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Et Tu Brute

In Shakespeare’s famous play “Julius Caesar”, a group of conspirators gather in the Roman Senate to assassinate the emperor.

Brutus was one of Caesar’s most trusted confidants.

He and the other murderers pull their swords and stabbed him to death on the Senate floor.

With his dying breath, Caesar looks on in shock and betrayal and utters the words “Et tu Brute”.

Across the country today, regional bank CEOs must feel the same betrayal.

Yesterday, the Federal Reserve raised rates an additional 0.25%.

The Federal Reserve is supposed to be the banking system’s most adamant supporter.

After all, their primary job is “financial stability”, and they are considered the “lender of last resort”.

Yet, they inexplicably betrayed the entire banking system with another unnecessary rate hike.

In the midst of an obvious banking crisis, Chairman Powell referred to the banking system as “secure and resilient”. In the past month, we’ve had 3 of the 4 largest bank failures in history. Ah yes, the epitome of strength and resilience for sure.

The primary problem in the banking system right now are deposit rates versus safe alternatives.

This banking crisis is NOT over by any means.

In fact, risks right now are higher than we’ve ever seen them.

Let’s look at the Fed, Regional Banks and the Commercial Real Estate market to assess risks.

The Fed’s Last Hike

In their meeting yesterday, the Fed left the door open to additional interest rate hikes.

Let’s be clear. We believe there is NO REASON for the Fed to hike again.  Whether they will or not is anyone’s guess.

They have yet to explicitly acknowledge it, but inflation is no longer the problem.

They are fighting a banking crisis that it nowhere close to being over.

Instead of pausing, Chairman Powell felt he had to project confidence in the financial system.

He was faced with a difficult choice:

  • Don’t raise rates, and risk markets interpreting that as fear over the health of the banking sector;
  • Raise rates, but risk making the banking crisis worse.

Powell woke up and chose violence.

In the world of instant public relations campaigns, not raising rates would have been an admission that the financial system has major problems.

Even if the system is weak, they can’t let the market perceive that they think the system is weak.

But if they raise rates (like they did), they all but guarantee more stress on the banking system by boosting rates on money markets, increasing the risk of deposit flight.

And if banks try to raise rates to slow the deposit outflow, they destroy any profitability they had.

In the end, the Fed decided to roll the dice and increase rates again.

Unfortunately, this will likely prove to be an incredibly poor decision.

In fact, markets are now pricing in a 15% likelihood that the Fed will CUT rates at their meeting in June. Not next year, but next month.

The chart below shows the implied Fed Funds rate through January of 2024.

The blue line (and left side of the chart) is the expected interest rate on the date along the x-axis. The orange bars (along the right side of the chart) is the number of expected cuts by next January.

Fed Funds implied interest rate for the remainder of 2023. Number of rate cuts and projected interest rate decreases.

Markets expect 4.5 interest rate cuts this year, and the rate to go from 5.25% down to 3.9%.

This is quite extraordinary given that the Fed raised rates YESTERDAY.

It firmly implies that markets think the Fed made a huge mistake with this recent hike and that the economy is about to be very bad.

Let’s turn our attention to the regional banks next.

Regional Banks

Regional bank stocks are suffering massively.

3 of the 4 largest bank failures in history have occurred in the past month, and there are more to come, likely this weekend with Pac-West Bank. It won’t be the last.

The next chart shows the ticker KRE, which is an ETF comprised of regional banks.

Regional bank stocks are down almost 60% since their highs last year.

They have also have given up ten years of gains. This is simply astonishing.

What this tells us is that the market thinks the banking crisis is much more urgent and important than inflation.

We agree.

Commercial Real Estate

Economic data is weakening. Fast.

Bank lending is one of the biggest contributions to economic growth. We live in a time where loans are the backbone of the US economic engine.

There has been more than $2 trillion of outflows from smaller banks over the past month.

If you are a bank CEO, do you think you would be aggressively handing out loans right now?

No.

You’re keeping all the reserves you can, hoping your customer base is loyal.

Lending standards were tightening before the banking crisis began. Now that it is accelerating, the problems will begin to spread.

The biggest area of concern for us is in commercial real estate.

Let’s look at some stats:

  • 67% of all commercial real estate loans were made by smaller banks.
  • 83% of all CRE loans are balloon notes. This means they mature and the owner is forced to do something (refinance or sell the property).

In the next two years, over $300 billion of CRE loans mature, as shown in the chart below from CRED IQ.

We must keep in mind that commercial real estate is a diverse market, and not all properties are created equal.

There are some areas of strength:

  • Manufacturing facilities are moving back to the U.S. from overseas, creating support for industrial space.
  • Grocery-anchored shopping centers (with an HEB for example) are doing quite well.
  • Senior-housing facilities are poised to benefit from aging demographics.

But these are relatively small areas in the CRE market.

Currently, these smaller and mid-size banks are dealing with a liquidity crisis.

They may start to face problems with their balance sheet. This would be an entirely different ballgame.

Bottom Line

Risks are incredibly high right now.

Despite that, markets have been relatively calm.

The next few months are perhaps the most important months of the past decade.

If we can get through them with relatively little damage from an economic and earnings standpoint, there is a chance that we avoid some very bad scenarios.

Until then, it is appropriate to err on the side of caution.

IronBridge clients continue to be extremely below their target risk, with elevated holdings in cash equivalents and various short-term high-quality fixed income holdings.

