A Note from Jeremy, CEO/CIO:

Happy Monday! We continue to watch the markets reach very narrow all-time highs as the economy starts showing the first real signs of cracks in the foundation. We reiterate that the current rally is so narrowly focused, and so fragilely constructed, a large “snap back” is the most likely short-term scenario. While our clients in our discretionary models remain defensively protected for this event, casual readers should seek a financial advisor to help assess their overall exposure to a broad downturn in equity prices in the coming weeks.

~ Jeremy, CEO

• Markets remain grossly overbought
• Jobs Update
• Real Estate Update

Markets remain grossly overbought.

Last week, I stressed the incongruity between current tech stock prices and the broader macroeconomy. This trend has continued into this week. We continue to believe very strongly that there will soon be a sharp downward correction in the stock market, for two reasons. First, the recent market rally has been predicated on two conflicting narratives: that the Federal Reserve bank would be dramatically cutting interest rates in 2024, and that the economy is growing at a rapid pace and employment remains very strong.

These two narratives are polar opposites. The Fed will lower rates when it has cause to – namely, to stave off a recession or to provide additional liquidity to the markets if things start breaking. But it has no reason to – at all – if the economy is booming. To lower rates in a growing economy, with inflationary pressure resuming (see below) would mean the Fed is surrendering its fight to reduce inflation back to the Fed’s 2% annual target.

The second reason for the rally for all of 2023 (though it fizzled out twice before November) is this almost religious fervor regarding the potential of artificial intelligence (“AI”). As a result, tech stocks, particularly (and cynically) those companies who were smart enough to pledge AI development in the past year’s investors’ earnings calls, saw their stocks soar so much, that it dwarfs the catastrophic bubble in tech stocks in 1999 and 2000 that resulted in a harsh, sharp recession, and tech stocks falling almost 90% from their peaks.

The rally into specific tech stocks is remarkable. This shows the rally in only a few tech stocks compared to the rest of the economy. Most are flat or down; ONLY technology is rallying so strongly. This is, we would argue, a blatantly obvious “Tech Bubble 2.0”:

You can see the “AI Bubble” in the graph below. The Top 10 tech companies (all aggressively hyping AI projects that have either been disappointments or not brought to market yet) is the green bar, and 2024 is on the far right.

Every rally (or panic sell) period that extends far past its moving average, has a strong propensity to pull back to its average price. This is called “reversion to the mean”, but think of it like a rubber band, stretched unnaturally up (or down) beyond what is its natural shape, MUST eventually snap back. In this case, the S&P 500 has stretched well beyond its 200-day moving average, indicating an overbought situation that will, with all likelihood, snap back.

And the longer and higher we stretch the rubber band, the snap back can be harsh. This is the longest weekly rally in the market without a necessary correction back to reality since I was born in 1971:

This isn’t the good news it looks like at first glance. When we get this kind of massive rally, in just a few stocks, the draw-down after that bubble pops can be significant (and pretty predictable). Here we see the last 1971-1972 bubble in the blue line, and the tech bubble in the gold line. Once these kind of irrational rallies end, the draw-down after was more than 40%:

And the optimism is being projected forward into next year, again, without support or evidence:

If it were true that these companies are thriving, business is booming, and profits are likely to soar, then the insiders at those companies would know it first, right? If the future for these companies was nothing but “up”, we would always see evidence from insider trading activity – company directors and managers buying more stock in expectation for great times ahead.

But that’s not what’s going in. Just the opposite is occurring – insiders all over these companies are SELLING stock, not buying it:

Insider trading, in fact, is SO bearish right now, we haven’t seen this kind of activity since the throes of the Covid pandemic:

Where markets are today alarms us at nVest Advisors from a perspective of safety for our client portfolios. We are not “bears” here and take no short positions against the market. We are data-dependent and focus first on risk aversion and letting events in the macroeconomy guide our model construction. We believe that it is preferable to sidestep markets when they rally too high and return to your typical risk profile once the market prices have corrected.

We never believed the November-to-Today rally in stocks (and actually, it’s not ALL stocks rallying, only about a dozen or so large-cap tech stocks) was sustainable or justifiable. Both the economy and the reality that AI, while carrying massive promise for the future like green energy does, is in its infancy. Just the launch of Gemini, Google’s language AI, last week, and the widespread outrage over its overpromised capabilities, built-in political bias, manufactured quotes, and chaotic (and inadvertently racist) image generation, should give investors pause going forward that AI has a long way to go before it can be incorporated into the workplace and academia the way the “Magnificent Seven” tech companies promised a year ago.

