“No matter how brilliant your mind or strategy, if you’re playing a solo game, you’ll always lose out to a team.”
– Reid Hoffman, co-founder, LinkedIn
Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities. As well, no part of this content was AI-assisted or created.
Friends & Partners,
Well, the typical summer doldrums aren’t the case this year, as July was certainly not short of events. A US presidential candidate got grazed by a bullet, geopolitical noise stayed strong across the globe, and wildfires burned in western Canada again which severely damaged our beloved Jasper (my heart goes out, and why the government isn’t throwing more resources at this issue is beyond me…). The S&P 500 hit yet another new high in July (the 36th of 2024!) as stocks continued to ride a “Goldilocks” setup and wave of optimism (especially around AI), which then pulled an abrupt “180” as volatility finally and suddenly struck through all of this. I devoted a section in last month’s Partner Memo to the idea that the market may just be getting a bit ahead of itself when it comes to AI optimism. I argued that we’ve seen this movie before, and though new technologies are undoubtedly ‘real’, large capital expenditures aimed towards these new technologies often ultimately incinerate capital as the optimism gets way over its skis in the early days.
Prior to the 180, the market reeked of complacency regarding some very substantial changes in macroeconomic forces compared to the past several years, and while I sincerely hope they all work out positively, we must acknowledge the downside of these events, because I will not let us get blindsided (as some advisors and investors will be).
Interest rates have started coming down in Canada, as the Bank of Canada lowered another quarter point. But in the US, after nearly a year of hand wringing, investors now finally know when rate cuts will start (September). But what we don’t know is whether that will be in time – here’s what I mean. That’s the question that needs to be on every investor’s mind and the answer to that will be in the economic data. That’s why economic data, not politics, remains the most important influence on this market.
As you likely know by now, I am in the camp that believes the market is currently underestimating the risks of an economic slowdown. Markets don’t need a recession to correct and check back. In fact, predicting a recession now isn’t reasonable, and it’s almost a false flag from the financial media to even put “recession” on the screen. The crowd is often wrong… Markets can and have corrected 10%-20% in recession fears, not an actual recession!
Markets will be forced to answer the question of whether Fed rate cuts are too late sooner than later.
Fed rate cuts will reduce the headwind on the economy, but it’s the “why” that matters. Is the Fed cutting rates because growth is slowing more than they anticipated? Slowing growth can be a major negative for markets and despite investor enthusiasm, rate cuts are a not a guaranteed market positive event.
However, it can also reduce corporate earnings. The pandemic inflation has been a boon to S&P 500 earnings, as well-heeled consumers simply digested the price increases, boosting both revenue and margins across most industries. However, inflation is now falling because 1) supply chains have normalized and 2) because the consumer is pulling back (less demand). Falling prices can compress margins and reduce revenue, and we’ve seen evidence of that occurring across some company earnings recently.
So, as we think about the Fed trying to time the cuts to ‘save’ the economy, it has to be noted that the Fed almost always begins cutting before the recession but it is usually still too late. We must pay heed:
The market has, until recently, been ignoring some recent economic surprises to the downside. The last of the ‘bears’ have been chased out of Wall Street (a few notable strategists who were cautious on markets recently left their firms), so it could be a fitting time for ‘something else to happen’ since everything has been so strong until recently…
Don’t get me wrong, I’m not a raging bear – I actually think the current general set up is solid. But, as I have been noting for 4 years, we are in a different environment than where we were for the prior 15, and this market will look a lot different moving forward. This requires a different approach, and different portfolio construct. We’re not in Kansas anymore.
Other Interesting Updates
After some deliberation, I decided to make the following post on LinkedIn last month. LinkedIn is not the platform for personal posts, but I thought it was worth sharing my son’s story given his impact on me and those around him. It seemed to make quite an impact, which I certainly appreciate! So I thought I would add it again here for you:
This is not a personal post - I will save those for Instagram. It's an inspirational one.
Stanley is my son, who keeps me grounded and guided. A true lesson in 'work hard, play hard' which has been an important tenet in life. But seeing him embrace and exhibit that an an early age has been impressive and inspiring, certainly for me and my family.
This is his grade 8 graduation night. He graduated with flying colours, and won the Science Award. That makes any parent so proud.
But he also finished his high school math this semester, with a 97 average. Leaving your public school every day to walk on your own into a high school to attend a math class (since grade 6) has to be daunting, but he never complained along the way. The work ethic required to do the homework and the study time to succeed in advanced high school math at that age is remarkable - we didn't have to 'push' him to do that. Like any 13 year old boy, he wants to dirt bike, snowboard, watch TV and play with his friends. (Aside: And he's not too bad at snowboarding, placing top in the province and nationally this past season). But to choose to buckle down and focus in the moment is already a hallmark of his personality.
