Inflation is becoming like the guest at a dinner party who just won’t leave. The February Consumer Price Index (CPI) data shows that it is grabbing at least one more cocktail and may not be able to drive home, instead needing to crash in the guest room.
Meanwhile, the host of the party (the Fed) seems to be hopeful that if they just ignore it, the problem will go away…
Good luck with that.
Inflation has not made a new low for this cycle since June 2023, that’s eight months ago. If you are counting, you might notice that we are now in April which means June was ten months ago, but due to the one-month lag in reporting and because the government has not yet released inflation data for March 2024, we are looking at the June 2023 through February 2024 period – so, eight months. We might be able to make it nine months when the March inflation data is released on the morning of Wednesday, April 10th.
Meanwhile, stocks just continue to chug along, going higher and higher while bonds keep falling, even if only slightly. For the first quarter of 2024, the S&P 500 Index was up 10.2% and the Aggregate Bond index was down 1.3%.
There is an old saying that the bond market is smarter than the stock market. Maybe it is true, maybe not – but the bond market seems to be telling us not to expect falling interest rates any time soon while the stock market appears to be rallying in hopes that the Fed will cut interest rates.
Regular readers know that I don’t expect the Fed to cut rates in 2024 unless the market is in free fall amidst a recession with rapidly rising unemployment. Which of course can happen at any time.
I increasingly believe that the longer the Fed goes without taking any action, neither raising nor cutting rates, the better it will be for the stock market. This may seem counterintuitive but for months now, the market has risen on just the hopes, or perhaps expectations, of future rate cuts.
First, the market rally was just in the (what turned out to be false) hopes of the Fed taking a break from increasing rates further despite widespread expectations of a recession and falling stock market due to the Fed’s aggressive campaign of raising interest rates.
Sure, the market fell hard in 2022 from the beginning of the year into October while the economy produced two back-to-back quarters of falling GDP. This normally indicates a recession, but that didn’t seem to matter to the organization responsible for officially recognizing a recession as a recession.
My point is that traditional economic correlations seem to be broken. Chalk it up to the pandemic distorting everything from our sense of taste and smell to our sense of risk and reward.
““It may be [unpleasant] to see what looks like stupid people making easy money owning garbage and gloating about it on social media [or at cocktail parties], but ultimately that’s just an argument for muting or deleting those apps on your phone. Remember, the most rational approach to trading a market bubble is to participate with a trailing stop!”
I think we are in a bubble of epic proportions, and it will be plainly obvious to anyone looking back on it 10, 20 or 50 years from now. As I have noted before, the only responsible thing to do when presented with a market bubble is to get long and follow trailing stops. Forget fundamental analysis. They wouldn’t call it a bubble if it didn’t keep inflating beyond all fundamental rationale.
Perhaps I’ll be wrong about the outcome if I am right about the Fed not cutting. Maybe when the market realizes it isn’t getting any reductions in interest rates this year, the market will fall. But the market hasn’t fallen on the Fed disappointing it yet this cycle. The market has been rallying while calling for the Fed to “pivot” to cutting interest rates since the October 2022 lows, and it still hasn’t happened. The market cares not.
In fact, as recently as January, the market was assigning a 100% chance that the Fed would begin cutting rates at their March meeting, which has come and gone without a rate cut. At that point the market was also expecting six total cuts in 2024 of 0.25% each for a reduction in rates of about 1.5%... today, the market is expecting only two cuts this year.
You would think that if the market rises on the expectations for something to happen, and then that thing does not happen, it would then fall. You would be wrong. At least for now.
And inflation still hasn’t come down to the Fed’s target.
Summers: "Meaningful Chance" That Fed Might Hike Rates
I think it is at least possible that in order to truly get the guest who won’t leave (inflation) to finally go home, the Fed will need to resume hiking rates rather than start cutting them. Former Treasury Secretary Lawrence (Larry) Summers apparently agrees.
What that would mean for markets is anybody’s guess in this economic world where historical correlations have become so disconnected.
As for alternative opinions on the Fed, interest rates, inflation, markets and the overall economy, I want to share a quick quote from David Einhorn, the billionaire founder of Greenlight Capital. The first hour or so of his recent interview on the “Masters in Business” podcast was excellent, and in it he offered an assessment of the current environment that is anything but consensus. Whether right or wrong, I find it interesting and at least plausible.
