Daily Stock Market Articles

Bulls Back Off
Thu, Aug 17, 2023

This month's negative tone continued in the past week as the S&P 500 collapsed through its 50-DMA. Not susprisingly, the weakness has put a dampener on sentiment. The latest investor sentiment survey from AAII showed only 35.9% of respondents reported as bullish. That is down for a second week in a row from 49% two weeks ago, and the 13.1 percentage point drop during that span ranks as the largest since the back half of February when bullish sentiment fell by more than 15 percentage points. It is an even more pronounced drop from 50%+ reading that was put in place the week of July 20th.



Bearish sentiment picked up some of the difference this week, rising 4.6 percentage points to 30.1% and is the highest reading since the first week of June.



With inverse moves in bullish and bearish sentiment, the bull bear spread has fallen sharply to 5.8 after ten consecutive weeks of double digit positive readings (what had been the longest such streak in over two years as shown in the second chart below). In other words, sentiment continues to favor bulls, but by a much narrower margin than what has been seen in the past few months.





In the table below, we show every other instance in the AAII survey's history in which streaks of at least ten weeks or more of bulls outnumbering bears by at least ten percentage points have come to an end. As shown above and below, these sorts of streaks tend to happen every few years and typically when they end, bullish and bearish sentiment are not far off from their overall historical averages. As for how the S&P 500 has tended to perform going forward, short term performance has been weak with an average decline one week later. However, performance one month to one year out is much more consistently positive. That being said, average/median returns six months to one year out have been smaller than the norm.



Finally, we would note that the AAII survey was not the only sentiment indicator to have taken a bearish turn in recent weeks. Other weekly sentiment gauges like the Investors Intelligence survey of newsletter writers and the NAAIM Exposure Index have also turned lower. In the case of the former, the percentage of respondents reporting as bullish is back below 50% for the first time since the end of May. The latter similarly shows active managers are the least exposed to equities since the end of May. Combined with the AAII survey, our sentiment composite shows investors are only slightly more bullish than what has historically been normal.

 

Markets Are Coming to Terms with the Fact That the Economy is Strong
Posted on August 18, 2023

Another month, another slew of economic data that not only shows that the economy is resilient, but it may in fact be accelerating. Here’s a quick recap.

Retail sales and food services rose 0.7% in July. One month may be noisy, but even if you take a 3-month average, retail sales rose 7% at an annualized pace. By the way, inflation was up just 1.9% over this period. Which means inflation-adjusted retail sales rose at a 5% annualized pace and leaves it 7% above the pre-pandemic trend. That’s incredible and it tells you how strong households are.



There are four positive stories on the manufacturing front as well, all of which are tailwinds for the economy.

Vehicle production has rebounded to the highest level since 2018 (which means it’s even higher than at any point in 2019). Even with that, we’ve yet to make up for a cumulative shortfall of 5 million vehicles due to pandemic shutdowns, which means production is likely to remain strong.



Production of medium and heavy trucks is also moving up, rising 14% this year.

The aerospace industry is also seeing a boom, with production up 4% this year.

High tech equipment production (computers, communication equipment, semiconductors) is surging once again, rising more than 7% over the first seven months of this year, and up 20% since February 2020 (pre-pandemic).

Suffice to say, none of this is what we’d expect to be seeing if the economy was heading into a recession. These are all large investments companies have to make, and it tells you that they believe future demand is going to be strong.

Overall, this is positive for current activity and GDP growth near-term. But its also positive in two other important ways:

• Inflationary pressure may be reduced as supply increases
• Productivity may rise in the future on the back of investments made today

We also received data from the housing market that shows single-family construction continues to rebound. Housing starts rose almost 7% in July and are up 22% since last November. Building permits, which are a sign of future supply, rose just under 1% and are up 24% since December. It tells you how homebuilders are viewing potential demand, despite mortgage rate rising above 7%. This is another tailwind for GDP growth, as we wrote in our Mid-Year Outlook.



All this has sent the Atlanta Fed’s nowcast of Q3 GDP growth to a whopping 5.8%. A month and a half ago, the median expectation for Q3 growth was zero! Which meant half of the polled economists were expecting negative growth. It’s hard to believe GDP will rise close to 4%, let alone 6% (this is after adjusting for inflation) – and we do have a long way to go before the quarter closes out. But the direction should tell you a lot about how the economy is doing.

Higher Interest Rates for Longer, Much Longer
Equity markets have pulled back despite this run of strong economic data. Of course, this is a period that has historically been weak for equities, as Ryan has pointed out. It’s ironic that this is happening even as a lot of bearish analysts are throwing in the towel and switching their estimates to less bearish outcomes.

But it’s the bond market that has my attention.

Investors are not expecting the Fed to raise rates any further despite the strong economic data. So, the fed funds rate is expected to peak around 5.4%. A 5.4% peak makes sense because inflation seems to be rolling over, and there’s potentially more disinflation in the pipeline, with vehicle and shelter inflation easing further.

What’s interesting, is that longer-term bond yields have been surging even as short-term rate remain steady. Some of this is because of a potentially increased supply of Treasuries, as the government looks to cover a rising deficit. But investors’ expectations of what may be coming has also changed.

Rising long-term yields mean investors expect the Fed to keep rates on the higher side long-term. The run of strong economic data, including employment, has surprised a lot of investors. As a result, expectations for future growth are shifting higher as the economy proves its resilience in the face of an aggressive Fed and higher interest rates.

Investors do expect the Fed to cut rates by about 1-1.25% in 2024, in the face of lower inflation. But not much more after that.



