It was another poor week for stocks, as the Iran conflict rages on and oil prices refuse to fall. The market has reached a "make or break" moment where it's either going to stage a bounce this week or else we could be in for a larger setback. The key as I see it is that expectations for looser monetary policy have hit a brick wall as inflation readings have come in hotter than-anticipated over the past couple of months, even as the jobs market has grown cold. Most assumed that rates would keep falling in 2026. These lower rates act as “rocket fuel” to the overall economy. This tends to provide a comfortable backdrop of available capital for much higher equity prices.
As the Fed sits between a proverbial rock and a hard place, it is clear that their hands are somewhat tied. Rates continue to rise- albeit not alarmingly so, but not in the direction that makes markets rest easy.
What I found particularly interesting last week was that virtually everything got kicked in the shins. Gold jumped off a cliff and was down multiple hundreds of dollars a day for numerous days, Crypto continued the decline it has been in for some time, and even the international markets that have been outperforming the US equity markets started to get their turn at the whipping post. Last but not least, bonds got beat up pretty bad due to the interest rate spike caused by the expected spill over effect of higher energy prices on consumer items like gasoline.
Oh, and let’s not forget the continued freeze up in the $350 Billion Private Debt market. Barron’s had a completely separate article all about this last weekend. If you would like to read it, “What Private-Credit Funds Should Do Now.” Although this is a small number in the broad scheme of things, it is still looked at as possibly the proverbial canary in the coal mine.
I want to be very clear on one point that I often bring up. Markets don’t go in a straight line. Sometimes they pull back. It has never yet been “the end” but rather a digestion or pause to refresh. As the chart below shows, a few times a year the markets have a 5-10% correction. They all happen for various reasons, and this time’s reason is very tangible with a war in place and concerns over a Bubble in AI and AI infrastructure spending. As can be seen below, this is something that happens regularly.
Will this manifest into a 10-20% drawdown? I don’t expect so as the economy is still on a very firm footing. Instead, as I mentioned last week, Mr. Market seems to be taking the market group by group out behind the woodshed and giving them a good whooping.
At a time like this, when markets have been negative for a number of weeks, investors tend to look for places where the markets could stabilize and then resume their previous advance. I believe we could be getting close to this and probably some kind of a decrease in the escalation of the conflict in Iran could be the catalyst, but that is not a sure bet.
What did start to look like a change could be close was the action of negative measures like the Volatility Index and the percentage of companies above their 50-day moving average lines. Both of these measures seemed to exhibit more positive reversal patterns or ranges. Despite volatility feeling like it's increasing, the Volatility Index (VIX) did not make a new higher high Friday even as the SPX broke down. That is usually consistent with a decline getting exhausted. Both intermediate and short-term breadth readings have also recently dropped into what is typically “bottoming” territory, with only 21% of NYSE operating companies above the 50-day moving average now. The only time that measure has been lower in the past couple of years was last April during the Tariff Tussle. Once again, this combination of factors does not guarantee a low will occur immediately but sets the stage for one. See the chart below of the companies above their 50-day moving average line. You can see, just to the left, where they went down to at the height of the hysteria during the Tariff Tussle.
So, like I have been writing about the last few weeks, and as I went into great detail on in the Special Report on War a couple of Fridays ago (if you didn’t read it, here is the link so you can refresh (https://bit.ly/4c0dJSG), I agree that there really isn't an obvious reason to step in and want to buy right now. I also prefer to be a bit late to the buy until I feel comfortable that there was a possible, durable low. Upside reversals in recent years have been so violent, however, that it is worth being vigilant since one social media post could change the balance. It does seem that all eyes and ears remain on the Iran war and oil prices. President Trump and Israeli Prime Minister Benjamin Netanyahu continue to contradict themselves from day to day, one moment saying the war will be over soon and then quickly doubling down on fighting the war until objectives are complete.
To maintain some perspective, even at Friday's low the S&P 500 was only down ~7.5% from its January all-time high, leaving it well within the realm of a normal pullback. At times like this the media and most investors are looking for a handle to grab hold of, an indicator that tells them that the pullback has run its course. “This time” I have found a somewhat different measure that I felt was particularly relevant in this set of circumstances we are dealing with today.
I was taking a look at the conflict, and my focus seemed to on where in the Middle East the hot point of the conflict lies. It appears to me that it is the Hormuz Strait. It appears to me that it is all about the closure of this “Oil Artery” from the Middle East to various places throughout the world. The issue is the ships / tankers that can’t go through there without fear of being blown up. So, I called upon an old friend of mine who has an affinity for shipping stocks. My friend, Eric Slade, gave me a list of six tanker companies. I started watching them and noticed that the middle of last week they all reversed from going down (due to daily tanker rates having risen 400% in a couple of weeks), had all of the sudden stopped going down. I thought to myself, if the price being charged to rent one of these tankers had suddenly stopped this spiking action, quite possibly the conflict has hit its high point and is ready to stabilize to some extent. This is not science, but rather art in recognizing something rather esoteric that could be the canary in this coal mine.
