“This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” - Winston Churchill, 1942
This week marked the end of the semester for me, as classes ended on April 30 and the students are now in finals week. Next week will be graduation festivities for all, including my youngest. It was definitely the end of a phase of life for many this week.
This weekend, my wife and I retreated to the lake house, to pull out some furniture and get things ready for the forthcoming summer. From this standpoint, it was also the beginning of our summer season where we will get to spend a lot of time with family and friends and celebrate all that is good.
The past week in the markets was a wild one. On Wednesday, pundits were asking Jay Powell if the Fed was playing on HIKING rates. By the Friday, after the non-farm payroll, the market was busy price two CUTS back into the curve. In addition, we have just finished the busiest two weeks of earnings and now more than 80% of the market has reported. There was an equal full range of emotions from the earnings news too.
So is it the beginning of the end of the bull market from 2023 until now or is it the end of beginning of the correction to the market as we are set up for better times ahead. When in doubt, I always go back to the three principle ways that I use to assess the market: Fundamentals, Behavioral and Catalyst.
Fundamental
In the Fundamental section, I aim to assess the trend in the economy, in central bank liquidity, in the supply & demand for money. I am always watching these even if I don’t write about them each week, as this is what drives the core trend for risk in markets.
At the FOMC presser, Jay was asked about the economy, and about the growing sense that we were going into stagflation. There are many on Wall Street that are debating whether we are, with most putting out articles that we are not at all. I feel too many are focused only on the 1970s version of stagflation, which is a very specific and extreme version of it. For instance, a depression is just a really bad recession. If we don’t have the conditions for a depression, does this mean we won’t have a recession? I think the same could be true about stagflation. I wrote about it this week on LinkedIn:
Chart of the Day - Stag & Flation
In his comments yesterday, Jay Powell said he didn't "really understand where talk of a stagflation scenario is coming from" given the preponderance of solid economic data. “I don’t see the stag, or the ’flation,” he said. Of course, he didn't see inflation sticking in 2021 either
Jay & the sell-siders who don't see stagflation are referring to a specific stagflation we had in the 1970s when prices & unemployment were both double digits.
Economic theory says stagflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, & unemployment remains steadily high
Let's look at each of these. For one, we will get the unemployment news tomorrow. The rate at 3.8% is not steadily high. I agree with this. However, it is also kept lower by the number of people that are taking two jobs in order to make ends meet
The Sahm Rule states that we will have a recession when the 3 month moving average of unemployment is 0.5% above the lows that it hit. Right now, that Rule is at 0.3% and rising. The Sahm Rule has been triggered in 19 of the 50 states, including my own. Not high unemployment yet, but a worsening situation. Let's see what tomorrow holds
Onto the economy & inflation. Yesterday we got the ISM data. It is in the top chart. The headline index moved back below the 50 threshold of expansion/contraction
More importantly, the new orders to inventory ratio fell for the 4th straight month. This is the ratio that signaled a better economy all of last year. Better than the sell-side analysts were saying at the time with notes calling for recession
Also, the ISM Prices Paid Index rose to 60.9, the highest in 5 months, & higher than the average over the last 24 years. Growth slowing & prices rising. Starting to sound like stagflation, Jay
Perhaps Jay prefers the GDP data which are 'hard numbers' & not surveys. Of course it has a long delay but he is in DC o who needs real-time info. The last GDP readings are in the bottom chart. I used qoq & not yoy to try & get a bit higher frequency look at the data
You can see that the growth number fell to 1.6%, below expectations & below the average of the post GFC world. The GDP Price index rose to 3.1% which would be considered high inflation in any period other than 2021-22. Growth falling & prices rises. Starting to sound like stagflation, Jay
I admit, we don't have the high & steady unemployment ... yet. Employment is a lagging indicator. In my portfolio management class, 10 teams built an economic model to forecast the economy over the next 6 to 9 months
The teams decided that the economic phase we will be going into over this period is stagflation, with growth falling & prices rising. This is important as it indicates that stock mkt returns are negative on average & the best performing sectors are energy & materials, which sounds like the mkt the last 6-8 wks
I have a former student who is wicked smart working with me on trying to convert my investing process over to AI. We are going through all of the variables I look at and the framework through which I assess. This is a little different than the students I worked with in the Fall that used a series of machine learning models to optimize the variables. In this approach, we are assessing them all and trying to determine, based on the subjective interpretation framework of the data, what is the optimal set of variables to use. For example, it is not looking at the ISM & running a correlation vs. the SPX. It is saying ‘the best returns are when below 50 and rising while the worst returns are below 50 and falling so what does this mean for SPX prediction?’