All this in the face of adversity - a few years ago he experienced Alopecia Totalis, an auto-immune disease that causes total hair loss. He has embraced opportunity and adversity and has channeled it into good things so far.
A true inspiration to me, and others I am sure. The kids are alright.
It’s OK To Look Dumb – And Why I Feel Like The Only One Still Talking About A Potential Recession *
As I have noted a number of times in this memo, when you feel stupid for touting a view, you just may be onto something. This is one of the best quotes I’ve seen on this topic, from an institutional portfolio manager friend of mine:
“Instead of being embarrassed, we view our ability and willingness to look stupid as a competitive advantage. If there were market leaders in looking stupid during irrational markets, we would like to think we’re on the short list… Investing differently during periods of inflated prices may not be stupid at all, but a sign of discipline, perseverance, and even intelligence. In other words, looking stupid is not the same as being stupid.”
So, with respect to a potential recension, so far so good I think. We are chugging along nicely, but things are beginning to slow no question. How far does that go? We will see. Economists are wondering when the long and variable lags will overwhelm the economy. They’ve been wrong so far.
American Economist Claudia Sahm developed a predictor for recessions called the “Sahm Rule”. It states that when the three-month moving average of the jobless rate rises by at least a half-percentage point from its low during the previous 12 months, then a recession has started. It has worked every time since the 1970s. According to the rule, we are very close to entering one. The US is close but not quite there, just .07% from the 0.50% trigger. It's good because it's simple and timely, and usually well ahead of other indicators. And because it's relative changes, it better takes into account changes in employment trends.
Source: Yardeni
Let’s Assess The Warning Signs Out There *
As I harped on in my opening monologue, a growth slowdown is one of the biggest risks. Inflation data has been positive of late – but beware… while the markets cheered the soft CPI (Consumer Price Inflation) print in July, I need to point out that the details in the CPI also point to potentially slowing growth. Core Services Inflation, which really is a factor demand, dropped to the lowest level since March 2021. That will push inflation lower, but it also hints that growth may slow also, thereby negating the medium-term positives of a rate cut.
This market is highly concentrated in the US – the tech sector is well over 40% of the exposure withing the S&P500! The largest 10 companies in the S&P 500 are more expensive today than the dotcom bubble. Historically, periods of market cap weighted S&P 500 outperformance have been followed by a period of mean reversion. These big tech companies will eventually run into the law of large numbers, and we may be seeing the start of that shift unfold:
And we all know that US stocks ain’t cheap (though Canadian and international stocks are more reasonably valued I would add):
Corporate executives don’t seem to be in the optimistic mood given what they’re seeing:
We see lots of data on how much cash the US consumer has, but BCA (who is a macro research shop I very much respect) argues otherwise:
Investors remain very optimistic however. According to Euphoriameter, a model created by Callum Thomas of Top Down Charts that combines key valuation, volatility, and investor sentiment measures, the current level of euphoria toward stocks now exceeds that of the Dot-Com era.
And lastly, this is a big one in my view – credit spreads are giving the same warning as before the dotcom crash. This is the spread at which a corporate bond will trade to a low risk government bond, so the tighter the spread, the more ‘comfortable’ the market is with things. Wider spreads are when things get uncertain. Currently, lower quality credits are diverging from the rest of the market, and are arguably very complacent in here. Canary in the coal mine stuff?
The Yield Curve Is Getting Close to Un-Inverting – That Must Be a Good Thing, Right? *
If an inverted yield curve is a recession warning signal, does that mean when the yield curve un-inverts (and turns back positive), it’s an economic all-clear signal? That’s a reasonable question to ask and it’s especially timely right now because, after more than two years of an inverted yield curve, the 10s-2s spread is near multi-month highs and threatening to turn back positive (un-invert) for the first time since mid-2022. Sadly, it would NOT be an economic “all clear”.
It would actually be especially negative for the stock market according to recent market history.
Since 1998 there have been six inversions of the 10s-2s yield spread: June 1998, February 2000, January 2006, June 2006 and, more recently, August 2019 and July 2022. Three of those inversions, June 1998, January 2006 and August 2019 were extremely limited to around a month in 1998 and January 2006, and just a day or two for the August 2019 inversion. Because the current inversion is over two years old, I don’t think analyzing those three instances is particularly useful, as they sent a much different economic signal than the longer inversions.
