The Weekly Random Walk – September 11, 2023 From Stephen Colavito
An Aggregation of Various Economic, Market Research, and Data
Dragnet
Even though we celebrated a birthday last week, it doesn’t mean I am old enough to have seen all of the episodes of Dragnet. However, I remember Joe Friday, the actor Jack Webb played. Joe Friday didn’t get to be a sergeant by beating around the bush. He wanted to get to the heart of the matter, hence the famous catchphrase when interrogating female suspects: “Just the facts, ma’am.”
Because of our travel schedule, this week will be our version of Joe Friday, where we get to the heart of data and provide “Just the Facts.”
Where’s The Sell-Offs
As of last week, the market had 91 straight days since that previous 1.5% (or more) sell-off of the S&P 500. That time without a one-day equity shock is rare and has only happened five times in the last fifteen years (see chart below). The market has little equity protection (people buying puts or long volatility, other than Michael Burry), and shorts have been reluctant to step into this rally.
If the markets start to correct, equities may be a little more volatile than usual because of the lack of shorts that would cover and provide some downside protection.
As we have discussed, historically, September and October bring renewed volatility to the market after a summer lull, with VIX rising 3%+ (on average). The VIX (volatility index) is currently at 14-15 and close to the cycle lows, leading volatility control funds and risk parity funds to overweight equities (hence, there are not a lot of shorts to balance the longs right now). A pick-up in volatility might be the first sign the market may get bumpy.
What’s Driving The Markets Higher
The S&P 500 defensive stocks are down for the year, while cyclicals are slightly higher. The single most significant sector driving the S&P higher is the growth sector. The price/earnings (P/E) multiple for cyclicals remains depressed, with earnings expected to fall through the end of 2023. In contrast, the P/E for growth stocks has returned to the 2021 highs, expecting earnings to grow at 17% in 2024. Growth P/E multiples remain well below levels reached in the 2000 bubble but could compress rapidly if Q3 or Q4 earnings disappoint.
On The Margin
Something that is also helping the S&P 500 is with wage inflation finally cooling, profit margins are expected to grow by 16% in 2024. This is helping the markets rationalize the higher-than-mean P/E ratios. AI is also starting to create a noticeable difference. But the “X” factor that could have a negative (immediate impact) is fuel prices, which can squeeze margins due to higher transportation costs.
Higher P/Es have not slowed stock buybacks; in fact, they are near a 30-year high. According to Bank of America, 29% of companies are buying back shares, up from 16% just over a year ago. Not surprisingly, sizeable cash-rich tech firms are leading the way. A recent report from S&P shows that four firms (Microsoft, Google, Meta, and Apple) spent over one trillion (with a “T”) on stock buybacks over the last ten years. Nvidia joined the fun previous quarter, announcing a 25 billion dollar buyback over the next 12 months. These buybacks act as a “double whammy” as they help earnings by shrinking the float (number of shares) in the marketplace.
On The Border
Last week, when we looked at the employment data, things (on the surface) looked favorable for the Fed as they tried to increase the unemployment rate and slow wage growth. However, digging into the numbers last week, we found something interesting.
The surge in the labor force from illegal and foreign-born workers last month helped increase the unemployment rate, with the overall trend higher this year. This would coincide with the massive increase in border encounters over the previous two years (US Customs and Border Protection estimate 2,096,346 YTD through May – source www.cbp.gov).
While immigration reform and border security remain a hot potato between the two parties, the rise in the labor force due to recent immigration can not be denied, and we would argue that the unemployment numbers look better than they are. Undeniably, immigration is hurting the US workers to get a better wage because of more labor in the marketplace via immigration.
On The Bubble
Even though wage increases have slowed, the average 30-year fixed mortgage reached a cycle high of 7.58% last month, leading the Goldman Sachs housing affordability index to fall to its lowest level. As discussed last week, the supply of existing single-family homes has continued to fall as homeowners choose to keep their low locked-in mortgage rates. Most of the supply in housing is coming from new construction, but now homebuilders are slowing down due to concerns about elevated mortgage rates.
The question of the pain inflicted on the economy via the Fed is not in doubt. The question is whether it’s “Merely a flesh wound” (insert Monty Python) or an absolute beat down. Time will tell.
On The Brink
Small to midsized banks continue to struggle with the high cost of capital, but now they are seeing delinquency rates on their assets (loans) rise to 7.5% on average, the highest since 1990. Since delinquency and defaults require higher reserves, it becomes a snowball effect for small banks trying to entice capital at CD and MMDA rates north of 5.0%. These are the same banks that the Fed had to help when SVB Bank collapsed.
Meanwhile, delinquency rates at large banks are 2.9%, well below that of smaller banks but up from 1.5%. Large banks like JPM and Wells are capturing capital at rates at or around 1%, so they have a very low cost of capital and are generally not under pressure.
We will add one more curve ball to this data; all this happens while unemployment (U3) is at historic lows. If one prophesies over the next 12-24 months, the Fed has made it clear it wants unemployment at around 4.5% to tame inflation. What happens to delinquency rates then?
Seriously, Just The Facts
Over Labor Day, the President boasted that his administration was cutting the federal budget deficit. Someone on his staff may want to inform his speech writers that the CBO has recently changed their projections and now believes the deficit will hit two trillion in 2023, double what it was in 2022. We didn’t get a PhD in mathematics, but if you double something, we don’t think that is the definition of reduction.
That brings us to Part II of “Shutdown Theatre,” starring the boneheads in DC. Our elected officials once again are setting the stage for a chaotic September as the next potential shutdown looms in roughly three weeks. Unlike earlier in the year, this negotiation may be more difficult as House Republicans are calling out their own Speaker over a 40 billion dollar supplemental spending request, which includes an additional 24 billion dollars for Ukraine (where’s Hawaii’s money?).
Since the war began, the US has spent more than 113 billion in aid (note: Russia’s defense budget is about 75 billion per year) and wants to give more. With various domestic issues, we think this could be a real political hot potato issue for candidates come November 2024.
We keep beating the (oil) drum on oil prices; this week is no different. I spoke with several folks on Capitol Hill this week, and there is growing concern as Saudi Arabia (and then moments later Russia) surprised markets by extending (and increasing) their production cuts through the end of the year. This came as a “shock” to members on the hill (but not to us) as OPEC+ wants higher prices going into the winter, as some estimate 100+ dollars per barrel.
The biggest issue with oil is twofold: 1) There seems to be a global caucus of both oil-producing and non-oil-producing states that want to put pressure on the US as we continue to employ our alternative energy strategy and turn our backs on a fossil fuel energy policy and 2) If the US goes the way of Europe for oil and natural gas dependency, it will be much harder for the Fed (or Treasury) to control inflation. We are not transporting groceries via Teslas anytime soon, and we are not sure why folks in DC are so “shocked” and don’t seem to understand this.
No change in what we believe is a trading range for the S&P 500. The 4600 mark seems to be the resistance level, while 4400 is the initial support. We believe that September and October will be very choppy for markets as more and more data is conflicted, and the direction of rates in November continues to be difficult to predict. We continue to urge caution in this market and would dollar cost average with any new investments.
Have a great week.
Stephen Colavito
Chief Investment Officer
San Blas Securities
stephen.colavito@sanblas-advisory.com
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