We just came off inflation week. The indicators were supposed to let us know where we were on the inflation front. Wednesday was CPI (consumer measure of inflation), Thursday was PPI (producer measure of inflation), and Friday was the labor numbers. The last thing that showed its ugly head was inflation!
In this week’s note I want to go over these inflation numbers, but first I think we are at a very interesting point in the market to discuss what has happened in the last couple of months. Just when things should have been negative and clearly started that way, an about face was done and off to the races we went once again. “Sell in May and go away” has a nice ring to it. A more precise description of negative seasonal tendencies could also be “sell in August and come back in a few weeks,” but that doesn’t roll off the tongue as easily. August-October is the weakest three-month span for the S&P 500 on average, going back to the last century. But before we dive into this statistic, I think it might make sense to look at many points.
The Bad and the Ugly:
- August- early October is seasonally the worst period of time for the US stock market. This is part of the reason why I have been saying to exercise a high degree of caution during this time.
- We are in the second year of President Trump’s presidential term. This has historically been the worst year of a four-year presidential cycle for the US stock market.
- This is the honeymoon period for Kevin Warsh, the new Federal Reserve Chairman. In the beginning of a new Fed Chair’s term the markets have taken a roughly 10% drop. This is due to not only a new style, but also a new way the new Chair communicates. Since this requires market participants to figure out a new way to handicap the new Fed Chair, there has been a significant pullback in the case of every new Fed Chair.
- The markets took an elevator straight up since the March lows right into Mid-May. At this point a much-deserved breather was clearly deserved. This is when the markets went sideways in a compressed triangle formation. On the day of the Fed announcement a couple of weeks ago it jumped off a cliff on the day.
- Interest rates across the maturity curve, anywhere from the two-year to the 30-year have been steadily rising. This also stresses an advance in the equity market as capital gets more costly and bonds become more attractive as their yield rises.
- Oil prices, supposedly based on the Iran conflict are staying stubbornly high. This translates into higher fuel prices which challenges the spending power of the consumer.
- Pick a war, any war, whether it is the Russia / Ukraine, Iran / US, or other smaller squirmishes in the Middle East regain.
- And of course, we can’t forget the Mid-Term elections coming in November that are sure to be contested and contentious.
Needless to say, there is truly a full slate of possible “reasons” for the markets to have a difficult time. What were the catalysts this time were truly fascinating I believe. This time it came in sort of a trifecta. Just when the markets were absolutely raging, and virtually all sectors- and I mean all sectors were ripping to the upside, almost like a gun was shot off, these things all happened:
- The big tech darlings that before the full heat of AI presented itself, were considered cyclical, all of the sudden weren’t and the earnings reported made virtually every Wall Street analyst out there look incredibly foolish as their numbers were in some cases double or triple what was expected. But instead of these tech juggernauts continuing their marches higher they fell off a cliff.
- The memory stocks, which were primarily two giants in South Korea and two giants in the US had extremely large pullbacks. This was OK since they had gone up just so much, but since the two biggies in South Korea, that represent a huge percentage of their entire stock markets got crushed and most investors in the area were margined to the gills on these holdings, the South Korean government came out and stated that all margin must be ended for fear of a complete collapse of their entire stock market. You have to love it when rules are changed in the middle of a market storm. This created an exogenous event that magnified the pullback and forced magnified selling.
- Stateside we had an equally earthquake like event occur. The wonderkid, the AI-focused hedge fundSituational Awarenesswas started in 2024 byLeopold Aschenbrenner, a former OpenAI researcher and employee. He named the investment firm after his widely circulated 2024 essay titled"Situational Awareness: The Decade Ahead.” Leopold started with approximately $200 million, grew it in under three years to $45 billion, and then due to his belief in his AI projections, leveraged the fund up to $150 billion. The sinister Billionaire Ken Griffin, who was an investor in his fund took this opportunity to spread social commentaries on the bubble-like characteristics of AI companies just as the memory debacle was in full swing. In an almost Lehman Brothers like overnight disaster, Situational Awareness was forced to shut down this massive, margined portfolio. This forced massive selling across the sector and set it up perfectly for Griffin to swoop in and take it over.
- The market indexes that were within a small percentage of new all-time highs yet still in their sideways triangle formation, punched through the downside and created a level of market fear and hysteria often seen when there are numerous rumors manifesting themselves as facts when their directional message is validated. This was violently reversed the following day, and here we are, back above the upper border of the triangle formation at new highs once again.
Please excuse me for the length of this explanation, but investors should really wrap their heads around how so many things can happen so quickly and create massive volatility.
I believe now it is time to go into a bit more detail on where we are based on the presidential cycle data and take a deeper analysis into the inflation data.
