How About This for a Crazy Idea?

”I am only a psychopath on weekdays.”

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Being a contrarian pays if you know when to pick your fights.

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Key takeaway: We are approaching the point where small cap and fixed income underperformance could reverse and finally become a compelling trade on the upside. The question is timing, and whether growth matters more than inflation. Patience for now.

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Steve H. Dept: I worked with Steve H. at SAC who was known for a special moment when he was trading stocks at Drexel on October 19, 1987. On that day, when the Dow was down 250 points, he emphatically jumped on top of his desk and yelled to the rest of the trading floor that NOW was the time to get long. To put that in perspective, since the Dow Jones Industrial Average is 15x higher currently, that would be Steve H. taking a stand with the Dow down 3,750 points today. Sounds reasonable, right? Well, in dog years, the S&P closed another 3,750 points lower a few hours later.

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I mention this to make a statement. When things look ridiculously cheap, they can get cheaper.

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A whole lot cheaper.

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So, with that in mind, the trade to get long bonds and long small caps needs to have a host of conditions fall into place to make them compelling risk / return propositions. When either trade is deemed to be worthy of risking capital, the first step, as Steve H. would advise, would be to know the level below your entry price where you are wrong, and get out.

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Two major prerequisites for outperformance: 1) interest rates need to fall

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Normally, high rates due to a strong economy are good for small caps. However, the market needs to convincingly price in that the next move by the Fed will be a rate cut to get the dollar weaker and the yield curve steeper, two foundations for a small cap rally.? Currently, high rates are perceived to depress small caps, primarily because they carry more debt that needs to be refinanced than large caps:

Additionally, large caps, given their large cash balances, are outstripping Russell 2000 small cap stocks thanks to higher interest income that inflates large cap non-operating income levels.

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Last week small caps took another leg lower, and the National Federation of Independent Business (NFIB) survey for the average interest rate paid on loans did not help. The rate for short-term loan interest jumped to 9.8% in September versus 9.0% in August:

This series appears as though it is accelerating as it moves toward the upper limit of its 30-year range. The next quarterly survey for the NFIB is for October, which has more than double the number of respondents than the August and September off-months, and we will be focusing on October’s data when it is released in four weeks.

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If the Fed does need to hop back on the hiking trail, it presents obvious problems for an economy whose small business community—the driver of employment growth—is facing an already onerous interest rate expense environment.

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Yields took a small breather last week when Dallas Fed President Lorie Logan, Federal Open Market Committee (FOMC) Vice Chairman Jefferson, and Governor Waller discussed how the current tight financial conditions could be the equivalent of a rate hike. Those comments pushed markets to price in a higher probability for the “no more rate hikes” scenario. Of course, that relief made financial conditions loosen (stocks bounced, yields and the dollar fell, and corporate spreads tightened), and if they continue to loosen, FOMC voters such as Logan, Jefferson, and Waller will end up retracting their statements.

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This latest hope that financial conditions would slow the economy and cause the Fed to pause has several problems:

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First, the opening sentence of the Staff Economic Outlook section from the September 20 FOMC meeting minutes mentioned that their September economic forecast

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“Was stronger than the July projection, as consumer and business spending appeared to be more resilient to tight financial conditions than previously expected.” (my emphasis)

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Second, the Staff found that the dealer community viewed higher rates in September were a result of economic data surprising on the upside. Chairman Powell’s September 20 press conference posed the question whether economic strength could become a “threat to our ability to get back to 2% inflation” and intensified the bond selloff as upside economic surprises continued. Powell speaks at the Economic Club of NY this Thursday, and if he does not echo the view that financial conditions are tight enough so the central bank can back off hiking, then ironically, financial conditions will tighten more.

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Third, the CPI data showed core services ex-housing rising at a brisk .6% last month, which was the highest monthly inflation increase in a year. That higher inflation number will be a concern as wage-driven service inflation is developing into what the Fed fears: impervious to rate hikes so far.

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Finally, Friday’s University of Michigan Survey of Consumers showed one-year inflation expectations had a big jump to 3.8% following August’s 3.2%. (Another notable item in the report was that one-year expected business conditions plummeted almost 20%). While 3.0% long-term inflation expectations remain within that tight 2.9-3.1% range over the last two years, FOMC voters have been focusing on one-year inflation expectations despite its inherent volatility as it reacts to crude oil and gasoline prices.