We anticipate that will continue, but as always we will continue to monitor markets for signals to add risk where appropriate.

Please do not hesitate to reach out with any questions.

Invest wisely!

Bank Run: Silicon Valley Bank Goes Under

Today, Silicon Valley Bank became the second largest bank failure in US history. What happened and what does it mean going forward?

Who is Silicon Valley Bank?

  • Silicon Valley Bank, or SVB, was the 16th largest bank in the US.
  • This was the second largest bank failure in US history.
  • Based in Santa Clara, California, they focused on startups, founders and private equity investors.
  • Frankly, this was a great bank with fantastic employees, seemingly well capitalized, that went under incredibly quickly. So what happened?

How did SVB get into this Situation?

In order to fully understand the events that transpired this week, we first need to look at the past few years.

The roots of their collapse started in 2021. Their deposit base jumped from $61 billion at the end of 2019 to $189 billion at the end of 2021.

When banks bring in deposits, they have to do something with them.

Like all banks, the goal is to lend the money out, and earn profits by charging higher interest rates on loans than what they pay on deposits. This difference is called “Net Interest Margin”, or NIM. Banks charge you 6% on a loan, and they pay you 0.5% on your cash. Voila, they earn 5.5% in NIM.

Because their deposit base grew so quickly, they couldn’t underwrite enough loans to put that money to work. In order for them to earn a higher yield on their customers’ deposits, they purchased over $80 billion worth of Mortgage Backed Securities, or MBS. These are financial instruments similar to bonds that are made of up of many different mortgages.

97% of the MBS they purchased had maturities of longer than 10 years. These were purchased before interest rates began to increase last year. (This is important.)

Why did they Go Under?

When banks buy securities with customer deposits, they have to put them in one of two buckets: 1) Available-for-Sale, or 2) Hold-to-Maturity.

Available-for-Sale assets must be “marked-to-market”. This simply means they report the current market value of each investment they hold, just like you see on your investment statements each month.

Hold-to-Maturity securities, on the other hand, don’t have to be reported that way. If you bought your house for a million dollars, and the value fell, you could still report the value as a million dollars.

The $80 billion of MBS were held in the Hold-to-Maturity bucket.

Last year, when interest rates rose so dramatically, the value of these securities fell. A lot. They lost billions of dollars. And because SVB had longer-maturity securities, they fell more that shorter-duration ones would have.

This week, they had to sell at least $21 billion of assets to meet withdrawal requests after depositors essentially made a run on the bank.

Once Hold-to-Maturity assets are sold, any gains or losses must be disclosed and reported. The sells they had to make this week resulted in a nearly $2 billion loss.

Between the MBS losses and continued customer withdrawals, the bank was forced into receivership by the FDIC.

What Does it Mean for You?

First, recognize what a bank deposit really is. Banks do not have a safe where they keep your money.

The following clip from “It’s a Wonderful Life” perfectly exemplifies what really happens when depositors want to withdraw money from a bank. (Fast forward to 3:50 in the clip to view the most relevant part.)

Banks don’t keep your funds. They lend them out, and invest it, and do other things to make themselves a profit.

As George Bailey says, “You’re money is not here.”

Why do you think the new account agreement is so big when you open a new checking or savings account?

You are not an account owner of a bank account. You are a bank creditor.

You lend the bank your money.

They do with it what they want.

Now that people can earn a decent yield on short-term cash funds and US Treasuries, there is competition for those deposits.

This is a good reminder to pay attention to your deposits, especially now that there are good alternatives.

Is there Risk of Contagion?

Quite frankly, yes there is.

That doesn’t mean that other banks will definitely go under, but it is absolutely possible.

Smaller and regional banks are most at risk right now, but there is also risk to the broader markets.

We have long been saying that risks are incredibly elevated right now. This is a good example of what can happen when risks are high. Banks don’t tend to fail in bull markets.

In our opinion, the full effects of higher interest rates have not been felt yet.

This is a major example of the unintended consequences that can happen in a complex system like financial markets.

Portfolio Implications

IronBridge clients continue to be very underweight risk exposure right now.

We believe that risks will remain elevated at least through this summer, and you should position your portfolio for continued volatility.

We discussed the two most likely scenarios in our recent video from last week.

We further reduced risk this week for clients, and view any rallies attempts in markets as good opportunities to de-risk even further.

It is much better to not participate in short-term rallies than to participate in long-term declines.

As always, let us know if you have any questions.

Invest wisely!

Recession Risks Remain High

Markets have calmed down quite a bit from the volatility of 2022.

This had led many people to believe that the worst might be behind us.

Maybe that is the case, but there are many data points suggesting we shouldn’t be too optimistic (at least not yet).

Let’s look at the data to see what it says.

Indicators a Recession is Near:

By far the bulk of the macroeconomic data is negative. In fact, many indicators suggest a recession is imminent.

While we haven’t seen anything bad happen yet, that doesn’t mean we’re out of the woods.

There are major economic drivers of the US economy that are flashing warnings signs:

  • Yield Curve
  • Leading Economic Indicators
  • Banks’ Willingness to Lend
  • CEO Confidence
  • Forward Earnings per Share

Let’s take a brief look at each of these items.

Yield Curve

The yield curve shows interest rates at various maturities.

When longer-term bond pay more interest than shorter-term ones, the yield curve is “normal”.

