I had the privilege of interviewing Barry Knapp, a long-time market strategist on the sell-side and buy-side, for the CFA Society Chicago. Barry is always thinking about issues and topics before others in the market and so my conversation with him are thought-provoking. If you haven’t read his Substack, you can find it at Ironsides Macro Substack. I think it is excellent and would highly recommend it for anyone interested in macro.
Barry spoke about the idea of Twin Peaks. If you recall, Mr. Risk also spoke about Twin Peaks in the podcast last week. Not surprising that they might be thinking about something similar because they both worked at Lehman together back in the day. After interviewing both 3 weeks ago, I had written about the Twin Peaks on my LinkedIn:
“Chart of the Day - twin peaks. This week I was fortunate to host two podcasts with people I have known for a long time & for whom I have a lot of respect. They each bring a very unique view for how to navigate markets, especially difficult markets. They each can cut right to the heart of what is most important to determine on both the reward side of investing & on the risk side of investing. After all, every investment has a reward & a risk & it is our job to weigh our options comparing each. Each of these, in separate conversations, referred to the idea of twin peaks.
The twin peaks that they referred to that the market needs to see before investors of any asset will feel comfortable to take risk are the peaks in Fed Funds rate (in blue) & the peak in inflation (in white). We have seen this playing out over the course of the summer & so it should not come as a surprise to us.
I use the SPX Index in orange as the proxy for the risky mkt. You can see that the market bottomed over the summer when the expectation for Fed hikes (in purple - hikes over next 1 yr) was falling. This coincided with the peak in inflation on a year over year basis back in June. This gave rise to the discussion of a Fed pivot & the bond mkt started to price rate CUTS into the 2023 curve. Stocks liked this. We rallied 20% from the lows. However, what caused this rally to stall?
The stall came from the Fed commentary, after both the July FOMC but also during the Jackson Hole Symposium, that the Fed is not done. There is no peak in Fed Funds. We see the purple line start to move back higher & stocks sell off. Then we get the tick higher in CPI this week - not large from 8.1 to 8.3 - and the bond mkt realizes even further that the Fed is not done. 1.5 more hikes are priced into the Fed Funds. Stocks have a big move lower on Tuesday & have continued.
You see, for a bottom to be in, a necessary pre-condition, perhaps not the only condition, is for us to see the twin peaks - the peaks in inflation & the peak in Fed Funds i.e. for the Fed to at least pause. Until then, we are in a volatile mkt with a downward bias.
Since it is the weekend & we are discussing peaks I thought I would end by passing on some other advice. Twin Peaks is also a very interesting TV show from the 90s (they took off Netflix so need Showtime). Or as you watch your favorite sports this weekend, consider perhaps Four Peaks, a terrific beer brewed out in Tempe, AZ. If beer is not your thing, there is Six Peaks winery which makes a nice Pinot in Hillsboro, OR. Finally, for those in the intl audience, that want something different, try Eight Peaks (Hakkaisan), a lighter style junmai sake that comes from the Hakkai Mountains in Niigata, Japan. Even as you enjoy, remember to ...
Stay Vigilant”
The market is still trying to call the bottom based on primarily the first of the Twin Peaks being Peak Fed or as Barry says, Peak Fed Hawkishness. Just this week we saw a major rally on Monday and Tuesday as the Prices Paid component of ISM fell sharply indicating perhaps the Fed could slow. However, by Friday, the unemployment rate dropping as well indicated the Fed will still be largely in play.
Ironically, what might be ignored in that number is that it suggests the economy is holding onto more strength than many believe is possible. I know earlier this year I discussed the notion that the housing, construction and vacationing I was seeing in the Spring and early Summer had the possibility of keeping the economy strong through the end of the year. That may in fact be what we are seeing. I allowed myself to forget about this in the previous weeks and buy into the market notion that earnings have to drop in Q3 because housing and orders already have. What if the economy stays a bit strong? After all, if we look at the unemployment rate (inverse here) vs. the actual S& P earnings the last 10 years, the pattern is roughly the same:
Yes, multiples will go lower with the Fed still in play, but P = P/E * E. A declining P/E vs. a rising E can suggest that P does not need to fall that much. If quarterly earnings stay around $55 that could be year ahead earnings at $220. If the multiple declines to the last 30 year average of 15x that puts the market at 3300. With earnings really kicking off this week with the big bank stocks, the focus will be on how much earnings can put a floor in the market. I am not turning wildly bullish on you, I am just trying to think about what can happen.
Back to the discussion with Barry, he also spoke about how the market is pricing in that once the Fed pauses, it will have a cut in the next year. He does not see this to be the case and thinks inflation staying structurally higher led by energy, will mean there could be a restart. The spread he mentioned was the December 2022 Eurodollar future vs. the December 2023 Eurodollar future. You can still see there are about 18 basis points of cuts priced into the Fed rates for next year.
Barry also spoke about the Fed’s impact on housing via the effects of QE and QT on mortgage spreads. I had written about the spread of 30 year mortgages to the 10 year bond and spoke about bankers being greedy and then nervous, expecting the greed to come back. Mike Dulla, an astute reader and a mortgage market expert, also pointed out the impact the Fed was having on the mortgage market. For those looking for a pivot, perhaps a reduction in QT is more likely than a pause in rate hikes:
Both Barry and Mr. Risk spoke about the positive trends in household formation which also provide a secular tailwind for housing around this cycle downturn we may see:
I have also tried to pull together the impact of mortgage rates and the job market on housing. We know higher mortgage rates will hurt housing but by how much? Also, the rate on a mortgage is NOT the only determinant. The buyer has to ask themselves about their job situation and if they can afford it. After all, a mortgage rate of 0 will not attract buyers if the unemployment rate is 25%. However, with even slightly higher mortgage rates, and a healthy job market, combined with a secular demographic trend toward more home ownership, and housing does NOT have to fall off a cliff. The mort*job here is simply a geometric average of 30 year mortgage rates and the unemployment rate. You can see it is nowhere near where it was in 2008 or 2020. In fact, it is lower than where it was back on 2004 when we had a national housing bubble.
The last notes of optimism I want to leave you with this week because Barry had a more optimistic tone, are updates on positioning, which continues to be a reason that bears need to be cautious.
Leverage accounts have reduced their shorts but still are quite short:
The American Association of Individual Investors survey is historically bearish:
The CNN Fear and Greed Index that looks at multiple market measures is still in Extreme Fear:
Finally, as Barry mentioned, S&P 500 skew levels seen in QuikStrike, the premium paid for put options over call options, is still very benign which suggests investors are positioned for a move lower, hugging their benchmarks, keeping low leverage, holding cash.
The earnings season is kicking off in earnest this week. We ended last week with a very poor day but the overall week was not bad given it had started strongly. Positioning and sentiment is still quite poor. This could be the type of market that is very responsive to any sense of good news. Last week that good news was meant to be the Fed. Perhaps this week the good news will be that a stronger than expected economy is leading to better than feared earnings. This is not my base case but I think we need to be aware it could happen. Of course, we need to …
Stay Vigilant
Twin Peaks