The good, the bad and the ugly

It has been a heck of a year already as most of you already know. Realistically, you are probably thinking we have never seen anything like it. I know many people I speak to who are early in their careers make that comment. While there are clearly some unique aspects to the market volatility in 2025, in reality, it is far from unusual. When all is said and done, the market was leaning too much in one direction - positioning and valuation. There was a negative catalyst which led to a position reduction, mostly by leveraged institutional investors. In fact, by all accounts, retail investors bought the dip. As the catalyst went away almost as quickly as it came, markets have moved back to largely where they were, which is very surprising to even the most seasoned investor. Now, with volatility falling, and a new month beginning, sidelined institutional investors may well get involved and this could squeeze risky prices even higher still. However, all is still not right with the world. Let’s explore further.

In a round of golf on Friday, talking to a sage market veteran, the topic came up that people are really not down that much money. In fact, looking at the US 60-40 Index, it is down by less than 1% (76 bps actually) on a year-to-date basis, and if we are waiting for retail investors to slow down consumption because of negative wealth effects, we might be waiting for some time. Sure, over the course of the month it was much worse. Those of us who watch day-t0-day know this. However, many only look at their monthly statements, and on that basis, things look pretty good. Imagine reading all of the negative headlines about the market crash and how things look worse than the Great Depression, then opening up the monthly statement from your broker and seeing you are down 1% give or take, certainly less than 2%. You would wonder what all the noise was about. In fact, if we go back to election day, the 60-40 is pretty flat. This assumes they were not adding to their equity positions at the lows, even though we know many were. Thus, for now, I would say the retail investors and retail consumption probably feel pretty good right now. The jobs data from last week suggest that things are still fine too. I would expect the 401k inflows to continue in earnest.

The Good

How can there be any good news you might ask? Well, sometimes we are looking at a stock market, or a macro market driven by the big picture. The other times, it is a market of stocks, driven by idiosyncratic news. We just finished one of the busiest weeks of the quarter for earnings. now, as we sit, more than 70% of companies have reported. When all is said and done, the news is pretty darn good. Earnings growth is over 8% for the SPX. Sure, sales growth is only up small (though it is up a lot more than the negative GDP print) but companies continue to show the ability to squeeze more earnings out of the business. Actually, in the lower left we can see that this quarters’ earnings growth is at the highs of the last couple of years, so not only good, but really good.

Lest you think this is still a bifurcated market like the bifurcated economy that we had, the Russell 2000 small caps have put up even more earnings growth. Similarly, sales is only up small, but earnings showed double digit increases. We will have a bigger week of earnings coming up, as only about 40% have reported, but the news in small cap land, which have lagged large caps badly, was similarly good. When all is said and done earnings drive stocks and right now, earnings are still really good.

The Bad

All is not perfect though. The economy can lead earnings and so we want to know what the economy will due. I shared several notes this week on the economy as data came out, and I am copying one of the charts - the ISM data. It showed the headline was lower this month while prices moved higher. Both were worse on a month-over-month basis but better than expected. Positively, the new orders to inventories ratio was better suggesting ISM may bounce back higher next month. This data came out after Liberation Day, so it is real time (unlike GDP). The stagflationary narrative is similar to the reports from all of the regional Feds. it doesn’t sound great, but it is better news than the recession that many sectors, and many asset classes are pricing in. That said, we know that when the ISM is below 50 and falling, it is the worst time to own stocks. Thus, I am not going to try and give you the warm and fuzzies here. I am maybe more upbeat because investors had gotten so negative so quickly, and this was not as bad as feared. However, we still need to see this improve to want to jump in with both feet.

The Ugly

As I said, it is still difficult to have the warm and fuzzies. In fact, I told you last week that I took my round trip on the stocks I bought at the lows, and I am happily in cash, trying to be very tactical in this market. Even with better earnings, I am not looking to go all in just yet. Part of that is because of the economy uncertainty and what that means for paralyzing business investment decisions and probably even larger consumer decisions. Would you buy a house now or wait just a bit? I know now is seasonally better, and maybe give the age of your kids and the schools, you still would. However, with uncertainty, it is a harder decision. For a business, looking at the IRR of any expansion, there has to be a higher discount rate to account for the uncertainty. Also, where do you want that plant to go and will you even need it if demand collapses? The chart shows the economic policy uncertainty index and not surprisingly, it tends to mirror the volatility of the markets, measured here by VIX for stocks and MOVE for bonds. Stocks in particular are correlated with this data, until recently. While the uncertainty index is still higher than at any time this century, including the Great Financial Crisis and Covid, the volatility in both markets came lower over the last week, bringing more investors back into the market from a Value-at-Risk allocation process. Given where this index is, will volatility stay this low? Are we still at risk of another vol shock that gets the institutions out again? This is one thing that keeps me thinking tactically at this point still. It could suggest that using options to implement any longs you put on could make sense at this time.

All in all, investor portfolios are still in fine shape, in spite of the noise of the markets. Will this continue? The coincident data suggest it may not. There is also reason to believe volatility may pick up again, keeping institutions on the sidelines. However, earnings are driving the market of stocks, and before long, retail investors may even be up on the year. This could pose a problem for the bond market expecting the Fed to aggressively cut rates.

Uncertain times require investors to be flexible and adaptable to changing dynamics. As you are, make sure you are watching all of the news and data because it isn’t all good and it isn’t all bad. In fact, some of it is still ugly.

Stay Vigilant