However, when shorter-term bonds pay more, the curve is “inverted”.

An inverted yield curve has a 100% success rate in predicting recessions. Currently, the curve is inverted, as shown on our first chart below.

A recession has always followed when the yield curve has been this inverted.

On average, a recession begins within 12-18 months after the initial inversion. This happened one year ago.

If history is any precedent, a recession should start by this summer.

Leading Economic Indicators

The Leading Economic Indicators (LEI) is a measurement of ten data points on the earliest stage of economic activity.

Right now, LEI is very negative. In fact, every time LEI has dropped this much, a recession has followed.

This next chart shows the LEI index. Green shows positive year-0ver-year growth, while declines are in red. Recessions are shown in the red shaded areas.

Typically, a recession starts 7-8 months after LEI growth drops by 3% year-over-year. This happened in December.

If history is any precedent, a recession should start by this summer.

Tightening Lending Standards

Banks are tightening lending standards and access to credit.

The US economy is driven by debt. When banks tighten, the economy slows.

Except for 1994, every time bank have pulled back on their willingness to lend money, a recession starts within months.

This suggests that we may already be in a recession.

CEO Confidence

Corporate CEOs have access to real time economic data on how their company (and more broadly the overall economy) is performing.

When CEO confidence falls, recessions typically follow.

Earnings Growth

The previous data points are all macro-economic data points.

The next has to do directly with stocks.

If we do enter a recession, corporate earnings will decline. In fact, we’re already starting to see that.

All of the data points above suggest risks in financial markets remain very high over the next few months.

However, there are data points telling us a recession may not be quite as likely.

Indicators Suggesting a Recession is Less Likely:

While the bulk of the data is poor, there are some data points suggesting that a recession may not be imminent:

  • The US Consumer has been Resilient
  • Light Vehicle Sales are Steady
  • Employment Numbers aren’t Bad
  • VIX has remained low
  • Market Breadth is Improving
US Consumer Spending

70% of the US economy is dependent on the consumer.

If the consumer can remain resilient, then there still remains hope that we will avoid a recession (or at least have a mild one).

The next chart, courtesy of Bank of America, shows that consumer spending increased in January.

This is an important indicator to watch over the coming months.

Light Vehicle Sales are Steady

Another indicator showing that the consumer is resilient and there is still overall demand in the economy can be seen in vehicle sales.

Light vehicles include almost every consumer auto. This categorization includes all cars and trucks weighing less than 10,000 pounds. (For reference, the maximum curb weight of a Ford F-150 is about 5,600 pounds.)

While this chart doesn’t necessarily show excessive strength, it also doesn’t show weakness either.

Employment Numbers Remain Strong

One of the most widely watched economic indicators is the unemployment number.

The chart below shows jobless claims. So far, unemployment has remained resilient.

This is very closely tied to the consumer spending data we mentioned above. When people have jobs, people spend money. Especially when prices are higher on just about everything they buy.

We’ve all heard of the layoff announcements by the Tech giants Amazon, Microsoft, Apple, Google, Microsoft, and more. These are concerning, and could be the tip of the iceberg.

But for now, those layoffs have not spilled over to the broader economy. At least not yet.

This is another data point we will watch with great interest in the coming months.

VIX Index

The VIX has reflected the relative market calm over the past few months.

While each recession has had a spike in the VIX, not every spike in the VIX has lead to a recession.

The VIX is a relatively fickle index, and there is little to no predictive power in it. But it does tell us that despite the high economic risks right now, the market is not overly fearful.

Market Breadth

The last chart we’ll discuss has to do with market breadth.

In order for the overall market to move higher, its underlying constituents need to be doing well.

And in the past few weeks, there has been improvement.

This chart shows the percent of stocks within the S&P 500 that are above their respective 200-day moving average. (This is simply the average price of that stock over the past 200 days.)

The current reading is 68%. This is a healthy number. While this number in isolation doesn’t give us an “all-clear” to invest, it is a good sign.

Bottom Line

Despite recent market strength, risks remain incredibly high.

At this point, it appears that the rally we’ve seen this year is another bear market rally.

The next few months are very critical. If a recession hasn’t started by mid-year, then the Fed very well may have manufactured a “soft landing”.

Client portfolios remain conservatively positioned, as they have been for the past 8-9 months.

The further we get into this year without bad things happening in the market, the better the overall risk/reward profile of this market becomes.

We’ll publish a video in the coming weeks to discuss the specific scenarios we see happening over the coming months.

Until then, please do not hesitate to reach out with any questions.

Invest wisely!

Scrooged?

stern looking mature man in victorian costume carrying a cane . Model is wearing a dark suit , top hat, glasses and prosthetic make up , the look created is also similar to a Dickens victorian type character .

Men’s courses will foreshadow certain ends, to which, if persevered in, they must lead,” said Scrooge. “But if the courses be departed from, the ends will change.”

charles dickens, “A christmas carol”

In Charles Dickens’ famous book, A Christmas Carol, Ebenezer Scrooge begins the story as a mean-spirited and angry old man.

But he undergoes a transformative experience that changes him into someone who cares for others and embraces the spirit of giving.

The quote above by Mr. Scrooge is not the easiest quote to read.

If we paraphrase it, it may read something like this:

“If you go down a dangerous path, bad things will probably happen. But if things change, they might not be so bad after all.”