One variable that consistently shows up as one of the strongest is the Fundamental Stock Indicator. I learned this one from Ed Yardeni about 20 years ago. It is simple yet intuitive in its construct. There are three components: consumer confidence, jobless claims and commodity prices. The logic here is that the economy leads earnings and earnings lead stocks. Companies are making money when consumers are feeling good about the economy, people are employed, and commodities are showing demand. It has a very good track record even if the Covid noise that really impacted consumers and jobs, has caused it to be too volatile of late. Lately, this indicator is pointing south for stocks
This is the chart of this indicator pre-Covid. You can see that it has done a nice job of identifying the proper trend and leading the stock market:
I still find myself in the ‘no cut’ camp for the FOMC this year. Looking at the financial conditions per the Chicago Fed, the availability of capital still looks easy which I think will end up keeping inflation a persistent problem throughout the year, regardless of the labor market. I think this keeps the Fed on hold.
Putting this all together, I feel this means the economy is still strong but is weakening. The summer months, while we are at the lake and trying to relax, probably are the start of an economy that is starting to look decidedly weaker into the election. I think this will be the buzz over the summer. It is the beginning of the end of the strong economy we have had.
Behavioral
We have perhaps been in this situation before. The end of 2022 and early 2023 had signs that the fundamentals were starting to look weak, but the behavioral aspect of the market kept stocks moving higher. Maybe that happens again. That was also bolstered by an Administration that actively drove down oil prices and pumped stimulus into the economy. I am not sure those levers are available right now.
The market only seems to care about the Fed these days, however. I wrote about a new model on Bloomberg I came across that measured whether the Fed was dovish or hawkish in their commentary. I wrote this early last week and by the end of the week, the model was suggesting the Fed was dovish, which I think had something to do with the strong end of week rally, though better than expected Apple earnings didn’t hurt. With the Fed the story of the market still, I think this Fedspeak model is an interesting one to follow:
Chart of the Day - it's not what you say, it's how you say it
Yesterday I came across an article that discussed the new Fedspeak AI tool that Bloomberg has developed in order to parse the commentary from the FOMC. With an important FOMC meeting this week, I thought it was quite interesting
This tool uses natural language processing. Natural language processing (NLP) is the ability of a computer program to understand human language as it's spoken and written -- referred to as natural language. It's a component of artificial intelligence (AI)
NLP has existed for more than 50 years and has roots in the field of linguistics. I have worked with a few grad students that are going beyond simply having the computer read & understand the words, but also delving into the intonation & sentiment analysis of the content
In many ways, NLP will do more to replace the job of an analyst than machine learning & compute power. After all, the models we build are only as good as the assumptions & forecasts we make to build them
I took a look at the Fedspeak model that Bloomberg built & plotted it against a few things to see if it had much correlation to other variables I consider. Perhaps not surprisingly, one that it had the most correlation to was the equity multiple
I have discussed this in the past but for me an equity multiple is simply a sentiment measure. I think some people in the comparable company & multiples analysis, think the equity multiple is some mathematical fact
Sure, it has its roots in & can be linked to the company's weighted average cost of capital. However, that number rarely changes much. The equity multiple will have wide swings throughout the year. Why?
