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Selloff Over or Just Getting Started?

The S&P 500 officially fell 20% from it’s highs this morning.

But last Thursday morning, it was down only 7% from its highs.

Then Trump unleashed his tariff “plan”. Stocks were down over 10% in two days last Thursday and Friday, and another 4% at the open this morning.

This was a mini-crash.

A quick, but relatively normal pullback turned into a bloodbath on fears that tariffs will cause a recession and further market volatility.

This report is brief and to the point, and we will go over more in our webinar tomorrow. The registration link is further down in this report.

What happened?

  • Stocks had a mini-crash on Thursday and Friday, falling over 10% in just two days, after Trump announced tariffs that were much more widespread than many anticipated.
  • Concern over tariffs caused a technical selloff similar to last summer’s Japanese Yen selloff.
  • Market behavior the past few days has been similar to the COVID-lows.
  • This selloff has been about the unknowns with tariffs, as opposed to a deeply engrained structural problem like mortgages in 2008.
  • At this point we don’t anticipate this turning into a deeper bear market, but we can’t rule that out yet either.
  • We do think we are at or near a short-term low in stocks.

What to Do?

  • Don’t panic.
  • Keep the selloff in context…markets were only down 7% from all-time highs last Thursday morning.
  • Wait until a stronger rally develops to assess whether or not to reduce risk, not while fear and panic are extremely elevated.
  • This is not a dip to sell into, despite the elevated fear.
  • Stay calm, and reassess market dynamics on a rally.

Why do we think this could be a low?

There are a number of signs pointing to this being a near-term low in markets either today or tomorrow.

  • Sentiment at extremes
  • VIX spike higher
  • Treasury yields reversing higher
  • Option flow data is bullish
  • Capitulation signals
  • Broad, indiscriminate selling
  • Bullish divergences
  • Panicky conversations with clients

These data points are all quite bullish.

And while they don’t guarantee that the overall pullback is over, it does increase the likelihood that we have seen an interim low in prices.

We will look at charts of these in more detail in tomorrow’s webinar.

Tariffs Discussion

We will also discuss tariffs in more detail tomorrow, but here are our initial thoughts on tariffs:

  • Tariffs by themselves are not good, but if their implementation results in the elimination of all or a majority of income taxes in the US, it will be hugely beneficial.
  • The stated goal of the Trump administration is to use tariffs to eliminate income taxes of various kinds. A proposal today aims at eliminating capital gains taxes by the end of this year.
  • A broader stated goal by the administration is to eliminate the IRS entirely by reducing spending via DOGE and replacing income tax revenue with revenue from tariffs and a national sales tax.
  • Tariffs are inherently inflationary.
  • Tariffs are more steps towards economic de-globalization, which started with the semiconductor bill passed by the Biden administration. De-globalization is also inflationary without efficiency and productivity gains.
  • Potential productivity gains by the implementation of AI could be deflationary.
  • Small caps and mid caps may have an advantage over large caps going forward due to less overseas revenue and a lower impact from tariffs.

If you are looking to reduce risk, our advice is to wait until volatility has calmed down, which we expect over the coming weeks, if not sooner.

Don’t forget to register for our webinar tomorrow at 4pm central time. Click to register.

Volatility Spikes Occur Around Lows

Dramatic spikes higher in volatility tend to be a characteristic of a low point in markets.

This latest pullback appears to be no different, despite the harshness of the move.

In fact, we should probably get used to environments where volatility spikes very quickly like we have seen the past few days.

We know, that doesn’t make it feel any better.

But this type of move tends to occur at or near the end of major selloffs, as shown in the chart below.

The bear market of 2008 had multiple spikes in the VIX that only resulted in short-term rallies of a few weeks.

But during other selloffs, the VIX moving near or above 50 marked the end of the selling. Today, the VIX touched 60, the highest level since the Japanese Yen selling last summer.

We have now seen two days (Thursday and Friday) that were both down at least 4%.

With stocks down again today, this marks only the 4th time in history we’ve seen selling like this.

What happened next was bullish over the near term, as shown in our next chart below.

Returns following this type of volatility has been strong historically.

Average returns were over 11% when looking one week out.

This is a small sample size with only 3 occurrences, so we can’t take too much concrete information from it. But it shows that markets tend to bounce back strongly, at least over the near term.

Largest Two-Day Declines

The two-day decline last Thursday and Friday was the 5th largest two-day decline in history.

What has happened after previous large declines?

The first chart below from Charlie Bilello (twiiter @charliebilello) shows the ten largest two-day declines in S&P 500 history.

There is no question about it, these have been buying opportunities, not selling opportunities. Returns have been much higher than average following selloffs like this.

If we look more closely at the chart above, all of the declines took place in 1987, 2008 or 2020. Not great company.

But this type of volatility not only tends to have strong returns looking over a 1-year timeframe or more, it also has marked the low point of major bear markets, as shown in the next chart below.

The top half of this chart shows a two-day performance of the S&P 500, while the red dots on the bottom half of the chart show when two day returns fell more than 10%.

Each of these occurred near the ultimate low of major bear markets.

But what about on a shorter time horizon?

Let’s look at what happened when we had very fast corrections.

Fastest 10% Corrections

Before the tariff selloff last week, markets were already moving quickly lower.