A month ago, they expected the Fed to keep rates around 3.2% into 2027. That’s now almost up to 4%, which is well above Fed officials’ own “long-run” forecast of 2.5%. This long-run expectation is similar to what the Fed expected over the last decade, and so they’re definitely anchored to that.

Yet, investors see it different. They’re saying that the economy is resilient, and its likely to remain that way. But it also means that interest rates will have to be higher than what we saw over the past decade.

 

Why We’re Not Too Worried About Rising Bankruptcies
Posted on August 15, 2023

Consumer credit card has recently been in the news after it hit a record $1 trillion. However, Ryan walked us through several reasons why this eye-popping number is not that concerning.

On the business side, rising bankruptcies have also been making headlines month after month, as chapter 11 filings this year exceed what we saw last year. There were 402 bankruptcy filings over the first seven months of 2023, close to double the 2022 rate and the highest since 2010. The blame has landed on higher interest rates and a tough operating environment.

Bond Markets Don’t Seem Concerned
Interest rates have certainly risen thanks to an aggressive Federal Reserve looking to push inflation lower. However, bond investors don’t seem worried about a potential rise in bankruptcies and associated loan defaults, even for below investment-grade borrowers.

One way to monitor this to look at spreads for “high-yield” borrowers. These spreads represent the interest rate premium that companies rated below investment-grade companies have to pay over risk-free Treasury interest rates.

Typically, if investors expect economic hardship, and a higher likelihood of default, they will charge these companies higher interest rates on loans. That would result in larger spreads against Treasury rates.

The good news is that high-yield spreads are currently at 3.8%, which is in just the 28th percentile across the data going back to 1997. The average spread across the entire period is 5.4%. The current spread is also below what we saw last June, which is when the Federal Reserve signaled they were going to get a lot more aggressive. Notably, as you can see in the chart below, the current level remains well below what we’ve seen ahead of prior crises, including in 2000 and late 2007.



Bond investors typically sniff out hard economic times for companies well ahead of other investors. And right now, they don’t see any signs of that.

Banks Aren’t Seeing Elevated Risk Either
The other group that deeply cares about potential defaults are banks, since their entire business model is based on lending money out and getting paid back interest and principal. There are always some loans that default but the goal is to minimize these. The good news is that delinquency rates on business loans have been falling for a couple of quarters now, and as of Q1 they’re just under 1%. Delinquency rates were at 1.1% before the pandemic, and historically, they’ve averaged about 2.7% outside of recessions.



The Federal Reserve also collects “charge-off” data from all commercial banks – these are losses on loans that a bank recognizes, after they consider any recovery on defaulted loans. As a percent of average loans outstanding over a quarter, the “charge-off rate” in the first quarter was just 0.28%. This is obviously lagging data but that’s still well below the pre-pandemic non-recessionary average of 0.72%. We’re a long way below that right now.


Entrepreneurship Is Rising
The other side of bankruptcies is entrepreneurship, especially entrepreneurs who plan to turn payroll. The Census Bureau tracks monthly business applications. Especially useful is a category called business applications with “planned wages.” These are applications that include a first wages-paid date on the IRS form SS-4, indicating a high likelihood of transitioning into a business with payroll.

There were more than 293,000 such business applications in the first half of 2023, which is 2% higher than what we saw last year. It’s also 21% higher than what we saw in the first half of 2019, the year prior to the pandemic.



Entrepreneurship kicked into overdrive after the pandemic, as people ended up with more money in their pockets – thanks to federal aid and money saved from limited spending during lockdowns.

Applications jumped in 2020 and 2021 to an average of 582,000 a year, which was a 17% increase from the average we saw in the previous decade. And the good news is that we didn’t see a huge falloff in 2022 despite aggressive rate hikes by the Fed.

It looks like applications are picking up again in 2023. Score that against rising bankruptcy data, and yet another data point to put things in perspective.

 

Energy Holds The 100% Line
Tue, Aug 22, 2023

Each day in our Sector Snapshot, among a number of sector level internal metrics, we show the percentage of stocks trading above their 50-DMAs. Yesterday, that reading fell down to 33% for the S&P 500. While last Thursday saw a slightly lower reading and 33% is far from the worst in recent years (as shown in the first chart below), this month has seen a material decline in the percentage of stocks trading above their respective 50-DMAs. One sector has proved to be an exception, though; while just a third of the S&P 500 components are above their 50-days, 100% of stocks in the Energy sector are still above their 50-DMAs.



Going back to 1990, it has been rare to see such a small share of the broader market above their 50-DMA while all the components of an entire sector are above their respective 50-DMAs. In fact, it's only happened six other times. In the table below, we show each of those previous periods as well as the S&P 500 and each sectors' reading on the percentage of stocks above their 50-DMAs. As shown, since 2021 there have been multiple similar instances in which every stock in the Energy sector has bucked the general trend of the broader market. One notable difference this time around is some of the most heavily weighted sectors like Tech and Health Care have far stronger breadth readings. In other words, breadth is healthier (relatively speaking) for those more impactful groups.

Prior to the pandemic, 2006, 2014, and 2016 were the only other periods. In 2006 and again in 2016, Utilities was the sector with 100% of stocks above their 50-DMAs while around 30% of the S&P 500 was above. Then in 2014, Communication Services (when it was much smaller - about ten stocks- and before it was reconfigured to include stocks like Alphabet, Meta, etc.) was the sector with strong breath.

 

Eight Questions About China
Posted on August 22, 2023

We’ve gotten a lot of questions on China, including what’s happening there and how it’ll impact the US, and potentially, financial markets. We’re going to tackle all of those in this blog.

1. What’s happening in China?

The economy is in trouble. Retail sales are up just 2.5% year over year, well off the pre-pandemic average pace of 7-10%. Usually, the industrial side of the economy makes up for slow consumer spending, but not this time. Industrial production is up just 3.7% since last year, which is well below the average 6% pace we saw before the pandemic.



