The S&P 500 has advanced another +2.5% so far in 2024, extending last year’s monster +26% return. Perhaps more importantly, the S&P 500 and Nasdaq-100 have both broken out to fresh all-time highs after a 2+ year wait. Those who are acute on technical analysis would say this is a significant breakout that is likely to fuel additional gains purely on market momentum driven by a fundamental expectation of an economic ‘soft landing’ where inflation successfully returns to 2% without overshooting and sending the economy into recession. As a result, long-term interest rates have fallen significantly, and market expects the Fed to follow with the short-term benchmark rate. This is very bullish for both P/E multiples as well as earnings, as the cost of capital eases. As a result of these expectations, the SPX continues to trade well above its 30-week EMA, which, if you’re been following me here, is my ‘line in the sand’ for risk management. This trading system I follow issued a buy rating on the SPX upon its daily close above that 30-week EMA on 11/2 @ 4317. As the market continues to trade above that moving average, I recommend remaining long as long as this condition is met.
However, I continue to remain fundamentally bearish. While market participants anticipate a soft landing, I expect a hard landing recession.
Core PCE last week clocked in at +2.0% YoY, which has basically confirmed we have now descended to the Fed’s long-term inflation target. Monthly YoY core PCE has remained at or below 2% in six out of the last seven months. This is why equity and bond markets have rallied.
Last week, the Conference Board once again reported their Leading Economic Index declined -0.1%, making it the 21st consecutive monthly decline, lead by continued weakness in new orders and credit. Never in the history of the index has it been in contraction for that long without tipping into recession.
Also last week, the BEA reported Q4 GDP astonishingly strong +3.1% YoY, lead by a cyclical recovery in durable goods, business equipment and residential investments. That is undoubtedly very strong across the board and flies counter to my recession theory. However, despite real GDP clocking in strong in 2023 at +3.1% for the full year vs 2022, corporate earnings actually fell by -2% YoY. This is one of the larger disparities we’ve seen between GDP growth and corporate earnings, which may explain why GDI (gross domestic income) has failed to confirm the exceptionally strong GDP all year. A breakdown in the ratio of GDI to GDP typically occurs during and around recessions. A two-quarter YoY decline in real GDI has coincided with recession every single time over the past 80 years with no false positives. Q4 real GDI will be published on March 28.
What good is GDP when earnings do not confirm? In my view, GDP has very little to no predictive power because it is the ultimate coincident indicator. However, the rebound in the cyclical components of GDP, which are leading, is noteworthy. I will continue to monitor this well into 2024.
I also see emerging cracks in the labor market. The BLS reported the US economy added +216,000 jobs in December; however, payrolls from cyclical industries increased by only 5,000 sequentially to 26.231 million, which is a -0.5% decline YoY. That is the first YoY contraction, which historically only occurs during and around recessions. Cyclical industries are particularly important to watch as they are the first ones affected by changing macro conditions—bullish or bearish—and therefore turn ahead of the aggregate GDP cycle. These industries include plastics manufacturing, trucking, wholesale trade, administrative and civil engineering and construction jobs. Together, these industries provide a ~6 month leadtime to aggregate payrolls. The December contraction is noteworthy and suggests the overall job market may enter recession around summertime unless anticyclical forces, such as government, education and healthcare jobs, make up for the slack. Aggregate weekly hours remained virtually unchanged, but average weekly hours in manufacturing continued its relentless decline to just over 40 hours, down from the 2021 peak of 41.5. Permanent Job Losers, which I have specifically highlighted in past articles, actually eased for the second month in a row from its highs has now crossed below its 24-month moving average after previously crossing above. All this together means that we are seeing early signs of labor market weakness, but it is subtle and has not become meaningful enough to impact the economy yet.
Manufacturing remains in recession. Weekly hours in manufacturing are at recession levels, while every major manufacturing production gauge – ISM Manufacturing PMI, Chicago PMI, Philly Fed Index, and Empire State Index, Dallas Fed Index – remains in contraction for 13-16 consecutive months. The correlation between ISM and corporate earnings has always been very strong, and so as long as this sector remains weak, I believe earnings will come under pressure with negative revisions.
This week will see a substantial onslaught of corporate earnings, and earnings for fiscal year 2024 will largely depend on guidance given by these companies this week.