Currently, equity markets are trying to show more of a giving spirit like that of the transformed Scrooge.

But there are still MAJOR macro-economic signals with a grumpy, “old-Scrooge” like demeanor.

But will they will turn into positives in the coming months?

Grumpy Scrooge

First, let’s look at the more concerning indicators.

Specifically, there are three data points worth watching that are showing elevated risks for 2023:

  1. The Inverted Yield Curve
  2. Leading Economic Indicators
  3. Money Supply (M2)

These indicators tend to be excellent predicters of recessions when they turn negative.

And right now they are VERY negative.

Inverted Yield Curve

The yield curve is simply what a specific investment instrument yields at different maturities.

To understand the current yield curve environment, think of it like this:

Let’s say you want to invest in a Certificate of Deposit at a bank. You speak to a banker, and ask for the rates on a 2-year CD and a 10-year CD.

Logically, you expect the 10-year CD to be at a higher interest rate. You are, after all, committing funds to the bank for a decade.

But the banker tells you that the 2-year rate is paying 4.6%, while the 10-year rate is only 3.8%. This is an “inverted” yield curve.

When the yield curve on US Treasuries inverts, it has been the single best predictor of a recession in the past 100 years.

Right now, the yield curve is more inverted than anytime in the past 40 years.

The chart below shows the difference between a 2-year US Treasury bond and a 10-year one.

US Treasury yield curve is the 2-year yield versus the 10-year yield. It is currently inverted by the most in nearly 50 years, signaling a deep recession is likely in 2023.

When the line is above zero, the curve is “normal”. Below zero and it is “inverted”.

The past three times the yield curve was inverted was in 2008, 2000 and 1987. It became inverted before the markets had extreme stress, and each time led to a recession and tremendous market volatility.

This chart above only goes back to the 1970’s, but it’s the same well before that as well.

The depth of this inversion is worrisome too.

At roughly 0.83%, this is a very steep inversion, and one that is signaling not just a recession, but a deep one.

Leading Economic Indicators

Another key data point to monitor is the Leading Economic Indicator Index (LEI). We discussed this in our Thanksgiving report (read it HERE).

The LEI is another excellent recession predicter.

It’s so good, in fact, that EVERY time in the past 70 years we’ve seen the LEI at these levels a recession has followed.

The chart below, courtesy of Charles Schwab and Bloomberg, shows that the negative LEI is below the average level where recessions begin.

Schwab Bloomberg leading economic indicators showing negative data and at a level below where recessions typically begin.

LEI is telling us that a recession is imminent (unless this time is different, which is a dangerous assumption in financial markets).  But LEI is not a good timing tool…it does not tell us when a recession might begin.

It only tells us that one is close. 

And the rate of change does in fact suggest that a recession is likely to be worse than “mild”.

Another way to look at LEI is to look at the diffusion of the data.

Diffusion measures how widespread any strength or weakness is within the data. In the next chart, the diffusion index ranges from -50 to 50.  A reading below zero tells us that the majority of the data is weakening. 

Leading economic indicators diffusion index has an active recession signal.

When the diffusion index is below zero, it is indicating that a majority of the underlying data is weakening.  A reading above zero tells us the opposite, that most data is improving. 

When the diffusion goes below zero, it is a warning sign that economic trouble could be happening.  But a recession has not followed every time diffusion has turned negative.

Only when the index gets to minus-4 has it signaled that a recession is imminent.  The index is currently at minus-6. This is another excellent predicter of a recession, and it tells us that one is very likely to occur in 2023.

Money Supply (M2)

Another important, but little discussed aspect of financial market performance is the money supply.

There are various ways to measure the overall supply of money in a society. One of the broadest definitions is called “M2”. It measures the total amount of liquid funds in cash or near cash within a region.

This number includes cash, checking deposits and non-cash assets that can easily be converted into cash, like savings accounts and money markets.

If you’d like to learn more about M2, Investopedia has a nice article about it HERE.

M2 has a very high correlation to inflation. More accurately, changes in M2 have a very high correlation to inflation.

The next chart shows this phenomenon, courtesy of our friends at Real Investment Advice in Houston.

The black line is the year-over-year change in M2 (moved forward 16 months), while the orange line is CPI.

M2 is telling us that inflation is likely to head much lower in the coming 12 months.

On the surface, this would appear to be a good thing. After all, isn’t inflation one of the problems that markets face right now?

Maybe it is a good thing.

But the real problem is the extent of the decline.

After a massive increase in M2 during COVID, the rate of change has collapsed.

The problem arises in how big this decline has been.

It is not signaling that inflation should moderate. It suggest that inflation may turn into outright deflation.

The only way this happens is if we enter a moderate-to-deep recession. When major data points align like these three do right now, we must pay attention.

The New, More Giving Scrooge

While there are plenty of reasons to believe that 2023 is going to be a bad year again for stocks, not everything is bad.

Let’s look at some good data points right now:

  • The consumer remains strong. Shoppers spent a record $5.29 billion this Thanksgiving, an all-time record high. Yes, inflation had some to do with this, but at this point inflation is not having a meaningful impact on the consumer, at least; not yet.
  • Unemployment is low. The unemployment rate remains below 4%, primarily due to the services sector being strong.
  • Inflation is slowing some. CPI for October came in at 7.7%, below estimates of 7.9%. November’s CPI data will be published tomorrow. As we can see from the M2, we should expect inflation to slow in the coming months.
  • The Fed may be close to pausing. The market is anticipating a 0.50% increase at their meeting next week, with an additional 0.25% at their February meeting. Currently, markets expect that to be the end of interest rate increases for now. Historically, when the Fed Funds rate gets above the 2-year treasury yield, the Fed pauses interest rate increases. This will likely happen this week, so they very well could be done raising rates for a while.