Over the last few years, exports have been a big driver of growth, but exports have fallen almost 15% over the past year as the rest of the world shifts spending from goods, China’s main source of exports, to services in the current post-pandemic environment. Perhaps even more concerning was that imports also fell 12% over the past year, which is a sign that internal demand in China is really slowing down.

2. What does that mean for their economy?

Economic growth in the second largest economy in the world is set to slow meaningfully. In inflation-adjusted terms, the Chinese economy grew an average of 7.7% per year between 2010 and 2019. That’s slowed to 4.4% over the last 3 years (2020-2021), and it looks like growth is likely to slow even further, perhaps to 3-4%.

3. Why is the economy slowing anyway?

In the US, just under 70% of the economy is made up of consumer spending. However, in China, that’s under 40%. It’s the supply-side that matters more, and that’s driven by investment spending, which accounts for 44% of GDP (versus about 20% in the US).

The problem is that a lot of this investment spending was in the real estate sector, and that was on the back of rising debt. Overall debt to the non-financial sector soared over the past decade, from about 140% of GDP at the end of 2008 to almost 300% at the end of 2022. Contrast that to the US, where it’s stayed relatively steady around 250% of GDP. This was how China grew after the Great Financial Crisis. A lot of the debt went to goose up real estate activity, which by some estimates accounts for just under 30% of GDP (versus about 17% in the US).



However, authorities were aware that it drove a lot of unproductive “investments,” including infrastructure, like airports, bridges, and highways. Overbuilding is present on the residential side as well. The that about one-fifth of apartments in urban China (about 130 million units) were estimated to be unoccupied in 2018 (when the latest data was available).

Authorities started clamping down a couple of years ago. You may have heard of problems with Evergrande, China’s second largest developer. They experienced massive losses amid new regulations, ended up defaulting on debt payments, and eventually filed for bankruptcy. And they were just one among many.

Investment in the real estate sector was running around 10% annually before the pandemic. As of July, real estate investment is down almost 8% year over year (y/y). So, it shouldn’t be a surprise that real estate activity has crashed.

• Property sales are down 15% y/y in volume terms
• Floor space under construction is down 7% y/y
• New home starts growth is down 26% y/y

This is not good news for Chinese households. The absence of safety net programs (like social security and Medicare) mean Chinese households save a lot, and they typically invest income and savings in real estate/homes. Crashing prices means they’re less likely to spend their savings on real estate. But that also means there’s less money going into the sector.

Developers in China have historically raised capital by selling apartments they’ve yet to build and used that capital to finance operations. This was an easy game to play when prices were rising and demand was high. Now, it’s gone the other way, and there’s no easy way out. Developers are scrapped for capital, leading to even more defaults. Another large developer, Country Garden, is in the news now for this very reason (they recently missed a couple of interest payments).

4. Can’t they just bail out the real estate sector?

They probably could, but they’re reluctant to do so. Authorities have been clear that the country cannot depend on real estate for economic growth. They seem to recognize that putting more money behind bad investments is not the way to go. As the economists now estimate that China now has to invest $9 to produce each dollar of GDP growth, up from $5 dollar a decade ago. There’s going to be a period of hard adjustments ahead.

5. Can China boost households by sending checks, like the US?

Historically, any “stimulus” has been on the supply-side, typically by making it easy to borrow. However, they seem wary to do so now, for a lot of the reasons I mentioned above, they’re only nibbling around the edges with a few interest rate cuts.

But Chinese authorities appear to believe that empowering households to consume more would undermine state authority, and as such, they are.

More importantly, transforming the economy from one led by investment to one led by consumption would involve a lot of income redistribution, for example by shoring up China’s weak social safety net by introducing something akin to social security and better unemployment benefits. But that would mean less money would be going to the local governments and the industrial/property. Those kinds of changes just aren’t politically palatable, and hence the economic adjustment is going to be hard.

6. Will this impact the US economy?

From an economic perspective, not much. The reality is that US imports from China have been falling a lot over the past year – we need less of pandemic related materials and other goods as people continue to spend more on services now. There is some decoupling going on as well, with goods imports from China falling as a percent of GDP. It’s fallen to below 2% of GDP right now – the lowest since 2006. Instead, imports from everywhere else have picked up.

Trade with China is not going to zero but it’s likely to get relatively smaller. Note that part of what’s happening is increased trade with Asian nations like Vietnam, Philippines, and India, as imported goods get re-routed from China to the US via these countries.



The reality is that China needs the US more than the other way around. The US economy is reliant on consumption, and that’s internally generated demand. Whereas China is very dependent on investment and exports, and for that they need demand outside to be strong.

7. Can they “hurt” the US by selling treasuries?

If the Chinese sell treasuries, we see it as more of a sign of their weakness than anything else.

Historically, they’ve been able to hold their currency relatively lower to help the export sector. How did they do that? The Chinese central bank sold their currency (CNY) and bought USD assets, namely treasuries. Though over the last decade they’ve purchased more agency-mortgage backed securities (MBS). They weren’t buying US treasuries as a favor to the US, but rather, because they had to. They were reliant on exporting to Americans and got dollars in return. With those dollars, they bought US treasuries/securities, and kept their currency relatively low.

The problem now is that capital is trying to leave China because of slowing growth. That puts downward pressure on their currency – more than they would like. So, they’re starting to sell off some of their “war chest” of reserves (Treasuries and US agency mortgage-backed securities) to defend the currency. That’s essentially the equivalent of selling US dollars and buying yuan.