In fact, the S&P 500 had the 6th fastest 10% correction from all-time highs in history recently.

What happened next?

This chart shows that on average the market is nearly 15% higher on average after only 6 months.

This tells us that the speed of this overall correction also suggests that forward returns should be strong over the shorter-term as well, not just over the longer-term.

Bottom Line

The data suggests that we should expect an interim low any day, followed by a strong rally.

This doesn’t mean the decline is over, but economic and earnings data would have to deteriorate badly for further declines in stocks to occur. We are not ruling that out, it is just not the likely scenario at this point.

Earnings reports are starting this week, so we will have plenty of commentary from CEOs on the impact of tariffs on their business.

We will discuss more in our webinar tomorrow.

Invest wisely!

Correction Nearing an End?

Volatility over the past month was fast, but positive signs suggest the recent correction may be over.

Volatility may be rising simply because investors must digest more information every day. – Alex Berenson

Market volatility is never fun.

But the recent volatility has felt more intense than previous pullbacks.

Why and what are we doing?

Context:

  • While volatility has increased, stocks are less than 10% from their all-time-highs.
  • Since 1950, the S&P 500 averages a decline of 16% once per year. We are currently less than what an average intra-year decline looks like.
  • It feels bad, but so far it is a normal but very fast pullback.

What Next?:

  • Following back-to-back 90% up days this past Friday and Monday, the recent pullback has a high probability of being over.
  • Expect volatility to stay high, but prices should hold the recent lows and start to work higher.
  • A bounce is expected to last 2-3 weeks, but could be slightly faster or slower.
  • The strength of the bounce will determine next steps:
    • A strong bounce would suggest a grind higher to new all-time-highs this spring/summer.
    • A weak bounce, followed by additional downside acceleration, would trigger cash raises across portfolios.

A few reasons why:

  • Two major sources of uncertainty from the Trump administration: tariffs and governmental spending.
  • Corrections happen in markets, and this appears fairly normal at this point.
  • The 10% correction happened in only 16 days, amplifying the anxiety of the volatility.

What are we doing?

  • The fast pullback triggered our volatility override triggers. This means that volatility was high enough where selling on a decline is not beneficial.
  • The market should have a bounce, which most likely began on Friday, March 14th.
  • The strength of that bounce will determine next steps.
    • A weak bounce likely leads to reduced risk exposure on a rally.
    • A stronger bounce suggests a move back to new highs.

Let’s dig in.

Corrections Happen

The S&P 500 Index just fell 10% from its all-time-highs.

That sounds like a lot, but this happens quite often.

In fact, the S&P 500 averages a pullback of 16% once per year.

The primary question anytime this happens is this: Will this turn into something bigger and more damaging, or is the selloff over?

The real answer is “nobody knows”.

But like most things, we like to look at previous examples to help guide our expectations.

The first chart shows the times the S&P 500 Index fell more than 10% from all-time-highs, but didn’t fall far enough to get to a 20% decline.

The results are bullish.

Previous times markets fell 10% but not 20% from all-time-highs led to above average returns over the next 1-, 3-, 6- and 12-months.

Both 6 and 12-month returns were very good at 12% and 14.7% respectively.

This pullback feels worse than others, partially because it was so quick. It took only 16 trading days to fall 10% from the all-time-high.

This is the 6th fastest 10% decline in history.

What happened in previous times we saw prices drop so fast?

The results are also bullish.

Similar to times when the market was down 10% but not 20%, forward returns are good after speedy declines.

What about insiders? Are we seeing part of the “smart money” crowd sell?

Tech Insiders are Buying

When discussing stocks, “insiders” are simply anyone with material, non-public information. In other words, they have information about a company that has not been publicly disclosed.

When insiders are buying, they are investing their own money to buy more of their company’s stock.

This is typically a positive sign that people who know about the company’s growth prospects are using a decline in the price of their stock to purchase more.

When insiders are selling, this often signals that the business could be having trouble or may be seeing a slowdown.

We’re seeing very strong insider buying within the technology sector, as shown in the next chart.

Source: SentimenTrader

Previous times that insiders were buying this quickly resulted in strong forward returns in the technology sector, averaging over 20% returns over the next 12 months.

This is another bullish sign for stocks for the next year.

Trump Policies

We still think that we have yet to learn about the extent of corruption in Washington, DC.

In the meantime, tariff uncertainties continue to influence markets.

The narrative risk will continue to be confusing, especially if you’re not prepared for it.

But market data will continue to drive our decision-making. For now, at least, that data remains positive, despite the anxiety in markets and uncertainty from Washington.

Bottom Line

As mentioned earlier, a major positive development is the consecutive 90% up days. This is a very good development, showing big money was buying on the dip.

That combined with a handful of other indicators suggest that there is a good likelihood the correction is over.

However, we should continue to expect to have uncertainty out of Washington DC, and we should also expect to have relatively big moves on a daily basis.

We will continue to monitor developments and make adjustments to your portfolio as necessary.

Invest wisely!

Rate Cuts at New Highs

The Federal Reserve cut its target interest rate by 0.50% on Wednesday, with stock markets at or near all-time-highs. What does that signal for the economy and markets?

“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”

warren buffet

Focus on economic data and the weirdest presidential election in memory took a pause on Wednesday as the Federal Reserve met and reduced interest rates by a half of a percent.

