If you have been to a high school or college commencement lately, then you know the drill: at some point, at least one speaker will urge the graduates to be instrumental in bettering society. They are suggesting they'd like to see these students make the world a better place through some sort of conservative organization and work effort. What seems to be lacking is any effort to discuss what is wrong with our overly frictional political environment that seems to be precluding our economy from recovering from a combination of COVID, the banking crisis, and inflation fighting. But I digress!
The problem with goading students to think this way is that it assumes they should be dissatisfied with the status quo. It asks students to dwell on the negative (of which there are more to choose from currently than I would like to admit), to focus on what is wrong, and to obsess over injustices, whether perceived or real. Seldom do they refer to really hard work, working through adversity, and reinstating conservative values of family and work ethic for the betterment of our domestic society. At the same time; what does changing or reimagining the US mean? No country close to the population size of the US has wealth or income per person even close. People from around the world are eager to move here. Think about our blessings: property rights, freedom of contract and the ability to enforce those contracts, a democratic republic with a Constitution that separates executive and legislative functions, a bipartisan legislature that makes it tough for temporary voting majorities to impose their will, and social institutions that foster individual rights. The list goes on.
Just Monday of this week as McCarthy came out after negotiations with Biden he said, "Why do we want to give our money to the Chinese and pay people to just sit on the couch? Reforms are needed." Boy, do I ever love this country!
Enough of that! Let's address the issues that are present in our financial markets currently. The Fed continues to raise interest rates. The current pressing question is whether they will refrain from additional hikes in June or whether they will continue to try and put the screws to inflation. Even though S&P 500 earnings seem to be "better than feared," they still declined year-over-year for the second straight quarter and the ISM manufacturing survey shows seven straight months of 50-or-below readings suggesting to us that the market is already digesting a "recession" ahead of economic deceleration. This, to us, means that the pain trade is now for the markets to go higher rather than to reflect the negativity that is clearly present. While an economic slowdown may materialize, by the time it is confirmed by the lagging GDP data, the earnings data will have already told the story.
Importantly, the benign decline in earnings estimates compares to consensus expectations for a much harsher decline. Bettering harsh expectations should cushion equity markets into a buyback window against the negative sentiment which could drive upside risk to broader stock market indexes and be coupled with withering longer-term interest rates. What I'm trying to say is, "The Bad News Is Long In The Tooth!"
At the same time, we are noticing a change in the Housing Market. While the housing market is by no means an indicator to be recognized on its own, when the homebuilding index is turning while the ISM numbers in the above chart are changing, history suggests we pay attention when both are troughing at the same time.
So, I wanted to touch for just a minute on the current level of interest rate hikes from the Fed and the obvious effect it is having on our (now fragile) banking sector. Obviously, inflation is disliked. But disinflation may be likable, hence the move up in big-cap technology due to their deflationary effect on business costs and immediate enhancement to business revenues. If the Fed doesn't want banking deposit stress, then they will have to start punishing the cash stacked in short-term instruments that have been pulled out of banks forcing them to book losses on their longer maturity investments. Since the markets seem to think that interest rates may be at a temporary high point, regional bank deposits have been coming back. According to Reuters, May 17th report, some of the most negatively affected smaller S&Ls are seeing billions of dollars repatriated to their establishments.
I am beginning to see a continental divide develop between the negativity of the individual investor and what institutions like FundStrat are seeing. According to Thomas Lee of FundStrat, "We see 14% upside to equities in the next 12 months, where many clients believe we will 'retest' the lows, which implies -15% downside." To give the bullet points as to why investors are still negative:
- Debt ceiling risks are unquantifiable.
- Fears of more regional bank failures are hard to know ahead of time.
- Growing office vacancies are threatening the entire CRE (commercial real estate) market.
- Earnings for companies will continue to decline due to the Fed tightening coupled with the banking problem.
- Inflation is too sticky to slow down.
- Fed might pause, but only to catch its breath to start raising again.
- The Russia-Ukraine war could easily become a much broader European conflict.
But the positives that are starting to surface are as follows:
- Inflation has already been showing cracks in its major components.
- If inflation does stabilize or back off, many of the above-mentioned ills correct themselves.
- The drawdown of the 27% decline in the S&P 500 in 2022 already discounted the problems being reported now in lagging indicators.
- 10-year yields seem to have seen their high point and began declining. This is being confirmed by the US Dollar decline.
- When rates decline, this is very positive going forward for the stock markets of the world.
So how can we tell that the man-on-the-street investor is overly negative? The simplest is to follow the level of margin they are using in their investments. If they are ebullient, they are levering up expecting greater returns than their cost of borrowing. If they are scared and concerned, they pay off their leverage and sit on the sidelines waiting for better times. So here are the facts on investor leverage:
- FINRA margin debt levels have collapsed. The latest figure is down 35% since late 2021.
- During the Great Financial Crisis, the FINRA margin debt declined over 50%. Current numbers are the closest to this.
- The last, other time that margin debt reflected investors cashing in was the Dot Com Bubble.
If money comes rushing back in due to a soft landing in the economy or some other series of positive inflation measurements, the bounce could be quite impressive.
I'll end with the comments of Jeff Saut from Monday of this week. Jeff said, "When there is a high concentration of large-cap tech issues accounting for close to a quarter of the entire S&P 500 index performance, such concentrations have led to an average gain of 13.9% over the next 6 months." This is happening at a time when the University of Michigan Consumer Sentiment Index has just hit its lowest level in 40 years. These kinds of extremes don't manifest themselves at market tops! In past reports, I have given statistic after statistic as to why the markets are exhibiting characteristics of change to the upside at the same time that the news reports continue to pull more negative rabbits out of the hat. Today it is the issue of the Debt Ceiling. We have dealt with this issue before, yet I will say, not with the media being able to provide blow-by-blow commentary from any member of the political constituency as often as they can with today's technology. Neither party wants to lose voters for the 2024 election by taking away benefits from their constituency. But neither one wants to be accused of continuing to spend frivolously. It will end, the markets should recover, and if positioned correctly investors should benefit.
In closing, we want to wish everyone a very happy Memorial Day. Hopefully, this May-Gray will end and we will be blessed with some sunshine this weekend!
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