So, as I said, it’s a sign of economic weakness more than anything else.

8. Will this impact financial markets?

If there’s any impact, it’ll be in financial markets via headline risk, similar to 2015-2016 when China devalued their currency. The difference is that the US economy is now on firmer footing.

• If the Chinese are selling down their reserves of MBS and Treasuries, that could put more upward pressure on US Treasury yields, though only at the margin since we’re talking about the most liquid market in the world.

Most of what happens with yields is still going to be driven by US growth prospects and Fed policy expectations. US economic growth, in sharp contrast to China, has been resilient – rising 2.6% over the past year, which is faster than pre-pandemic. And it may be accelerating in the 3rd quarter, based on a slew of solid economic data we received recently.

China’s problems didn’t start this year. I’d argue it started a decade ago as growth became increasingly reliant on debt. Our leading economic index for China has shown economic growth downshifting below trend for several years now, with only brief periods when activity picked up.



It’s quite amazing to think that the US economy is probably growing faster than the Chinese economy at this point. That’s something we haven’t seen in decades, and right now, the US economy’s relative strength looks set to continue. That’s a big reason why we continue to be overweight US equities and underweight emerging markets, where China as the largest constituent.

 

Falling 10-Year Yield Rallies Stocks On Seasonal Cue

But overarching seasonal weakness still looms. Early August weakness persisted through mid-August’s usually seasonal favorable period. The absence of strength during this usually bullish period is a concern. From their recent highs DJIA corrected 3.8%, S&P 500 fell 4.8% and NASDAQ pulled back 7.4%.

While today’s rally was encouraging, the lack of the usual mid-month strength this year is clear in August’s Seasonal Pattern Chart comparing Pre-election Years (right axis) to 2023 (left axis).

Going forward August’s pattern suggests continued weakness and volatility before a modest rebound just ahead of the end of the month. Even if late-August strength does materialize, it is not likely to persist during the historically weakest month of the year, September.

Even though mid-August strength was overridden, the S&P 500 continues to track applicable full-year seasonal patterns closely this year. This chart also suggests continued weakness and volatility lasting possibly until late October.

Looking at S&P 500’s pullback in February and March of this year when it went from well above average to below average pre-election performance suggests the current pullback could be around the halfway point.

At the S&P 500’s late July peak, numerous excesses had accumulated. Valuations were stretched in many segments of the market, sentiment had reached frothy levels, and technical indicators were overbought. Some progress has been made unwinding those, but more remains to be done. Expect more volatility and chop through the rest of August and September. A Q4 rally into the New Year is still in play.

 

Volatility Is The Toll We Pay
Posted on August 24, 2023

“The stock market is a giant distraction to the business of investing.” Jack Bogle, Founder of Vanguard

With stocks up five months in a row, we’ve hit some weakness so far in August, which is fairly normal as we discussed in Stocks Don’t Like August, Now What? Here’s the truth, investors have been rather spoiled this year, with stocks having one of their best starts to a year ever. Yet it is important to remember that while stocks usually go up, they can also go down. Even in some of the best years ever, stocks tend to see double digit corrections at some point during the year.

The S&P 500 pulled back nearly 8% back in March during the regional banking crisis and recently was down nearly 5% from the late July peak. Here’s the thing, volatility is normal (even in bull markets) and around here we like to say volatility is the toll we pay to invest. Or as the great Jack Bogle put it in the quote above, stock market volatility can make you take your eyes off the prize of longer-term investing.

With help from our friends at Ned Davis Research, here is a great chart that shows just how often you can expect said volatility.



A few takeaways:

• More than three 5% mild corrections a year, which puts the only one we’ve seen so far this year in perspective.
• There tends to be one 10% correction a year, while a bear market happens close to every three years on average.
• Then the real interesting one to me is each year sees an average of seven separate 3% dips. That isn’t much of a dip, sure, but when they happen they can cause quite a bit of worry and angst.

I’m out in Denver right now for a client event and a conference, so I wanted today’s blog to be short and sweet. Plus, the chart above is one of those charts that investors need to always remember, as when volatility hits (and it will) you need to be prepared for it. Print it off, save it, put it on the fridge, just don’t forget it. As Dwight Eisenhower said, “Plans are useless, but planning is everything.” Plan for each year to have scary headlines and volatility.

 

Gassy Summer
Mon, Aug 28, 2023

With Labor Day weekend on the horizon, Americans who were on the road this summer experienced a bit of sticker shock as prices surged in late July and into early August. Through Sunday, the national average price of a gallon of gas, according to AAA, stood at $3.82 which is the second highest price for this time of year since at least 2004. The only year that the national average price was higher as of 8/27 was last year ($3.85), and the average price for this time of year has historically been $2.91. Looking at the summer driving season (Memorial Day through Labor Day), the national price has increased by 6.7% this year. While 6.7% may not sound particularly large, we would note that the median change during the summer driving season since 2004 has been a decline of 3.7%, and prices have only increased 35% of the time. In addition, this year's increase ranks as the fourth largest trailing only 2017 (+11.8%), 2020 (+13.0%), and the 46.1% surge in 2005 due to the landfall of Hurricane Katrina in the Gulf of Mexico.



While prices this summer increased much more than normal, on a YTD basis, the increase has been right in line with the historical norm. As shown in the chart below, while the average YTD change through 8/27 has been a gain of 17.5% since 2005, this year's increase of 19.0% is less than two percentage points more than normal. For the last four months of the year, can we expect to see the typical seasonal decline? Since 2004, the AAA national price's median change from Labor Day through year end has been a decline of 7.5% with increases just 36% of the time. Investors looking for inflation to continue to trend lower so that interest rates might come down will certainly be hoping gas prices follow the historical script over the final four months of 2023.