As I’ve been writing, the leading indicators of manufacturing, credit, cyclical GDP, cyclical employment, cost of capital, inverted yield curve, excess savings and retail spending are suggesting EPS expectations for 2024 are significantly overstated, and therefore will come down in the coming months. To that end, EPS growth expectations for Q4 have completely evaporated: in August, expectations for Q4 were for +5.5% growth YoY. That has now been revised down to zero. I expect such cuts to begin affecting FY 2024 in the coming weeks.
The softness in all this data, combined with easing long bond yields thanks to core inflation making its way lower, has been the driving force behind the furious rally in stocks.
However, I continue to believe this will prove to be a misreading: we aren’t just softening. We’re entering recession.
Retail sales have remained strong primarily because consumption has outpaced incomes. This is only possible when consumers have excess savings – which they had in record amounts during the post-pandemic period. These excess savings are projected to completely run out by April or May this year, according to the latest analysis by the San Francisco Fed. Excess savings hit a record $2.1 trillion at the top in 2021. That figure has now dwindled to just $290 billion through November 2023, according to the Bureau of Economic Analysis. Without significant job gains or wage gains, or a meaningful uptick in credit, this trend cannot continue. I therefore expect a notable slowdown in retail spending in 2H 2024.
Banks continue to taper credit as a result of multiple hits from a variety of areas: large losses on the HTM portfolio of bonds, increasing delinquencies, and a depressed commercial real estate market where an increasing number of loans now exceed property values. Total bank lending is down -0.7% YoY as a result, and continues to trend lower. This only happens during recessions. Fed survey respondants are also reporting lenders are tightening credit standards at the fastest rate consistent with recessionary environments.
The weakening consumer is also being felt by credit card lenders, including Discover and American Express. Discover (DFS ) shares dropped -10% upon posting Q4 earnings as the company surprised investors with loan loss provisions more than doubling YoY from $900m to $1.9 billion, driven by a surge in delinquencies. Credit card chargeoffs rose +231 bps YoY. Discover is particularly important as a bellwether institution for the financial health of over 60 million primarily middle class Americans.
American Express (AXP) similarly confirmed what has been hitting Discover, as the company last week reported total provisions for credit losses reached $1.37 billion—the highest levels since the 2020 covid crisis, and prior to that, since the 2008 financial crisis.
This rise in delinquencies are consistent with what we are seeing in the aggregate data: credit card delinquencies have reached 3%, which is the highest levels since exiting the Great Financial Crisis in 2011. This trend is likely to continue if I am right about the direction of excess savings, manufacturing and other cyclical job industries.
These trends are not what we typically see in healthy bull markets. We only see leading indicators of employment negative for consecutive months during and around recessions.
Unless either wages, jobs, or credit picks up pace, it is not possible for retail sales to avoid contraction.
Given the ongoing material weakness in leading indicators of the business cycle and corporate earnings, I expect the cuts to EPS expectations to continue well into 2024.
As a result of all this soft economic data, the 10-year yield fell to 4.1%, well off the highs of 5% in October. I remain split on where Treasury yields will go: on the one hand, long bond yields should be receiving a strong bid as the economy (and therefore inflation) slips into recession. But on the other hand, the long bond may remain under pressure as the US government runs the largest deficits in history, outside COVID and WWII and will be raising several trillions in new debt at much higher interest rates to refinance old, low interest debt that will be maturing over the next 6-12 months. The UST market, as a result, will remain a battleground market for the foreseeable future, in my opinion and therefore may not be as effective at signaling growth or recession as it has in the past.
The spread between the 2-year and 10-year Treasury has once again steepened after its also remained a battleground between inversion and steepening. The spread has remained negative since late March 2022. Recessions historically develop 12-24 months after the first inversion. That 24-month timeframe roughly aligns with when I expect retail sales to begin to decline as well as cyclical unemployment to rise.
With how long it has taken inflation to moderate, I continue to believe the Fed will remain “higher for longer”. However, I believe the forces of recession will ultimately prevail over other factors that push prices higher. We went from an epic supply-shock that sent manufacturing backlogs to 40-year highs to now significant excess capacity with slowing demand. Slowing demand from higher cost of capital, tightening budgets, and contracting credit will continue to weigh on inflation and earnings in the months ahead, in my view.
Perhaps even more important are real yields. The 10-year real rate, which subtracts inflation expectations implied in 10-year TIPS, climbed to 2.49% recently, the highest levels since July 2006. It has since eased to 2.0% but still remains at levels not seen in 15 years.