We also know market history, and the technology sector, for lack of a more polite way to say it, is often found peddling B.S. Whether that’s in the capabilities of their products, the pacing of product delivery, or even the value of their companies, few sectors in U.S. history have had more concentrated incidents of fraud, over-hyped valuations, and wishful thinking.

So, we believe the market has to come to a reckoning about the recent rally, based mostly on pipe dreams and the smoke-and-mirrors of a few tech companies promising what they simply cannot deliver. We may have a few more months of tech company overvaluation, but both the weakening economy and the failure of many of these AI projects (or promised projects that never take off), will correct stock prices back down to earth.

As it stands today, we can see several indications of the stock market being wildly disconnected from reality. First, in historical P/E ratios :

Then there is the “Buffett Indicator”, which compares stock valuations to the actual productive output of the economy:

The “Fear and Greed Index” echoes our sentiment. Stocks are wildly out-of-alignment with realistic valuations:

What this means for you

We continue to adjust our investment models for our clients who engage with us, and our recommendation is to remain conservatively invested for now.

Jobs Update

The weekly jobs numbers continue to give many economists the (we believe, false) notion of a robust economy. The issue is that unemployment filings are one indicator (typically, the last one) of a deteriorating labor market. Companies don’t want to lay off workers until they have to, and we’ve shown our readers several times over the last few months that unemployment filings typically don’t start really climbing until we are about 1/3 of the way through a recession. Job losses are the result of a recession, not a predictor.

That said, the current initial unemployment filings came in low last week, and followed seasonal trends (job losses typically drop off at the start of the year):

But as we’ve warned for over a year now, CONTINUING claims are telling us another part of the story. It is difficult to replace a job if you do lose it. Continuing unemployment is now higher than 2018, 2019, pre-Covid 2020, 2022, and 2023, and the trend is worsening (2nd graph):

There is also the simple truth that the numbers no longer make sense, and haven’t since late last year. Generally, initial claims and continuing claims run pretty closely to each other, and that makes perfect sense – if jobs are hard to get, losing one means it may take a while to find a new one. If jobs are plentiful, you won’t have trouble and layoffs will be minimal.

But that’s not the case for the last six months. One of these will have to adjust sharply to reconnect with the other. We believe it will be INITIAL claims pulling up sharply, for the reasons we discuss below.

These graphs also show what has already occurred, but do we have any indication of what’s coming? Yes, several.

Let’s begin with the number of WARN notices (60-day required advance notices of layoffs for companies with more than 100 employees) that have taken place so far. So while we currently have a low initial unemployment claims rate, we have a substantially higher number of companies who have now given warning of layoffs coming (over 300,000 next month):

And a strong jobs market is more a matter of where you live, than a wide, robust economy throughout the United States. More than 60% of the country’s metro areas are now showing rising unemployment (let me note here that the last times we were anywhere near this figure, without exception, we had a recession):

Once again, tech companies are leading with the layoff announcements, which is one reason that we believe the recent rally in tech company stocks was far too optimistic and premature. How can tech company profits be booming but the companies are laying off more and more people? We believe: they can’t.

We also mentioned over the last two updates that most of the recent hiring was in government positions, not in private companies. The number of total number of PRIVATE job hires is rapidly declining, following exactly the same kind of trend that has always led into recessions (and, you will note that the bulk of the layoffs happened DURING the recession, not BEFORE it):

Digging a little deeper, we can see the private jobs more closely. In companies with 10 or more employees, you can see that both the hiring (black line) and the job listings (red line) have been in sharp decline since 2022:

But in companies with less than 10 employees, we see things appear to be a little more optimistic (or at least, on the surface). Hiring in the very small firms never really took off after Covid, but the number of available jobs appears to have soared in a way that never happened in the last 20 years. In recent weeks, a number of owners and employees of very small companies publicly admitted that they post a large number of jobs they have no intention of ever filling, because it gives their company the false impression of robust growth to potential investors.

In short, we believe many of the listings for jobs in small companies are “ghost jobs” as the linked article above describes, and that explains the strange disconnect in 2021 from the previous measures of this metric.

One area we expect to see more job losses is in construction. The housing market (see below) is now in freefall, and we can see now that the gap between construction employment (very high) and construction activity (low and dropping quickly) has never been greater. There will, sadly, be many more layoffs coming in the real estate and construction sector in the coming weeks.

What this means for you

We continue to watch employment for several 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 comes from.