“I disagree with the Fed’s view on the relationship between interest rates and the economy and inflation and what they’re actually doing. I believe that when rates get low, below a certain amount, the Fed actually slows down the economy by lowering [rates] further.
So as a result, I have this thesis called “The Jelly Donut Monetary Policy,” where the first jelly donut tastes great but the 25th jelly donut you’re not really helping yourself anymore. And so, you had these emergency Fed policies and in an emergency that makes sense but then after the emergency passes, they kept the policies, and you kept rates at zero for like some really long period of time and it was essentially like giving a diabetic person more jelly donuts and so the economy had a very gradual and slow recovery.
And now as they have inflation and the rates have come back up, they thought that they would be slowing the economy but they’re actually strengthening the economy.
Higher rates getting off the zero bound - if you raised rates from 5% to 10% it would certainly slow the economy - but from 0% to 5% it actually strengthens the economy. I think that’s why we have this really strong GDP growth that is persisting right now, and I think it has surprised a lot of people.
And so, I think it’s really weird now that everybody thinks they’re going to lower rates. Things are pretty good. Like, employment is really pretty full right now and the economy is kind of humming along and I think the idea that they’re going to rush back to really lower rates - and they may do it - but I don’t think they’re really going to help anybody by doing so.”
-David Einhorn on the “Masters in Business” podcast
10-year Yield minus 2-year Yield
It has been a while since we checked in on the “10’s minus 2’s” yield spread in this commentary, so I wanted to share a quick thought or two there.
For those who are unfamiliar, or who need a quick refresher, normally the more time you lend money for the higher the interest rate you would receive, all else equal. So, whether you are lending money to the US government, or your cousin Fred, you would charge a higher rate of interest to the same borrower for a 10-year loan compared to a 2-year loan. This is to compensate for the greater uncertainty of what might happen over 10 years compared to 2 years.
But sometimes things get out of whack and the shorter term carries a higher interest rate than the longer term. We call this an inverted yield curve, or a negative yield spread. These terms are typically used intangibly.
These inversions in long-term vs. short-term rates generally foretell recessions with a very high degree of accuracy. Usually, once the spread goes negative a (formal) recession will begin within 18-24 months.
Well, the spread has been negative every single day since July 6, 2022 – 641 days ago. This is the longest stretch of negative spreads in the 10-year minus 2-year bonds in history.
The next longest period of negative spread in the 10’s minus 2’s was from August 18, 1978, through May 2, 1980. That was 623 consecutive days, or 1.7 years.
Q: What happened after that extended period of inverted yields?
A: The economy spent 24 of the next 35 months in recession from 1980-1982.
Once the yield curve reverted to its normal shape with long-term yields higher than short-term yields, there were two recessions in relatively short order. The first recession lasted 147 days during 1980. During that recession the stock market experienced a drop of 17% in just 30 days. Then, the economy expanded for 11 months before falling back into recession. The second recession lasted 358 days and saw the market drop 23% over the course of 254 days.
Measuring from the bottom of the first recession to the bottom of the second recession, the market effectively went nowhere for 600 days.
Another interesting item I noticed is that the market technically rose during each of the official recession periods; the first time by 15% and the second time by 7%. However, because of the extreme volatility, you could have done better with less volatility by following a rules-based trailing stop to exit and a rules based entry strategy to re-buy much lower.
During the first recession the market rose 24% from the lows before it was over, and in the second recession the market rose 35% from the lows!
I am not saying that there will be two recessions back-to-back once the yield curve finally does revert to its normal shape. It could be much better than that – or much worse. But as the saying goes, “those who don’t learn from history are doomed to repeat it,” or something like that. So, I study history, and I use it as a guide but not as though it is security camera footage of the future. At Elevate we prepare, we don’t predict.
I am also not suggesting that anyone can perfectly time the tops and bottoms. However, with that much volatility and a rules-based exit and entry strategy (like the one we use at Elevate), it certainly isn’t impossible to do better than the market - perhaps A LOT better - and doing better is a worthy objective.
