Will it do so again?

The behavioral category has more worrying signs than positive signs. I won’t get actionably nervous until we see a turn in put-call and a break of the cloud on the weekly charts, however, we need to be aware of these tactical risks to the market entering the new year. I would encourage you to look for option market protection or to at least have stop-loss orders in.

CATALYST

Michael Steinhardt, the first HF manager, says there are four steps in his process: what is the idea, where is consensus, what is your view, and what is the catalyst to get people to change their mind. In markets, catalysts tend to come from earnings (we won’t get until the end of next month), economic data, and geopolitical events. Let’s take a look.

Economic Surprise

I use the Citi data for this. It is broken into two parts - economic surprise, assessing how data is coming in relative to expectations, not in absolute terms, & the same but for inflation data. It is important to consider both as the FOMC has a dual mandate of full employment (growth) and price stability (inflation). The ECB and BOJ on the other hand really only care about inflation. Let’s consider both the US data and the Global data. We see that the US economic data had been surprising on the upside from the start of the year through March. This is why rate cuts were pushed out. Since the spring, it has disappointed, up until the FOMC starting cutting. Then from September thru November, it was better, and now the FOMC is on hold. All while US inflation data has bounced around and not really gone anywhere. The guess going forward will be whether inflation stays tame and whether the growth data disappoints. This will guide us into the March FOMC. We see a very similar pattern for global data. The US is really holding up the rest of the world since China and the EU are not. If the US suffers, what happens to global data? Will we see more aggressive global rate cutting?

Geopolitics

Geopolitics are never positive, just degrees of bad. One could argue, that given the many wars going on right now, there is scope for things to only get better with a new US administration. Interestingly, the economic policy surprise index it rather tame given the various potential exogenous shocks to the markets. In addition, the global financial stress index is showing no signs of trouble. Both measures are relatively low, which is why the headlines we see are simply not impacting markets.

No particularly strong signs from the catalyst section. Nothing to get one to change their minds. There is scope for movement in either direction from this section, just nothing happening right now.

Thus, in summary, the fundament trend looks rather supportive, but the near-term supply and demand is showing signs of strain. Nothing is happening now to get people to change their minds, but looking into next month, we need to be vigilant to how things can play out either positively or negatively. If invested, use options protection or a stop-loss. If in cash, look for the signs above to resolve positively to get invested.

Most importantly, have a joyous holiday season!