Equity investors sometimes feel better than normal & sometimes feel worse than normal. What drives this? Well, since 2021, it has been the extent to which they feel the Fed is fighting against them vs. getting out of the way
The chart today shows the level of hawkishness from the Fed. As it moves higher, hawkishness is going up - in what they are saying, not in what they are doing
I plotted this vs. the forward earnings yield, which is the inverse of P/E. As hawkishness goes higher, investors get less confident & demand a higher yield/pay a lower P/E. As dovishness kicks in & the white line moves lower, investors feel more confident & pay higher multiples/demand a lower yield
You can see the Fed dovishness led this yield, which in turn drove stock prices higher. After all, it was not earnings that carried stocks higher but higher multiples/lower yields. In the last few weeks, the hawkishness has ticked a little higher but still is not hawkish by any stretch
How will this line move over the next couple of days at the conclusion of the FOMC meeting? How will it move when we hear Fed speakers discuss the ISM number or the non-farm payroll number etc?
Fedspeak has been the driver of risk. This week should be interesting
As I said above, the behavioral category, namely the technicals of the market, were the sign of good times ahead last year. Traders and investors ignored those at their peril. How are the technicals looking right now? I wrote about that on LinkedIn this week:
Chart of the Day - Sell in May?
There is an old adage in financial markets that investors should Sell in May and Go Away. It actually started in London & was longer: Sell in May & Go Away & come back on St. Leger's Day (which is Sept 15)
The idea here is that the summer months is a slowdown in markets. We are past the point of peak spending from holidays, Christmas, Valentine's etc. Bonuses have been paid out (or not) & spent or invested. There are just no catalysts for the next several months
If you look at returns in the US in the post GFC era, the May-Sept returns are about 1.3% while the October-April returns are 10%. Thus, it is a period of worse returns, though not negative. A good deal of this is due to the avg negative returns in August & September however
However, I had to think about this maxim after my colleague Tony brought it up on our last Macro Matters podcast. We had outlined how it looked like US rates were heading higher & how this could be a headwind for risk
Today I open my Bloomberg & see the top chart. It is the daily chart of Bitcoin. I feel Bitcoin is a canary in the coal mine for risk, either positive or negative. When investors are feeling bullish on Bitcoin, we tend to see other risk assets rally. When they sour, other sour
I think this is because, as we showed yesterday, the mkt is intensely focused on the Fed. Bitcoin is the ultimate long duration asset that is impacted positively or negatively by the Fed. The daily chart is ugly. It has broken down & is headed to 50k pretty quickly with a final stop at the 200 day mov avg of 45k if I had to guess
If you look at the middle chart, you can see confirmation. It is coming off an extremely overbought weekly RSI & the MACD is crossing lower. It is past the base & conversion lines on the ichimoku & appears headed to 40k. Suffice to say, Bitcoin investors will be challenged
There are many who likely bought on the anticipation of the halving in Bitcoin, because Bitcoin always went higher after that. This theory is being tested in real-time
The bottom chart shows the overlay of Bitcoin & the Nasdaq (NDX). NDX has held up relatively better. Sure, earnings could be a catalyst, the same way the halving was a catalyst for Bitcoin
However, maybe the more powerful force here is the cost & availability of capital. We see yields moving higher across the curve. Cost is higher. We see the global pools of investor money in Asia have their purchasing power weaken. Money will be puled back home. Availability will weaken
Canaries were used in coal mines until 1986. They would be affected by the carbon monoxide first, giving miners an early warning. Technology ended up replacing the canaries
This canary (Bitcoin) might be sensing that there is not enough oxygen in the fincl mkts & telling the technology (NDX) that it is time to exit the mine
Another of the powerful signals we are finding in trying to use AI to replicate my process is the 20 day moving average of the put-call ratio. I talk about this ratio in many of my classes. I am not surprised to see it has some statistical significance. The market moves are inverse to this indicator so I have inverted the SPX here. Higher put-call ratios mean lower stocks and vice versa. The inflections of this measure matter the most. Right now, this measure is moving higher and has since early March. This is still pointing to weaker times for stocks.