Unemployment is a big data point here. Once the unemployment rate starts to rise, it has a direct impact on spending.

And consumer spending is roughly 70% of the US economy.

The main problem with looking at unemployment and other actual economic data is that they are backward-looking.

Once unemployment increases, we are already likely in a recession (even if it is not officially announced yet).

Which makes the forward-looking data points that much more important to consider.

Bottom Line

Despite the recent calm in markets, this is not a time for complacency.

Over the past 50 years, every time markets were volatile and NOT in a recession, NONE of the three indicators listed above were negative.  

Now, all of them are negative. And all of them were negative prior to recessions.

This tells us that the likelihood of a recession next year is extremely high. In fact, the data suggests that it should be more of a question about the extent of the decline, not whether one occurs.

Fortunately, it is not a foregone conclusion that a recession will be deep and painful. There is still plenty of time for things to change into something more positive.

Hopefully, this angry Scrooge-like data will transform to be something less angry and more joyous towards everyone.

But as we always say, hope is not an investment strategy.

For now, we must deal with the realities of the environment at hand.  And the current environment has major risks that should not be ignored.

Invest wisely!

Thanksgiving Appetizer Report

Fall theme charcuterie board for holiday entertaining

Just wanted to provide a quick update as everyone prepares for the holiday week. We’ll send out a more detailed report next week.

Big Picture

  • Markets have remained calm after the massive gain two weeks ago following a milder than expected inflation number.
  • Earnings for the most part have been better than feared.
  • Markets are entering a seasonally strong period. From the Tuesday before Thanksgiving thru January 2nd, markets are up on average 79% of the time, averaging a 2.7% gain.  This is what is commonly known as the “Santa Rally”.
  • Despite these positives, many
    warning signs still exist: leading economic indicators are weak, overall
    financial conditions are deteriorating, and the housing market is under
    stress. These conditions have not shown up in economic numbers (yet).

Economy

  • The good news: Economic activity remains resilient. GDP was up 2.6% in the 3rd quarter. 4th quarter GDP, according to GDPNow, is tracking up 4.2%. View it HERE.
  • The bad news: Leading economic activity is at recessionary levels as shown in the first chart below.
  • If you’re curious as to what makes up the Leading Economic Index, the second chart below shows the ten components with contribution from each.

Equity Markets

  • On November 10th, the S&P was up nearly 6%, and the Nasdaq was up 7.4%. This accounts for more than half of the return in the past two months.
  • The big jump in markets on was due to inflation coming in at 7.7% instead of 7.9%.
  • Big daily increases like this do not occur in good markets. The chart below shows the 20 largest increases in Nasdaq history.
  • 17 of the previous 19 largest daily increases occurred during major bear markets and did not mark the bottom.
  • The other 2 happened one week after the ultimate bear markets lows in 2009 and 2020 under very different conditions than we have now (VIX then was above 80, while VIX currently is at 22.)
  • Near-term, markets could continue to drift higher. Looking past the next few weeks, things appear to be very weak. Caution is advised.

Interest Rates

  • The Fed is likely to increase rates by 0.50% in December, then another 0.25% in February. The market anticipates that the Fed will stop raising rates after that.
  • Longer term rates appear to be calming down, and may be starting to price in recessionary risks.

Bottom Line

While the relative calmness has been a welcome respite from the volatility this year, we do not believe this is a time for complacency.

We would love to believe that the bear market is over. At our core, we are optimists.

But more importantly, we are realists.

Equity exposure has steadily increased in client portfolios this quarter. If market and economic conditions continue to improve, we will continue to do so.

But we view any new equity exposure as potentially having a very short shelf-life.

We will not hesitate to reduce equity exposure, increase cash levels, and do more hedging to protect portfolio values if and when these actions are warranted.

We hope you and your loved ones have a wonderful Thanksgiving holiday.

Invest wisely!

Are We There Yet?

Looking into the back of the car at two children passengers passing the trip away teasing and crying.

We’ve all been there. (At least those of us with kids have been.)

The start of a long road trip. Everyone is excited to get going. Then you get 8 minutes into an 11-hour drive, and you hear the famous words emanate from the backseat…”Are we there yet?”

We’ve all been through bear markets too. (Although it’s been 15 years this month since the last real one began.)

Yesterday, markets had one of the largest reversal days in history.

Which begs the question…”are we there yet?”. Is this bear market over?

SPOLIER ALERT…the answer is pretty clear…no, we’re not there yet.

What about that Giant Reversal Day Yesterday?

Inflation data for September was announced yesterday morning. The CPI came in higher than expected, at 8.2% year-over-year. Markets expected a reading of 8.1%.

Last month, the same thing happened. And markets fell over 3% on the day.

Initially, it looked like we were going to see repeat of the damage. Markets fell hard in the morning, and were down over 2%.

But by the end of the day, all major US stock indices were HIGHER by more than 2%.

On the surface, this would seem like a good thing.

Markets heard bad news but rallied on it.

This isn’t the first time the market has had a big reversal like this.

