Expansion, Contraction and Return

    Once again, we’re facing a market that seems content to lure buyers on the notion that if the economy is growing that’s a reason to buy, and if an economy is slowing, the Federal Reserve will lower interest rates and that’s a reason to buy. When economies grow businesses invest, GDP stays firm, consumer spending rises, and optimism prevails. When an economy peaks, it’s usually because wages and prices are rising too quickly, consumers and businesses are cutting back on spending. When the economy slows, economic data show signs of slowing, which brings GDP down. Businesses reducing spending may include a reduction in hiring as well, putting upward pressure on the Unemployment rate. In presenting the economic cycle this way it is better understood that markets shouldn’t react favorably to slowing economies, not until the Federal Reserve lowers rates, but when that action produces results.

 

    In the meantime, on the back of today’s Bureau of Labor release of downward revisions of previous months of payroll growth, the likelihood of the Fed lowering rates is making traders and their AI buddies happy. But, tomorrow and Thursday, data for the Producer Price Index (PPI) and the Consumer Price Index will be released. This is important, because last month showed PPI above 3% year over year and is expected to remain at that level. CPI, which came in last month at 2.7% is expected to increase to 2.9%. This outcome would likely cause the Fed some pause as both indexes are moving away from their much publicized goal of 2%. A level, which everyone knows, makes little sense to me. Add to that, oil remains near a level not seen since 2021, when oil spiked and inflation spiked with it. This week the Organization of the Petroleum Exporting Countries (OPEC) raised output, which should place some stability on prices, especially as the West enters the colder seasons. Non- Manufacturing industries, which provide services such as Healthcare, Finance and Hospitality, has remained above 50 at 52, which suggests expansion over contraction. Personal Income rose in July to 5% year over year along with Spending which increased 4.7% for the same period. Enough to keep prices rising, or can the moderation seen in Manufacturing data be the stabilizer I think it will be?

 

    A lot for the Fed to take in at next week’s meeting. Pressure from the Administration doesn’t, or shouldn’t, matter. Likewise, the impact on the economy of lower rates should have less effect on current economic growth, credit card debt may get some relief, as may mortgage rates. Housing might see a rise as debt is the primary financing for that industry. And let’s not forget the Fed has also used other forms of stimulus in the past such as Quantitative Easing. But, in my experience the Fed has only used that tool if rates are significantly lower than they are expected to be by the end of the year.

 

    Which leave us to my final opinion, the economy is showing some slowing and some growth. Payroll growth, while still in the positive range, is under pressure less from companies pulling back on hiring and maybe more on immigration deportation and government employee reduction policies, the former of which is still progressing and latter of which has lost its luster, for now. Overall, the Fed will lower rates sooner rather than later, and while the markets can remain volatile, the bond markets can raise rates without the Fed, if necessary, and if economic growth shows any sign of resuming, the markets will love it, and so will we.

Welcome to the Holodeck

An occurrence that has historical precedence is that the economy has slowed down, or slid into recession 6-7 months after the Fed has stopped raising interest rates. Therefore, the optimism that is projected in the media knows that even if the economy slows down, the outcome would signal a near end of the bear market experienced over the las 18 months. In short, the markets, in their tendency to look forward, will take notice of the proverbial light at the end of the tunnel and begin to show genuine strength. The question is, what will be the driver of that strength?

 Well, so far, we know AI is going to be a big contributor. But this week a new product entered the picture, that would be Augmented Reality. Some will recall my comments on the difference between Virtual Reality and Augmented Reality, and how the latter technology will find use within a broad number of sectors, including Industrials and Energy. But what really got me thinking was an article in the National Library of Medicine outlining the emerging use of Virtual Reality as a therapy to treat Post-Traumatic Stress Disorder (PTSD).  I bring these ideas up because this week Warren Buffett’s favorite company, Apple (AAPL), introduced a new product called Vision Pro designed to introduce the user to the world of the internet, not from the outside, but from the inside. This is what Augmented Realty is all about. And with existing technologies such Digital Twin, Machine Learning Robotics, all driven by AI, just looking at a statue online, you will be able to walk up to it and touch it. Sounds like an episode out of Star Trek, it is. One problem, drove the narrative, it’s expensive at $3,500.

 First of all, I agree. But Apple has a history of catering to a loyal tribe of users, and high prices contribute to the pride in owning an Apple device. Whether an iPhone, iPad, Mac, MacBook, Air pods, Watches, the list goes on and it’s all comparatively expensive. But when I did research, it was curious to find the number of companies, some familiar, that sold their VR products at a much lower price, and some less familiar, at prices over $10,000, and it occurred to me that Apple was onto something new.