 

Major Hurricanes Making US Landfall Since 1990
Tue, Aug 29, 2023

Hurricane Idalia currently has maximum sustained winds of just 75 miles per hour (MPH), but the storm is forecast to intensify as it barrels closer towards land, and by the time of the expected landfall on Wednesday morning, it is expected to have maximum sustained winds of 125 MPH making it a category-3 'major' hurricane. Idalia is the 9th named storm of the 2023 hurricane season which still doesn't reach its peak for another two weeks.

If Idalia does strengthen to a category-3 storm before making landfall, it will be the 19th major Atlantic hurricane to make a US landfall. The table below was created using information from Wikipedia and lists each of those prior storms with the most recent being Ian last September. Major hurricanes making landfall in the US have tended be sporadic over the last 30+ year. While there have been seven in the last six years, from late 2005 through August 2017, there was a nearly 12-year stretch without a single major hurricane making landfall.



Most hurricanes, even major ones, have an insignificant impact on the broader US economy. While Katrina, Harvey, and Ian had major impacts, a third of the 18 storms listed above didn't even cause $10 billion in damages. We'd also note that for this analysis, we only looked at major hurricanes, so Super Storm Sandy didn't make the cut even though it caused nearly $70 billion in damage. Even if they don't ultimately have much of a lasting impact on the economy, we were curious to see if there were any trends related to market performance, so in the charts below we show the performance of the S&P 500 in the day and week after each of the prior hurricanes made landfall.

It may sound hard to believe, but the S&P 500 has tended to rally in the short-term following prior landfalls of major hurricanes on the US coast. In the day after the 18 prior landfalls, the S&P 500's median gain was 0.32% with positive returns 72% of the time. One week later, performance was even stronger at 1.22% with gains 83% of the time. This could all be coincidence more than anything else, but given the preparations that go into storms like these, the costs involved can have a short-term stimulatory impact.

 

September No Relief in Pre-Election Years for Worst Month

Start of the business year, end of summer vacations, and back to school made September a leading barometer month in first 60 years of 20th century, now portfolio managers back after Labor Day tend to clean house. Since 1950, September has been the worst performing month of the year for DJIA, S&P 500, NASDAQ (since 1971), Russell 1000 and Russell 2000 (since 1979).

September was creamed four years straight from 1999-2002 after four solid years from 1995-1998 during the dot.com bubble madness. More recently, S&P 500 has been down in six of the last nine Septembers. September gets no respite from positive pre-election year forces.

Although the month used to open strong, S&P 500 has declined nine times in the last fifteen years on the first trading day. With fund managers tending to sell underperforming positions ahead of the end of the third quarter there have been some nasty selloffs near month-end over the years.

Recent substantial declines occurred following the terrorist attacks in 2001 (DJIA: –11.1%), 2002 (DJIA –12.4%), the collapse of Lehman Brothers in 2008 (DJIA: –6.0%), U.S. debt ceiling debacle in 2011 (DJIA –6.0%) and in 2022 (DJIA –8.8%).

 

Thinking About Risks to The Outlook
Posted on August 29, 2023

We started the year believing the economy would avoid a recession and that markets would rebound, and everything that’s happened since has mostly reinforced that view, which we outlined in our Mid-Year Outlook. At the same time, investing is about dealing with probabilities as opposed to thinking in terms of binary outcomes.

Ryan and I were recently honored to join Investment Masterminds with Jeff Thomas from Swan Global Investments, and one of the questions we got were what risks we were worried about (you can watch the full interview here). It seems like this is in the air quite a bit – I’ve been invited to speak at a wealth management retreat on a panel titled “All the things that could go wrong.”

So, I thought I’d write about it. I could name any number of things that could potentially go wrong – a bank crisis (a la SVB), commercial real estate, etc. – but I’m not too worried about those things.

What I do worry about is an energy price shock.

Falling energy prices have been the big reason why inflation’s fallen from a peak of 9.1% to 3.2% as of July. Of that 5.9 percentage point drop, 4.0 percentage points were due to falling energy prices.

Gas Prices Have Been Moving Higher Recently
The nationwide average gas price hit a peak of $5.0/gal in June 2022 (the month inflation peaked). It subsequently collapsed 38% to hit $3.10 at the end of last year. Since then, it’s been rising fairly steadily up until June, and over the past 6-7 weeks, we saw bit of a spike to $3.80. Note that energy prices in the official inflation data have remained flat (through July) because of falling gas utility prices, which have come on the back of collapsing natural gas prices. Of course, the question is what happens next.



Gas prices are mostly driven by oil prices, and oil’s rebounded over the past two months as well. WTI crude prices have risen from about $69 a barrel to $83. There was a pullback last week to $80, bringing it back into the fairly tight range we’ve seen since last November.



However, oil prices are not the only thing that determine gas prices, or even diesel prices. Another major factor (and a volatile one) is refining spreads. Refining or “crack” spreads are the price difference between crude oil and refined product. Here’s a schematic from the Energy Information Administration (EIA) showing what makes up prices at the pump. Oil prices account for just about 50% , while refining spreads make up 20-25% of the rest. High refining spreads are why gas prices at the pump didn’t fall significantly even when crude oil prices fell below $70 a barrel back in June – average gas prices remained around $3.60.



The chart below shows crack spreads for gasoline and diesel, and a few things stand out. Spreads spiked last summer, contributing to high inflation. They’ve pulled back since then but remain well above pre-pandemic levels (when they averaged below $20 a barrel). Spreads are rising once again, especially diesel crack spreads. That worries me.



