For those of you who would prefer to listen:
Forget “Sell in May and Go Away.” June brought some serious Stock Market strength. This rip-roaring rally sure caught us by surprise. The yield curve has been inverted for over a year, amongst the widest levels in history. The aggressive Fed tightening, the slowing Economy, simmering geopolitical tensions, not even the serious risk of an American debt default has tamed this Bull. Or is this another one of those violent Bear Market rallies? One never knows until it’s over. It’s important to remember that some of the most powerful rallies come in the Bear variety. Usually, it pays to not fight the Fed. In this case, it hasn’t paid to be diversified and it hasn’t paid to fight the tape. This stretch has been incredibly confusing.
Bubble-like conditions are certainly present now. It’s primarily centered in Tech, which has been led by the explosive AI revolution. The opportunity ahead for AI is real. But so is the current euphoria. There’s a serious chase going on. It’s a powerful force that sucks people in. There’s that fear of missing out. These moves tend to end poorly. It’s just never clear where that end is. We still think choppy waters lie ahead in 2023.
Interest rates have spiked like few times in history. The Fed said they’re not done. But this week brought a hawkish pause. That’s how it’s being described. The overnight rate stood above 5%, following 10 consecutive hikes before the pause. America’s central bank said there are 2 more hikes ahead this year. Some Fed members think they need 4. That would take rates over 6%, a level that would definitely slam the brakes on robust economic activity. None of them projected a rate cut for 2023. The Market still thinks a cut is coming; Just not this year.
The hawkish pause was a surprise. That surprise initially put a big dent in the Market as stocks immediately sold-off. It didn’t last long. Higher-for-longer from the Fed is driven by that sticky core inflation. It’s the result of a really strong labor market. That’s supporting what an increasing number of people believe will be a soft-landing for the Economy. That said, Fed Chair Powell and others warned, the US Economy doesn’t stop on a dime. It takes time. The central bank’s tightening measures may have yet to be fully felt throughout the system.
The good news is inflation keeps shrinking. There was a lot of economic data released this week. May CPI (Consumer Price Index) increased at a 4% rate from a year ago. That’s down from 4.9% in April. CPI growth has shrunk each month since it peaked at 9% a year ago. The 11-month decline is the longest stretch of inflation reduction since 1921. That’s a long time. What’s more, the headline growth, which includes food and energy, saw the slowest increase since April of 2021. There was a big monthly decline in energy prices. The price at the pump fell 5.6% as Oil has declined. More on this below. Less payment at the pump means more money to be spent elsewhere. That’s a really good thing.
CPI measures the price of a set basket of goods. It’s a consistent price metric in terms of categories. The Personal Consumption Expenditure (PCE) measures what consumers are actually spending. This is what the Fed pays closest attention to. In a large way, Americans have traded down to generic and store-brand products rather than remain with higher price name brands. The May PCE doesn’t come out until June 30. So, the Fed made the call to pause its interest rate hike for now to study more data and allow the aggressive hikes to work their way through the system. Inflation keeps coming down.
Not all prices are falling as fast. Food prices continued to rise. You still see it at the grocery store. The price of meat, produce, bread and sugar are still elevated. They grew a combined 5.8% in May. Price increases are even more pronounced at restaurants which is surely influenced by the tight labor market. Restaurants still have trouble filling jobs, so they have to pay more. That means we pay more. You know where else prices fell? In the henhouse. Egg Prices fell 14%, the largest monthly decline since the 1950s!
Oil prices have fallen sharply too. Both WTI and Brent crude hit their lowest levels this week since late 2021. West Texas Intermediate (WTI) fell below $70 before closing the week just above. The price shock associated with the Ukraine invasion has completely evaporated. Worries range from reduced Chinese demand and a potential recession in the US to increased production out of Russia. Increased supply with reduced demand sends prices lower. It’s Econ 101. Saudi Arabia is not happy with Russia’s move, selling more Oil at steeply discounted rates. The Saudis decided to cut production by 1 Million barrels to prop up the price. It hasn’t worked.
China is facing some serious economic challenges. Growth is slowing. The Chinese people aren’t happy. The unemployment rate for those aged 16-24 is at 20%! An almost daily barrage of bad economic news out of China finally forced the government’s hand. It is increasing stimulus to the Chinese Economy in attempt to stop the bleeding.
