August started with a bang, but not the bang that makes investors happy. True to form, the first week of August followed the previous Thursday’s negative reversal, engulfing day (a negative engulfing day is when the market is higher and lower than the previous day and closes lower) with higher interest rates and slightly stronger than expected labor numbers. Currently, we have:
- Very low unemployment.
- Wages growing at a palatable rate.
- Job openings are slowing to a slight extent, but not one that makes the Fed necessarily think that the job is done.
In this week's note, I am going to go over the Fitch downgrade of US Government debt last week from AAA to AA+. But before I dive into this issue, I wanted to give you the picture that is worth 1,000 words from my friend Ari Wald, Chief Technician at Oppenheimer. Ari eloquently stated that what we are experiencing is a "Textbook Seasonal Correction."
Seasonal trends don't often determine the ultimate directional moves in the markets, but often they repeat themselves with enough consistency that they create high-probability cases that can weigh one's investment decisions in the short run. I tend to use them as secondary confirmations to primary indicators.
My primary indicator is measures of overvaluation/undervaluation, along with some cycle work that I follow from Larry Williams and Tom DeMark. Larry's and Tom's work are quite esoteric, but when I find both their work and my work saying the same thing, I listen. When I overlay this with seasonal trends that have higher than normal probabilities, I pay attention.
Now, let me be clear, markets- stocks or bonds, country, sector, and company size still stand on their own, but I often use the above-mentioned measures to help me decide if it is time to put the pedal to the metal or pump the brakes.
Last October, these indicators weren't particularly positive, but the confluence of very extreme market measures tended to infer markets were oversold and possibly ready for a bounce. To the shock of many, this bounce occurred and did so even in the face of negative inflation readings and an aggressive Fed that continued to chip away at inflation with higher and higher interest rates.
Even though this was true, "seasonally" the S&P 500 continued and continues to track its seasonal tendencies. Looking at the last ten pre-election years, an average composite of the S&P 500 temporarily peaks in July and bottoms in late August. See Ari's picture of this seasonal phenomenon overlayed with this year's market:
In Friday's Wall Street Journal article, "U.S. Debt Problems Set to Remain," many issues were discussed with the Fitch downgrade from last week. Fitch explained their downgrade by chastising Washington policymakers for major policy mistakes:
- Spending too much. Adding to the deficit.
- Cutting taxes too much. Taking away from much-needed revenues to pay down the deficit.
- Watching tax receipts decline. Business slowdown causing decreased tax revenues.
Barron’s actually led the Wall Street Journal with their online article, “The S&P 500 Fell 7% After the Last U.S. Credit Downgrade. What Happens Next After Fitch.” Please take a moment and read this as they go into some detail. History does not always repeat itself, but it often rhymes.
Treasury Secretary Janet Yellen took issue with Fitch's negative assessment, which she said was based on outdated numbers. I disagree with her as she defended Washington even though they continue to go higher and higher in debt. Moody’s even followed suit by downgrading money center banks yesterday. The simple answer would be to reduce the budget deficit, through cutting spending or increasing revenue. Both are politically unpalatable.
One question that I keep asking myself is what is with this 2% inflation target? Wringing out the last bit of inflation could come at the cost of higher unemployment and a prolonged recession. This would force the Fed to go right back to the printing press and compound the current problem. Needless to say, this wouldn't be worth it.
Fitch's downgrade obviated the extreme lack of tax revenue coupled with overzealous spending and in the process made the problem worse. If the credit rating is lower, the risk on the debt is inferred to be higher and therefore market rates are forced higher. Not good!
Congress is still hashing out next year's budget and neither party wants to upset their constituency. Of course, Biden administration officials lambasted the Fitch decision, blaming the Trump administration. Fitch focused on US deficits as a sign of the country's troubled fiscal outlook. After dropping sharply last year, the gap between spending and revenue has grown by 170% in the first nine months of this fiscal year according to Treasury data through June (source: Bloomberg).
Given higher interest rates, the US has spent $131 billion more on interest payments so far, this fiscal year, a 25% increase from the prior year. Tax revenue has also dropped by 11% after surging last year.
Apparently, given a presidential election in 2024, both parties appear to have no desire to act responsibly. And in looking at the cause, both parties are responsible to some extent and to fix the problem both parties need to be involved. What is more important I believe is how the US stock and bond markets tend to react subsequently.
I believe that this downgrade is as silly as it was in 2011, the last time Fitch downgraded our sovereign debt. The US government should never default on its debt because that debt is denominated in dollars, which can always be printed by the Federal Reserve (what those dollars might be worth in purchasing power is another story). In 2011 the downgrade was a shock, but it was also a far shakier economic time. See below, the picture of exactly how the S&P 500 acted at that time:
As I see it, rates are going up, so the overall cost of servicing the debt is going up, but at the same time, as the Fed works incessantly at squashing inflation, they are slowing the growth of the economy and in the process, decreasing the amount of tax receipts. See the Piper Sandler chart below:
Ultimately, we all know the issues. The question as investors, that we must ask ourselves is whether ultimately these two pillars of concern are enough to topple the US Dollar and the US Stock market. At present, we are at historically low unemployment rates, consumption is high, and with all the cash still sloshing around, it does not appear that a retest of the October 2021 lows is immediately in our future.
Thursday, July 27th, the equity markets wobbled, but it is still too early to predict that a stock market correction is in the cards. Earnings continue to be better than forecasted/feared, and as a result, positive earnings surprises seem to be celebrated. As of yesterday, 433 of the 500 companies in the S&P 500 Index had reported. Of these, 81% beat analyst estimates by 7% (source: John Johnson, Eagle Financial Publications).
According to Thomas Lee, this week could be the August correction. According to Larry Williams, August could be treacherous into the second week of September. According to Tom DeMark, July 28th was exhaustion to the upside. In all cases, how deep the digestion might go is not agreed upon. Monday of this week the markets were extremely strong, with virtually no reason. All I know is that it is summertime, and many participants are on vacation. Seasonally I will continue to be careful. It doesn't look like a correction to the size of 2011 is in the cards either. We will continue to monitor all markets and look for clues that make us comfortable with our decisions. Please call if you would like to pose any questions about your situation. -
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