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One could make a strong argument that short-term inflation expectations in the U Mich survey were above 5% in 2022, so a one-month spike to 3.8% should not present a problem for markets. However, inflation expectations are key for the Fed, due to their fear that inflation becomes embedded in the buying and saving decisions of consumers and businesses. Hence, the following chart should scare them:

The dotted line marks the percentage of those respondents saying that inflation is a major reason for their deteriorating financial situation. This recent spike returning to previous highs could mean that people do not think inflation has peaked, and we could start seeing higher inflationary expectations begin to become embedded in their psyche, much to the chagrin of the FOMC. The number is as high as it was last year when the Fed was tightening by 75 bp a meeting between June and November and adopting the language: “In support of these goals, the Committee anticipates that ongoing increases in the target range will be appropriate.”

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The problem with the Fed tightening since last year is the risk of recession, which creates a special case for IWM and fixed income long ideas. The former would be best positioned long but hedged against a short position in the S&P 500 or the NASDAQ 100 in the case of a recession. A fixed income long would be best expressed as longer duration but focused exclusively on Treasuries, not Corporates, due to the potential of a default wave. Only once the recession is underway do you rotate into High Yield and Investment Grade corporate bonds (and remove short equity hedges). High yield spreads have a strong negative correlation to small cap performance (-.75), so one needs to see a peak in spreads before going outright long in small caps during a recession.

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The second outperformance requirement for small caps particularly: economic growth bottoms

Lower inflation is good. But wages are falling at a rate that will not support strong spending, especially if employment moves lower.

First, lower inflation: While CPI has been ticking up, Median CPI (the inflation rate of the component whose expenditure weight is the 50th percentile) and the Trimmed-Mean CPI (excludes the biggest and lowest 8th percentile of price changes) have been falling. The highlighted series below is headline CPI since 2014, while the orange series is Median CPI, and the blue series is the Trimmed-Mean CPI as calculated by the Cleveland Fed:

This is welcome news, but I am more concerned about sticky inflation, and its relationship to wages, as seen below.

Second, Lower Wages: the following chart contains a 40-year history of the 3-month smoothed median hourly wage growth, which is coming off steadily.

Nominal wage growth currently stands at 5.2% and net of the 12-month sticky CPI inflation of 5.1%, real wages are barely growing at 0.1%. However, if you take the most recent sticky inflation data and annualize it, comes in at 5.5%, translating to -0.3% negative real wage growth yearly, a strong headwind to consumption growth.

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Recession…finally?

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I have written about how the typical lag of monetary policy targets a recession in Q4 2023. The path of least resistance calls for the yield curve to continue to normalize, which fits the historical pattern leading into a recession and a stock selloff. The yield curve just notched its longest inversion in history, as measured by the 3-month Treasury-Bill spread to the 10-Year Treasury Note:

If you average the 3-month Treasury Bill to 10-year Treasury Note yield spread over three months, it illustrates below that the critical time for an acceleration in unemployment occurs about now:

This recessionary outlook will be beneficial for Treasury Bonds, and the inevitability of the Fed easing short rates under that scenario underlines the value of pushing out one’s duration to go farther out on the yield curve. It does not surprise me that Blackrock Investment Institute just raised long U.S. Treasuries to neutral from underweight today.

At the risk of repeating myself, recessions carry increased default risk, therefore corporate bond yield spreads will widen out. It is prudent to wait for a better time to rotate from long treasuries to investment grade or high yield. As for small caps, you are playing a relative value game until the market arrives at a washout level assuming the recession plays out as expected.

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Concluding note on small cap valuation: Buying the Russell 2000 is the most attractive level in more than 20 years relative to the Russell 1000. The Russell 2000 is trading close to its long-term averages in terms of forward P/E (16.3 vs. 16.6) and Price to Cash Flow (17.9 vs. 17.6). However, it is trading above its long-term average on a P/E to Growth metric by 23% (1.4 vs. 1.16 average). Granted, the Russell 1000 at 2.4x is trading 70% higher than its 1.4x average, but perhaps the growth at a reasonable price crowd is waiting for P/E to Growth to move back to more attractive levels. We are monitoring that small cap P/E to Growth ratio against a falling IWM/IWB ratio (Russell 2000/Russell 1000) for potential reversal signals.