Looking through the behavioral aspects of the market, things still look a little more difficult for risk-taking. I know we ended the market on a strong note, and with technical analysis, the view can switch pretty quickly which is why more traders than investors prefer it. I will be watching closely, but for now, the behavioral category also looks like the beginning of the end of this strong start to the year we have had.
Catalyst
The last category I watch is the catalyst category. This is the one that gets people to change their minds. The fundamentals can help us dictate secular trend. The behavioral can tell us about the cycle around the trend. The catalysts tell us about what is happening that will get people to re-assess their views. We don’t always get catalysts, but when we do, we should pay attention. As I wrote before, we just ended a busy two-week period for earnings. This is one of the most important catalysts we get. On Friday, I wrote about how earnings were coming out on LinkedIn:
Chart of the Day -surprise!
When I got home from Champaign yesterday, I got a big surprise. My daughter had flown in from California unbeknownst to me. She came in for the Gies Business Alumni luncheon where I am fortunate to get an award. Thank you to all for your very nice comments on that post yesterday
The stock market has also gotten a really nice surprise lately. The last two weeks are the busiest two weeks of the season for earnings. It really ended with Apple giving better than expected numbers & some hope with a WWDC catalyst now on June 10
It isn't just Apple though. You can see 400 of the 500 stocks have reported & earnings surprises are coming in close to 9%. Sales surprises are coming in close to 1%. The actual earnings growth is about 4.6% & the actual sales growth is 4% so earnings were expected to decline but have gone up some
Two weeks ago, I mentioned that the multiple on stocks would be challenged with the Fed discussion, inflation, 10yr yields etc. However, stocks could still go higher but would have to be driven by earnings. That is happening right now
Another surprise is the reaction of the stocks to this news on day one. You can see that in the lower right of the chart. On average, the moves are negative over the first day. This is indicative that the news for this quarter may be good, but the outlook may not be as strong
We will also get some other surprises in a short time as we get the non-farm payroll number. Of course, we have already gotten several other looks at the labor market such as jobless claims, ADP surveys, ISM employment, NFIP employment & unit labor costs. All point to a stronger than expected number today
If we look at the revisions to the data over the last several years, we see that April jobs numbers usually come in strong & are then revised lower then next couple of months. Another suggestion we could get a strong number today
The surprise might be that good news is actually bad news because those 1.6 cuts priced into Fed Funds may not come to fruition. There was a relief rally in bonds because the Fed says it won't hike & the Treasury is slowing down issuance. However, that doesn't mean it will cut
Markets always move at the margin. This is because some level of news is priced into the expectation of traders & investors. When those expectations are not met, positively or negatively, bigger moves happen
The last week of FOMC, economic data & especially earnings have been positive surprises, just like my daughter flying in unexpectedly. Will this continue through the jobs number today?
Another catalyst for markets is the economic surprises we get. We have also finished a busy two-week period for economic data. I prefer the Citi economic surprise index. Over the last two years in particular, this economic surprise index has had a good fit with two-year yields. As it falls, that is we get bad news on the economy, rate cuts get priced in. As it rises, so we are seeing better than expected data, rate cuts get priced out. Given the level of the fall the past two weeks, with worse than expected data, It is somewhat surprising we have not seen the two-year yield fall and more rate cuts get priced in. This definitely falls into the bad news is good news category.
You can see that the market got more dovish over the course of the week. On April 30, the market had only 1 cut priced in for this year, with that not coming until December.
But by Friday, the market was closer to two cuts, with the first cut coming in September. Clearly a more dovish bond market which gave hope to equity investors.