I discussed active vs. passive strategies in greater detail last month and I was glad to see that even Dr. David Kelly, Chief Strategist at JP Morgan Asset Management is advocating for a more active approach in the current environment. In this quarter’s Guide to the Markets, he said:
“The historically narrow nature of the recent rally has left the top 10 stocks significantly more expensive than the broader index, while the remaining stocks look cheap comparatively and are trading closer to their long-term average.
Indeed, index concentration is not a new phenomenon as the weight of the top 10 stocks in the S&P 500 has been rising since 2016. However, while the top 10 stocks dominated earnings growth last year, their earnings contribution hasn’t kept pace over the long run. With the top 10 stocks now representing a third of the index but only a fourth of the earnings, there appears to be a strong case for investing in the rest of the index.
If economic growth continues at a steady pace in 2024, gains should broaden out beyond the largest names as the market grinds higher. In this environment, an active approach can help identify those companies with high quality earnings and attractive valuations that are being overlooked by the markets.”
-Dr. David Kelly, JP Morgan Asset Management Chief Strategist
Even though I agree with Dr. Kelly for the most part, I do still think it makes some sense for people who want to invest passively to maintain exposure to the largest stocks in the market which will continue to blindly attract outsized amounts of capital without any fundamental analysis whatsoever.
In the first quarter, the top 10 stocks were up 23.5% compared to only 10.2% for the S&P 500 and just 7.4% for the S&P 500 Equal Weight. Even the Magnificent 7 (Mag7) index was only up 16.9%. Meanwhile, the very much cherry picked “Fabulous Four” was up a whopping 37.6% for the quarter!
During the second half of the quarter though, the rally broadened with the S&P 500 Equal Weight Index outpacing the S&P 500, the Top 10, and the Mag7. It would be healthy for that to continue but only time will tell if it will.
The economy might be “humming along” as Mr. Einhorn said, but under the surface there are still many reasons to be concerned.
One such reason has to do with the insane amounts of debt our citizens and government are carrying - and the interest payments due just to maintain those debts. It is truly astonishing. Yes, I have written about these debts before, but it bears repeating. And below you’ll find a slightly different perspective than I have covered in the past.
“Since the Fed began raising rates in 1Q 2022, the assets of the bottom 50% of U.S. households have declined by $30.1 billion. Meanwhile, Consumer Credit to those same households has increased by $105.6 billion.”
Despite the current delinquency rate on credit cards being only 60% of the all time peak (currently 14.88% vs. all-time high of 24.74%) the dollar amount of that delinquency is 85% of the peak ($167.9 billion vs. all time high of $197.6 billion).
If the delinquency rate as of 12/31/2023 was 24.74% (the all-time high) the total dollar value of delinquent credit card debt would have been $279.3 billion, 42% higher than in 2009.
Those are some big numbers.
At the current rate of increasing delinquencies we are likely to to surpass the all-time high of dollar-based delinquency this quarter or next.
Another reason to be concerned comes from the earnings report of a “dollar store.” Why are people earning more than $125,000/yr starting to shop at Dollar Tree in record numbers?
🚨 "Dollar Tree added 3.4 million new customers in 2023, mostly from households earning over $125,000 a year."
🚨 "[T]he macro environment has gotten in our way and we are dealing with high shrink (theft) numbers."
🚨 "...persistent inflation and reduced government benefits continue to pressure the lower income consumers..."
🚨 “This year, across 3,000 stores, we expect to expand our multi price assortment by over 300 items at price points ranging from $1.50 to $7.”-Rick Drelling, Chairman and CEO of Dollar Tree on their recent earnings call.
I guess it is now a seven dollar store. Some economy!
As always, there are reasons to be bullish and optimistic - mostly momentum. And there are reasons to be bearish - pretty much every fundamental measure I can think of.
I remain fundamentally bearish but aggressively long the stock market (yes, I can be both at the same time). If the momentum continues, we will do well and if the rally fades our stops will get us out before the market drops too far, at least in our active strategies.
I am going to leave you with this article (unlocked for you to read for free) from Bloomberg. It has been widely circulated on “Wall Street” over the past week or so.
The headline reads: A Million Simulations, One Verdict for US Economy: Debt Danger Ahead
Click here to read it.
And please, let me know if you are unable to access it for free.
Until next time, I thank God for each of you, and I thank each of you for reading this commentary.
Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed vs. the markets last month.
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors
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