While I continue to believe inflation will steadily ease, it remains possible that long rates actually increase due to the perception of increasing credit risk. Some 31% of all Treasury debt outstanding is set to mature in the coming 12 months, and with a large and burgeoning $2 trillion budget deficit—or 8% of GDP, highest in 60 years—that the US government will have to refinance at significantly higher rates partially due to the notable absence of buyers at the Federal Reserve and China this time around.
The effects of high nominal and real yields together for an extended period of time, including the possibility of even higher real yields in the near future, will exert extraordinary pressure on economic decision-making at the margin and tilt us toward recession, in my view. The Fed is clear they are okay with a mild recession so long as they achieve their objective of inflation sustainably around 2%.
I believe these metrics will deteriorate further and significantly increase the chance something ‘breaks’ under pressure, catalyzing a sharper and more painful recession.
The #1 global shipping company Maersk (AMKBY ) shares cratered -18% following its Q3 earnings report that continued its warning of slowing global growth and subdued demand. “Since the summer, we have seen overcapacity across most regions triggering price drops and no noticeable uptick in ship recycling or idling,” they wrote. As a result, the company announced plans to slash 10,000 jobs. CEO Vincent Clerk stated he believes the subdued outlook may persist till 2026. This comes after the company already issued a profit warning for 2H 2023 and into 2024 on their Q2 earnings report, citing major demand challenges stemming from a global trade slowdown. “Survey indicators point to flat growth, at best, in Europe and US in H2 of 2023 and the start of 2024, with a material risk of recession in both regions,” they wrote in their Q2 earnings release. “The manufacturing sector continues to struggle, and the Global Purchasing Managers Index has remained in contractionary territory since September 2022…the combination of recession concerns and high inventories has resulted in poor demand growth…currently there is no sign of a substantial rebound in volumes…”
Since then, shares have recovered swiftly, but I will be watching company’s Q4 earnings on February 8 like a hawk.
With manufacturing remaining in recession, it is likely that factories will soon begin to become idled if this trend continues for another few months. Keep an eye on Capacity Utilization, which is published monthly by the Federal Reserve Board. The latest reading was 79.7%. If my thesis is correct, we should see capacity utilization drop to well below 75%. This will trigger rising unemployment in the manufacturing sector, which we have already started to see in the form of declining Weekly Hours Worked in Manufacturing since summer 2021 and is now at the lowest levels since 2009. These trends are, in my view, a direct reflection of deteriorating growth and typically only occur at the onset of recession.
The regional banking crisis that began with Silicon Valley Bank in February this year is therefore not over, in my opinion. Banks remain under significant stress, in my view, as they are attempting to put out multiple fires simultaneously. As the Fed has raised rates, customers have increased the pace of withdrawals out of commercial banks, which still pay close to zero deposit rates, into money market mutual funds. Meanwhile, declining commercial real estate prices put pressure on many banks with exposure to borrowers in that sector. Combined with deteriorating credit quality of borrowers, this has in part triggered banks to increase loan loss provisions, which have now risen to the highest levels since 2007 (excluding COVID). All this while banks continue to experience large unrealized losses on their Treasury portfolios, which exacerbates the situation. As a result, banks are now being forced to tighten lending standards by the greatest extent since 2008 according to Federal Reserve reports. Analysts have consequently dramatically marked down FY 2023 and 2024 EPS estimates across the board, and I believe the worst isn’t over yet. It is entirely possible another bank (or multiple?) enters distress and requires external assistance. In this regard, I would keep a close watch on US Bancorp (USB), the #5 bank in the US by total assets.
For all these reasons, Moody’s cut credit ratings across 10 banks and issued warnings on additional downgrades for several large financial institutions including US Bancorp, which is the fifth largest US bank by total assets. Following Moody’s lead, S&P later downgraded several regional banks.
Services remain the source of the majority of S&P 500 earnings, but even ISM Services PMI has slowed significantly. The figure remains only marginally expansionary, but the rate of change has slowed and I believe it will follow the manufacturing gauges into contraction.
I believe the data suggests continued downward pressure on prices, including shelter and services where prices have remained stubbornly high, as unemployment continues to build and production capacity continues to outstrip declining demand. Key commodities—crude oil, gasoline, natural gas, wheat, lumber—have all roundtripped their post-COVID surge and now trade squarely within their normal 20-year ranges.
