By John Goltermann, CFA, CGMA
“To understand the actual world as it is, not as we should wish it to be, is the beginning of wisdom.”
— Bertrand Russell
Except for a hiccup in early August, around the writing of this article (in early September) 2024 has been another year of generally low price volatility for stocks and rising prices.
Markets have risen in anticipation of rate cuts by the Federal Reserve. Its rate hiking cycle ended in August of 2023. The stock and bond rallies were especially strong in August as we saw a huge revision to the payroll numbers, which is calculated by the Bureau of Labor Statistics (BLS). That rally was associated with a strong prospect of Fed Funds rate cuts going forward.
The revision was to the number of reported new hires being 818,000 lower than reported for the period March 2023 to March 2024. It was the largest revision since 2009 and means job growth was 1.2%, not the 1.9% reported. Therefore, the economy is much weaker than previously thought. Had the Fed had accurate data, it may not have raised rates as much as it did, which strengthens the case for cuts.
Year-to-date (through Sept. 5) the S&P 500 is up 16.5%, and the NASDAQ is up 14.1%. Interestingly, the equal-weighted S&P 500 has played catch-up this last quarter and is up 10.3%. What this shows is that the strong rally in mega cap tech stocks has stalled a bit and liquidity has flowed to other better/cheaper opportunities. The valuations in mega-cap tech, in my opinion, suggest limited upside and huge downside going forward whenever fundamentals start to matter.
While the markets have been generally buoyant, there is a lot happening under the surface. Volatility picked up a bit in August and September as the effects of rate hikes have started to impact the economy. We see these effects primarily in the jobs market, but also in residential real estate prices rolling over, economically sensitive stocks softening, bonds rallying, defaults and delinquencies increasing (see chart below on multifamily housing delinquencies), crude oil prices under pressure and myriad other data. The point is that rising rates do have an effect. The effect takes place with a long-time lag, but it is happening now.
One of the factors behind recent volatility and reduction in market liquidity is a strengthening Yen. I do not want to get too into the weeds on this, but for those of you who want to look into it, it’s an interesting phenomenon. The short version is that the Japanese Yen is what they call a ‘funding currency’, meaning that global investors borrow in Yen because the Yen is structurally weak (for all sorts of reasons). The proceeds from that borrowing fund speculative activities of all sorts. They call this the ‘yen carry trade’. When the yen strengthens, like it did recently, the cost of borrowing for those speculators increases dramatically and they close out positions (sell assets and close out trades) that they had with their yen-based loans. There is a momentum effect here, so this could have further to go and reduce market liquidity (putting pressure on stock prices) in the US.
The jobs situation is a factor that has begun to signal increasing slack in the economy. The recent data reveals softening in the labor market. Yes, some of the uptick in the unemployment rate (about 40% of it) is due to new entrants and re-entrants coming back into the labor pool, but some is also due to business conditions, a reduction in hiring, and outright layoffs. You can see from the chart below that when the unemployment rate ticks up, it ticks up by a lot, not a tiny bit. It has increased by at least 2% in each cycle, sometimes by 5% and it has happened quickly. So, we are probably at the beginning of a slowing cycle.
We are also faced with a backdrop of high prices in US stocks. As I have discussed before, this statistic is skewed higher by a heavy weighting of the technology sector in indices (tech carries characteristics of being in a bubble), so is not an accurate depiction of stocks overall. But it is important to keep in mind that whenever there is a bubble, the prevailing view is that there is not a bubble. Almost nowhere in the financial press today is there talk that the Magnificent 7 stocks, or tech stocks in general, may be in a bubble. And because everything is obvious only in hindsight, we don’t want to be on the wrong side of history repeating itself and will stay mostly disinvested here.
So how do we deal with this situation? The first thing is to stay on top of the data. We can’t predict the future, but it appears we are indeed lining up toward a slowdown and we want to monitor it closely. The second is to prepare mentally for the possibility for tougher times ahead. Markets and economies are cyclical by nature, but recessions do not automatically mean lower stock prices. Moreover, recessions bring benefits through the creative destruction of inefficient businesses and their replacement with better ones. They also reset investor expectations and bring more efficient allocations of resources.
Some stocks, namely those with prices implying extremely optimistic profit growth, are more exposed to permanent losses. Value investors in the 2000 – 2002 timeframe (during a recession) performed well, but price volatility did pick up. Broad stock prices will decline dramatically at some point and when that happens, we want to be focused on opportunities to reallocate to attractively priced investments coming out of any major selloff. We, however, cannot time any selloff and we will not try. So having an appropriate asset allocation for your financial situation and comfort level is extremely important.
We try to own stocks of businesses with pricing power that should survive a recession and get stronger. We will try to stay out of stocks that only offer limited long-term upside and large risk of permanent losses, and instead to be invested in high quality assets that are underpriced and underappreciated. Musical chairs is not a wise game to play with investment dollars. We try to maintain hedges against inflation if the Fed and Congress are overstimulative by owning some resource producers, foreign stocks and precious metals. Apart from that, we try to leave emotions out of our decisions as emotions tend to lead to low-quality decisions. From where we sit, many investments already reflect expectations of an economic slowdown. The data has confirmed the slowdown. We expect headline reactions leading into the election, and, because volatility is common in the fall, there will likely be choppiness ahead. This is not a cause to do anything different. But please know we want nothing more than to deliver the best outcomes to you, our clients, to honor the trust you have put in us.