A Note from Jeremy:
Good morning! We resume our weekly economic updates in 2024 with a revised approach. For more than a year, we’ve provided regular updates for our clients about the state of the economy as it slows down due to high inflation and the actions of the Federal Reserve as they combat it. We’ve seen a slow but consistently negative trend in most economic indicators that has pointed us directly at a recession. This is historically correct, as well, whenever the Federal Reserve must undergo a period of quantitative tightening like we’ve seen since early 2022.
However, the U.S. stock market has not followed the economic trends, with alarming implications for investors who are following market sentiment instead of the reality of the economic conditions upon which companies must build and grow their businesses. Sentiment simply means emotional response and collective intuition, and market participants tend to make decisions not based on reasoned research, but on where the herd is running. It is very easy to “run with the bulls” we instinctively want to do so – even when the cliff’s edge is directly ahead.
But because investors will ignore economic trends for as long as possible and run with gut instinct, peer pressure, headline hype, and emotional responses, we need to keep a closer eye on market movements as well, to try to determine when they are consistent with what we know about the economy, and when they run wildly off-course. In the past, I’ve taken the approach that our investment recommendations would largely ignore short-term market reactions (because no one can predict those with any degree of accuracy), and instead make investing decisions for trends we see taking place for six months or longer. We still wholeheartedly believe that, but as we learn more about market sentiment, the prevalence of robotic, algorithmic trading, and the timing of the mistakes most investors make, we can begin to take market sentiment into account more for the benefit of our clients and readers. For that reason, 2024’s economic updates will include much more about current market conditions, as well.
As the CEO and CIO of nVest Advisors, I have been cautioning our clients for over a year about deteriorating economic conditions, and many of our clients have placed their funds in our protective defensive models as we anticipate a significant pullback in equity prices ahead of what looks more and more like an inevitable recession. “The market”, particularly in the last 3 months, has gone the other direction, to what I consider absurd and unsustainable highs.
Let’s look back at 2023 for a moment. The year started with the markets rallying strongly in large tech company stocks after a pretty brutal 2022 that our clients had been largely protected from. Stocks rallied strongly on the belief that the Fed would surely reverse course (you’ll hear the word “pivot” a lot regarding the change in policy investors are betting on the Fed taking).
Actually, let me clarify. It’s incorrect to say that stocks rallied. About 10 stocks were all that meaningfully rallied for nearly all of 2023. And those 10 stocks were tech companies whose stock prices were beaten up significantly in 2022. Yet these 10 also make up a disproportionately large portion of what you see reflected in the S&P 500 and the NASDAQ index each day. So while these stocks rallied strongly, the rest of the index didn’t.
(Not coincidentally, all of these companies also made a point to mention, repeatedly, that they were interested in pursuing “AI” (artificial intelligence) projects when they had their investor conference calls last year, but I digress.)
The AI-hype-fueled rally ended in March of 2023 with the failure of four large regional banks, mostly related to cryptocurrency and tech companies. Stocks erased all of their gains for 2023 in just a couple of weeks. Many banks were already struggling with significant losses on their books from the drop in prices in their treasury bond holdings in 2022, and these four were also disproportionately exposed to tech companies and crypto.
The Fed stepped in with an emergency line of credit for distressed banks (called the “BTFP”), investors felt the crisis was contained, and the rally started again and continued into July, when it hit a brick wall, again, on deteriorating economic news and the reality that inflation was going to be harder to pull down than most investors thought. The much-predicted summer Fed “pivot” didn’t happen, and stocks again erased their gains for 2023 in August and September and bobbed up and down into October. On October 7, Hamas terrorists invaded Israel, sparking a Middle East conflict that is increasing in spread and intensity even as I write this today.
Then, at the November Fed meeting, Chairman Jerome Powell told reporters that he was cautiously optimistic that inflation was on a sustainable path back down to a 2% annual rate (this is the Fed’s “target”), and the Fed’s voting members decided not to increase interest rates for the fourth meeting in a row.
This simple statement was the cause of the market rally that continues to this day. But it’s not based on an improving economy or growing corporate profits, or even the current trend in inflation, which looks like it might try to head up again. Instead, this rally is based entirely on the hope that interest rates will be coming down in rapid succession, starting in a month. Investors were so eager to once again believe the Fed was soon going to “pivot” and start lowering rates, that they sent stock markets to record highs on merely the hope of something happening this year that no one at the Fed has promised or even implied.
The Federal Reserve Open Markets Committee only meets eight times each year. The markets fully priced a total of 7 rate cuts out of those 8 meetings. Even the Fed speculated there might only be 2 or 3, and that would be late in the year as the economy worsened, if at all. But Wall Street decided to go “all-in” on words no one at the Fed said, but that the market believes were implied. Investors read “between the lines” and drew their own conclusions, again. And that is the reason for this recent rally.
Rallies based entirely on hype and hope and “hidden meaning in Fed comments” cannot be sustained.
The market is currently “buying the rumor, and selling the news,” which is a terrible strategy for anything but casino-style day trading.
