Confounding the Bears

By Crest Capital Advisors on March 25, 2022

Dow: 0.31% to 34,861.24
S&P 500: 1.79% to 4,543.04
Nasdaq: 1.98% to 14,169.30
Russell 2000: (0.39%) to 2,077.98
10 Year Yield: 2.48%
Outperformers: Energy 7.42%, Materials 4.10%, Utilities 3.45%
Underperformers: Healthcare (0.23%)

US stocks shrugged off many of the prevailing market misgivings to finish higher for a second straight week. The big story continued to revolve around the “hawkish” Fed policy shift as the latest batch of “Fed-speak” prompted Wall Street traders to further ratchet up calls for an aggressive, frontloaded tightening cycle. As a result, bond yields moved sharply higher (10-year treasury ended the week at 2.48%) in response, while the curve continued its flattening trend (more on this below). Despite the upward pressure on yields, which earlier in the year would have easily derailed the stock market, stocks shrugged off the headlines and moved steadily higher on the week. Perhaps we’ve reached the realization point where traders embrace stocks as an inflation hedge?

Geopolitical headlines remained busy but also seemed to move further to the back burner in terms of having a directional influence on markets. There’s still an opportunity for talks to produce a peace accord, and depending on what form it takes, could help ignite a further rally from current levels.

One of the bigger bullish talking points helping drive recent performance is a condition we’ve been noting in recent CMDs…the oversold conditions and depressed positioning and sentiment indicators. Bank of America pointed out that its Bull & Bear Indicator triggered a contrarian buy signal. It added that in the 12 weeks following the eight previous buy signals since 2013, global equities have averaged an 8% increase. Prime brokerage desks also flagged increased participation on the long side by systematic investors, short-covering, and continued dip-buying interest from retail investors.

Next week brings a number of high profile economic reports with the highlights being the Personal Consumption Expenditure (PCE) report on Wednesday (This is the Fed’s favored measure of inflation). And, next Friday brings the March employment report.

Tactical Outlook

Last week’s rally reversed a declining price channel the S&P 500 had been stuck in since December. And this week’s performance maintained that reversal and built upon it, albeit slightly. We’ve noted above-average volume and bullish momentum confirming the reversal. The trend-following moving average (MACD) indicator flipped back into a buy position, while relative strength climbed to its highest level since the January record-high. Market breadth also improved as around half of the S&P constituents closed above their 200-day moving averages and nearly 90% are trading above their 20-day moving average.

Looking ahead, traders are now eying the February highs at around 4,589 as the next key level of resistance. Downside support comes into play at 4,402 (200-day moving average). Overall, we do not believe the recent trend reversal implies a linear rally to new highs; so we expect volatility along the way. However, the collective technical evidence suggests the correction lows have likely been set.

Chart Manipulation

First glance at this massive rise in mortgage rates over the past few months and you might draw the conclusion that the housing market is in trouble.

Well, that might be the wrong conclusion. Why? Because when we zoom out to take a look at the longer-term perspective, you get this chart of mortgage rates:

You have to really look hard to find that ominous red uptrend. (Hint: It’s way down and to the right.) See that blip? Not so scary. And ask yourself, was housing hot in the mid-2000s? Where were mortgage rates back then? (Answer: Materially higher than they are today)

Yield Curve Discussion: Inside Baseball

First, a short primer on the yield curve; For those who are already versed on the subject, feel free to skip ahead to the next paragraph. The yield curve is simply a graphical representation of the yield of various fixed income securities (in this case, US Gov’t bonds) plotted against the length of time they have to maturity. The chart below shows the yield curve today (Green) v. one week ago (Blue), one month ago (Red), and one year ago (Yellow). In normal times, the yield available on longer-dated bonds will be higher than that available on a short-term bond. This makes logical sense as the longer the duration, the higher the return should be. It’s basic risk v. reward. However, in some timeframes, like we have today, the yield curve may ‘flatten out’, where the yield on lengthier maturities is not much different than what is available in shorter-term maturities. Today, for example, the yield of a 30-year treasury bond is 2.59% whereas the yield on a 7-year treasury bond is 2.55%. That’s extremely flat and a very rare difference of just 0.04%! You’ll note last year (again, the yellow line) we had an upward sloping yield curve, which is more indicative of “normal” times.

The yield curve between 2 and 10 years has also flattened a lot and is at risk of inverting. (Today’s levels are 2.3% on as 2-year and 2.47% on a 10-year, a difference of just 0.17%. The 3 to 10-year portion of the curve has already inverted. In this type of situation, talk of recession typically intensifies. The reason is the bond market is often signaling that there is trouble ahead. Weaker economic growth typically goes hand in hand with lower bond yields so the concern is always somehow that the smart money in bonds is sniffing out something the rest of us aren’t seeing yet.

There are reasons to be worried about the future, but before getting too gloomy, it’s worth keeping in mind a few points.