The one area that has been stubbornly strong in America has been Jobs. If you want one, you got one. At just 3.7%, the unemployment rate is hovering near 50-year lows. There are more than 1.5 jobs available for every unemployed person. When you have a job, you have an income. When you have an income, you spend money. Consumer confidence numbers have increased in 8 of the last 10 months. Unfortunately, overall GDP growth has slowed from the previous 2 quarters. That said, the annualized growth rate of 1.6% is still higher than it was in Q4 of last year. But spending habits are shifting. Kroger said this week it has noticed an increase in off-brand sales and a decrease in the number of items purchased at checkout in their stores. Wallets are tightening again.
Americans have been buying less stuff. After a consumption boom early in Covid while sheltering in place, people have switched to travel and experiences for their discretionary spend. Malls across America have felt the shift. But despite the reduction, people are still spending in stores and online. May retail sales were up 0.3% month-over-month. That was much better than the 0.2% decline expected. Sales were up 1.6% year-over-year. Inflation accounts for a lot of that. We’re still paying more for less. Strength came from vehicle sales and building materials. It’s sort of curious. The areas that would normally slow down as interest rates rise, namely houses and cars, are seeing demand and prices accelerate again. It’s happening with 7% mortgages and 8% car loans. That is inflationary. It’s precisely what the Fed is trying to stop.
Back to the Market:
The S&P banked its fifth straight week of gains. That hasn’t happened since November of 2021. Investor enthusiasm has jumped on board too. What was the most bearish sentiment in decades coming off the brutal 2022 and the Silicon Valley Bank collapse has quickly turned to the most bullish since November of 2021. There’s that date again. What significance does November of 2021 represent you might ask? That was the peak of the Covid bubble, that’s when all equity indexes made their all-time highs led by Crypto and high-flying Tech. The Bear Market of 2022 thereafter began.
So, is this a new Bull or are we still in an unresolved Bear? As mentioned before, it’s impossible to know. The model the NY Fed uses to monitor to estimate the probability of recession sits at 72% – a level not seen since Paul Volcker was back fighting inflation at the helm of the Fed. For perspective, since the 1980s, a recession has occurred every time the Fed’s model pushes through the 20% threshold, again it sits at 72% today. But what is clear is the euphoria around AI. It’s clearly a bubble. But bubbles can last for a while. The concept of risk gets tossed aside. To be sure, the companies that are leading the charge are dominant in their areas. We own a number of them. The issue is about pricing for perfection. But not everywhere. Many areas of the Market are not in bubble-like conditions. The good news is participation has expanded. The rally has broadened out. The majority of stocks in the Stock Market have really done nothing this year. That seems to be changing. The torrid pace for Tech is well overdue for a breather. Rotation into these other areas makes sense. There’s a lot going on beneath the surface.
Friday was another Options expiration day. This time it was a “Quadruple Witching Day”, which means all 4 sets of options expired simultaneously. All told, an estimated $4 Trillion in options settled. That definitely has an underlying influence in price action. And something new has been brewing of late. 40% of options activity has been in zero-date expirations. In other words, these are bets made for the day. Time horizons can’t get much shorter. Over time, options activity has transitioned beyond quarterly and monthly expirations, which were traditional. Weekly option expirations gained popularity in recent years, but the rise of daily options trading has exploded. Thursday’s 1-day Call Option buying in the S&P 500 index had 1.8 Million contracts. That was the largest volume ever. As they say, ever is a long time. It also provides an increased speculative fervor under the Market.
These 2020s sure have brought a lot of Boom-Bust cycles. There was a boom in demand for goods with a bust in travel as people sheltered in place. Then it completely reversed. People stopped buying stuff and jumped on planes. We’ve seen a series of them with the Market, going from Boom to Bust back to Boom in the Stock Market in the early days of Covid. The Covid Boom turned to Bust late in 2021 lasting most of 2022. And now we’ve just experienced perhaps the mother of all Booms with this AI revolution. It’s clearly exciting. But risks are everywhere. This Bull doesn’t care. Or is it still a Bear? It’s early. It’s only mid-year.
Our goal is to provide stability within volatility, to smooth out the bumps. Easier said than done. We manage risk by trying to protect from various landmines as we navigate through seemingly uncharted territory. A lot of what’s happening in these 2020s has never before been seen.
Have a nice weekend. Happy Father’s Day to my fellow dads. The Market will be closed on Monday in observance of Juneteenth. Our office will be closed too. We’ll be back, dark and early on Tuesday.