March 8, 2023

Wesley Chapel, FL

Market Performance

The S&P 500 pulled back a bit, down 2.51% in February, after its best January since 2001. It actually pulled back a little more than 5% from the intra-month high on February 2nd.

To be totally honest, there wasn’t much change in either the markets or in my outlook since my February commentary. With that in mind I will try to keep this commentary a little shorter, especially since I am already a little late getting it out.

Powell Testimony

Chairman of the Federal Reserve Bank (The FED) is testifying before the House of Representatives today after testifying yesterday before the Senate in hearings entitled: The Federal Reserve’s Semi-Annual Monetary Policy Report.

The markets didn’t like what he had to say in his prepared remarks, or his testimony yesterday. The S&P 500 dropped 1.75% from the time the hearings started to the intra-day lows. The prepared remarks for today’s hearing were identical to yesterday.

Here are a couple of highlights from the prepared remarks:

“My colleagues and I are acutely aware that high inflation is causing significant hardship, and we are strongly committed to returning inflation to our 2 percent goal. Over the past year, we have taken forceful actions to tighten the stance of monetary policy. We have covered a lot of ground, and the full effects of our tightening so far are yet to be felt. Even so, we have more work to do.”
“…inflationary pressures are running higher than expected at the time of our previous Federal Open Market Committee (FOMC) meeting.”
“…housing services inflation remains too high…”
“…there is little sign of disinflation thus far in the category of core services excluding housing, which accounts for more than half of core consumer expenditures. To restore price stability, we will need to see lower inflation in this sector, and there will very likely be some softening in labor market conditions. Although nominal wage gains have slowed somewhat in recent months, they remain above what is consistent with 2 percent inflation and current trends in productivity.”
“With inflation well above our longer-run goal of 2 percent and with the labor market remaining extremely tight… We continue to anticipate that ongoing increases in the target range for the federal funds rate will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In addition, we are continuing the process of significantly reducing the size of our balance sheet.”
“…the Committee slowed the pace of interest rate increases over its past two meetings. We will continue to make our decisions meeting by meeting…”
“…the process of getting inflation back down to 2 percent has a long way to go…”
“…the latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes. Restoring price stability will likely require that we maintain a restrictive stance of monetary policy for some time.”
“The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

Does any of that sound bullish to you? It doesn’t to me.

Of course that doesn’t mean that the market can’t go higher from here, but I think that would be an unusual outcome, to say the least.

Comment #8 from the list above is particularly interesting because it implies that the FED is noticing the impotency of their actions thus far and they are prepared to dial the intensity back up.

Unfortunately, the hearings are mostly a side show of political gamesmanship and finger pointing with questions largely designed to further the agendas of members of congress, which of course, is simply to get reelected.

I do not envy this part of Mr. Powell’s job. I suppose I don’t envy any part of his job, nor do I think it should even be a job, but I digress.

As I type, (mid-day Wednesday 3/8) the markets are still under pressure as the hearing continues and concludes later today.

10’s minus 2’s

As I have written about extensively in my commentary, the spread between the 10-year US Treasury yield and the 2-year US Treasury yield is perhaps the most reliable leading indicator of an economic recession. When the 2-year rate is higher than the 10-year rate the spread is negative. When this happens you can be highly confident that a recession will arrive within 18 months. Of course, you can’t be certain. The further the spread pushes into negative territory and the longer it stays negative, the more painful and longer lasting the subsequent recession should be. Again, we cant be certain of this but it makes good fundamental sense.

As of this morning the 10’s minus 2’s spread plunged to fresh cycle lows of -1.07%. When I wrote to you last month, it was -0.81%.

10-year US Treasury Yield minus 2-year US Treasury Yield | Click Image to Enlarge
*Source: Federal Reserve Bank of St. Louis*

Money Supply

I mentioned last month that the supply of money in circulation declined year-over-year (y/y) for the first time in recorded history. Turns out I was mistaken… there was technically one week in 1995 where the data showed a 0.1% y/y decline, but it quickly bounced back the following week. Thanks to my friend John Fazio for causing me to take a closer look!

Either way, this has my (almost) undivided attention. In the most recent numbers, M2 once again declined year-over-year for the second month in a row - which is a first time ever event. On top of that, the magnitude (-2.0%) is 20x worse than the one week anomaly in 1995.

This is a great way to bring down inflation but as money comes out of circulation there are fewer dollars for folks to spend and consumption is 70% of our economy. This indicator logically signals a looming recession. Perhaps the likes of which we have never seen.

Y/Y % Change in Money Supply | Click Image to Enlarge
*Source: Federal Reserve Bank of St. Louis*

Inflation and Fed Funds Rate

As we all know, inflation has had everyone’s attention for the past year. For better or worse it still does. I remember a time not so long ago when I didn’t ever need to look at the date that the Bureau of Labor Statistics released its Consumer Price Index (CPI) data for the month… it was mostly a non-event. These days, you can plan on major volatility every month when the numbers come out. The higher the reported number the more likely the FED is to hike rates and the market plunges, and vice versa.

Projected Real FED Funds Rate = FED Funds - Y/Y CPI
Click Image to Enlarge
My projections are currently unchanged assuming only one more 0.25% rate hike in the March 22-23 meeting. Depending on CPI the next couple months the Real FED Funds Rate could go positive in May without further increases. That said, I think it is *reasonably* possible that the FED could hike by 0.50% in the March meeting, and then continue to hike after that.

My opinion is that CPI is yesterday’s news and the primary driver of the market over the next several months and quarters will be the impending recession. The profit recession is already well under way for the companies in the S&P 500 as they reported a decline in earnings of 4.9% for Q4 2022.