Side Note: We will publish an election report in the coming weeks with our analysis of the potential election outcomes.

When the Fed cuts rates, it is important to understand the context in which the cut happens.

Essentially there are two environments to consider:

  1. Deteriorating economy and market
  2. Stable/Improving economy and market

Today, there is little question that the economy and market are stable.

Things can always change. And can change quickly.

But as of right now, stocks are at all-time-highs and gaining momentum. Economic data is holding up just fine, and we’re not seeing stress in the places that would be concerning.

So why cut?

Why did the Fed cut rates now?

In the two rate cutting environments mentioned above (deteriorating or stable data), interest rate cuts take on different roles.

When economic data is starting to weaken and markets are showing signs of stress, rate cuts help to pump liquidity into financial markets.

In theory, lower rates help to lessen the negative effects of a recession.

The idea is that lower rates decrease the cost of debt (consumer, corporate and government debt), helping the overall economy reduce costs to offset the potential for reduced economic output during a recession.

But today’s data is not recessionary.

In fact, we’re simply not seeing many signs at all of stress in financial markets that would be worrisome.

That means that this rate cut is likely a “normalization” rate cut.

Normalization Rate Cut

Normalization rate cuts are nothing more than cuts that happen outside of a pending recession.

The Federal Reserve spent over a decade at “abnormal” rates. (Zero percent rates for well over a decade is not normal).

This week’s cut appears to be a normalization with regards to inflation, not with regards to unemployment or the economy.

When inflation went from 1% to 9%, the Fed raised rates to slow inflation.

Then, inflation went from 9% to 3%. So the Fed cut rates this week.

Not because the economy is falling off a cliff, and not because unemployment ticked higher. (Higher unemployment numbers occurred because the government is now beginning to count illegal aliens in the number of unemployed people).

Anyone else getting frustrated with data manipulation?

But we digress.

With the cut this week, the Fed simply made the rates more in line with what the market is telling them they should be, and it appears the Fed is doing two things:

  1. The Fed is continuing to normalize interest rate policy after the chaotic inflation during COVID (caused by the Fed and other government policies).
  2. The Fed Funds rate is substantially higher than the 2-year Treasury yield, implying that the Fed is too restrictive with current rates, especially given the decline in inflation.

Our first chart shows these two yields.

This chart shows the 2-year Treasury yield (orange) versus the Fed Funds Rate (blue).

When the 2-year Treasury is higher than the Fed Funds rate (on the left side of the chart), the Fed is being restrictive in its policy. This is because the market is pricing in rates that are higher than what the 400 PhD. economists at the Fed think should be the proper rate.

The opposite is also true. When the 2-year Treasury yield is lower than the Fed Funds rate, they are being restrictive, as the market is telling them that rates should be reduced.

That has been the case for all of 2023 and 2024.

In this sense, the rate cuts were justified.

If we don’t see any further deterioration in the economy, this rate cut should be bullish.

Based on the initial reaction in stocks, the market agrees.

Normalization cuts overwhelmingly happen at or near all-time-highs, and they typically don’t signal an end to the bull market.

What has happened in the past when the Fed cut with markets at highs?

Rate Cuts with Stocks at All-Time-Highs

Another important data point when it comes to rate cuts is the timing of the first cut.

Our friend, Ryan Detrick, with the Carson Group, consistently has excellent charts about historical market reactions.

The two charts below show the times since 1980 that the Fed has cut rates when the S&P 500 Index was within 2% of an all-time-high.

Historically, when the Fed cuts rates with markets at all-time-highs, the market is higher one year later 100% of the time with an average gain of nearly 14%.

Bottom line is that being bearish on the markets at this point does not appear justified by the data.

Again, this can change and change quickly.

But for now, things look pretty good.

What Does Well After the First Rate Cut?

Another bullish development over the summer was a broadening out of participation in the bull market.

We have consistently been saying that small cap US stocks should play catch-up to the mega-cap tech that has done so well over the past two years.

This is supported also by stock performance after the first rate cut.

The next chart, courtesy of Bank of America, shows that small caps tend to outperform following the first rate cut.

This chart shows that over the next 6 and 12 months, small caps should outperform large caps if this historical relationship continues.

The reason this works is that smaller companies are more sensitive to bank interest rates than their large counterparts.

A 0.50% decrease in interest rates go mostly to the bottom line for smaller companies with debt.

This increases profitability and free cash flow, so it is logical that this would be the case.

More Rate Cuts?

Should we expect more rate cuts?

The real discussion is around the future path of interest rates.

Some people are predicting another 2% of cuts by the end of 2025.

It is our position that if we see another 1-2 rate cuts of 0.25% each, that would signal that we are likely headed to a recession.

It also would make sense that the Fed did a larger, 0.50% rate cut (instead of just 0.25%), so they wouldn’t have the appearance of propping up markets too close to the election.

Bottom Line

Bottom line is that this cut does not appear to be a signal that doom and gloom is headed our way.

That can happen, but the probabilities are not high that it will.

Instead, this rate cut looks like a normal response to declining inflation, and not a signal that the economy is deteriorating.

The market will now start to focus on earnings and the election.

We’ll put out another report discussing the election in the next few weeks.

Until then, invest wisely!

Can Market Strength Continue?