Low Inventory Leaves Us Vulnerable to a Supply Shock
Crack spreads usually rise when there’s not much inventory of refined product, i.e. low stocks of gasoline, diesel, and even jet fuel. This is due to various reasons, including refinery closures and lack of investment in capacity.

Also, US oil production is climbing on the back of improved productivity, and is on track to a hit a record high of 12.8 million barrels per day in 2023, and 13.1 million in 2024. Despite that petroleum inventories are running below 2015-2019 averages.



The problem with low inventories is that it leaves prices vulnerable to supply shock. This is what happened when Russia invaded Ukraine. We got another reminder of this last week, when a storage tank caught fire at an oil refinery in Louisiana, the third largest in the US. As a result, some fuel processing operations shut down, and that sent diesel and jet fuel prices up 5% last Friday. Prices pulled back more than 3% on Monday, but both jet fuel and diesel prices have been on an upward trajectory recently.

An Energy Spike Can Be Negative for the Economy
The immediate impact is on pump prices, which is most salient with consumers. That’s going to hit consumer confidence, which tends to be correlated with gas prices.

Then we also must think about how the Federal Reserve reacts. They focus on core inflation, which excludes energy. However, last year, they accelerated the pace of rate hikes in June from 0.5% to 0.75% on the back of an energy price shock.

At the same time, higher energy prices can also show up in core inflation, via higher diesel and jet fuel prices. As the economists at Employ America have noted, airfares are particularly sensitive to jet fuel prices. Food costs are also very vulnerable to diesel prices. And higher food costs can feed into restaurant prices, which is part of core inflation. It can also increase transportation costs, including freight.

This immediately becomes a problem for two reasons in particular:

• It may force the Fed to react and raise rates again, and quickly.
• It reduces households’ real income, i.e. incomes adjusted for inflation, which would hit consumption.

We saw both play out last year. The economy was resilient enough to get through it, but I’d rather not see the economy battle through that again.
Again, as I noted at the top, this is not our base case. We do think a lot more things are going right than wrong. However, we account for potential risk when creating portfolios. In our house view models, we remain overweight equities, underweight long-duration bonds, and overweight commodities, to account for all of this.

 

Chart of the Day - No Reason to Move
Wed, Aug 30, 2023

COTD Bullet Points:

• The national average of a 30-year fixed rate mortgage is at the highest level in over 20 years.
  
• Rates for new mortgages are especially elevated relative to rates on already outstanding mortgages, and that creates no incentive for existing homeowners to enter the housing market or put their home up for sale.

Chart of the Day:

Last week's update on the national average of a 30-year fixed rate mortgage continued to rise, coming in at 7.23% which is a level not seen since June 2001.



Earlier this morning, the Bureau of Economic Analysis revised data on the effective mortgage rate on outstanding mortgage debt through the second quarter. Whereas the aforementioned 7.23% mortgage rate is for anyone looking to enter into a new 30-year mortgage today, this effective rate can be thought of as the average rate being paid by existing borrowers.

While current mortgage rates are higher than any point of the past two decades, they are even more elevated relative to the effective rate on outstanding mortgages. As shown below, the spread between the current national average and this effective rate on outstanding mortgage debt is slightly off the highs from late last year, however, that spread remains at some of the widest levels since the late 1970s/early 1980s. Admittedly, the two rates are not perfect comparisons given that outstanding debt likely looks very different (with regards to borrower profiles, terms, etc.) from that of a new 30-year fixed rate mortgage, but the general point is the same: for the bulk of those who already have a mortgage, a new mortgage at current rates would incur significantly higher costs. That gives them little reason to enter the housing market, and thus, is part of the reason for the dearth in housing inventories.



To show another way, below we show the difference in the monthly payment of a median priced existing home assuming a 20% down payment using the current average 30-year mortgage rate versus the effective rate on all outstanding mortgage debt. Again, this is an oversimplified analysis given the varying nature, structure, and terms of outstanding debt. Additionally, the payment using the effective rate is not to be confused for the actual observed amount existing borrowers are paying per month (which is lower due to less principal remaining on existing mortgages). Rather it is simply the monthly payment calculated by using the effective rate on all outstanding mortgages and applying it to a new mortgage based on the current median price of an existing home.

Based on this approach, the spread is even more blown out and has far surpassed readings from the late 1970s/early 1980s, and the incentive for an existing home/mortgage owner to move looks even worse. Based on the current median price of an existing home and the current average 30 year fixed mortgage rate, the typical payment comes up to a little over $2,000 per month. Substituting that current 30 year rate with the effective rate on outstanding mortgage debt, the payment would be much lower at just $1,421 per month!



Since homeowners have little reason to drop would be low payments and re-enter the market, there is not much reason to believe that existing homes will hit the market in any meaningful way soon without a drop in mortgage rates. That makes new homes an increasingly important share of supply; a good environment for homebuilders. Homebuilder stocks—proxied by the iShares US Home Construction ETF (ITB)— in response continues to sit in an undisturbed uptrend. This month did see iShares Home Construction ETF (ITB) fall sharply and test that uptrend as it dropped back below its 50-DMA which formerly was offering a consistent level of support. But, that was short lived as ITB is fighting to push back above its 50-DMA today.

 

This Is Normal
Posted on August 30, 2023

“Who you gonna believe, me or your own eyes?” Groucho Marx

Nearly right on cue, stocks have had a rough August. We noted at the start of the month that the odds were high for some type of seasonal weakness, coupled with many of the longtime bears suddenly changing their tunes. The good news is we don’t think this is the end of the world, but more a normal time for stocks to simply catch their breath.