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Markets: A good lesson to watch price action and not just the news

Last week saw what many would describe as a puzzling move higher in stocks given the news flow out of the Middle East. I looked back on February 24, 2022, the date of the Ukrainian invasion by Russia, and a remarkably similar pattern took place with an initial rally. If the pattern recognition world is driving the markets, then this analog maps out a rise early in the week (the rally could even make a slight new high), then a drop that falls short of making new lows. Wouldn’t bet on it but I did find the analog tracked so closely that it was worthy of mentioning.

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Fixed Income

I normally lead with equities; however, these bond charts merit a high priority. The volume in the TLT bond ETF over the last three weeks was a record, which could coincide with a massive selling climax, the mirror image of the buying climax that occurred in March 2020 when TLT was trading at twice its current price. As mentioned earlier, another record was set with the length of time the yield curve has been inverted.

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Fixed Income, 10-year Note:

We will use the following weekly model as a first signal for a buy and hold in fixed income:

This model has been on a sell signal for five months and the timing for long fixed income needs a break below the black filter line, and a flip to a red bar (a reversal on my proprietary trend model). For this week, a buy signal trigger translates to a move below 4.50%.

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Fixed Income, 2s 10s Yield Curve

The U.S. yield curve, as defined here as the weekly spread between the 10-year and 2-year treasury notes, was introduced last week with the Ichimoku cloud. Last week, the remarks by? the three FOMC voters about how tighter financial conditions could prevent the Fed from tightening helped flatten the curve last week.

I circled the area that saw a rejection so far from the cloud, hit resistance using another filter and a proprietary momentum sell signal triggered (red X). The spread fell short of the -20 basis point breakout level. Note that in November, the breakout resistance drops to -30 basis points, and in December, a curve that is inverted by less than 40 basis points will form a breakout above the cloud, triggering a steepening trade.

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Equity Market

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Drawing lines

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There is an interesting trendline that began to form in early June. The S&P 500 index broke out above it, followed by price distribution, then a breakdown in mid-September. The relationship of price to this trendline will pressure shorts above it and will continue to pressure longs below it.

The well-known “head and shoulders” top can be seen in the chart with the green circle as the head and the black circles identifying the left and right shoulders. These formations occur as cycles of varying length roll over, and traders often position themselves based on them, not to mention quant pattern recognition models. Shorts will set trading stops between 4388-4401 in the S&P this week, so that is a region we are watching for any bullish reversal.

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?More on levels: From last week “I would take advantage of bullish action above 14,980 in the NADAQ 100 index and above 4400 in the S&P 500 to add to exposure.” The NASDAQ 100 did close the week just above the 14,980 level at 14,995, which is a bullish trigger, but was not confirmed by the S&P 500 Index which closed at 4327, below the first level of resistance at 4335 mentioned for the last two weeks. Critical confirmation will be a close above 4400 in the S&P 500.

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Seasonals and Sentiment:? The seasonal chart for all the broad indices expects a significant low to be in place right around now. The relative strength chart of the Russell outperforming the S&P 500 index says the best time for IWM outperformance begins late October:

Granted, the relative strength chart of IWM/SPY so far this year has not conformed to its average seasonality so far. However, the last two months of the year are the most favorable of the year historically.

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This rally expectation combines with sentiment hitting very attractive long-term levels:

The intersection of positive seasonals and depressed sentiment generally sets up a great backdrop, albeit within a broad timing window. This would give us more confidence that a break above 4400 in the S&P 500 would be a positive turn of events. If there is a prolonged selloff starting now, despite this favorable combination of seasonals and sentiment, then we are entering into an extremely brittle situation that calls for defensive positioning.

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Corporates vs. Stocks

From a longer-term perspective, the following chart shows why Blackstone’s earnings call mentioned that pensions and endowments are considering moving into corporate bonds and out of stocks.

Final Caveat: I would like to put a Steve H. watermark behind this chart. Trades that are perceived as a question of “when, not whether it works” can become painful before the “when” plays out. ?

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Bitcoin

A quick comment that with the rapid pop above 29,000 today, bitcoin is forming a similar pattern to what I described in equities, signifying a top on any move below 26,000. I rarely highlight the commodity, but I could think of no better way to include Caroline Ellison’s comment “I didn’t want to be dishonest, but I also didn’t want them to know the truth,” which may become my favorite finance-related quotation of all time.

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Peter Corey

PavePro Team

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