The inversions of early 2000 and 2006 were much longer (just under a year in both instances) and are more analogous to the current inversion, which again is more than two years old. Because of this, I think the conclusion is notable: In both prior instances (2000 and 2006) the 10s-2s yield spread un-inverting (so turning back positive) was a decidedly negative signal for stocks. Looking at the early 2000’s inversion, the 10s-2s spread turned back positive on December 29, 2000, when the S&P 500 was trading 1,320. The S&P 500 declined for the next 22 months, bottoming out around 785 in October 2022. The S&P 500 didn’t return to 1,320 until the third quarter of 2006! Looking at the next example, the 10s-2s spread turned back positive on June 6, 2007, after being inverted for nearly a year. On June 6, the S&P 500 was trading at 1,517. The S&P 500 declined for the next 21 months bottoming out around 670 in March 2009. The S&P 500 didn’t trade back above 1,500 until the first quarter 2013.
I appreciate this is a somewhat simplistic look at things and that this era is not the same as the tech bubble burst of 2000 or the housing bubble burst of 2008. But I do think this is worth pointing out for a simple reason: 10s-2s turning back positive is both logically and practically a warning sign of an imminent economic slowdown. Here’s why.
When 10s-2s turns back positive, it’s usually because the 2-year Treasury yield is falling quickly as investors price in aggressive rate cuts. Rate cuts usually occur because the Fed is worried about economic growth. That’s happening right now, as the market prices in 100% chances for a September and December rate cuts and a growing chance for a third cut this year. The 2-year yield has declined from a high of 5% in April to ~4.45% today (and more than half that decline has come in the past month). That’s the market pricing in Fed rate cuts and the net result is a rise in 10s-2s as the spread has increased a bit.
The point here is the yield curve is getting close to un-inverting and that may be heralded as a positive by the financial media. However, for inversions that are lengthy (and this one is extremely lengthy) the 10s-2s yield spread turning back positive is not historically a positive event and may, in fact, be a signal for equity market volatility.
As such, the rise in 10s-2s is reinforcing my concern that investors are under appreciating the economic risks facing this market in the coming quarters. I hope this time is different than 2000 and 2006 and given how stretched the S&P 500 is on AI enthusiasm and how the rest of the market is trying to quickly catch up, it better be different. But we know how that usually ends.
Are Things All Bad? Certainly Not! *
Market climb a wall of worry – you’ve seen me say that before. So, negative data points out there always abound, and the market always finds its way over the valley, at least in the longer term. I try to find the risk so that we can take advantage of them, avoid major pitfalls, and tactically position towards attractive strategies. It works.
There are reasons to be optimistic on a number of fronts – let’s go thru them.
As more and more central banks move into rate cut mode, monetary policy is going from a headwind to a tailwind, and this has key implications for the global growth outlook in the second half of 2024.
The market continues to see a US rate cut in September in all likelihood – it’s coming soon regardless. There is a misconception that the Fed only cuts when things are bad. Reality is, the Fed routinely cuts with equities at or near all time highs:
Source: Yardeni
So there is now the prospect of “Reacceleration Risk“ — that after a clear and significant slowdown in global trade and manufacturing, things are set to reaccelerate (there may not have even been an official recession). We’ve seen no new incremental monetary headwinds, outright shifts to rate cuts (e.g. ECB, SNB, BOC), and a general easing of financial conditions. This by itself is a key support to the case.
The other supporting elements are the inventory cycle (firms ran down inventories during the rates/inflation shock and recession scare, now need to order more), generally resilient services, recovering real incomes (fading cost pressures), and improving economic confidence. And so animal spirits and optimism in consumers and companies can become a key driver.
US consumers are also still fairly healthy. They have less cash than they did, but still lots of access to credit. When the labour market breaks and the Fed is forced to cut (soon), it will be interesting because these household balance sheets remain healthy. Consumers have lots of room to lever up. (Unlike Canada however)
Analysts expect corporate earnings to remain strong, and grow aggressively. If they’re right, stocks have very solid support on that front.
Source: Carson
And earnings-per-share growth projections are trending up across regions:
Source: BofA
Valuations (at least in the US) may seem stretched, but that's largely attributable to the MegaCap-7 names. During June, the market-cap forward P/E was 21.2x while the median forward P/E was 17.8x. So, many would note that the broad market is not overvalued, and could rise longer term on a combination of better earnings and a higher valuation multiple yet.
Source: Yardeni
And disinflation is in full swing:
Source: JPM
Central banks across the globe are easing:
Source: BofA
And macro risks are down according to options markets. Options on rates declined most last month. This suggests the better inflation numbers on the CPI release provided much more clarity to the rates market and reduced the range of outcomes.
Source: Goldman
There’s a bunch of cash for dry powder yet. Consumers may not be cashed up at the bank account, but money market funds have a ton of balances.
Source: BofA
Even though AI may be ahead of itself, precedent suggests we may be early innings. The Nasdaq 100 post-ChatGPT at just over 400 days is now up more than it was following any of the other major technological releases of the last half-century. But if we are to follow the Netscape blueprint we have a lot of more bull left...
Source: Bespoke