Now for just one last moment I wanted to touch on the economy. It is appearing that the economy is growing just fine. So, if we see the recent decline in prices of companies in general and most specifically AI companies, it is clear that earnings continue to rise, and in some cases rise quite voraciously, and yet prices are declining. This has taken the markets from an “overvalued” status to a “fair valued” status. The number one topic I am hearing from clients has clearly been the Middle East and how this conflict could affect the broader economy. I believe I’ve touched that in the beginning of this note when discussing the inflationary affect of rising oil prices. The bigger topic that I expect will continue, even after the conflict is resolved, is the trajectory of AI. That is true regarding both the trajectory of investment spending and corporate adoption and the eventual productivity benefits. Many companies have given numbers that are pretty tough to fathom for capital spending on AI and yet only 1% of companies actually quantified the earnings benefit they are receiving from using AI.
As long as the capital investments continue to grow at the current rate, the best opportunity I believe is going to remain in the infrastructure space. This brings me to two areas to focus upon.
- AI infrastructure- instead of focusing on all the companies that are spending massive amounts on AI, instead focus on the companies that can’t even fill the demand for all the stuff these companies are buying. Do we know if there will be massive profit attached to the investment? No! We’ve never seen anything that has grown- globally almost as fast as a virus. As I said last week, many of these companies could be spending this money on building out their AI in fear of losing their competitive advantage if they didn’t spend on it. There was an article I read from March 5th titled, “Tech billionaire Shlomo Kramer: the cyber selloff proved that Wall Street can’t price tech anymore.” He states clearly that Wall Street is pricing AI as if it’s already reshaped the economy. Yet in February there was a survey released on AI use, with data from nearly 6,000 executives across the US, UK, Germany, and Australia. More than 80% reported zero measurable impact of AI on Productivity or employment this far.
- Energy and energy generation- whether it is oil companies specifically, or companies that generate energy directly or are part of the food chain. Energy will be a necessity. This cannot be disputed. Fossil fuels are still the only form of energy that is financially feasible and in great enough supply to be able to fuel current needs. Nuclear is coming stream, but wind, solar, and other nascent forms of energy production still are not economically feasible or robust enough in current delivery capabilities. Also, with Private Equity having coffers the size that they do, many of these small companies are being funded by non-public means so we can’t even know how well they are doing as they don’t need to tell anyone!
In closing, it is clear that everything I have discussed above is noise that has an effect on the overall economy. And the economy and laterally earnings are the ultimate determinants of the price of companies and markets throughout the world. And remember, every bear market has been preceded by a recession, but not every recession has ended in a bear market.
Since the 2001 recession, it’s been almost twenty-five years with the US economy only in two more recessions lasting a grand total of twenty months. By historical standards, it’s unusual to have spent so little time in recession. Even odder, is that the key factor behind the two recessions we’ve had since 2001 have not been overly tight money where the Fed has forced an economic slowdown by their actions.
The first recession was the so-called Great Recession of 2008-09, when overly stringent market-to-market accounting standards turned the spark of the bursting of the housing bubble into an inferno in the banking system. Yes, the Fed had been too loose for years before then, but it wasn’t particularly tight going into the crisis. It was a build-up of lending to unworthy borrowers across the globe.
Then came the mini-COVID depression of 2020, when governments and fear of illness led to massive temporary (and often irrational) shutdowns of economic activity. Once again, the Fed and monetary policy wasn’t the culprit. As a result, it’s sensible to fear that the next recession might also be for reasons other than monetary policy and the Iran War could fit the bill.
How this conflict ends and how quickly is hard to gauge. Although the US would like to see a popular revolt that transitions to a completely new and stable government, without rule by the mullahs, some sort of military coup is also possible, where more secular-oriented leaders in the Iranian armed forces step forward if they are willing to accommodate some US demands, perhaps in exchange for getting control of local oil revenue.
I will be keeping a close eye on all ways of measuring the affects of the conflict and be sure to bring them to your attention in our weekly comments. As for now, a correction / digestion was due. It is happening in the worst year in a Presidential 4-year cycle. It is happening prior to a new Fed Chair- which has been very negative 10 out of 13 times. And last, November is a very uncertain midterm election period. Needless to say, probably would have been tough to avoid even if there was no Iran conflict. On this one, we will never know!
- Ken South, Tower 68 Financial Advisors, Newport Beach
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