It is often said that markets are “rational and efficient”; this is based on what is known as the Efficient Market Hypothesis, and it’s something I’ve grown increasingly more skeptical about over my tenure as a professional investment manager. In short, the market is rallying like the best of times are directly ahead, which is in direct contradiction to what the economic indicators are telling us. There is much talk about “soft landings” for the economy, which seems to be the same mistake investors make immediately before most prior major market and economic downturns:
There are a number of reasons we believe stocks will correct downward in the near future.
First, the rally itself was based entirely on speculation of a Fed “pivot” that went wildly overboard. Also, the BTFP program for distressed banks is being terminated in a month, so banks will have to deal with any liquidity problems in more conventional ways. Third, interest rates will likely remain higher for longer than the market expects because inflation appears to have bottomed out and may be headed higher, particularly in energy and shipping costs related to the Middle East conflict. Fourth, the markets are notoriously wrong around the timing of economic events. This is because the economy appears to be chugging along until it “suddenly” and “unexpectedly” hits serious turbulence. Essentially, the feeling is that nothing happens for forever, and then everything happens all at once. Investors are strongly prone to a number of cognitive biases, one of which – recency bias – makes them believe that what has happened in the recent past will remain the same going forward.
The data supports this. Here, for example, is a comparison between the predicted price/earnings ratios of the Nasdaq index with that of 10-year treasury bonds. The idea is that once bond yields are higher than the growth potential of stocks, investors will smartly move away from riskier (and now overpriced) investments and toward the relative safety of a bond giving the same or better return. What we’ve had for all of 2023 is an unprecedented disconnect between these asset classes:
US stocks have also completely disconnected from stocks in other parts of the world, as well. This is the price of stocks both in the developed world (chart 1) and emerging markets (chart 2) compared to the prices of stocks in the S&P 500. Again, if investors are to be rational and efficient, these “cheap” investments won’t remain so for long, and there logically should be a move out of US stocks. International economies are actually in worse shape at the moment than our own, but once there are signs of recovery outside the U.S., the best investing returns may be found there for a while.
There is also the total lack of concern among investors in the U.S. right now which tells us that irrational exuberance and, frankly, greed, are the prevailing emotions. Here we can see that stock prices have risen by more than 1.5 standard deviations above the VIX (volatility index that measures fear and risk-aversion). When this happens, sharp contractions in stock prices typically follow because the market has rallied far too high. The last time we were anywhere near this overbought territory was during the years of recovery after the Great Recession, at which time the Trump tax cuts had taken effect, interest rates were at zero and the Fed was pumping a lot of money into the economy:
As we do our jobs for our clients each day, it is important for you to know our rationale for the decisions we make. Right or wrong, there is tremendous effort put into assembling and interpreting the data, both in isolation and how they interconnect to tell us a bigger story. The markets will do what they do, but the economy is the foundation of the entire house and is the “lighthouse” by which we try to steer your assets away from the rocky shores of speculation and wild swings in market sentiment.
We’ll never be perfect at it – no one in this business is – but we will continue the process of study, learning from our mistakes and correcting the course a little bit at a time, for your benefit.
Have a great week.
- Jobs Update
- Real Estate Update
- Consumer Confidence Reports
- Inflation isn’t finished
We do a lot of looking at jobs, so I’ll spare you this week and we will begin looking at them closely starting next week. However, this week, I wanted to bring your attention to the way job losses typically occur in recessions.
Generally, laying off staff is the last thing a company wants to do, and they will avoid doing so until the business needs demand a cut in expenses. It’s just too hard to re-hire skilled and trained employees on the other side of the downturn.
So we often don’t see major layoffs until we are into the first third or half of most prior recessions. Job losses, therefore, are a lagging indicator, not a leading one. Layoffs are the result of a recession, not a predictor.
However, historically we get warning signs right before major layoffs begin. The chart below shows current job openings that employers cannot fill (blue line), with the unemployment rate (red line). You can see that they work opposite each other, as they should. But the correlation here, and what is important to observe, is that whenever the blue line reverses trend and heads down, the red line quickly follows, and significant job losses result quickly afterward:
If history is any guide, unfortunately, layoffs should start rising rapidly in the coming weeks.
What this means for you
We continue to watch employment for a number of reasons. First, and most obviously, employment tends to give you an inside look at the overall financial health of a company, industry, and economy. But also, when unemployment spikes (and it does indeed spike it doesn’t usually just creep up, as the chart above demonstrates), it can happen very quickly. That loss of income will immediately impact spending and credit payments, which is where the recessionary pain really comes from.
Employment is a lagging indicator, as I mentioned above. It is not logical to watch for unemployment to change before you alter your investment risk profile. We believe we have already positioned our clients properly for what Wall Street will always claim is a “surprise” or “unexpected” spike in unemployment, because we have no reason to believe this business cycle will be substantially different than prior ones.