Our first chart shows the ten largest reversals when the the S&P 500 and the Nasdaq were each at respective 52-week lows, courtesy of SentimenTrader.

Largest 10 reversals from 52-week lows for the S&P 500 Index and the Nasdaq Composite Index. All events happened during major bear markets.

The red dots are times that this happened while the markets were in major bear markets.

What does this chart tell us about big reversals like we saw yesterday?

  • 16 out of 18 previous events (excluding yesterday) occurred during deep recessions.
  • 7 occurrences happened during the 2008 Financial Crisis
  • 6 occurrences happened during the 2001-2002 Tech Bust
  • All previous occurrences in the Nasdaq happened in 2001/02 or 2008. Both times the index lost over 60%.
  • None of these events occurred at the lows.

During 2008, these events actually happened before things really started to unwind.

For the S&P 500, reversals happened once in January and twice in September of 2008. After the occurrence in September of 2008, the S&P 500 fell another 46%.

Reversals on the Nasdaq happened throughout the fall of 2008.  After the first one occurred in September of 2008, the Nasdaq fell another 42%.

These events are not indications of hope. They are signs that things are broken.

Caution is still warranted.

High Inflation is not because of Supply Issues

Inflation is proving to be harder than the Fed expected to get under control.

By looking at the past 5 years, we can definitely see the spike in inflation in the US, as shown below courtesy of Bloomberg.

US inflation rate has been skyrocketing since the COVID lockdowns.

The low on this chart was during the COVID lockdown. It has skyrocketed since.

One major factor after COVID is that there were problems in the global supply chain.

The Baltic Dry Index is a measure of the cost of shipping containers across the globe. When it goes up, it means that there are supply chain issues and great demand for ships.

This index is shown in the next chart.

The spike in this chart in 2021 was when there were massive bottlenecks at ports across the globe. At one point there were hundreds of ships waiting to get into the port at Long Beach, California.

But this index has moved back to pre-COVID levels.

This suggests is that inflation is NOT due to supply constraints. At least not on a global level.

For the most part, things are moving quite normally across trading channels.

So why is inflation high?

Components of Inflation

To understand the inflation numbers, we must understand the various data points that go into the CPI number.

Here’s a helpful graph from the Pew Research Center that shows the various components of inflation.

Components of the US inflation rate index the Consumer Price Index or CPI. Shelter, food, transportation, education and medical services are the major components.

Shelter, food, education, transportation and medical care account for 74% of the CPI numbers.

None of these are showing signs of weakening yet.

It’s tough for the CPI number to get to their stated goal of 2% if the largest inputs continue to go up.

This is why the Fed is so focused on the housing market.

At 32%, it is more than double the next largest component.

Energy prices are a decent-sized component at 7.54%, but they would have to fall by 90% to get the CPI where the Fed wants.

So they are attacking home values.

What would make home prices fall?

People get laid off. They can’t afford their monthly payment. There are fewer buyers because interest rates are too high.

The Fed essentially has a goal of crushing lower and middle class Americans.

In our previous report, “A Recession or Not a Recession”, we discussed the belief that the housing market will be the key to whether we see a major recession or just a mild one. Here’s a link to that report:

A Recession or Not a Recession, That is the Question

We stand by this thought.

The housing market has been showing some minor indications of weakness, but nothing like what the Fed wants to see.

Bottom Line

We have been pretty clear for the past few months that it appears we are in a major bear market.

We don’t see any reason to abandon that point of view.

That said, we should expect some fierce bear market rallies. And ones that last longer than one or two days.

But as of right now, there is very little reason to expect that we are near a major bear market low.

As always, please do not hesitate to reach out with any questions.

Invest wisely!

Don’t Fight the Fed

The Federal Reserve met today and increased interest rates by 0.75%, as expected.

Stock markets were volatile all day, and ended up down almost 2%. So maybe it wasn’t so expected after all.

As we have consistently said in communications over the past few months, risks are very high right now.

Today didn’t do anything to change that in either our signals or our minds.

We’ll keep it short and to the point today, and let charts do most of the talking, but let’s do a brief portfolio update first.

Portfolio Update

Client portfolios are VERY conservative.

We have continued to reduce equity exposure in all portfolios, and we have added equity hedges to portfolios as well.

If markets continue to fall, your portfolio should remain very stable. We cannot eliminate risk, so there will always be fluctuations. But we have minimized those to properly handle the current environment.

We firmly believe this to be the proper course of action at this point.

As always, markets can change. If we get signals to increase risk, we will not hesitate to do so.

Yield Curve

The Yield Curve remains inverted. This means that short-term rates are higher than longer term rates. The yield curve is more inverted than it has been in almost 50 years.

US Treasury Yield Curve is inverted

Why does the yield curve get inverted in the first place?

There are two main reasons:

  • Short-term rates are mostly set by the Fed. They have been steadily increasing rates all year.
  • Longer-term rates are set by the market. When there are concerns about economic weakness, money flows into longer-term treasury bonds.

Longer-term yields have been relatively stable the past few months, while short-term rates have risen dramatically.

Inverted Yield Curves Lead to Recessions

As we have mentioned numerous times this year, an inverted yield curve has been an excellent indicator of recessions.

The next chart shows the percentage of the yield curve that is inverted (blue line), with recessionary periods in gray.

