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This, That and the Other Thing

| June 13, 2023

Last week we mentioned that the “model” had made a major shift toward “risk on.” It seems odd given everything we see in the news that it could possibly be a good time to invest in equities (stocks). Of course, we have also said that if you invest based on the newspaper or evening news, you’re likely to be very late to the party.

We have also said that investing is difficult, and the easy choice is often not the right choice. When the markets look the worst, that is typically the best time to invest. The opposite is also true, when things look great, it may be wise to check your enthusiasm. Take a look at the chart below and see where you think we are in the cycle.

There are certainly different emotions regarding different asset classes within the market. If we are talking about Artificial Intelligence, maybe that area is in the Euphoria phase. But in general, I would say most people are in the Hope phase. It’s also possible that the market could be in the Optimism phase, but I would say somewhere between those two points. What are your thoughts?

If we throw in sentiment surveys, we see the biggest swing in the AAII survey in a long time.

A one-week reading doesn’t typically mean that’s the end, but like we discussed many weeks ago, we want to see what people are doing with their money, not what they SAY they are doing with their money. Are we likely to see this continue? We will see. We said that the market will either turn back down (due to poor breadth) or it will broaden out and can go higher. Nobody really knows the answer at this point, but we know what the model is saying. Let’s take a look at the S&P 500 (large cap) versus the S&P 600 (small cap).

As you can see, there was a very narrow (but sharp) rally since the beginning of March in Large cap (mostly the seven largest tech stocks). Now, a week doesn’t make a trend, but small caps have outperformed the large cap stocks significantly over the last week. Is this a start of the market broadening out? I guess we’ll see.

So, we just discussed “This and That”…so let’s now talk about “The Other Thing.” The other thing might be the most important thing. That’s the FED. Will they, or won’t they?

Right now, the probability of another rate increase has gone down to 25%. Meaning there’s a 75% assigned probability that the FED will do nothing this month. See the chart below.

As you know, that has been our biggest concern…the FED driving the economic “car” into the ditch. We thought they should have left rates where they were last month and certainly think they should leave them at 5%-5.25% this month. It is interesting, the market is “saying” (based on where the collective market is putting it’s money) that the FED will pause this month, but when they meet at the end of July there is a 70% chance of another increase. Check out the July probabilities.

Let’s be clear on this. If the FED wants inflation to come down to 2%, there are likely more rate increases in the future. If, however, they are flexible on the time period in which they will allow the economy to slow, allowing for higher inflation rates (though coming down), they can allow the previous rate increases to work through the system. The “5-year, 5-year forward” inflation expectations are still in the 2.25% range that they have been for a couple of years. 

If that is the future, likely the FED is done, and I think the market has discounted current interest rates. That’s not to say that there won’t be some additional economic fallout or bank failures, but that the markets have factored that in already. I’m also not dismissing the absolute size of the US government debt or the ongoing debt service costs. There will have to be hard choices made over the next 5+ years. We have used borrowed money to prop up home prices, equity prices, and many other things. There are only two ways to fix this in the long-term. Pay down the debt slowly over time and pinch pennies elsewhere or monetize the debt and accept higher inflation and erode purchasing power. Then again, I did see someone build a case for the federal debt to be $100 trillion by the end of this decade. Seems crazy, but it has more than tripled since the beginning of the century.

That’s it for today. Have a good rest of the week and let’s talk if you need more information or clarification on anything discussed here.