The Ned Davis Research Cycle Composite for the S&P 500, which combines the one-, four-, and 10-year cycles, tends to be very weak from mid-August into early October and then reverse blast higher. Here is where we are overlayed on what has been the average going back to 1928:
Seasonal tendencies are just that…tendencies. They rarely make it into most analysts’ models. The reason? In some years, like in 2008 (the Great Financial Crisis) macro factors overwhelm them. Even in years when the market follows seasonals, rarely does the timing line up exactly. Further rallying that pulls enough traders off the sidelines to push the Sentiment Composite into its optimistic zone would be a better starting point for seasonal weakness. Whether that occurs in mid-August remains to be seen. Since August has had a high probability of being a tough time and as we are at all-time highs, and as we are in year four of large market advances, I am being particularly sensitive to possible downdrafts. The bottom line is that we are maintaining our overweight exposure to U.S. stocks versus bonds and cash.
Growth’s deeply oversold condition
Excitement over AI drove the Russell 1000 Growth Index to over two standard deviations overbought versus the Russell 1000 Value by late May. The unwind of the trade turned extreme in the other direction, partly driven by the blow-up of the AI-focused hedge fund Situational Awareness. As a result, the Russell 1000 Growth flipped to being over two standard deviations oversold versus the Russell 1000 Value by July 29. On a year/year basis, Growth is also about two standard deviations oversold, similar to where it was in November 2022.
I bring this sort of off the subject fact up for a very specific reason. What if, and I mean what if, the markets have, since Mid-May done an “internal correction” where different sectors are taken out back and shot, and yet the broad market stays relatively constant. What I mean is that tech got bashed and at the same time energy, industrials and financials moved to all-time highs at the same time. The equally weighted S&P 500 moved comfortably to new highs while many of the tech darlings were down 30-50% from their highs. So, if this observation by NDR research proves true, and this aggressive digestion in growth is now starting to reengage to the upside as it seems to have begun since South Korea instituted its new margin rules, Situational Awareness blew up, and earnings have continued almost without exception to stun both analysts and investors, maybe the difficult period has already been endured?
These extremes are really quite unprecedented, and I believe partially because of the political polarization we are dealing with. As Americans we really only hear and see what is going on here, but here is the level of political friction being seen throughout the world:
This is the classic situation that forces virtually everyone to be on edge due to differences of opinion causing breakups of friendships and families across the globe.
I want to give just a bit of attention to the labor situation as this is a major sticking point on what could be negative about embracing the AI revolution, we are in the throes of.
What Does the Latest Jobs Report from Friday Mean for the Economy?
While the July report showed weaker job growth, the overall economy remains healthy. It’s important for investors to look beyond a single month’s numbers to understand the broader trend. As can be seen below, even though AI has been thought to possibly eviscerate many professions, in reality, it has been so positive for virtually every industry that even more jobs have been created than ever before!
The strange thing is that fewer and fewer people are looking for jobs. I believe this could to a great extent be attributed to our aging population, but also that many are not doing a conventional job.
- Job growth has slowed.The economy shed 23,000 jobs in July, well below expectations for an 83,000 gain. May and June were also revised down by a combined 103,000. Still, recent payroll trends have been stronger this year.
- The unemployment rate doesn’t tell the full story. While the unemployment rate improved to 4.1%, this was because the labor force participation rate fell to 61.4%. This reflects longer-term trends that also kept unemployment low last year, including slower immigration, baby boomers retiring, globalization, and advances in technology.
- For investors, the broader trend matters more than one month’s data. Labor market conditions are softening, but the economy continues to expand, reinforcing the importance of staying focused on the underlying economic cycle.
The latest U Mich consumer survey released, and inflation expectations anchored and latest example that economists have "inflation derangement syndrome"
- U Mich 1-yr inflation political affiliation shows Dems are the ones seeing "high inflation"
- 5-yr inflation expectations at 3.3%, basically at the 50-yr survey avg of 3.2%
Does it make sense for pundits to call for Fed to raise rates? Nope
So, if we follow what the expectations are out of the “new” Fed, this is where the fears of potential rate hikes lie:
In closing, much like other fears that never quite manifested into economic and market disasters, I believe that the market is exhibiting a case of “inflation derangement syndrome.”
Do I mean this to say that the markets should go straight up? Of course not! But what I do mean is that we really need to turn off all the news pundits that make outrageous claims just to scare us, playing on the emotions of the political divide I have shown above, and instead we need to focus on the real level of interest rates, the real progression of earnings, and the real valuation of companies.
To close, I want to show what the old line telecom company, Cisco, did during the tech advance into the 2000 Tech Bubble. It needs to be recognized that Cisco had much further to go even when experiencing very painful digestive periods. Could this be what we could expect in the new AI Revolution? Only time will tell, but as with previous world changing events like the telephone, the car, and other advancements, history is yet to be written.
- Ken South, Tower 68 Financial Advisors, Newport Beach
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