 As most investors know, Apple has created products, mostly from the technical modernization of existing products. But sometimes, as with iPhone. the new product is revolutionary. Over the years Apple has built up grand loyalty among its personal users and among academic institutions, filmmakers and other creative users. But one area that has never been drawn to Apple in meaningful way has been the corporate side of the economy. Industries such as Manufacturing, Transportation, Finance and Energy, have mostly connected to Microsoft Office products. But what if Manufacturing uses Augmented Reality to provide maintenance, as described above, transportation to more closely navigate global shipping challenges, Finance to produce an environment where meetings can take place, in a real office environment as real people, not the goofy avatars that meta introduced last year?

In my opinion, the introduction of Augmented Realty Headwear, has a genuine purpose that goes beyond it most obvious use. I think this because in the world of Digital Twin technology, when an industrial factory can be recreated on the internet to be examined to the last screw, Augmented Realty will allow the user to walk up to the factory door, go inside, find the screw, and replace it. I Think Apple is on to something unique to its history, when the competition begins to justify this prediction, which in my opinion will happen, further investment in Technology will see its next great historical wave. That’s why I like to be prepared, I love this stuff. 

Monetizing Events

Total nonfarm payroll employment rose by 253,000 in April

February was revised down by 78,000, from +326,000 to +248,000 (-24%)

March was revised down by 71,000, from +236,000 to +165,000 (-30%)

 The broad indexes showed welcome relief this past week and while much can be attributed to the Fed increase in interest rates it was the stronger than expected unemployment data that triggered a rebound in stock prices at the end of the week. This outcome for the week was not because of the strong growth in payrolls, but rather the revisions made to the previous two months, signaling that job growth isn’t as strong as it appears. The suggestion that the Fed needs to continue to raise rates is also, in my opinion, not without merit. Last week I drew attention to my opinion that the markets are too efficient to be predictable, and that’s simply because most predictions are built in hindsight, always obvious after the fact, as opposed to unpredictive before that fact. That’s why I choose to state, in my opinion, because unlike a casual belief, it’s my opinion, therefore, I own it. So, I’ve looked at hindsight, not without some skepticism, and concluded that whatever the future holds for employment payroll growth, I prefer to focus less on what hindsight tells me and more on what the present is telling me, I focus on events. What are events?

 There’s been plentiful discussion on AI, a little less, but still ample, on robotics, electric vehicles, have I missed anything that aren’t real events? Does the demand of markets provide predictable consideration or is it more of taking advantage of an event in process? Sometimes tracking an event leads to an outcome that is challenging. For example, AI is a worthwhile investment from the software to the hardware, but what about the applications? Healthcare companies are using AI to accompany vascular related blood tests with a second diagnostic opinion. In the realm of electric vehicles, AI is being used to introduce the efficient management needed for autonomous driving. Robotics, currently filling positions in warehouses, all the way to hospital operating rooms. These are some of the applications that in my opinion have future potential, and present application supports that.

Other events, right or wrong, I’ve been favoring the energy sector. Not just renewables, we have plenty of exposure to that, through energy storage and more commercial renewables such as Hydrogen fuels. But the importance of companies engaged in production and distribution of fossil fuels is also in my focus. Not because of the current platform, but where that platform is going, what event has been triggered. The revival of liquid natural gas (LNG) has met the demand of the global market, has been cleaned up to produce less than half the carbon of oil, all easily captured and stored for other industrial uses.  Oil companies have been pandering to an overly idealistic vision, in my opinion, suggesting their commitment to a future of safe energy, but are actually doing little in response. Except a few that are investing in the future of nuclear energy, such as Chevron (CVX), thanks to the introduction of nuclear fusion, a new technology, not to be confused with historically unclean nuclear fission, to fully meet unlimited renewable demands. Still too early to go all in, since most of the companies perfecting the process are private. But definitely an event space I’ll be watching.

 My ambition is to keep looking at technology, keep following the claims of change, and keep focused on interpreting the outcome of currently proven innovations as opposed to predicting the future of old ideas. Especially in this day and age, when the politization of the debt ceiling brews, the threats of nuclear war, the fear mongering over claims of a coming banking crisis.  By the way, I’ll cover the finance sector at another time, definitely a lot of potential events there, but for now too much from unpredictable distractions such as those external events just mentioned.   