I’ve shared this chart a bunch this year, so I might as well do it one more time. It shouldn’t have been a shock that stocks did as well as they did the three quarters ending in June, as those were the three best quarters out of the entire 4-year Presidential cycle. Sure enough, the third quarter of pre-election years has tended to be weak, but the fourth quarter, still ahead of us, has done well. This is how we see things playing out again, with likely new highs happening, but it might take more time and consolidation first.



We had an 8% pullback back in March during the regional bank crisis and just missed a 5% minor pullback recently. Maybe we do go on to break the recent lows and officially tag a 5% minor pullback or a little more, but the good news is there is major support just beneath current levels.

As the chart below shows, the June lows are near 4,328, while the peak from last August is around 4,300. Those two areas should act as strong support and we don’t expect them to be violated. Additionally, at the bottom panel of the chart we show the 10-day moving average of the CBOE Equity Put/Call Ratio moving to its highest level this year. This is a sign that the market is getting worried, exactly what is needed to flush out the weak hands.



There are other signs that with the August swoon, some worry has been entering the picure. The NAAIM Exposure Index represents the average exposure to US equity markets from investent managers. Sure enough, they’ve gone from wildly bullish late last month to quite worried near the end of this month.

To put things in perspective, this was above 100 at the end of July for the first time since late 2021, right before the vicious bear market of 2022. Now four weeks later it has fallen to the lowest level this year, down 67 points in four weeks. The only time in history to see a larger four-week drop? March of 2020 and the COVID crash.



Lastly, credit spreads tell us how much extra interest over Treasury rates investors are demanding from companies that want to borrow money — if investors believe a recession is imminent, they may expect lending to companies to be more risky and hence demand higher interest rates. In other words, if there was a monster under the bed the credit markets would likely show it. Go read that quote from Groucho Marx at the top one more time. I grew up being told that is was wise to listen to the credit markets. You might hear some economist on TV with a bowtie telling you the end is near, but if the credit markets aren’t worried, I’m not worried.

The chart below shows that during past recessions spreads have soared, but they remain quite tight currently. We think credit markets have some of the smartest investors in the room, and if they aren’t worried, the weakness in the market likely won’t get much worse and may offer an opportunity to add to equities.



So there you have it, stocks have pulled back in August and fear has increased. These were things we’ve been talking about and expecting for weeks. We still have the tricky month of September ahead of us, but with credit markets showing very little stress, we don’t expect a major stock meltdown like so many on TV keep predicting. Instead, we remain overweight equities and do expect stocks to make new highs before the year is done, it just might take a little more consolidation first.

 

Wednesday before Labor Day Best, Friday Weakest

In recent years, Labor Day has become the unofficial end of summer and the three-day weekend has become prime vacation time for many. Business activity ahead of the holiday was more energetic in the old days. From 1950 through 1977 the three days before Labor Day pushed the DJIA higher in 23 of 28 years.

Since then the days leading up to the long weekend have become less bullish. In the last 21 years, Friday has been the weakest on average with declines across all four indexes. However, Wednesday has outperformed over the years with DJIA, S&P 500, NASDAQ, and Russell 2000 all up two-thirds of the time or better. Average gains on Wednesday range from 0.40% by DJIA to 0.67% by Russell 2000.

 

Claims Improve Ahead of Nonfarm Payrolls
Thu, Aug 31, 2023

Ahead of tomorrow's nonfarm payrolls report (which is expected to show a deceleration in jobs growth), initial jobless claims have been reversing lower in the past few weeks and are back down to the low end of the past several months' range. At 228K, the seasonally adjusted number came in well below expectations which were anticipated to rise to 235K. Overall, claims continue to indicate a historically healthy labor market albeit with almost a year in the rearview since the absolute best levels.



On a non-seasonally adjusted basis, claims came in below 200K for a second week in a row. At 192.5K, claims are near similar levels to the comparable weeks of last year and 2017 through 2019. From a seasonal perspective, this week or next is likely to mark the annual low for claims before drifting higher through year end.



Unlike initial claims, continuing claims were higher this week rising to 1.725 million which was a much larger increase than was forecasted. Regardless, claims remain at healthy levels even after rounding out a bottom and beginning to trend higher more recently.

 

Sentiment Stays Down
Thu, Aug 31, 2023

Although the S&P 500 has risen 3.25% in the past week, sentiment has seen little in the way of recovery from the substantial increase in bearish sentiment earlier this month. The AAII's weekly sentiment survey saw bullish sentiment rise just 0.8 percentage points week over week to 33.1%. While that is a few percentage points below the historical average of 37.5%, bullish sentiment is above the consistently weak range of readings observed from early 2022 through this past spring.



Bearish sentiment, on the other hand, was slightly lower falling to 34.5% this week. Like bullish sentiment, that is a few percentage points off the historical average of 31%.



The inverse moves to bullish and bearish sentiment means the bull-bear spread was modestly higher this week. However, that increase was not enough to lift it back into positive territory meaning bears outnumbered bulls in back to back weeks for the first time since the end of May and first week of June.



Factoring other sentiment surveys echo the recent turn toward bearish sentiment. In the chart below, in addition to the AAII survey we have added the Investors Intelligence and NAAIM Exposure Index readings to create a sentiment composite. This index plummeted in August as increasingly bearish readings were observed across all three surveys. Last week, that bearishness hit a low point of -0.45. Although it has bounced back this week, it is still in negative territory (meaning sentiment is more bearish than what has been the historical average). Just like the bull-bear spread for the AAII survey, that is the first back to back negative readings since May/June.

 

September’s First Trading Day Leans Bearish Last 15 Years

Even though S&P 500 has been up in 17 of the last 28 years on the first trading day of September, this trend appears to be fading as the S&P 500 has been down nine of the last fifteen first trading days. DJIA’s first trading day performance has experienced a similar trend reversal, also down nine times since 2008. NASDAQ has been modestly stronger recently, but is still mixed, up eight and down seven. Proximity to the three-day Labor Day holiday weekend can dampen trading activity, which could be a factor this year with the first day falling on Friday.