The idea which some people seem to entertain, that an active policy involves taking more risks than an inactive policy, is exactly the opposite of the truth. The inactive investor who takes up an obstinate attitude about his holdings and refuses to change his opinion merely because facts and circumstances have changed is the one who in the long run comes to grievous loss.

– John Maynard Keynes

The US stock market just had one of the strongest four months in history.

Can this market strength continue?

Spoiler alert…probably.

This time last year the data was NOT good, and risks to markets were incredibly high.

But as the year went on, the data improved. Our signals added risk back to target levels in client portfolios, and we were able to capture nice gains.

Fast-forward one year, and we have almost the exact opposite situation: good data, good markets and a generally positive environment.

However, the quote above from Keynes is as applicable today as when it was originally said in the 1930’s…as investors we MUST be able to look at data objectively and change strategy when it is required.

We were required to do that in 2023.

Will we be required to change from a bullish stance to a more negative one in 2024?

Let’s do a quick market scan to determine the likelihood of this.

Stock Strength to Continue?

As we mentioned earlier, stocks just had one of the strongest four-month spans in history.

In the 20 weeks that ended on March 15th, the S&P 500 index gained over 24%.

One might logically think that since stocks went up so much, they are overdue for a major pullback.

But the data tells a different story.

Our first chart is courtesy of Ryan Detrick of Carson Investment Research.

This chart shows the previous times the S&P 500 was up over 20% after 20 weeks. (You may need to click on the image to enlarge it.)

Since 1950, there have been 22 times the S&P 500 has been up over 20% in 20 weeks, as shown by the green diamonds in the chart above.

In 21 of those 22 times, the market was higher 12 months later by an average of 13%.

This is on top of the 20% that already occurred.

Even over the shorter timeframes, markets tended to do well.

Markets are higher one-month later roughly 72% of the time with an average performance of 2.3%. This beats the average monthly gain of 0.7% by nearly 3x.

Bottom line is that recent strength is positive, and despite any near-term correction that may occur, higher prices appear likely over the course of the year.

Opportunity Still in Small Caps

If we do see the historical trends mentioned above continue, then there still remains an opportunity in small cap US stocks.

We discussed small caps in detail in our 2024 Outlook report, which can be viewed here:

The summary of our analysis was that if markets continue higher, we should expect smaller companies to perform well, possibly outperforming large cap stocks.

The next chart below shows this opportunity.

While the S&P 500 surpassed its previous all-time-highs last year, small caps still have a ways to go to achieve the same result.

In fact, the ticker IWM needs to go up 21% to get back to it’s previous highs.

Small caps are trying to break out of their range from the past two years, and if they are successful, then we should see the next leg higher for markets in general.

That is, as long as problems in the commercial real estate sector stay contained.

Commercial Real Estate is Stable (for now)

The wild card in small cap stocks remain the challenges from commercial real estate (CRE) debt.

So far, CRE debt has not been an issue in 2024.

Delinquency rates continue to be elevated, but there has been no further deterioration, which is a good sign.

Optimism that interest rates would fall this year has helped contribute to a stabilization in commercial real estate prices.

This stabilization has been needed for that sector of the economy.

CRE debt remains the single biggest risk to stock prices, in our opinion, given the potential to cause failures in smaller banks.

Inflation Pressures may keep Rates High

What about interest rates?

After all, the Fed did meet yesterday and kept rates unchanged.

Two months ago, markets expected the Fed to have 6 rate cuts this year. Now, we’re down to an expected 3 rate cuts this year, with another expected next January, as shown in the chart below.

The blue line above shows the implied policy rate, or the rate which the Fed charges banks to hold funds overnight. This rate is currently in a range of 5.25 – 5.50%.

Learn more about the Fed Funds rate HERE.

With this many rate cuts projected, the market still appears to be anticipating a recession, despite the lack of recessionary data.

Why do we say that?

First, financial conditions are as loose as they’ve been since at anytime since the ’08 financial crisis.

Loose financial conditions imply that stress is low in the markets and the economy, providing support for economic growth.

Second, credit spreads are narrow.

This simply means that the riskier parts of the bond market are not showing signs of stress when compared to US Treasuries. Credit spreads are one of the earliest signs of stress in financial markets.

Third, inflation could be headed higher.

With a tight labor market, loose financial conditions, a supportive Fed, and an economy moving in the right direction, the conditions exist for another wave higher in inflation.

Higher inflation will NOT warrant rate cuts by the Fed.

In order for the Fed to cut rates, we believe that there needs to be a recession. And we simply don’t see that in the data in the near term.

But what if they do cut? What should we expect from markets?

Rate Cuts when Markets are near All-Time-Highs

Let’s imagine that the Fed does decide to cut rates in the next few months, and stocks remain around these levels or higher.

What would that mean for stocks?

Our friend Ryan Detrick once again has excellent data.

He looked at every time we saw a Fed rate cut with the S&P 500 within 2% of all-time-highs.

What he found was also bullish.

There were 20 times previously that the Fed cut rates with markets near all-time-highs.

Of those, markets were higher 20 out of 20 times, with an average gain of 13.9%.

Put another one in the bullish camp for 2024.

Bottom Line

The weight of the evidence suggests higher prices over the next year.