Not all of the curve has been flattening or inverting. The short end, for example, has been steepening.
The fact that recessions follow inversions is quite obvious. Yield curves invert close to the peak of a cycle, and of course, after a peak, there will be a recession. What we don’t know is when.
An inverted curve, no matter the maturities involved, is not very good at predicting the timing of recessions—historically, recessions follow inversions with long and variable lags.
What’s more, stock prices tend to appreciate between curve inversions and recessions, and sometimes a lot: It definitely doesn’t pay to be too pessimistic as soon as the curve inverts.
An important note of caution is that the recent flattening has been caused by expectations of Fed overtightening, and overtightening has indeed led to recessions in the past (still at unknown points).

The chart above plots the difference between the ten-year and two-year Treasury yields, which many investors watch carefully for signs of economic trouble ahead (high values of the spread indicate a steep yield curve, low values imply a flat curve, and negative value signify an inverted curve). At first sight, the chart is ominous: After each flattening/inversion, a grey bar (recession) appears. However, things are not so clear and simple.

First, while the attention of most investors is focused on the two to ten years spread, the yield curve is constituted of many portions. For example, as the first chart above showed, the yield curve this year has flattened completely between three and thirty years; indeed, it is slightly inverted between three and ten years. However, the curve also steepened between very short maturities (0-3 months) and two years. Which portion should we pay more attention to? Careful statistical analyses have shown that it is actually the short end of the curve that has the best predicting power for recessions.

Clearly, at the moment the different portions of the curve don’t agree with each other; this conflicting information, just by itself, is a sign that we should be careful before jumping to macroeconomic conclusions. The yield curves of 2019 also offer an important note of caution about the predictive power of curve inversion. At that time, all portions inverted a few months before the Covid recession. Yet, Covid wasn’t on the radar screen in the spring or summer of 2019 when the curves inverted. For sure the economy was slowing in 2019, but we can be certain the curve inversion had nothing to do with Covid.

This brings us to the question of why curves invert and whether that has anything to do with future recessions. Remember that a Treasury yield is always equal to the average expected federal funds rate over the maturity of the bond in question plus a term premium. Holding the latter constant for now, the whole yield curve (not just some portions) flattens completely when the market expects the funds rate to be at its peak. That happens at the top of a cycle. And after the top of a cycle there always is a recession, at some point. So, it is rather obvious that a recession follows an inversion: That’s because a recession follows a peak, and the curve flattens/inverts at the peak.

What we would really like to know is when— how far after the peak—a recession will happen. Unfortunately, the yield curve, and especially the two- to ten-year portion that most people watch, doesn’t help a ton in determining the timing of recessions. The two tables below look at when recessions happened following the inversion of two separate portions of the yield curve— the two years to three months (top) and the ten years to two years (bottom). On average, the short end of the curve is better at anticipating recessions: Its average lead time is about a year, vs. the year and a quarter for the long end. Ironically, the lowest lead time between inversion and recession when it comes to the 2 to 10-year portion of the curve—just six months—belongs to the Covid recession. This, of course, highlights how much randomness affects these things and how careful we should be before attributing any particular predictive power to the yield curve.

In general, the variability of lead times is large for both portions of the curve. Sometimes, like after the 2006 inversions, we had to “wait” one-and-a-half to two years for the recession to follow (but when we got it, it was a big one). Some other times, a recession did not follow an inversion within a reasonable period of time (in 1996 and 1998). And of course, a lot of things can happen in financial markets over long periods of time.

One important question for investors is, what do equity prices tend to do between inversions and subsequent recessions? Perhaps surprisingly, the answer is pretty clear, as the final chart below shows: Historically, stock prices have always increased between an inversion of the curve and the onset of the next recession. Sometimes, the appreciation was small, but sometimes it was rather large.

So far, the conclusion is to take curve flattening and inversions with many grains of salt. However, it is also important to pay attention to the reason why the curve flattens or inverts; if we do that, we see that some notes of caution are in order about the present situation. Today, the yield curve has been flattening and is at risk of completely inverting soon because the market thinks the Fed will tighten policy too much in order to bring down inflation.
We can clearly see that today’s Fed policy expectations are very different from what they normally are so early in the hiking cycle. Normally, at liftoff, the market expects the Fed to raise rates smoothly and eventually reach the neutral rate. Today, instead, the market expects the Fed to quickly tighten above the market’s estimate of neutral, and then to cut back a couple of times in late 2023 and early 2024. Rate cuts normally don’t happen if the economy is doing spectacularly.
Tightening above neutral is dangerous and historically has been a harbinger of recessions. For that reason, we are concerned about a possible downturn next year. Of course, it’s not a given that the Fed will overtighten, and in any case, a couple of expected rate cuts in 2023-24 don’t necessarily imply recession. But our general message is to pay more attention to the reason why curves invert rather than just the inversion and to keep in mind that historically stocks have performed well even after an inversion occurs.