Employment is a lagging indicator. It is not logical to watch for unemployment to change before you alter your investment risk profile ahead of economic challenges. 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

The sale of new single family homes are pacing below 2022 and 2023, but still relatively strong historically. We believe this will drop further due to increases in the mortgage rates since January:

The time to sell a newly built home sits at almost 3 months, a relatively short time and in line with 2022 (longer than 2023):

Much of it still has to do with housing affordability. We’ve looked at home inventories a lot in recent weeks and will do so again, but combining high home prices with both higher mortgage rates and the willingness of banks to offer mortgage loans (the chart below), you can quickly see there is much more weakness coming in the housing market. Buyers simply cannot afford the mortgage payments, and banks are very nervous to lend with a deteriorating economy underway.

As interest rates climb again in the wake of likely higher-for-longer Federal Funds rates, we can see the issue of affordability for buyers remains a major challenge.

And with the strength in home prices (and now rent rates resuming their climb after a brief pull-back), inflationary pressures may persist for much longer than investors are expecting. If rates cannot come down to make expensive homes affordable, then the home prices themselves MUST come down:

And we can see that the price of a home and/or rent are nearly all showing a flattening or rebound back up (depending on who is tracking). Inflationary pressures are, frustratingly, resuming:

The cost of living isn’t just a problem for homeowners, obviously. Renters are subject to inflation in this expense, too.

This chart is kind of hard to read, but this shows the number of rent rate INCREASES vs. DECREASES in a given month. The GREEN portion shows the number of rental rates that have declined over a prior month, and the gray line shows the number of rental prices that have gone up. We can see that rent rate drops peaked in August of last year, but that rent rates have been climbing ever since.

We believe the biggest concern in real estate right now is not residential (but that will come later in this recessionary cycle), but rather, COMMERCIAL real estate, which has struggled ever since “work from home” became common during the Covid-19 pandemic. As office space vacates, landlords are faced with more than $2 Trillion of mortgages on commercial property that are due to be refinanced this year…

…and with interest rates remaining much higher than many real estate investors believed they would be, we think a cascade of defaults and bankruptcies in the commercial real estate market will be the first of two major credit events in this recessionary cycle.

Most commercial property lending is actually handled by regional and local banks, not by larger international banks. Almost none of the commercial real estate loans are protected by government-backed insurance:

And this week, we got a look at foreclosures now occurring in commercial properties. It is rapidly climbing, and already at levels not seen in over a decade (the aftermath of the Great Financial Crisis of 2007-2010):

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.

Inflation Update

We continue to be concerned about several current and leading indicators, hinting strongly that we are going to have an upsurge in inflation in the coming months. This will significantly retard the Fed’s efforts to lower interest rates, which is a large part of the reason for the stock market rally that began in November.

First, independent analysis from the BLS and Barclay’s shows that the CPI inflation index significantly increased in January:

The Cleveland Fed also revised their January and February inflation metrics upward, providing a third confirmation (this time from an official Fed source):

Small businesses also report that their cost of goods is increasing, indicating that they will likely have to raise prices on their products and services shortly:

What this means for you

We do not believe the Fed will be able to lower interest rates shortly, unless something significant “breaks” first in the economy. This event might be a string of bank failures or other liquidity and credit issues, or else a dramatic upswing in unemployment. We urge our clients and readers to remain conservatively invested for the time being.

Recession Warning Signs

It’s not a surprise to our clients or readers that we believe a recession is very near. We also believe that stock prices, being astronomically out-of-touch with the economic reality, must correct sharply in the wake of the recession’s arrival.

Are there indicators besides the ones we’ve discussed above and in previous weeks, that help us see what is our possible near-term future? Certainly, there are.

First, a look at the borrowing happening in private companies at the moment. Companies are pulling back sharply on their own lending. If we are really rallying and the economy is booming, this would not be the case:

There is also the Conference Board’s Leading Economic Index (LEI), which we’ve reviewed many times in this space. Currently, the LEI continues to contract:

This has been the second-longest period of consecutive monthly declines in decades (and we are actually very near the WORST of the GFC and we haven’t even hit a recession yet).

This chart gives us a breakdown of what makes up the LEI and where each component is today. Presently, there are only three positive components: availability of credit (which is rapidly declining), consumer goods orders (that index also went negative in February), and stock prices, which we’ve argued above are grossly overvalued. We do not see, from the indicators below, that there is any reasonable cause to believe a recession is going to be avoided.

You can see the impact of the stock market’s rally on the LEI below We are still well below the start of all previous recessions (blue bar), and the only reason the trendline reversed slightly was the recent market rally, which we strongly believe is unsupportable and unsustainable.

Finally, the Fed’s OWN RECESSION INDICATOR is flashing a 62% chance of a recession this year:

Bottom Line:

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.

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 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:

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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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