 Follow the Light

 “If you can't explain it to a six-year-old, then you don't understand it yourself”

-Albert Einstein

 Some have heard me comment on my experience in knowing that when I’ve read something written by an academic, my frequent need is often, to read it twice. This is because academic grammar, and the use of syntax as an aesthetic, often navigates the ability to present a position with language that flirts with incompleteness as a shield for being simply wrong. I bring this up because in the world of financial narrative it’s become harder to read between the lines without understanding the line to begin with. This is creating an environment favoring the words of the expert, and even Influencers and Pindudes are sounding like ChatGPT bots these days. So, let’s make it easy.

 Markets

The Capital markets are finishing the first quarter of 2023 in positive territory. Part of this achievement can be attributed to the overall oversold condition that existed at the end of 2022. And while there has been enough volatility to feed hungry bears, there is a clear shift in the appetite the Bulls are looking feed. As expectations of Fed rate hikes have been disrupted by the various bank problems the narrative used to describe every day is when markets go up, investors feel comfortable with the banking sector, and when it goes down, they fear it. I prefer to pay attention to neither. As outlined last week, the bankruptcy of SVB and depositor challenges facing First Republic could be a gift to the Fed, and it’s a position that has a growing agreement. Overall activity in the equity markets has also reacted favorably to declining treasury yields. For now, the recent technically oversold condition of both equities and bonds has made its way, in my opinion, into overbought territory. Not a reason to sell nor buy, but hold and continue to wait patiently for opportunities to use available cash. Earnings results should provide us with such opportunities.

 Economics

From the standpoint of the domestic economy, the release this week of GDP data for the last quarter of 2022 shows a slight revision down from the original estimate, from 2.7% to 2.6%. Much of the gain was attributed to inventory growth and consumer spending, and this week .3% rise in Personal Income will likely keep spending active. Most notable, was the decline in corporate profits, an outcome that should make for an interesting earnings season. This week also saw a softening of inflation from the U.S. Core PCE (Personal Consumption Expenditure) Index, which measures the changes in the price of goods and services purchased by consumers for the purpose of consumption (excluding food and energy) from last month, from .05% to .03%. Good news that’s been reflected in the stock market’s recent rise. That said, the Feds recent increase in short rates was followed by Chairman Powell’s speech where he explicitly stated that the board saw the potential for recession before the end of this year. Good or bad news?

 External Events

Currently there are no clear signals of an impending recession, however, in my opinion, it doesn’t historically pay to doubt the Fed. But I would also welcome a slowdown in academic activity for two reasons. One, because a pause in Fed actions would be likely, and two, recessions are a certainty, and the capital markets love certainties. This doesn’t imply that the headwinds to a genuine Bull market won’t sit idly without a fight, as by the end of the year the next election will be news, and we know how much of a distraction that can be. Non-domestic events, such as the war in Ukraine and the increasing presence of China on the capitalist stage, emphasized by their recently launched cybersecurity investigation into semiconductor company Micron (MU), also are both troubling uncertainties. In the interim, in my opinion, a recession will likely have a global impact, and will grab far more attention from the consuming public, leaving a complicated narrative and naysayers with a small audience. A positive for the forward focus of the capital markets.  

The Proverbial Hook

 Having spent most of my career working on the institutional and corporate side of asset management, organization and focus have been handy skills. However, since I’ve come into a more retail setting, I’ve observed another skill, monetizing the hook. The hook is the one idea to hang the direction of the capital markets on, for a single day. I’ve also observed that this skill has created a bit of a quandary lately. Strong indicators of economic growth, employment growth, wage growth and consumption growth all suggest, in my opinion, the Fed isn’t finished raising interest rates. So why have the broad indexes started the year in a rallying mode, and can it continue?

 Markets

A commonly heard narrative is the markets are overbought and need to correct. This is currently true, in my opinion, however it’s important to stay focused on what that means. At this moment in time, a welcome start to the year is where some correction is being correlated. But where is the cause of that correlation within the broad indexes, is the Dow Jones correlating, yes, the S&P500, yes, the Nasdaq, not so much? First of all, last year the most beloved stocks helped the Dow Index perform substantially better than both the S&P500 and the Nasdaq. And the S&P 500 finished last year 10% better than the Nasdaq. So, what does this mean? In my opinion it means that the Dow needs to correct more than the S&P, and the S&P needs to correct more than the Nasdaq. And because the S&P500 and the Nasdaq share a number of influential stocks in the Technology Sector, and the Nasdaq has been the best performer starting 2023, its strength won’t keep the S&P from a necessary correction, but, in my opinion, it will keep it from collapsing, the probable hook the narrative is looking for.