 

Busting 7 Common Myths
Posted on August 31, 2023

We’ve been hearing many of the same myths over and over, yet we don’t think they are the big worry that the media and many make them out to be. These are legitimate concerns and have many investors worried, but we think the chances of them becoming larger issues are smaller than many expect. We are going myth busting today and here are seven of the biggest ones we’re targeting.

Myth 1: Credit Card Debt Is Out of Control
We hear a lot about how credit card debt cracked $1 billion for the first time ever and the only reason the economy is growing is because people are buying everything on credit cards. We discussed this in detail here, but the truth is equity and net wealth have also increased, so it makes sense people have more debt. Also, credit card debt as a percent of overall debt has remained steady over time.


Myth 2: Student Loan Repayments Will Lead to a Recession
After not having to pay student loans for years, those repayments are starting back up in Octobber, with many expecting this to lead to a crash in consumer spending overall.

Americans paid $70 billion toward student loans in 2019 and it isn’t like this will all start right back up.

• First off, many people continued to pay their loans and didn’t use the government’s free pass to stop paying.
• We don’t expect to start right back up at $70 billion though, more likely in the $20-$30 billion range.
• The Biden administration recently cancelled $39 billion in loans on 800,000 borrowers.
• Also, you don’t have to pay all of your student loans at once. It’ll allow consequence free nonpayment for the first 12 months after restart, meaning they won’t be reported to collection agencies credit bureaus, etc.
• Lastly, the administration released a new plan called Saving on a Valuable Education (SAVE) that could benefit up to another 20 million borrowers, with the administration estimating that payments will be cut in half. It will also forgive loan balances after 10 years of payments, versus the prior 20 years.

The bottom line is the loan repayments won’t come in near as much as the media makes it sound, likely not upsetting the strong consumer.

Myth 3: Excess Savings is Gone and Trouble Is Coming
After people stayed in during the pandemic, they didn’t spend nearly as much as they would have. Additionally, the government gave people money, so there was a lot of excess savings, peaking at an estimated $2.3 trillion, which is nearly all gone. Many are claiming this will mean the consumer is tapped.

First off, this is a good thing, as we are getting back to normal. There have been many expansions that didn’t see trillions in excess savings, so it is possible for the economy to grow with little excess savings. Additionally, people hold a historic level of liquid cash (think savings, CDs, money market fund shares). This myth is also a function of how excess savings is calculated and to us, we’d think one should include liquid cash in the whole pie.

Lastly, the savings rate has increased over the past year, from a low of 3.2% last summer, up to 4.5% right now. Again, without getting too into the weeds here, savings have actually been increasing over the past year, something that you’d never know if all you looked at was excess savings.



Myth 4: High Profile Retailers Blowing Up Means the Consumer Is Tapped
Some well-known retailers had horrible reactions to earnings. Footlocker fell 28%, Dick’s 24%, Peloton 23%, and DollarTree 13%, while Macy’s fell as it noted weakness in consumers and worries over credit cards. So, the logical worry is whether this means the consumer is strapped.

We say no, as there were also some big winners, with Abercrombie & Fitch up 23%, Williams Sonoma up 13%, Toll Brothers guided higher, and Guess adding 26%. We didn’t hear as much about the good news, did we?

Then look at what Wal-Mart said. They noted online sales were strong once again. The truth is consumers simply don’t go to brick and mortar stores like they once did. Additionally, many younger people will quickly tell you they’d rather pay for experiences versus stuff. Add it all up and we don’t think the consumer is in trouble at all.

Here’s a nice chart of real retail sales showing very little slowdown in spending.



Myth 5: Bankruptcies Are Surging and This Is the First Domino to Fall
Through July there had been 402 U.S. corporate bankruptcies, compared with only 205 last year. In fact, it was the highest since 2010, which saw 530 in the first seven months.



Here’s what is so surprising, if there really was worry about credit, wouldn’t the credit markets show some stress? High yield corporate bond spreads have been falling since last year, the opposite of what you’d expect if bankruptcies surging meant a bigger issue was coming.

Also, the other side to bankruptcies is entrepreneurship, or creation of new businesses and companies. That’s right, we’ve seen a solid number of monthly business applications the first six months of the year, to the tune of 293,000 business applications with planned wages. This was 21% higher than 2019 for instance and much higher than any other time during the last decade.




Myth 6: Higher Rates Are Bad for the Economy and Stock Market
Rates have soared lately, with mortgages at the highest levels in decades and the 10-year yield recently hitting the highest levels since 2007. This has brought with it many concerns, but once again, we don’t buy it.

Plain and simple, we think rates are going higher because the economy is strengthening, not because of inflation, the Fed, or some other reason. To see rates increasing for the right reasons isn’t a bad thing. In fact, historically a higher trending 10-year yield amid an improving economy has led to strong stock gains.

Don’t forget, the late ‘90s saw mortgage rates above 7% and the 10-year yield consistently above 6%. Stocks and the economy did just fine back then. Let’s be clear, rising rates aren’t good for bonds, but we’ve been (and remain) overweight stocks and underweight bonds all year.

Myth 7: The Government Is Awash in Debt and It’ll Bring the System Down
Our country has more than $32 trillion in debt, but this might not be as worrisome as it sounds. For this, I invite you to listen to our watch our latest Facts vs Feelings where Sonu and I discuss this, along with the other six myths above. Lastly, thanks to Sonu for creating many of the tables and charts in this blog.