Collectively, the catalyst section is much more positive. Earnings are better and while the reaction to the news has not been strong overall, it has been strong for the names people are most long. The economic data has been much worse, and while this suggests the trend of the economy is weakening as I mentioned earlier, it could well mean the Fed will cut. I still don’t think so, but I respect that the market feels this way and I can see why it does. For me, this then comes in counter to the other categories, and I see it as the end of the beginning. The market was beginning to get nervous the Fed wouldn’t have its back or that earnings would not come through. At this point, the market should feel more confident about earnings & is feeling more confident the Fed will have its back.
What is an investor meant to do with all of this conflicting data? On the one hand, the economic trend is weakening. Growth is showing signs of decay & the labor market, which has been leading us for some time, is getting close to the signs of a recession again. I still think inflation will be a persistent problem, so I am leaning toward the stagflation call, but this puts me in a minority. Even those that think we get a recession (they are out there), think that this will pull down inflation and enable the Fed to cut rates.
Behaviorally, we have had a really good run for risk since the end of October. The 6 months returns to the SPX are 17.65% and every sector is positive. Investors in communications, tech, industrials and financials have all made more than 20%. That is a great run. There are signs that this is starting to give way, though. The canary in the coal mine for risk is fading. Investors are looking to hedge their portfolios. Technicals are looking stretched.
Finally, bad news is good news when it comes to the economy and good news is good news when it comes to earnings. The catalyst section is the reason we ended the week strongly. I think it may be the reason we begin next week on a strong foot too. It is not all unicorns and rainbows, as we have two wars going on, sanctions and tariffs going up left and right, & let’s not forget about protests across college campuses that suggest this year’s election cycle will be nerve-wracking. However, the stock market, for now, cares about the former and not the latter.
Investors should stay their course. I am not an advisor so I won’t tell you what is right for you. However, if you are in cash and looking for better opportunities, I think you will see those. So be patient. If you are invested and were treated to good earnings, I would suggest you stay invested, though you might want to take out some insurance in the options market as institutions are doing. If you are invested in stocks that have disappointed, there has been little reprieve for these names. As I have seen in our Investment Mangement Academy and Applied Portfolio Management portfolios, names that disappoint are in the doghouse so it is best to move in.
It is not an easy market. Some see the beginning of the end for risk-taking. However, there are some other hopeful signs and others see the end of the beginning of this correction with better markets and a nicer Fed ahead. Uncertain markets call for investors to be very disciplined and very patient. Uncertain markets call for investors to …
Stay Vigilant
Thank you, Beachman! It is quite exciting that all of our kids are now off into their career journey.
The markets and the economy are certainly difficult to navigate. Expectations have gotten high as they tend to when we have had a good run. This make me feel like there is a looming disappointment and there have been for many names which are summarily punished by investors. I completely agree that well-run companies have many levers to pull and that is what we are seeing.
It will be an interesting summer for sure.
Have a great week!
Richard - Congrats on the graduation of your youngest child. What a proud achievement for the padawan as well as the Jedi masters (parents). Next year, we will be celebrating two graduations in our family - one from college and the other from high school. Yes, my wife and I planned it such that we only have one kid in college at a time. LOL.
I always read your post as soon as possible after it hits my inbox and this week I was not disappointed. I rarely am. I continue to be intrigued by your students' work especially the economic modeling and applying AI to your investing process..please keep us informed on that front.
"Sell in May and go away" is top of mind for me as an investor...many conflicting macro and market signals that are keeping us guessing. 2024 could shape up to be an average year of returns (7-9%) in the face of 1.5-2% GDP growth and higher earnings growth predicated on lower sales. Overall, SP500 earnings are expected to grow by 5% in Q1, by almost 10% in Q2, almost 9% in Q3 and more than 17% in Q4. These forward estimates are bullish for markets, but they are quite a ways away on the calendar and you will note that they are about earnings growth and not revenue growth. Well run companies have many levers at their disposal to show higher earnings in the face of slower sales i.e. cut headcount, stop hiring, shut down side projects, pay off expensive debt etc.