You Got To Know When To Hold 'Em
By Scott Poore, AIF, AWMA, APMA
Chief Investment Officer, Eudaimonia Group
The Fed is the ultimate gambler, especially when it's "house money." All of last year we were told that inflation was "transitory" and the Fed was late to address the rise in consumer prices. This year, the Fed has had their foot on the brakes, which has so far worked out. It reminds me of one of my favorite country songs, "The Gambler" by Kenny Rogers. The song, in-and-of-itself, was a bit of a gamble. The song was written by Don Schlitz in 1976 and it was recorded by 5 other country stars - including Johnny Cash - but the song never caught on. Rogers got hold of the music and offered it to Willie Nelson who turned it down; Willie thought the song was too long. With 5 other artists having crashed-and-burned on the song and Nelson not even willing to touch it, Rogers forged ahead anyway. Rogers released his version of the song in 1978, which won him a Grammy for "Best Male Country Vocal Performance." The song peaked at #1 on the Country charts, but also made it to a respectable #3 on the Billboard charts.
"You got to know when to hold 'em
Know when to fold 'em
Know when to walk away
And know when to run
You never count your money
When you're sittin' at the table
There'll be time enough for countin'
When the dealing's done"
Now that the Fed has gambled the economy on whether or not inflation would take it down, the question now remains, where do we go from here? Let's take a look at what we're seeing so far this week...
You Got To Know When To Hold 'Em. You have to hand it to the Fed, they have all of the data points and were able to somewhat navigate the economic slowdown this year. After two consecutive quarters of negative GDP growth in Q1 & Q2, the report released this morning showed +2.6% for 3rd quarter GDP, which was above +2.4% estimate and much higher compared to the 2nd quarter's decline of 0.6%. That would mean that, technically speaking, the recession would be over and that the declines in the 1st quarter (-1.6%) and the 2nd quarter (-0.6%) were mild when compared to previous recessions. The Fed looks like it was able to this year's challenges well. However, as we will show, a potential scenario presents itself that could be problematic.
Some other positive news in the GDP report is that the GDP Price Index declined from +9.1% in Q2 to +4.1% in Q3. This is good news on the inflation front as it means the price of goods and services included in GDP declined quarter-over-quarter. Again, this doesn't mean that inflation is going away quickly, but the peak for inflation has likely already been reached. Gas prices, a major input of both the Producer Price Index (PPI) and the Consumer Price Index (CPI) have dropped another 5% over the last 2 and a half weeks. One input that was cause for concern earlier this year was the price of used cars. The Manheim Used Vehicle Index has declined 15% since the beginning of the year. The Baltic Dry Index, which measures the cost of transporting raw materials, has plummeted 71% since peaking on October 7th of last year. It looks like the consumer held up well in September as Personal Spending came in higher than expected and in-line with August (+0.6%). The Fed's preferred index, PCE Prices, in September was on par with August (+0.3%). Lastly, the Employment Cost Index was also on par quarter-over-quarter (+1.2%). If we get a slightly lower or flat inflation reading for October, it's likely the worst is over - for now.
You Never Count Your Money. Equity markets are up broadly this week, but not all sectors are created equal. Nine of the 11 S&P 500 sectors are up for the week and 6 of those 9 are up more than 3%. However, the indices are being dragged down by Technology and Communication Services. Why is this the case? For the most part, those two sectors are plagued by disappointing earnings this week. If we look at industrials, energy, and financials, most companies (such as Visa, Catepillar, Murphy USA) have exceeded earnings expectations. Conversely, FAANG members have disappointed either on earnings or revenues or both (with the exception of Apple). These companies are down for the week, such as Apple (-2%), META (-25%), Google (-9%), and Amazon (-8%), which is bringing some of the broad indices down for the week. We're not suggesting to remove Tech or Communication Services companies from your portfolio. But clearly, high quality and dividend-paying are still a good place to have exposure and may hold up better as the economy attempts to find its footing.
At this point, we need to get just a little technical. The question I hear a lot now is this just another Bear Market Rally or can we begin to step into equities. That's obviously not an easy question to answer. However, if we look at SKEW (potential risk in financial markets) it might provide some insight. What exactly does this index measure? Like the VIX, it picks up volatility in the market, yet, unlike the VIX, it seeks to measure 2 or 3 Standard Deviation events. Most market returns occur in the 68th percentile (1 standard deviation). Outsized returns typically occur in the 95th (2 standard deviations) or 97.5th (3 standard deviations) percentiles (see graphic). The SKEW index is trading at 7-month lows and is down 30% from the June 12th peak. This means that, at the moment, outsized returns are not likely, so we may see less volatility in the near future. That's not to say the worst is over just yet, but we have covered the probability of positive returns post-Mid-term Elections. If the consumer holds up, we might have some positive returns from here until year-end.
And Know When To Run. So, what's keeping me up at night? I think some really bright economists have gotten this particular recession wrong. These economists, who I have a ton of respect for, have mistaken the strange data during this recession in suggesting it's really not a recession at all. I've previously written about the strange data we've seen during the most recent recession. Yet, I think the outliers (low unemployment and stable retail sales) are lingering effects from the craziness of COVID. We pumped too much money into the system and locked people in their homes for months (years, in some cases). The excess money supply added during COVID and the loss of millions of jobs in the early days of the pandemic has thrown some of the economic data out of whack. We are just now seeing the job market recover the losses from the pandemic, which means companies did not have to lay off people like in a normal recession. While the current "technical" recession is now over given Q3 positive GDP, what we could be setting ourselves up for is a "double-dip" recession. Many were speaking about a double-dip shortly after the 2008 Financial Crisis, which obviously never materialized. However, if a scenario occurs where inflation doesn't completely get back to normal over the next 12-18 months, we could re-establish another equity bubble that could set us up for another recession. Why do I bring this up? The 10-year Yield and 3-month Yield have closed inverted 3 days in a row after inverting briefly last week. As I pointed out last week, this type of inversion is a leading indicator of recessions on average 14 months ahead. As I stated last week, "Either that particular indicator is "broken" or there is more pain on the way for equities." What if that pain comes in the form of a double-dip recession?
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