Investors Remain Cautious as We Wait for Markets to Bottom on Bad News

Investors Remain Cautious as We Wait for Markets to Bottom on Bad News

October 25, 2023

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Unfortunately, equities are still caught in a buyer's strike. That is, investors are sidelined as the uncertainties abound and cumulatively are preventing investors from adding growth / risk to their portfolios. As the films of atrocities in Israel and 10-year interest rates hit 5% these uncertainties seem to be gaining strength rather than hitting a high point and rolling over. In looking at what I feel is the most important moniker of concern, I focus on the 10-year US Treasury interest rate. It is important as it has now become an attractive alternative to riskier assets even though few look at the after tax and inflation return that these notes generate. The combined shock of interest rates moving faster than seen in decades along with a rate that was last seen in 2007 has caused money to flow out of stocks and into the safety of arguably the safest instrument on the planet. See chart below of the course of the 10-year:

We of course have no idea when the change in interest rates will occur, but we will certainly welcome it when it does! Just this Tuesday Bill Ackman and Bill Gross (famed PIMCO bond guru) both stated that they were changing their opinion on interest rates given the international turmoil and the heavily anticipated recession here in the US. One of the most important indicators that I have found is the activity of the consumer vs. all types of loans, real estate, commercial, and agricultural. Please note that in the illustration below, Consumer Loans are finally cracking. This could mean that the consumer has run out of the free cash afforded by the current administration and yet their addiction to spending has not kept pace with the drain on their savings. This could also be a canary in the coal mine for overall economic expansion slowing. Will it result in the next fear- recession? Well, that is still to be seen but the GDP numbers on Thursday might give a hint. What I will be watching for is how interest rates react to this number. See Consumer delinquencies below:

I have gone into detail to show many perspectives on what the markets tend to do in years like this, in pre-presidential election years, in the period of time since mid to late October, but given the intensity and gravity of the current set of domestic and global events, it almost seems like all these statistical measures are of no meaning. These are the kind of things that bottoms in the markets are made of. Just when it appears that all hope is lost, green shoots begin to appear.

When we talk about green shoots, maybe these are the earnings reports that are coming out for the third quarter in the S&P 500 companies. As of Friday, 86 companies had declared their earnings and 78% came in above street expectations by an average margin of a little more than 6%. The big cap subscription movie company even came out last week and strongly beat estimates. I find it sort of interesting that this was such a surprise as it seems logical to me that when the economy is hitting a bit of a rough patch and there are many stresses in the world, people tend to stay home and enjoy their entertainment. This can also be seen in the actions of the airlines which have gone through quite a drubbing. The next thing that tells me we are probably close to a change in growth of consumption inflation is what I call my "Happy Hour" barometer. This is something I have noticed in having discussions with restaurant and bar owners. Post Covid I was told that spending was quite liberal and there was really no need to advertise, but this has come to a screeching halt and many establishments are now advertising Happy Hours to drum up business as they have noticed a large drop off in patronage. This dovetails with the consumer being overextended on their consumer debt as highlighted above and patronage to bars and restaurants once again becoming competitive given a slowdown in pub crawlers. Here is what I am referring to:

The next point I wanted to stress was the current state of housing. Last week, it was announced that Housing Starts were up 7% in September, yet down 7.2% versus last year. At the same time Existing Home Sales declined 2%. Sales were actually down 15.4% versus a year ago. This is a clear indication of the effect of a spike in interest rates. Not only can far fewer people afford a new home, current homeowners that have real estate financed at fixed rates in the 2-4% range surely aren't going to sell these homes and go into another at 7-9%. This has brought pre-owned home sales to a screeching halt unless the buyer is all cash. This is called the "Mortgage Lock-In" phenomenon. Even the inventory of homes for sale is virtually non-existent. It is down to 3.4 months’ supply. An even more glaring number is that the construction of single-family homes is up 8.6% in the last year while multi-unit activity is down 31.4%. At present, the number of homes under construction is hovering near the highest level on record back to 1970. Have you tried to find a contractor lately?

Overall, I would say that recent action has been constructive in showing a market that is bottoming in the course of a longer-term uptrend that started back in October of 2022. We may continue to see stocks fluctuate from session to session based on the intensity of the conflict in Israel, the daily direction of interest rates at this critical 5% number and the course of third quarter earnings. I continue to think that the 4,200 area should act as a sort of magnet for the low end of the range, and if interest rates really did hit a short-term high at 5% on Friday, the major correction experienced by large-cap growth companies could have run their course. Below there, many negative issues combined could pull the markets a bit lower and scare out even more investors. I believe that it will take some time for the conflict in Israel to subside, but military conflict tends to be bullish for our domestic stock market. This would coincide with a late October bottom and a rally into the end of the year. Ned Davis Research put out this graph of a one-year calendar cycle going back to 1900. As can be seen we are right at the end of the toughest period of the year after the August-October digestion. If the stars align, the year could end pretty well. I will of course keep you informed. 

Many have seemed to forget about the strength of the rally in the equity markets this year up into July. Yet, many still have the highs of 2021 galvanized in their minds. We have gone through many negative market issues of late and few realize that although quickly spiking interest rates can have an immediate effect on home inventories and sales, economic reports and inflation reports take much longer to move through the system. It must be remembered that the stock market is a discounting mechanism, and it would seem quite strange to many if the GDP numbers were to come in strong, yet interest rates didn’t go to new highs as a result. This would almost certainly hint to a coming economic slowdown. Stay tuned and we will let you know what is happening and what we feel is important to focus on.

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