A Note from Jeremy, CEO/CIO: Economic News

Happy Monday! The economy continues to show signs of slowing and the stock market, particularly the tech stocks we’ve been arguing are overvalued, have started a downside correction. Last Friday, especially, equity indexes were significantly down and the trend continues as we complete this update this morning.

Remember that markets, with rare exception, “zig-zag” their way up or down, though when panic sets in, it can feel much faster on the downside than the upside. There’s an old saying that stocks take the stairs up, but the elevator down, and that is why we have our clients very defensively allocated until we see the “elevator” back on the ground floor in coming weeks.

NOTE: Starting April 1, I will be providing a DAILY economic update on my personal blog, “Think Like A Rich Guy”. Economic and market insight from all over the world will begin appearing there. We are also working on a weekly podcast! Stay tuned.

~ Jeremy, CEO

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

Markets remain overbought.

Last week, we looked closely at overall market valuation metrics, to show you two important concepts:

1. The Market as a whole is grossly overbought, and
2. The Market is concentrated at historical levels (this means only a few companies are actually up, but up so much that they’re dragging the entire index with them).

We reiterate that sentiment this week, even as we see markets starting to pull back from these astronomical high valuations in these “meme” stocks that grab the attention of the public at large, and suddenly, valuations are up so high that they can’t be logically justified or sustained.

There is a strategy called “Momentum Investing” that we are studying more closely for our client models that may be able to capture – safely – some of those returns for our model portfolios, but at the moment, we are still skeptical that the tops and bottoms of these stocks can be ascertained.

These charts show why that’s the case – momentum factors didn’t drive investment returns early in 2023 at all, but did do so strongly later in the year, and the Momentum Factor is, for all intents and purposes, the Magnificent Seven stocks. At first glance, the rally looks strong and sustained since the November Fed meeting, in which markets immediately priced in seven (what is it with the number “7” that the market obsesses with so much?) interest rate cuts in 2024 that we now know for certain will not happen.

We told our clients back then that the recent run-up was not sustainable because the premise upon which it was built was entirely speculative and unrealistic. We remain confident that the recent rally can – and likely will – “snap back” with very little warning to investors.

What is causing the stocks to rally is also a backward-looking indicator right now. Many factors can contribute to a stock’s value rising or falling, but currently, the reported change in their sales is having the biggest impact.

This is allowing investors to forget many of the more important fundamentals such as the total yield of the stock (dividends plus or minus price changes), the Price/Earnings ratios (these meme stocks’ valuations are astronomically too high based on this measure alone), and the improvement in their profit margins.

Right now, a high reported sales figure wins the day, even though those sales have already in the past. Past sales (not profit) is driving future valuations at the moment, and that doesn’t make sense to us.

Because of this extreme focus on only a few companies, and only their sales for the previous quarter, the concentration risk in stocks has reached its highest point in several generations. Not even the Tech Bubble of 1999-2001 comes close to where we are today.

In fact, it’s been since the 1920s for us to have we seen the top 10 stocks in the S&P 500 be as much as a third of the overall valuation of the index. Think of it this way: out of 500 stocks that make up the S&P, only 10 (2% of companies) are providing 33% of the returns. 490 companies are responsible for the rest. When concentration gets this high, it can cause the index to crash suddenly if one or more of these companies suddenly drop due to changing economic or business conditions.  This is not a broad-based rally across the entire economy – this is a highly focused rally, in 10 stocks only, in stock prices only.

Let’s give you just one example of this concentration in real time. Nvidia (NVDA), the maker of microchips and every graphics card my kids ever owned, reported sales last year of $63 billion. This sounds like a lot, but the stock price change as a result of this report was so astronomically and unsustainably high, it created a company valued at $2.3 TRILLION. In comparison, NVDA now dwarfs the sizes of the companies on the right, COMBINED (and those companies, combined, have total sales of over $1.04 Trilion, more than 20 TIMES what NVDA produces, and a combined profit EBIT of roughly 5 TIMES Nvidia’s):

The recent rally is so strong that previously, it’s only happened immediately AFTER a recession (when stock prices had been down 40% or more), or when bubbles formed like in 1999. Since we have not yet seen the retraction in stock prices due to an economic downturn, we conclude that this is an asset bubble that cannot be sustained, because it’s not rallying back from an irrational sell-off first.

Indeed, ancillary evidence tells us that we have likely past the peak of the bubble, and things will begin to cool off. Google searches for the “Magnificent 7 stocks” is fading quickly:

I’d like to take an additional minute to discuss the current rally in crypto, which I believe is coming from three different sets of investors. First, we have what I call the “crypto bros”; investors who have an almost religious fervor for cryptocurrencies being a sort of financial savior for the world, someday replacing fiat currencies and decentralizing (or often, in their words, “democratizing” finance). The second comes from the investors who are speculating simply because crypto coins trade wildly and completely without logic. And the third are people who are normally more conservative investors who are looking at Bitcoin, especially, as a form of safety similar to gold.

These three are rallying at the same time for different reasons, and it’s caused the Fear and Greed Index in crypto to reach record levels of “extreme greed”. Again, this is an emotional bubble that must eventually burst and return to earth, and when it does so, it can be extremely fast.

And many coins are rallying in the wake of Bitcoin, none of which makes any logical or rational sense, none of which can be valued accurately day-to-day, and none of which have anything to offer on their own except they sit in Bitcoin’s shadow:

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. Instead, we are data-dependent and focus first on risk aversion and letting events in the macroeconomy guide our model construction. As fiduciary advisors, 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.

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.

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):

Continuing claims continues to buck the trend and give us a different picture of the long-term job market. And as you’ll see below, we strongly believe that the initial claims will begin to rise rapidly in the coming few weeks due to WARN notices and other indicators:

The disconnect between the inital claims and the continuing claims is, historically, very unusual. Normally, they are very closely correlated. We believe that as continuing claims continue to trend upward, initial claims will rise to reconnect.

Also, WARN notices are skyrocketing since the beginning of the year. A WARN notice is an announcement of an intended layoff by a company that has 100 or more employees, which must be given at least 60 days in advance. As you can see below, the number of initial unemployment claims (black line) is lagging behind a big rise in layoff notices. We believe the unemployment claims will spike in coming weeks.

There is also the number of job cut announcements by the Challenger report. 2024 is the highest number of announced layoffs in any February for the last decade (and January was the second-highest in that same time period). Those people have not been laid off yet, or are just starting to be. We believe this will reflect in initial claims very quickly.

We can also see it in the hiring plans for small businesses, of which there are over 33 million in the United States. Small business makes up about 34% of our total GDP:

Of note is that the overall unemployment rate has risen to 3.9% despite the low layoff notices. This is getting close to recession territory, in which unemployment above 4% is typically described as a soft or declining economy.

We can also see unemployment rising if we look city by city. As of now, more than 60% of the country’s metro areas are showing rising unemployment (let me note here that the last times we were anywhere near this figure, without exception, we had a recession):

 

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.

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:

Schedule a Free Q&A Call with Jeremy Now

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.

For more information about our investment philosophies and management style, click here. To receive these economic updates and other company news via email when they are published, always free of charge, please subscribe here.

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