Real Estate Update
Home builder confidence improved slightly this past month based on slightly lower mortgage rates and, again, the hope of a Fed “pivot”:
We believe there will still be much more pain in the housing market, as the supply of homes is still far too tight. Mortgages and sales of existing homes started out the year at decade lows:
What this means for you
We believe there will be continued pain in the mortgage and real estate sectors, particularly in commercial real estate investments where office space is a high percentage of the assets. A large number of people who bought homes in 2021, 2022 and 2023 did so in the hope of a quick refinance to a lower rate as soon as the Fed pivoted. However, with inflation running well above the target, and inflationary pressures resuming, this may not happen very quickly. Additionally, a large number of investors in homes for short-term rentals (think AirBnB) are starting to struggle with fewer and fewer bookings, and cities and counties starting to restrict or even ban these kinds of uses of residential property. We believe a large number of the homes currently listed on AirBnB may, in fact, return to the market as they prove to be harder and harder to achieve profits.
If you are in the market to buy a home, we urge patience – we believe that both house prices and interest rates will decline in the coming months.
Leading Economic Indicators
We have had 21 months (and counting) of negative leading indicators (first graph). As far back as 1960, there has never been anything even close to this that did not end up in a recession (second graph). If at first the smaller number in December looks promising, remember that this is a Month-over-Month graph, so for two years now, we have had the leading economic indicators get progressively worse and worse.
What this means for you
We currently have two paradigms in the investing world: a stock market at record highs, and an economy telling us over and over, 100 different ways, that there is danger ahead. One of these must be wrong.
Because the economy is measured by thousands of different metrics and approached from hundreds of different angles and is dispassionate and has no political agenda, the congruity of the economic data is what convinces us that caution must be taken in your investments at this time.
Inflation isn’t finished
Most of the recent market rally has been based on the notion that inflation has truly been beaten and the Federal Reserve will now begin to lower interest rates. It’s a rally based, again for the fifth time, on a narrative that so far has not been true, and ultimately reverses.
So is inflation finished this time? We don’t believe it is. Inflation tends to run in waves over successive years, each wave slightly higher than the one before (because after each wave, you’re still slightly above where you started). We therefore have said for months now that the Federal Reserve will likely have to hold interest rates high, or even raise them slightly from here, in order to make sure inflation is truly crushed.
Even Fed Chairman Jerome Powell tried to warn the markets last week that inflation was likely not finished, a warning that market participants, hell-bent on a “Santa Claus” rally to end the year, ignored. We not only heed his warning; we’ve been saying the same thing for months.
The evidence of inflationary pressure resuming is easily seen in this composite graph of other indexes. In each instance, the lower inflation trend of late has reversed and is headed up again.
We’ve been alerting our clients for nearly two years now that inflation was going to cause significant problems and our central banks would have to take progressively stronger actions to combat it. No one knows exactly when a recession will be declared, but we believe most of the larger economies of the world are right at the door of one now. Recessions can take years to recover from, which is why we believe it is vitally important to get your family and business finances ready to weather through such a storm.
We predicted the beginning of a turn in the current market rally last week, and we reiterate that sentiment now. There will always be market movements that run counter to the economic data because markets are much more short-term focused, and let’s face it: until fear takes hold, greed is the prevailing emotional state of most of Wall Street. We do believe, however, that the recent rally has fully run its course, and the shift from stocks into safer investment options such as gold, cash, and government bonds will continue. With interest rates this high, getting a 5% or better yield, risk-free is becoming a more and more attractive option for investors concerned about the coming economic uncertainty. Once there is consensus that either the economy is earnestly deteriorating, or the Fed announces the end of rate hikes, the move from stocks to bonds will accelerate.
Whether you are our client or not, you need to consider the broader economy (and much less so the daily market fluctuations) when making investment decisions. The economy is telling us clearly what is coming, and you need to have your investment accounts prepared before that happens.
Almost a year ago, I published an ebook to help you get your finances ready for the recession directly ahead. It’s yours totally free. Just click on the book image to access and download it.
Use these economic reports, and those of others working in this space, to prepare. You can not only avoid much of the pain that is coming, but you might actually profit from it, if your investments are properly positioned, and you’ve done what you can to shore up your business’ and family’s financial situation. If you need help with this, nVest Advisors has amazingly affordable personal financial planning and fiduciary investment management services to help you.
This is what we do for a living, and we’re very happy to partner with you on that endeavor.
Reach out to us for a totally free financial and portfolio checkup today if you’re concerned about where your finances sit for the coming few years, particularly if you are at or approaching retirement age. We’re delighted to offer you our thoughts. You can schedule that time with us below:
Our Economic nSight articles are typically written once weekly by nVest Advisors CEO Jeremy Torgerson for the general education of the public, and as a way to provide transparency for our clients and sponsored-plan participants as to how we create and modify our investment models. It is copyrighted and may not be republished in whole or in part without written permission.
At nVest Advisors, we believe that successful investing depends on an understanding of, and correct response to, changes in the world economy as they happen. We incorporate real-world economic conditions into almost all of our investment models and strategies at nVest Advisors, which we believe provides significant benefit to our clients’ overall investment returns by reducing various short-term market risks and enhancing portfolio performance over time.
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