The combination of a strong market, loose financial conditions and stability in the commercial real estate market point to a generally calm market environment over the near term.

Things can always can change, so we must remember the quote above from Keynes and be vigilant in assessing risks and opportunities.

But for now, we should expect near term volatility to occur at any time, but expect that it should be short-lived and followed by higher prices.

Invest wisely!

Where Oceans Meet but Don’t Mix

He released the two seas, meeting side by side. Between them is a barrier neither of them can transgress.

– The quran 55:19-21

Financial markets work in cycles.

Some cycles are short, lasting only hours. Like those following Fed meetings.

Others, however, last decades.

And when longer-term investment cycles change, things don’t always mix well.

Like many characteristics of financial markets, we see this phenomenon in nature as well.

What implications will this transition of investment cycles have on financial markets?

The Meeting of Oceans

At the southern tip of South Africa, the warm currents of the Indian Ocean meet the frigid currents of the Atlantic Ocean, as seen in the illustration below.

The dividing line between the Atlantic ocean and the Indian ocean is similar to when long-term investment cycles change.

Unlike geographic boundaries, the dividing line where these two oceans meet is determined by the CONDITIONS on each side of the line.

And despite their proximity, the composition of nearly everything in each respective ocean is different from one another.

Lifeforms, currents, temperatures, and mineral composition of the water all differ depending on which side of the boundary you look.

What is common place and normal under one set of conditions is abnormal and unusual in the next cycle.

Today, we are dealing with the transition from a falling interest rate cycle to a rising one.

The investment cycle, much like the meeting point of the Atlantic and Indian Oceans, is a place where forces collide, currents shift, and the landscape changes in unpredictable ways.

The transition between cycles is not always a clean one, either.

It can be messy.

This is because with longer-term cycles, investors become engrained in their belief that the underlying causes of the previous market cycle will continue into the next cycle.

Inflation & Interest Rate Cycles

The cycle we’re dealing with today is the inflation and interest cycle.

Historically, the full cycle lasts 60 years.

That’s 30 years of rising rates followed by 30 years of declining rates.

We can see this cycle on our first the chart below, courtesy of Tom McClellan.

The declining interest rate cycle that likely ended last year is actually quite late getting started.

According to the 30-year cycle, rates should have begun moving higher in 2010.

But the Fed had a different idea, and placed their thumb on the scale to keep interest rates at zero for another decade.

The decline in rates began in 1982. And began moving higher again in 2022.

That’s 40 years of a financial tailwind of declining interest rates supporting higher and higher asset prices.

When interest rates fall, the cost of money decreases. And when the cost of money decreases, profits rise.

This creates a “virtuous circle” of investment, where the declining cost of debt makes investment projects more and more appealing as rates fall.

But the inverse is true also.

Rising interest rates push the cost of capital higher, putting downward pressure on profit margins.

This pressure on profits results in many stocks struggling to grow during rising rate environments, mostly due to the influence of interest rates on valuations.

Stock Valuations and Interest Rates

One of the easiest places to visualize the effect of interest rates on the stock market is via valuations.

The next chart shows a scatter plot of the P/E ratio of the S&P 500 versus the 10-year US Treasury yield.

The yield of the 10-year Treasury is shows on the x-axis from left to right. The y-axis is the forward P/E ratio of the S&P 500 index.

Each blue dot shows the P/E ratio at the end of each month for the past 20 years, along with the corresponding 10-year US Treasury yield.

What this chart tells us is that there is a DIRECT correlation between interest rates and valuations.

And the formula is pretty easy: higher rates = lower valuations.

Most of the market is respecting this phenomenon.

The “Magnificent 7” is a term used for the largest seven companies in the index: Apple, Microsoft, Amazon, Nvidia, Meta, Google and Tesla.

This “Magnificent 7” is still trading as if interest rates were almost zero.

In the chart above, the red dot shows these seven stocks.

At an average valuation of 29.5, they are 72% more expensive than the rest of the S&P 500.

They may have better future growth prospects than other stocks, but this is still a very obvious data point where investors are assuming the lessons of the previous cycle will repeat in the next one.

The implication is that at some point in the next few months or years we should see reality start to set in for these big tech stocks.

That means that eventually we will start to see mid-caps, small-caps, international stocks and other investments start to outperform big tech stocks.

We’re seeing this in our system. We have recently added small caps, mid-caps and international stocks to client portfolios.

If interest rates put downward pressure on valuations, what does that mean bigger picture for the stock market?

Let’s look at the last two rising rate cycles for clues.

Rising Interest Rate Cycle (early 1900’s)

The last two times US markets experienced a rising interest rate cycle was in the 1970’s and the early 1900’s.

Let’s look at the early 1900’s first.

The next chart shows the Dow Jones Industrial Average from 1895 to 1925.

During this time, interest rates moved from a low of 3.7% to a high of over 6%.

This was the last interest rate cycle that happened before the existence of the Federal Reserve.

Over this period, stocks returned a whopping 1.4% per year compounded return.

Not great.

Interestingly, both GDP and earnings grew over the same period of time, much faster than the overall growth in equities.

This is because higher rates kept valuations low compared to the low rates of the previous cycle.

That’s great, but can we really compare today’s world to the one 100 years ago?

After all, isn’t everything different?

Sort of.

The one common denominator is us.