 Economics

The usual mixture of data that has been released recently suggests the economy is slowing, but not the entire economy. For example, the U.S. Manufacturing Purchasing Managers Index (PMI) and the U.S. Services Purchasing Managers Index both came in at 46.6 and 46.8 respectively. I focus on any number below 50, which suggests a contracting sector of the economy. In the case of these two indicators, both have been below 50 since November 2022, a condition last observed in 2008. In addition, recent releases in Retail Sales falling 1.1% and Industrial Production falling .07%, in December, there is definitely some economic moderation taking place, and this explains, to some extent, why the markets interpret inflation as having peaked already. I agree with this interpretation, but I also need more proof. Today the Unemployment data for January showed very strong growth in Non-Farm Payrolls (517K) and the Unemployment Rate declined (3.4%) and naturally this was the hook for the opening day’s narrative. And while the numbers are concerning, wage growth, Average Hourly Earnings and Average Weekly Hours all came in static from the previous month. Another interestingly favorable outcome was the U6 Unemployment Rate, which includes a wider range of the unemployed that includes underemployed and discouraged participants, which came in slightly higher (6.6%). While a number of economists view the U6 data and more comprehensive, my takeaway is, it tells us the story isn’t over.

 External Events

In the past few weeks, the new majority in Congress has engaged its political agenda and the first legislation on the docket will likely be the Debt Ceiling. For now, In my opinion, the Debt Ceiling will likely be raised, but with some concessions, namely the promise of no further spending packages that got us into this problem in the first place. This week, the Federal Reserve raised interest rates again and the speech given by Chairman Powell reiterated that inflation is moderating but still too high and the Fed is intent to keep raising rates. While he gave no hint of today’s Unemployment report, I take the Feds actions and statements at face value. And for now, that’s my proverbial hook to hang my strategy on.

Don’t Fight the Fed

When I entered the asset management arm of my career, I was focused on the bond markets. The process of research and analysis that accompanies the bond market is different than that which covers the stock market. This is because when researching and analyzing a stock one focuses on the fundamentals of the that company, with bonds, the focus is on interest rates and the economic fundamentals are the best source to search for the right investment. Most of the time, bond yields tend to stay relatively lower to modest economic growth and inflation, which has been the case for the last 20 years. But now, as inflation has risen to the concern of the Fed, the impact has been to drive bond yields markedly higher and stocks markedly lower. This is what the Fed has wanted since beginning the fight to end inflation, are they winning?

 I bring this to light because after three days of the broad indexes working off some overbought conditions, Fed Chairman Powell then gave a speech that triggered a quick turnaround, leaving the broad indexes, in the black for the week. Why did this happen, and is the Fed’s work nearing the end? In my opinion, no. As a lifelong interest rate follower, there is long followed advice, if you think the Fed is wrong in being less aggressive with rate hikes, then you’re fighting with the Fed. The more reliable posture has always been, “don’t fight the Fed”. Why?

 This week revealed data showing a slight decrease in home prices. Also, GDP for the 3^rd Quarter was revisited and remained modestly strong at 2.9%. The more positive news in the data was the GDP Price Index that came in at 4.3% further suggesting some deflation occurring in process. Consumer Spending showed slightly stronger data than the consensus of economists was expecting. Less welcome news was the data on national holdings of oil and gas which showed depleted inventory levels in need of resupplying. Although both fuels have been steady, they have also nonetheless remained historically high on average (Oil $80, Gas $7). Finally, today saw the release of monthly Employment data that showed stronger than expected Non-Farm Payroll Growth (263K), a steady, and low, Unemployment Rate (3.7%), Higher Average Hourly Earnings (5.1% vs 4.6% last month) and a slight decline in the overall Participation Rate (62.2% to 62.1%). By any measure, the Employment data showed a much stronger economic condition than suggested by Fed Chairman Powell. The economy is not weak, but slowing, inflation is still high, but peaking and until both conditions are realized to a measurable degree, the broad indexes will trade in a silo, waiting to break out.

 The humorous part of the narrative lately has been to talk about what the market wants rather than what the economics is telling us. The data this week undermines the arguments that recession is imminent. In my opinion, a recession is nonrandom, but not necessarily predictable. The reason for this is that prices in freely traded markets are determined by the economic principles of supply and demand.  Prices discount everything and as with the markets they impact, tend to travel in observable trends. The Fed is watching those trends, the market is watching those trends and this week, both got it wrong. But as behavior and history in the marketplace will tend to repeat itself, while the narratives will fail to embrace accountability, the Fed has always found it easy to change their mind. Therefore, in the meantime, in my opinion, best not to fight the Fed. 

