Weekly Market Insights
The “frothy valuation scenario” we’ve been talking about in these reports for some time now finally materialized last week as investors were forced to recognize the economic backdrop, while still good, isn’t perfect. The selloff was initially triggered by the weak ISM Manufacturing PMI report on Thursday, but the jobs report Friday morning sealed the deal with the unemployment rate unexpectedly jumping to 4.3%. This triggered the extremely reliable (100% accuracy in predicting recessions since 1959) Sahm Rule Recession Indicator warning, which occurs when the three-month moving average of the national unemployment rate exceeds the lowest three-month moving average unemployment rate from the previous year by 0.5% or more. Volatility actually began to pick up earlier in the week when the Bank of Japan (BOJ) announced it was anticipating a .25% rate hike, which has major implications with regards to the carry trade, but this was rather muted by a round of solid earnings reports.
All of this resulted in a sharp drop in equities and a collapse in Treasury yields to nearly six-month lows sending bond prices higher and the US dollar towards it’s YTD lows. In the wake of the “growth scare”, commodities, in general, traded with a heavy tone, while gold soared to new records highs.
Source: www.stockcharts.com
Key Takeaway:
The actual data last week wasn’t that bad. Despite the softer labor readings, jobs are still on the rise per the JOLTS (Job Openings and Labor Turnover) report, the unemployment rate is historically low, GDP continues to beat expectations, and corporate earnings and sales are trending higher. This doesn’t necessarily foreshadow a recession to me.
The Yen carry trade is a very popular institutional trading strategy whereby investors borrow money in a country with low interest rates and a weaker currency (i.e. Japan) and then reinvest the money in assets of another country with a higher rate of return (i.e. USA). When the BOJ announced a rate increase just as the US Federal Reserve all but signaled a rate cut is coming, one can only imagine the scramble taking place to unwind these carry trade positions. Couple this with high valuations and the first talks of a “Growth Scare” and you have the recipe for a swift sell off.
As painful and scary as these events can be, history tells us they are very common, happening occurring a few times a year on average, and often providing great opportunities to put capital to work at lower prices and enhancing ones overall returns throughout the market cycle.
The Week Ahead:
We get a reprieve this week from the intense data flows with only one key report, the ISM Services PMI due out Monday morning. This is an important report in light of the recent weakening trend in economic activity and we will want to see the numbers back above 50 (signaling economic expansion) or investors are going to start recognizing the data is becoming a negative trend.
Source: Trading Economics (https://tradingeconomics.com/united-states/calendar#)
Tidbits & Technicals: (New developments will be denoted via***)
Current Headwinds:
- Valuations seem frothy given the current rate environment, leaving the markets subject to a potential swift pullback!
- “Higher for Longer” – Risk that the Federal Reserve waits too long to begin lowering rates and threatens economic growth.
- ***Very narrow market participation, apparently driven primarily by mega cap tech and AI-related companies, has dominated the indices; however, over the last couple of weeks we have witnessed a significant broadening effect with “the rest of the market” showing stronger returns.
Current Tailwinds:
- Optimism surrounding Artificial Intelligence (AI)
- The Federal Reserve potentially cutting rates in the future.
- Strong Labor Market
- Solid Economic Growth
- Continued Earnings Growth (the pace of which may be slowing)
- Momentum
- 10-year Treasury yields continue to hover near their lowest levels since March of this year.
Sentiment:
- Credit Spreads remain tight, hitting their lowest levels recently since peaking in 2022 signaling the bond market (aka “Smart Money”) is not worried about a recession in the near future.
- ***The VIX (CBOE Volatility Index) has lept higher suggesting fear among investors at the present time
- ***The CNN FEAR & Greed Index has moved to Extreme Fear
Source: https://www.cnn.com/markets/fear-and-greed
Intermarket Trends:
- ***The major Indices (Dow Jones Industrial Average, S&P 500, and NASDAQ) recently posted new highs signifying a positive long-term trend, however, in the short-term they are trending downward
- ***Interest rates have been volatile lately and are trending lower
- ***The US Dollar has reversed course and is now trading near YTD lows
- ***Gold recently broke out of its trading range to record highs.
- Industrial Metals, which raced higher recently, have retraced all recent gains and are back in the middle of the large consolidation zone of the past year
- Oil futures are in the middle of their one-year trading band and appear to be stuck in a trading range
Tying it all together:
In the long term, economic growth is the primary driver and, while growth remains robust, we are now seeing signs of moderation. This does not mean everything is falling apart, in fact, this was the Federal Reserve Board’s intention. They have held interest rates high for a long time to combat inflation and the expected result of such policies is economic moderation and a cooling of the labor market. The Fed is shooting for a soft landing, a scenario whereby inflation returns towards their 2% target without destroying economic growth, and so far that scenario appears most likely.
I’m keeping this paragraph below from my prior reports as it really sums up expectations and what is currently taking place:
“Four main factors have seemingly been supporting the markets — strong growth, falling inflation, expectations of Fed rate cuts, and AI enthusiasm. These drivers remain intact; however, some key economic data points, like rising unemployment, are flashing warning signals at the present time. While the economy is not weak, some of the data suggests a weakening trend and this is a concern given the equity markets are not acknowledging the possibility of any sort of economic contraction. Current valuations have certain equities priced for perfection, so it would be fair to say that any type of growth scare could result in rather extreme volatility in the short run.”
I will reiterate that the best approach in these environments is to ensure that one’s overall portfolio aligns with their risk tolerance and long-term goals and add to this the importance of keeping emotions at bay. Markets tend to overreact to both positive and negative data and keeping a calm perspective has always proven prudent.
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