Humans are the key to the investment cycle.

With all of our flaws, behavioral oddities and penchant for making the same mistakes over and over and over, we bring our inherent biases to our actions whether we know it or not.

Sure, we think we’re smarter. After all, we have all the information in the world at our fingertips via our smart phones. But we tend to use it to view cat videos. So are we really that much more advanced?

But we digress.

So what about a more recent rising rate cycle?

Rising Interest Rate Cycle (1970’s)

The last time the US economy went through a rising rate cycle was in the 1970’s.

How did this compare to the period in the early 1900’s?

Answer?

Not any better.

In fact, stocks returned 0% over nearly 20 years.

Stocks had a nice move higher post-WWII, but ran into the same valuation wall as it did in the early 1900’s.

Higher interest rates simply make it more difficult for stocks to grow over time.

There are many factors that go into the relationship between interest rates and valuations:

  • High interest rates compete for capital. Cash paying 5% has attracted dollars that otherwise would have gone into stocks.
  • The current value of a future stream of cash flows goes down as the discount rate goes up.
  • Financing costs increase, reducing profitability.

One thing is for sure: we must pay attention as these cycles change.

Mini-Cycles Within the Larger Cycle

If we have indeed made the transition from a declining rate environment to a rising one, we should expect broad stock markets to struggle more than they did in the previous cycle.

In these environments, bull markets will likely be measured in months instead of years.

In both previous rising rate cycles, stocks had mini-bull markets that lasted from 24-36 months.

They were typically followed by bear markets lasting 18-24 months.

During the 1970’s, we saw 5 mini-bull markets, and 5 mini-bear markets, shown in the next two charts.

During each mini-bull market, prices met or slightly exceeded new highs on each subsequent move.

But each time markets would try to push to new highs, inflation would rise and a mild recession would occur. Stocks would fall to the low end of the range, and a mini-bear market would ensue.

This is the definition of a choppy market.

And this is the market that we may very well have over the coming decade.

Flash forward to today, and we’re in a bull market that has lasted 13 months thus far.

If the current cycle is anything like previous ones, we could see this mini-bull last a bit longer, possibly into mid-to-late 2024.

But chances are we should not expect a long-term bull market like we had during the 1980’s, 1990’s and 2010’s.

Bottom Line

The ebb and flow of interest rates and inflation create a dynamic environment that demands careful navigation.

In the coming years, it will become increasingly important to adjust exposure to risk based on non-emotional signals.

It will also become increasingly important to generate yield and not just rely on market appreciation to meet your financial goals.

A higher interest rate environment allows you to reduce risk and volatility over time.

But this rising interest rate cycle is not a two-year cycle that began in 2022 and ends in 2023.

Higher interest rates will likely be with us for many years into the future.

Invest wisely!

Price versus Earnings

The stock market is never obvious. It is designed to fool most of the people, most of the time.

Jesse Livermore, stock trader and author

Stock markets are complex.

Unfortunately, there are many variables that move markets higher or lower.

However, not all variable are created equal.

Two of the big ones are the P/E ratio and earnings.

The P/E ratio (or price-to-earnings ratio) is a simple measurement that takes price per share of a stock or index and divides it by the earnings per share.

If a stock trade at $100, and earns $5/share, its P/E ratio is 20. ($100 divided by $5).

Another way to think about this is that the P/E ratio is a gauge of how much an investor is willing to pay per dollar of earnings.

One interesting aspect of the market increase this year is that it has been exclusively due to an increase in valuations.

Last October, the P/E ratio for the S&P 500 index was 16.3.

Today, it is 20.6.

Meanwhile, earnings for the S&P 500 have fallen 9.3% since last summer.

The chart below shows this discrepancy.

In this chart, the P/E ratio of the S&P 500 (shown in green) has mirrored the price of the S&P 500 (shown in blue).

Meanwhile, earnings (in orange) have consistently fallen over the past year. Granted, there is a glimmer of hope with the slight increase so far this quarter.

This discrepancy between the P/E ratio and EPS is the result of market participants paying more per dollar of earnings, and is essentially a sign of speculation.

However, this discrepancy could actually be a good sign.

Why?

This type of behavior typically happens when markets exit a recession.

Prices tend to move higher first, before the fundamentals start to reflect a more positive environment.

The next chart shows this same dynamic coming out of the 2009 lows.

The S&P and its P/E ratio rose in tandem after the lows in March of 2009, while EPS continued to fall.

There are major differences to consider in the comparison with 2009:

  • Today, valuations are elevated by historical standards at 21. In 2009, the P/E ratio was 12.
  • Interest rates today are over 5% and rising. In 2009, they were zero with no expectation of going up anytime soon.
  • We had one of the largest recessions in history in 2009, while we haven’t had one at all today.
  • Sentiment was extremely pessimistic in 2009, with optimism the overwhelming sentiment today.

So while today’s environment is very different from that of 2009, the behavior of the markets is very similar.

If earnings can start catching up to valuations, that will help remove the risk of a major decline in stocks.

Bottom line

While we are not out of the woods just yet, there are many positive developments happening.

With elevated valuations like we have now, the possibility of entering a long-term bull market seems low.

But the possibility of a major bear market is decreasing as well.

That means a sideways, choppy market for a long period of time could be what ends up happening.