The percentage of the yield curve that is inverted simply looks at various maturities and counts whether the short-term rate is higher than the long-term rate. (3-months vs 2-years, 3-months vs 5-years, etc.)

When more than 55% of the yield curve becomes inverted, it has ALWAYS preceded a recession. We are now at 65% of the yield curve that is inverted.

The Fed’s Dot Plot

This is a bit of a complex chart, but it shows how each member of the Federal Reserve Committee sees future interest rates.

This shows that the majority of Fed members believe they will hike rates to somewhere between 4.5% and 5.0%. The target rate is currently 3.00-3.25%. (They use a 0.25% range when setting the Fed Funds rate).

So we can assume that there is likely another 1.50-2.00% of interest rate increases to come. This would likely be another 0.75% at the next meeting in October, followed by slightly decreasing hikes (0.50% then 0.25% at the following two meetings).

Things can change, but this is a good gauge of their thoughts.

It is also interesting to note that almost every Fed member is then projecting rates to fall in 2024 and beyond.

When has the Fed Stopped Hiking Historically?

Historically, the Fed stops raising rates when the Fed Funds rate gets above the inflation rate. There may be some time to go before that happens.

Bottom Line

Today’s developments do not surprise us.

The Fed has been crystal clear about wanting to slow the economy, slow wage growth, and remove speculation from markets (meaning lower stock and home prices).

They re-emphasized that today in no uncertain terms.

The Fed wants prices to fall. Don’t fight them, you won’t win.

The downside scenarios are large enough that it still makes sense to reduce risk if you haven’t done so already.

As always, please do not hesitate to reach out with questions or to review your individual circumstance.

Invest wisely!

A Recession or Not a Recession, That is the Question

“To be or not to be–that is the question: Whether ’tis nobler in the mind to suffer the slings and arrows of outrageous fortune or to take arms against a sea of trouble and by opposing end them.”

hamlet, act 3, scene 1

July was a nice month in the markets.

Which begs the question…have we seen the lows in this bear market?

Should we expect markets to continue to rise and suffer the slings and arrows of outrageous fortune? Or is this yet another fake-out like we’ve seen twice already this year and we go back into a sea of trouble?

The answer? It depends.

In most environments, it “depends” on a complex series of data points could shape the direction of the markets.

However, today’s environment seems more simple on the surface.

It depends primarily on only one variable: whether we are in a recession or not.

The reason is very simple…markets respond differently to pullbacks similar to what we’ve seen this year based solely on if it happens during a recession or not.

Let’s look at some historical context.

S&P 500 Performance: Recession vs No Recession

Markets can decline without the economy being in a recession. Since 2009, we’ve seen this happen a few different times:

  • 2011: US Debt Downgrade
  • 2016: Chinese Yuan Devaluation and Oil Crash
  • 2018: Random 20% decline in the 4th quarter

Each of these times, markets fell roughly 20%.

And each of these times, markets recovered losses within 18-24 months.

But there was no recession during these periods.

Our first chart below, courtesy of Ned Davis Research, shows this dynamic. The chart shows declines of at least 18% and separates it between two categories: whether it occurred during a recession or not.

The black line is the performance of the S&P 500 when there was no recession, while the blue dotted line shows the performance if there was an official recession.

We are currently two months past the recent lows, as indicated by the red dashed line.

Based on what the market has done historically, the results are very clear: if we’re not in a recession, we should expect the next 12 months to be pretty good. If we are in a recession, we should expect more volatility and a retest of the lows.

Which begs the question…are we in a recession or not?

Are We in a Recession?

Normally, determining a recession is pretty straight-forward: it is two consecutive quarters of negative GDP growth.

Both Q1 and Q2 this year were negative.

So by historical definitions, yes, we are in a recession.

But it may not be quite that simple this time.

We don’t like to get political in these reports, because the world focuses way too much on the self-absorbed, sociopathic political class.

But with mid-term elections around the corner, the incumbents are trying to change the definition of a recession.

It’s an overly transparent pre-election tactic. But we will reluctantly admit that in this case, they may have a point.

(To be fair to our politician friends, many economists agree that the first quarter did not resemble a typical economic recession.)

Let’s look at the data.

The first quarter GDP came in at a negative 1.4%, mostly because of two things:

  • Defense spending fell 8.5%
  • A trade imbalance due to a strengthening US dollar resulted in a negative 3.2% from total GDP.

Remove these two factors, and GDP is positive. In fact, if you simply remove the trade imbalance, GDP is positive.

Economic data in the first quarter was fairly positive as well, led by consumer spending, which was up 2.7%.

While the first quarter showed relatively good economic data, the second quarter was recessionary without question.

Second quarter GDP was negative 0.9%. And the negativity was more widespread.

  • Inventory investment decreased 2.0%
  • Housing investments decreased 0.7%
  • Federal and State spending both decreased slightly
  • Business investment decreased 0.1%
  • Consumer spending rose by a more moderate 0.7% (down from 2.7% in Q1)

With the underlying strength in the first quarter, it’s not out of bounds to assume that we’ve only seen one quarter of truly negative GDP growth.

(For the record, we don’t think we should change the traditional definition of a recession, but we should always put GDP data in context, both positive and negative.)

Which makes the current quarter especially important.

If we have negative GDP this quarter, there is no question that we are in a recession. The question then becomes how bad it is and how long it lasts.