At the margin, these trends are a net-negative on S&P 500 earnings growth, and if the situation does not improve soon, it will begin to weigh on 2024 earnings expectations. For all these reasons, aggregate earnings expectations for both fiscal year 2023 and 2024 have been revised significantly lower over the past year but have largely remained sideways for the last six months. However, I believe 2024 expectations will be revised sharply lower as the lagged effects of Fed rate hikes and rising real yields begin exerting its toll on aggregate demand.
This is how recessions build: a slowing growth environment leads to tightening budgets, credit contraction, reduction of labor hours, job cuts, which begets additional demand declines, which prompts additional job cuts, and so on.
I remain fundamentally bearish as economic and earnings growth continue to be negative while indexes trade at bull market P/E multiples. History shows that an excessively restrictive Fed induces recession and can sometimes even lead to a disorderly blowup of an institution that triggers a chain-reaction of falling dominos. We will know that moment has arrived when there is a swift and sharp steepening of the 2-year/10-yr yield spread.
The S&P 500 is back to a 20x forward P/E, which ranks in the upper third of observed forward P/Es in its history. Equities remain in a bullish trend despite this data with global liquidity rising, defined as worldwide combined M2 growth.
I believe substantial downside risks exist in equities from today’s levels. Historically, whenever the Fed has gotten this restrictive by taking the Fed Funds Rate above the 2-year yield to this extent (+100 bps at its peak), especially during a time when economic fundamentals are weakening, something somewhere has broken down, which commences a domino-effect that ultimately serves recession and significant market declines.
The S&P 500 index broke down and had a daily close below its 30-week exponential moving average on Thursday, Oct 18 at 4314, and so I recommend remaining out of equities as of that level so long it remains below its 30-week moving average. However, it recaptured that moving average on Thursday, Nov 2 at 4317. As the market continues to trade above that 30-week through today, I recommend staying long for now.
This is the system I like to follow: if the market has a daily close below some medium-term moving average (100-day, 30-week, or 200-day), sell. And if the market subsequently recaptures that level and has a daily close above, then buy back in. Pick one moving average of your choice and stick to it. Rinse and repeat that process. Eventually the market will break decisively one way or the other, and if you remained disciplined with following this risk management approach, you are guaranteed to be on the right side of it.
I would therefore remain in equities for the time being despite being fundamentally bearish, unless and until the index shows a daily close back below the 30-week moving average again, which now sits at 4549.
With the S&P 500 cruising well above the 30-wma, I continue to recommend staying in equities here until we see a daily close back below that moving average, which now sits at 4549.
The market has shown extraordinary resilience at defending the 200-week moving average, which the Nasdaq-100 has triple-bottomed at 10,700. As I’ve written previously, 12 of the past 15 bear markets ended at the 200-week, so it is worth noting this rally is occurring off that base.
However, in the 3 bear markets in which the 200-wma broke, the market proceeded to drop another -30% on average.
If SPX 4000 breaks down, I believe recession risk will be the primary factor in driving markets substantially lower to target the 3150 area.
Bitcoin remains in a bullish primary trend and has gained its stride ever since the demise of SVB and SBNY, and especially so since the surge in the 10-year yield and rising geopolitical tensions in the Middle East. I would continue to be long Bitcoin with a stop loss at its 30-week EMA, which currently stands at $35,907.
U.S. oil prices surged with the breakout of war in Israel/Gaza, however, it has mostly roundtripped those gains and have now fallen below the 30-week moving average despite recent OPEC production cuts. As such, its now officially in a downtrend. I believe recessionary forces will ultimately overwhelm the world’s most important commodity and send it much lower, possibly into the $55-60 range by the end of Q1 2024.
Keep an eye on these four factors: 1) S&P 500 estimate revisions, 2) the trend in the CPI and PCE rate of change, 3) continuing unemployment claims and permanent job losers versus their 2-year moving averages, and 4) 2-yr minus 10-yr Treasury yield spread. I would also watch SPX 4000 very carefully, as a breakdown of that level coinciding with rapid steepening in the yield curve would indicate significantly elevated stress to the system that can be a catalyst for a recession. However, if all remain tame, the bear thesis becomes less viable. But if any one of the four begin to deteriorate, equities remain vulnerable at its current 20x forward p/e, which I believe is a full valuation that prices in a ‘soft landing’. For now, however, it looks like the S&P and Nasdaq want to continue to melt up.
Final call: remain long equities, but with a tight leash. If we get a daily close below the 30-week EMA, which currently sits at 4549, then sell. And if we get a daily close back above, switch to being long equities again. This approach may trigger unwanted trading, but it will ensure strong risk management without giving up much upside potential.
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