In that type of environment, income and dividends will be important.

It will also be very important to not chase every market rise, and to not feel FOMO when markets go through periods of positive price action.

In a sideways market, the turtle wins the race.

Invest wisely!

The Fed’s Mixed Messages

Anyone who isn’t confused really doesn’t understand the situation.

edward r. murrow

The Federal Reserve met today, and for the first time in over a year they kept interest rates unchanged.

Typically, when the Fed pauses, it is a signal that they are more confident that their objectives have been met.

But this meeting was a bit different.

It was full of mixed messages.

Instead of signaling to the market that they are seeing concrete signs that inflation is going down, their message was incredibly strong that inflation problems have gotten worse and that higher interest rates are still ahead.

Let’s look at their mixed messages from today’s meeting.

The Projected Terminal Rate Increased

The Federal Reserve has a dual mandate as dictated by Congress: stable prices and full employment.

The “terminal rate” is the rate at which the Fed believes will best balance these two objectives.

Think of the terminal rate like getting two sides of a scale to be in balance.

a golden balance scale beside a laptop

If interest rates are too low, the employment goal is achieved but inflation can run hot.

If they are too high, then inflation is tamed, but it risks high unemployment.

The projected terminal rate went up by 0.5% from their meeting one month ago.

This means they think they will increase rates at least two more times by the end of the year.

That may not seem like much, but in Fed-world, that is an enormous increase.

Which leads us to mixed message #1: They are MORE convinced today that inflation will continue to be a problem than they were at their last meeting. Yet, they chose to RAISE rates at the last meeting, and KEEP RATES UNCHANGED today.

Nine of the twelve voting members increased their projected terminal rate.

One member, in fact, believes the Fed will have to raise by another full percentage point to get inflation contained.

We can view this in the “dot plot” below.

Each dot in this chart represents one voting member’s view on where they think interest rates will be at the end of the year (shown along the bottom of the chart).

The grey dots were their previous projections and the blue dots are from today.

The question is…why pause if they are all so convinced inflation is still a problem?

It frankly doesn’t make much sense.

Especially given that inflation data has consistently been showing signs of slowing for at least a few months now.

So what does the inflation data tell us?

Inflation Data Differs from the Fed’s Message

This is where we start to question what the Fed is looking at.

If we look at numerous inflation data points, without question they are easing.

The next chart looks at a measure of inflation for the services sector of the U.S. economy (in orange) alongside the manufacturing supplier deliveries (in blue).

This is “fast data”.

Which means that it is an up-to-date measurement of inflationary pressures in the early stages of economic activity.

Think of supplier deliveries as the raw material ordered before a good is produced, sold and shipped. From electric vehicles to microwaves to jelly beans, this measures all of the various inputs to those end products.

This indicator tracks the actual deliveries, not just the orders.

And deliveries have fallen off a cliff in the past year.

Deliveries are important because they give us a glimpse into the first things that go into producing goods. Companies have purchasing managers who are responsible for getting the “stuff” in the door to make whatever widget that company produces.

This data is in recessionary territory (a reading below 50 signals a contraction).

You may think that this is just a result of the supply-chain issues being resolved after COVID. But that would make deliveries go UP. Companies would be receiving MORE of the inputs to their products, not less.

This is a sign that DEMAND is going down.

We can see this demand destruction in the business sector as well.

The next chart looks at final demand of producers (in blue) with final demand excluding the more volatile food and energy part of the economy (orange).

This also shows an environment where inflationary pressures are falling quite dramatically.

This is brings us to mixed message #2: the Fed has INCREASED their projected inflation targets while the data is showing exactly the opposite.

To be fair, employment continues to be strong, and the consumer remains resilient.

But employment data is “slow data”. When an employment number comes out it is typically at least a month old.

In fact, at the start of the last 4 recessions, employment indicators were all positive. It’s simply not a great tool to extract future economic activity.

Prioritizing slow data is like driving your car using the rear-view mirror. It doesn’t make much sense and it is incredibly dangerous.

And the Fed is doing just that.

Higher interest rates take time to work their way through the economy. They work on a lag. Increased rates now may take 6-12 months to show up in actual data.

They are prioritizing slow data to justify policies that work on a lag. It simply doesn’t make sense.

But there are very smart people working at the Fed. In addition to setting interest rates, they also provide numerous economic forecasts, including ones on unemployment.

This leads us to the last mixed message.

Unemployment Projections are Inconsistent with Growth Projections

As mentioned, the Fed does economic forecasts as a part of their “job”.

They should….there are over 400 Ph.D. economists employed there.

One forecast is on unemployment.

In May, they forecast that the unemployment rate would be 4.1% next year. (It is currently 3.7%).

But today they increased their forecast to 4.5%.

At the same time, they increased their GDP forecast from 0.6% annualized up to 1.0% annualized.

Here is mixed message #3: they think GDP will be STRONGER than they projected last month, but unemployment will be HIGHER than they thought as well.

We hate to break the news to them, but unemployment has NEVER risen by 0.8% in one year outside of a recession. (From the current 3.7% to their projected 4.5%).

Bottom Line

In our opinion, the mixed messages from today show just how different the potential outcomes are over the coming months.

On one hand, inflationary pressures are decreasing and economic data is showing signs of a slowdown. On the other hand, stock markets have remained surprisingly buoyant on the back of an artificial intelligence tech frenzy.