Atlanta Fed GDPNow

One way to keep track of current GDP estimates is through the Atlanta Fed’s “GDPNow” tracker. (You can view the site HERE.)

As of Thursday, August 4th, they are projecting a 1.4% GDP for Q3, as shown in the next chart.

Granted, the estimate has steadily declined since the start of the quarter, and we still have almost 2/3 of the quarter left. So anything can happen.

And this data is also based on human estimates, which can be skewed.

But it should at least give us some hope that maybe we don’t see a formal recession this year. And if we do see one, it would likely be fairly mild.

This morning’s jobs report adds to the hope that we may not be in a recession just yet. The economy added 528,000 new jobs this quarter, and as of July has officially recovered the number of jobs lost during COVID.

However, we shouldn’t get too complacent at this point.

While GDPNow is showing positive estimates for current GDP, there are huge warning signs right now that should give us cause for concern.

Inverted Yield Curve

Historically, one of the best recession indicators has been an inverted yield curve. This occurs when the 10-year yield on US Treasuries are LOWER than the 2-year yields.

The next chart, courtesy of Bloomberg, shows this inversion.

When the line goes below zero, the curve is inverted.

Right now, it is more inverted than at any time since Paul Volker started fighting inflation the early 1980’s.

It is more negative than COVID, than the global financial crisis, the tech bubble, and various recessions during the 80’s and 90’s.

We strongly believe that it is imprudent to ignore this data point.

But this data point isn’t a very good timing indicator of when a recession may happen.

In reality, it is when the curve starts to steepen AFTER it has been inverted that is a better indicator that a recession is imminent, and we haven’t seen that happen yet.

Housing Market Concerns

While the inverted yield curve is a bit more theoretical in nature, there are real economic data points that are showing signs of stress.

The housing market plays a huge part in economic activity, accounting for 15-18% of US economic activity on average.

Leading indicators in the housing market are showing reason to be concerned.

One of these is cancellation rates, as shown in the next chart from Redfin.

Cancellations happen when an accepted offer is withdrawn by either party.

In this case, the majority of cancellations are due to buyers backing out.

There are legitimate reasons for this happening:

  • Mortgage rates have increased, making it unaffordable for a buyer to proceed;
  • Property taxes have been reassessed higher, increasing the cost of housing;
  • People anticipating that prices may fall, causing buyers to withdraw offers.

Here’s a link to the article discussing cancellations:

The Deal Is Off: Home Sales Are Getting Canceled at the Highest Rate Since the Start of the Pandemic

Another reason for cancellations is a drop in consumer confidence, which has a big effect on economic conditions in the US.

Consumer Confidence

While the housing market is a large part of the economy, the consumer as a whole is much more important. Approximately 70% of the US economy is driven by the consumer in one way or another (this includes housing).

So when consumer confidence slows, economic activity typically slows along with it.

And the consumer is in the dumps right now, as shown in our next chart.

Right now, the consumer is the least confident they have been at any time in the past 60 years. This includes the Vietnam era, the inflation of the 1970’s, the tech crash, the global financial crisis, and COVID.

That is concerning.

But what does all of this tell us about the near-term direction of the market?

S&P 500 Index

All of the data listed above is not news to the market.

Despite these concerning data points, markets have rallied over the past seven weeks.

But the move higher since June looks almost identical to the one in March, as shown in the chart below.

Specifically, the pattern is a three-leg move higher into previous highs.

There was an initial leg higher, a move lower of roughly the same timeframe, then an extended move higher in both time and price.

The move in March followed the Ukraine invasion.

The move in June really didn’t have any catalyst, other than the overall market being incredibly pessimistic.

In addition to the S&P 500, nearly every major US stock index looks identical.

The next chart shows the S&P 500, the Russell 2000 small cap index, the Nasdaq Composite and the S&P Mid Cap index.

Every one of these indices are at the same resistance level. This means that the market thinks these levels are important.

Regardless of the reason for the move in June, it has been strong. Earnings reports have been more positive than expected, and the market is starting to predict that the Fed will become more accommodative and “pivot” by slowing the rise of interest rates.

If the market is going to do it’s own pivot and head back lower, it must do so very quickly.

If it breaks above this resistance area, then we can begin increasing equity exposure in client portfolios, at least for a period of time.

If it heads lower, then we should expect a fairly quick move to test the lows from June.

Bottom Line

While a big consideration for the market is the current recession debate, markets are extremely complex systems. Relying on only one data point for decision-making would be foolish.

When looking at a variety of data points, it truly is a mixed bag out right now.

Recent market strength and earnings reports have been mostly positive. As such, the market seems to believe the Fed will slow down the pace of interest rate increases. (Frankly, this expectation seems to be unwarranted, especially after today’s employment numbers.)

For now, the move higher over the summer appears to be a typical bear market rally. As such, we have been intentionally slow to add equity exposure.

Why?

Mainly because there is still plenty of upside if the market wants to keep pushing higher. For example, the Nasdaq is down nearly 23% this year, even after a big rally over the summer.

And big stocks like Google, Microsoft, Facebook and Netflix still have massive upside potential at current levels.

If the market can get above the levels noted in the S&P chart above, there starts to be more proof that this rally may be more than just another temporary rally.

But if we do go into a recession, all bets are off. And there are many indications to suggest we are headed in that direction.

Bottom line is that we believe it is prudent to underweight risk right now, given the massive uncertainties in the market and the economy.

Invest wisely!