What’s Going On

The broad indexes moved higher this week, led by the technology sector that has a woeful year, to say the least. But coming off yesterday’s release of CPI inflation data (Consumer Price Index) the reaction was for the indexes to move sharply higher, and the interpretation of that data is at the root. Our favorite Algochums obviously found the data proof that inflation has peaked and is going lower. The Pindudes jumped in to cover open, and derivative, shorts, but maintained some composure. And lastly the investor, such as myself, sat tight, maintained higher cash and continued the search for opportunities that are still present. Why? Because yesterday’s new data point was a welcome treat, but also, just one data point that is still telling us inflation is still too high. So, what’s going on?

 The strategy this year has been to maintain an allocation that favors less volatility when economic cycles are shifting lower, as they are now. Inflation has brought the Fed into aggressive mode with the explicit intent to slow the economy down and everything that goes with that, such as job losses. Maintaining investments in sectors that are less impacted by changes in the economic cycle and hold favorable fundamentals are the first place to start. These investments are focused on the products and services that are less likely to see the same pullback from the consumer. For example, makeup, fragrance and hair care product company Este Lauder (EL), or, global warehouse style retailer Costco (COST), a beverage and convenient food company Pepsi (PEP), are all companies that bring to the consumer, what the consumer always needs. Other sectors providing more calm include the healthcare, pharmaceutical companies such as Abbvie (ABBV) and service healthcare companies such as UnitedHealth Group (UNH). Most of the companies in these sectors have strong balance sheets, and also share their profits with investors in the form of dividend payments, a procedure that is less important and therefore less followed by our growth investments because they are focused on reinvesting excess free cash back into the company. And that can only be realized if inflation and the economy begin to look better than it does now. What about our growth investments?

 It is always, in my opinion, in the best interest of long term growth to maintain sector diversification in portfolios, to better capture the overall changes in the markets and economic cycles that will always ensue. But this year while favorites such as Apple (APPL), which has eked out a much better year (-9.4%) than say Amazon (AMZN) or semiconductor company NVIDIA Corp (NVDA) both down -46.9% and -53.9% for the year respectively. So why stick with them? Well, yesterday’s softer inflation data tells us just how that sector of technology companies will perform when the economy and inflation begin to normalize. And as the markets have moved lower, I’ve not shied away from investing in the sector as normalization may not be with us, but the sector only needs hope and certainty to recover, and that will eventually happen. And it’s those new investments that have focused on the technological changes that have impacted many different sectors. These investments are the other side of fundamental consideration, they include what I refer to as Event conditions as well. An event condition has always been the strategy of investors looking for companies that will be acquired or perhaps go out of business, but for my strategy the focus is on events that will have genuine impact on the economy and culture and therefore the companies as well. For example, industry cloud-based software solutions for the global healthcare industry Veeva Systems (VEEV) has done more to organize the data heavy healthcare industry by allowing providers wider access patient data instantaneously. A software and services company PTC Corp (PTC) is providing a new technology called Digital Twin that is impacting sectors such as Industrials and Energy to help focus on better servicing of processes such as warehouse machinery and refining facilities through virtual technology. This isn’t new, older tech companies such as General Electric (GE) are engaged, and the expansion of its impact is definitely an event in the making.

 As we come into the last six weeks of this year another casualty of the portfolios has been fixed income. On the lighter side, our exposure to the asset class has been comparatively light since 2003, when yields first reached historic lows and bonds became less interesting, and useful, all which pointed to greater risk. Much of that risk has been realized this year, enough to impact portfolios. But just as cycles effect the stock market, those same cycles can impact the fixed income markets as well. In my opinion, the aggressive moves by the Fed to increase interest rates has made the fixed income asset class more interesting than I’ve witnessed in the last 20 years. That isn’t to suggest the Fed is finished, but the higher yields go, the better the intermediate term advantage they will play in portfolios. In the meantime, the seasonal factors and the softer inflation data could be negatively divergent on Tuesday when the Producer Price Index (PPI) is released. If not, the markets could stay positive into the end of the year, but that isn’t a good reason not to be cautious. Recession is coming sometime over the next twelve months, and the Fed has promised to remain aggressive in the interim, both good reasons to continue looking for opportunities, and to maintain the current strategy as well.