Hands up, anyone else confused?

Okay. Honest answers only please.

From a stock market perspective, in a range of 1 – Gazillion, which of the following statements most accurately describes your state of confusion.

Lets check the facts. On the one hand, the US Federal Reserve has raised rates at the most aggressive pace to the highest rate for at least 50 years; and has indicated that there may well be more to come.?

Fed Chairman Powell himself clearly indicated that it would likely lead to a weakening of the labor market.

Yet the unemployment rate itself has barely budged and continues to signal full employment:

In fact, if anything, the labor market seems to be strengthening if anything, with the prime age labor force participation ratio rising to new all time highs, at levels not seen since 2000.

Inflation (and its effects on rates) has been a major driver for markets over the past couple of years. Inflation is clearly moving in the right direction, having fallen to sub 3% for the first time in more than 2 years. This is a tremendous improvement from the 9% peak reading seen in June 2022 (and significantly worse in various other parts of the Globe).?

Indeed, when looking at the PPI, the Producer Price Index, and thought to lead the CPI, the picture continues to be rosy with PPI actually falling outright year over year.

However, when looking at absolute values, one has to take into consideration that although it appears the PPI is deflating, much of this is to do with the base effect, as the surge from (just over) a year ago falls out of the equation, and one realizes that in reality prices remain about 20% above 2019 levels and is not actually deflating at all …….

So if inflation continues to be high (albeit cooling off), how does that affect wages? Well, despite stellar nominal wage growth, the average worker has seen the real value of his earnings evaporate, as inflation has made serious inroads into his purchasing power, as inflation has been above the growth in wages for a good number of months.?

Inflation is likely one of the major reasons why consumer sentiment has fallen off a cliff. Although the most recent consumer sentiment reading shows a marked improvement when compared against abject sentiment that has been reported over the last couple of years, there is still tremendous potential for strong improvements in the months ahead.?

How does all this feed through to Government bond yields? During what can be considered “normal” periods, the yield curve tends to be upward sloping, with longer dated Treasuries yielding more than shorter dated Treasuries. The current US yield curve remains anything but normal, and is highly inverted across all maturities with 3 month Treasuries yielding almost 50% more than 30 year Treasuries.?

In fact the 10-2 spread, the spread between yields available for a 2 year Treasury and a 10 year Treasury, currently at a negative 90 bps (up slightly from negative 110 bps last week), is significantly more negative, both in terms of depth and in terms of time than either the Global Financial crises or the 2000 Tech bubble.

A “normal” yield curve is upward sloping, whereby shorter term debt instruments have a lower yield than long term debt instruments of the same credit quality. This upward sloping shape depicts an expectation of higher interest rates in the future. This is considered normal, as the market usually expects more compensation for greater risk. Longer term bonds are exposed to more risk, such as changes in interest rates, and an increased exposure to potential defaults. Also, investing money for a longer period of time means an investor is unable to use the money in other ways, and investors are compensated accordingly.

Inverted yield curves implies that investors expect yields on longer dated bonds to trend down in the future. Essentially, they are pricing in slower growth/inflation in the years ahead, and indeed, an inverted yield curve has been associated with every recession of the past 50 years.

So with all this negativity around, one could understandably expect the market to be significantly off its highs. Yet, despite having drawn-down by 25% at its 2022 nadir, the S&P is a mere 6% off its all time highs.?

Unbelievable!

In fact, rationale investors are absolutely in their rights to be asking why should I be investing in equities at all? With the S&P 500 “boasting” an earnings yield of 4.7%, that is LOWER than the yield available on Investment Grade Bonds or indeed risk free Treasury bonds, its going to take one heck of an argument to justify continued exposure to equity markets at current levels.

Scratching a little beneath the hood, one of the claims that has been made is that the performance of the market has been heavily dominated by a small number of mega cap stocks. Currently, the top 10 holdings in the S&P 500 accounts for over 30%, which is the highest degree of concentration going back to 1980.?

In fact, the Tech sector’s percentage concentration is the highest it has been since the Tech bubble, 23 years and counting.

Indeed, it would appear that not only is the Tech sector becoming more overvalued in relation to the rest of the market, the growth is predicated upon unprecedented ongoing growth, as evidenced by the sheet value of the PEG value.

In the chart above, the Blue line is the relative P/E of Tech sector to the rest of S&P 500.

The rising trend means that Tech is becoming valued higher in relation to rest of the market.

However, the PE multiple does not take into account earnings growth. When comparing 2 companies (or sectors in this example, exclusively comparing at the PE ratios will likely provide a distorted picture, where on the surface, the company/sector may be valued more attractively by trading at a lower PE, however, when the earnings growth rate is factored into the equation, the more “expensive” company may be a more attractive option than just looking at valuation. This is the Price Earnings to Growth ratio. It is the (P/E)/EPS Growth.

Typically lower PEG ratios (Price Earnings to Growth ratio) are more desirable as it is indicative of being relatively undervalued given its growth rate.

The orange line shows how much growth IS ALREADY priced in (as the data is based upon forward estimates). So the rising blue line shows Tech is becoming more expensive to the rest of the market on a relative basis, whilst the high octane orange shows how much growth is already priced in to generate these?higher?levels. Kind of priced for perfection one could argue.

Moving on to the housing market. 30 year mortgage rates are pushing 7% once again. It was only 18 months ago that they were sub 3%! That is an almighty additional expense that those who are able to take on ?a new mortgage have to fork out.?

Theoretically, that shouldn’t bode well for house prices. But in actual fact, that doesn’t seem to have affected house prices all that much – both for new homes and existing homes:

But clearly, that is not the case. One of the reasons that home prices has remained so strong is due to the lack of supply, with the number of US homes listed for sale has dropped to a record low.?

I think what I am trying to point out, is that the world is a very confusing place. If one follows social media or the news, talk of an imminent?recession has been first and foremost on everyone’s mind, for the best part of 2 years. Its just that the timeline for imminent continues to be drawn out longer and longer. In fact, with the S&P 500 currently at 4532, it is already vastly ahead of all of the “2023 Year end” projections for all of Wall Street major banks put out at the end of 2022: ?

That’s already 25% higher than the lowest projection and 15% higher than the median projection.

Will the market continue higher? Will it head back lower? Only time will tell! There’s enough data out there for both the optimists and the pessimists. Data can be interpreted from both a glass full as well as a glass empty perspective. Inflation is still high. But well off the lows and heading lower still. The Fed has already raised Interest rates?aggressively for over a year now, and may indeed continue to raise them further. Nevertheless, at the most recent meeting, they did pause their hiking for the first time, and acknowledged the disinflationary processes in place. Recessionary signals continue to be flashing red. Though even if and when it ultimately comes, the consumer is seemingly coming in from a very strong position. Unemployment continues to be low. The unemployed continue to find jobs.

Ultimately, the market will continue to do what its best at, confounding as many people as is humanly possible! Long term investors need to remember that they are in it for the long haul. Recessions and bear markets are part and parcel of the game, and as always, portfolios should be diversified, as your source of return may well come from unexpected sources.

Dani Schijveschuurder is an investment advisor that provides advice regarding the financial vehicles mentioned in the article. The views and opinions of the writer are his own and do not represent the views or opinions of the Goldrock Partners or its affiliates.