Sure, inflation will still be a factor and have a major influence on monetary policy, but I think it has already begun to take a supporting role, aside from the release-day volatility it creates.

That said, I will continue to monitor CPI vs. the FED Funds Rate.

The Quads

The macroeconomic framework we primarily use to evaluate how to position our portfolios is thanks to our friends at Hedgeye Risk Management. They call it “The Quads.”

On the surface, it is very simple to understand and apply. It focuses on two major macro indicators, inflation, and GDP. At any given time, Inflation is either increasing or decreasing, and GDP growth is either increasing or decreasing. That creates 4 potential combinations, or Quads.

The folks at Hedgeye have undertaken to back test the performance of every asset class and sector of the market during each of the 4 environments, or Quads, and have identified those which have performed the best and the worst in each quad.

Every moment in markets, historically and presently are unique. So, it doesn’t follow that one can simply buy the best sector and sell short the worst sector according to the back tested results and forget about the current nuances.

A fish finder gadget doesn’t guarantee you will catch a fish but it does increase the probability of success by telling you where to fish. Similarly, the Quads don’t guarantee your stocks will go up, but it increases the probability of success by helping us understand which sectors to focus on and which to avoid, given the current and projected market environments.

Check out our recent Elevate Market Chat! Don’t forget to smash the like button and subscribe to our channel!

There is quite a lot more to determining which quad we might be in at any time, and for that, we depend heavily on Hedgeye’s top notch analysts and research team. It would be cost prohibitive for us to try to recreate that team at Elevate.

We are currently in Quad 4 with inflation declining and GDP slowing. We expect to remain in Quad 4 over the next two quarters.

In this Quad 4, I expect Dollars to perform the best, and Stocks to perform the worst. Within stocks, which is where we tend to focus our portfolios I expect Staples and Healthcare to perform the best while Technology performs the worst. Again, remember that every Quad 4 is unique.

JPM Guide to the Markets

Every month, I review the updated Guide to the Markets produced by JP Morgan. Like Hedgeye and our other data providers, JP Morgan has a way bigger research team than Elevate could hope to afford. I have no problem relying on good data from outside sources. From there, I do my own analysis of those data.

Here are a few notable charts from this month’s Guide to the Markets.

Mr. Powell said in his prepared remarks:

Click Image to Enlarge
*Source: JP Morgan Guide to the Markets*

“Despite the slowdown in growth, the labor market remains extremely tight. The unemployment rate was 3.4 percent in January, its lowest level since 1969. Job gains remained very strong in January, while the supply of labor has continued to lag. As of the end of December, there were 1.9 job openings for each unemployed individual, close to the all-time peak recorded last March, while unemployment insurance claims have remained near historical lows.”

I am not sure how this will play out but more jobs than seekers should mean that employers have to offer more and more compensation to attract talented employees. These increases in compensation should lead directly to increased prices for products and services offered by those companies, thereby underpinning higher inflation in the overall economy.

Through raising interest rates (although they won’t come right out and say so) the FED is trying to reduce the number of jobs available and increase the number of job seekers bringing the numbers into better alignment and keeping a lid on wage growth.

Interestingly, real wage growth has remained in negative territory for nearly the past two years with price increases (CPI 6%+) far outpacing wage growth (4%). Workers are actually going backwards.

The Congressional Budget Office (CBO) in its long-rage forecast doesn’t expect inflation to return to 2%... ever. Yet they do expect the government to continue borrowing money it doesn’t have to finance expenditures. If they would just stop borrowing and spending my bet is that inflation would be tamed quickly and the country would be in a much better position for the future. But that isn’t how you get people to vote for you!

Back in 2011 Warren Buffet said:

“I could end the deficit in 5 minutes. You just pass a law that says that anytime there is a deficit of more than 3% of GDP all sitting members of congress are ineligible for reelection.”

Sounds like a great idea to me!

During COVID, the government printed tons of money and gave it away to people who weren’t allowed to leave their homes or go to restaurants and events… So, many people just saved that money. It led to extremely high rates saving compared to normal. This led to something called “excess savings.” Well, since excess savings peaked in 2021, folks have been drawing down those savings to afford the higher cost of living due to the inflation that came with printing all that money and giving it away – and those folks collectively have about $800 billion left out of the $2.1 trillion they had at the peak.

Meanwhile, credit card balances are at all-time highs and so is the interest rate people are paying to carry that debt from one month to the next.

Consumer Credit Balances | Click Image to Enlarge
Source: Federal Reserve Bank of St. Louis

What could possibly go wrong?

Wrapping Up

Technical analysis of the stock market price charts looks bullish… but the fundamental backdrop is anything but. I am patiently awaiting the two to come into alignment, for better or worse. I don’t care which way they line up but I do expect them to do so eventually. Until then, I will be very cautious in adding new long exposure to our strategies while holding an excessive amount of cash.

One thing that might cause me to be a little less cautious even without alignment between the technical and fundamental picture is if the 200-day moving averages of the S&P 500 and the Nasdaq begin to turn higher for a sustained period, say 21 days or more… So that is something I will be keeping my eye on.

In the meantime, we are now earning close to 5% on most of our cash as we ladder US Treasuries into portfolios. I think that is a fair rate to get paid while we wait.

One Last Thing…

We normally do a fun contest where we guess where the S&P 500 will finish for the year. Unfortunately this year we received only a few responses from you, and we just have been too busy (and short-staffed) to make an effort to call everyone to get their prediction. So, for this year, we are going to press pause on the annual contest. Maybe we’ll pick it back up in 2024. For those of you who did send us a prediction – we’ll send you a consolation prize!

Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed vs. the markets last month.

Until next time, I thank God for each of you, and I thank each of you for reading this commentary.

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor

Legal Information and Disclosures

This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.