We’ll review these potential outcomes in our 2023 Mid-Year Outlook webinar that will be held on Tuesday, June 27th. You’ll receive details next week.

Until then we’ll continue to monitor the variety of differing data points to best help you achieve your financial goals.

Invest wisely!

Debt Ceiling: More Smoke than Fire

image of old building on american banknote

Negotiations on the debt limit are heating up in Washington.

What implications may it have?

In our view, negotiations are mostly political posturing by both sides trying to gauge the likelihood that the “other side” will ultimately be blamed from bad things that may or may not happen as a result of not raising the debt ceiling.

Unfortunately, this political grandstanding is all too common.

Regarding the debt ceiling, agreements have always been reached.

We have thought for many months that the risk of an actual default on U.S. Treasuries is very unlikely. Neither side benefits from this, and both sides are likely to be blamed.

However, politicians are gonna politic.

It appears that our fearless leaders want to sufficiently scare us in order to get their faces on the front page of every newspaper around the globe while we wait for them to announce an agreement.

But we digress.

In order to better understand the situation, let’s look at the history of the debt ceiling first, then look at the potential impact on financial markets.

Debt Ceiling Overview

The debt ceiling was first implemented in 1917 with the passage of the Second Liberty Bond Act.

This was done to fund the war effort during World War I.

The goal was to provide a limit to the amount of debt the U.S. government can issue via treasury bonds while keeping Congress fiscally constrained.

For many years, this worked.

But over the past few decades, the debt ceiling has done absolutely nothing to restrain spending.

The chart below from the BBC shows the debt ceiling (black line) versus total outstanding federal debt. Republican presidents are shaded red while Democrats are blue.

It’s not hard to see that when debt reaches the debt ceiling, Congress simply raises it.

This is not a Democrat versus Republican thing. No one has fiscal restraint in Washington.

And despite “negotiating” spending limits nearly every time the debt limit is raised, there has been exactly zero reduction in spending during any administration, regardless of which party is in power.

We’ll discuss 2011 more below, but part of the deal to raise the debt limit then was that Congress projected over $2 trillion in savings over the next ten years.

What happened?

Debt increased by nearly $20 trillion.

Any talking points from a deal in 2023 is likely to be just that…talking points.

Previous deals to reduce spending failed. Why would this time be any different?

What are the potential market implications if a deal does or doesn’t get done?

Potential Market Implications

When looking at potential market implications with any type of event, it is most important to look at the actual data.

Since 1980, there have been 74 debt limit increases.

Only one of them truly resulted in major market volatility: 2011.

The vast majority of the time, the debt limit does not have any meaningful impact.

The next chart looks at the S&P 500 versus the statutory debt limit.

The orange line is the debt limit and the white line is the S&P 500.

It’s pretty easy to see that periods of volatility did not necessarily correlate to debt increases:

  • During the tech bubble, the debt limit remained flat. This was also the last time Washington was fiscally conservative.
  • The debt limit was increased in 2008, but that obviously was not the cause of the financial crisis.

In fact, you could argue that the markets and the debt limit are positively correlated. This means that when the debt limit goes up, so does the market.

As we mentioned earlier, the only real exception was in 2011.

What happened to asset prices then?

The next chart shows performance of various assets during and after the debt crisis in 2011.

This chart shows asset performance from May through December of 2011, and includes long-term treasury bonds, the broad bond market, large-cap stocks, and small-cap stocks, developed international stocks, and emerging market stocks.

The vertical red dashed line is the date when President Obama and Congressional Republicans finally agreed on an increase. At the same time, U.S. debt was downgraded from AAA to AA for the first time in history.

A few interesting observations from this chart:

  1. Volatility didn’t start until AFTER an agreement was reached.
  2. Ironically, the best performer by far was long-term U.S. treasury bonds.
  3. International stocks performed the worst, with developed and emerging markets both down over 25% through year-end.
  4. The S&P 500 index was down 12% in the months following the debt increase.

The other thing to note about 2011 is that the Fed ended QE2 in July of 2011. So there was a natural headwind from reduced Fed liquidity at the time of this volatility.

There are similarities between then and now:

  • Republicans won a mid-term election the year before.
  • The Fed is in tightening mode.
  • Political divisiveness is high.

Maybe we see a replay of the 2011 situation.

We hear many pundits saying that treasury bond prices will plummet if a deal isn’t reached. Others are saying that markets will crash.

But probabilities suggest otherwise.

Like most political events, this one is likely to have a very short-term effect on markets.

Bottom Line

By all indications, a deal to raise the debt ceiling is close.

But even if it extends out another few weeks, the likelihood that the U.S. defaults on its debt payments and a global catastrophe follows is extremely low.

Any reaction by financial markets, whether positive or negative, is likely to be temporary.

After that initial reaction, markets will go back to looking at data as if nothing happened.

Right now, data is extremely mixed.

Economic indicators are weakening, but overall, the stock market has remained very calm.

As we’ve said for months, risks from an economic standpoint remain very high. This week alone, JPMorgan and Goldman Sachs both announced that a recession this year is highly likely. We agree.

Without question, volatility will increase if negative economic events occur.

But don’t expect the debt ceiling to be culprit.

Invest wisely!