Long Term Growth Stocks: Focus on Fundamentals

In 2000, Amazon shares fell 80%. Today, many of the most innovative companies have experienced declines of similar magnitude over the past year. so the comparisons to the dot-com era are prevalent. So, how did Amazon CEO Jeff Bezos react to this decline? See below for a copy of the letter he wrote to shareholders:

We wholeheartedly agree with this assessment and encourage investors to maintain perspective on fundamentals, as stock prices will always eventually follow earnings.

Long Term Growth Stocks: Value is in the Eye of the Beholder

Since the onset of the pandemic and the rapid shift towards technology stocks, many emerging growth companies began trading at eye-popping price-to-sales ratios, the likes of which we haven’t seen in decades. To many skeptics, it had been a sign of excess, and, over the past year as valuations have come crashing lower, many of these premiums have been wrung out of the market. The question at hand was have we seen the last of these types of valuations for this cycle? Our answer…perhaps not. The evidence of this may just be like in a recent “take private” M&A announcement that hit the wires this week.

Anaplan To Be Acquired By Thoma Bravo (A private equity firm) For $10.7 Billion

Thoma Bravo is acquiring Anaplan for $10.7 billion or $66 per share in cash.
Thoma Bravo agreed to pay 18 times trailing sales and 14 times Jan 2023 expected revenue of $746 million.

So there you have it. The savvy investors at Thoma Bravo, one of the best performing technology/growth-focused PE firms in business today, have decided that 18x trailing cash flow is a bargain to own this business. And given the massive amount of dry powder available for growth/technology-oriented private equity firms, we expect this deal may just be scratching the surface of the deals to come.

A Time to Own, A Time to Sell

Despite the allure of the secular growth story in emerging markets, emerging market stocks have been a bit of a disappointment in the post-GFC era. In addition to a high level of volatility (and now outsized influence from Chinese equities), the overall rate of growth has been lackluster. While these long-term results have not been stellar, we do note that we are coming off yet another significant drawdown in the space. So, in the short run, perhaps staying the course makes sense. In the longer run, we’ll be re-evaluating whether exposure to this investing segment makes sense.

Fun Fact

When the Fed is tightening, you are never far from a rate cut. On average, the Fed begins to cut rates 5 months after they end a tightening cycle. Rate cuts in 2023 are a real possibility and the market-implied fed funds rate is already starting to price this in. The front running of policy action is just crazy this time around.

Crazy Stat(s) of the Week

Here are this week’s crazy stats:

According to data from the nonpartisan Tax Policy Center, a whopping 57% of US households paid ZERO federal income tax last year! This is up from 44% pre-pandemic.
For only the 5th time ever, the S&P 500 gained at least 1% on (4) consecutive days recently. This rare occurrence has historically been quite bullish, as a year later the market has been up more than 20% every single time with an average gain of 28%.

The US Economy still has more than 11 million job openings, an all-time record high level. Coupled with a 3.7% unemployment rate, we have a hard time seeing this economy as heading towards recession, despite the handwringing about future rate hikes by the Federal Reserve.

Quote of the Week

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
– Benjamin Graham

Calendar of Events to Watch for the Week of March 28th

In the week ahead, the economic calendar will be a busy one with key data points on Wholesale Inventories Monday; February’s Personal Consumption and Personal Income on Thursday, and wrap the week with a heavy slate on Friday with Hourly Earnings, Non-Farm Payrolls, Unemployment, and ISM Manufacturing.

Monday 3/28 – US Wholesale Inventories for February will be watched to see if inventories maintain the lower level of January (0.8) or resume toward inventory building again which we saw quite a bit of in Q4.

Tuesday 3/29 – March Consumer Confidence is expected to tick lower to 107.5, down from last month’s 110.5. The decrease due mainly to higher inflation expectations weighing on consumer sentiment.

Wednesday 3/30 – US Final Q4 GDP data is expected unchanged from prior estimates at 7% quarter-over-quarter and 5.6% year-over-year. The ADP Employment survey for March is expected to come in at 400k net new private-sector jobs, down from the 475k pace in February.

Thursday 3/31 – The Fed’s favored measure of inflation, the Personal Consumption Expenditure (PCE) report for February, is expected to come in at 6.4% year-over-year and 0.66% month-over-month. Until we start getting some relief on these inflation readings, they will continue to garner outsized attention from investors and traders who fear an overly aggressive Fed will be forced to hike rates and catalyze a significant economic slowdown.

Friday 4/1 – The March payrolls report is expected to come in at a solid 450k net new jobs, down from last month’s 678k pace. The unemployment rate is forecast to be 3.7%, with average hourly earnings up 0.45%. On the same day, we’ll get the ISM Manufacturing report for March which is forecast to post a robust 59.0, up slightly from the prior month’s 58.6 reading. Regular readers will note that anything above 50 is considered expansionary. Numbers at 60 or above are considered to be quite robust.

Source: FactSet