Summer Jitters
Financial markets have experienced quite a ride over the last six weeks. As discussed in our last Market Strategy webinar, there were two phases to the pullback. The first phase, which began on July 10th, was principally driven by buyer exhaustion of the frenzied AI stocks. The second phase was mainly driven by fears that the labor market was slowing faster than expected due to a weak payroll number. These concerns drove the Nasdaq down -13% during this period. The S&P 500 followed suit and pulled back -8.5%.
Since this correction, the market came roaring back driven by several encouraging economic datapoints. At issue is whether or not the Federal Reserve has kept monetary policy too tight for too long thereby putting the economy at risk of recession. With inflation in the rear-view mirror, the market has zeroed in on the weakening labor market. Since the Fed began increasing interest rates in March 2022 the unemployment rate has risen from 3.6% to 4.3%. As you can see in the graph below, this increase is now occurring at an accelerating rate, which is concerning. Furthermore, the Bureau of Labor Statistics recently revised the number of employed workers down -818,000. There is plenty of evidence that the labor market is weakening but so far that weakness has not been enough to cast the economy into recession.
Source: Bureau of Labor Statistics
This fear and uncertainty as to how the Fed will react is driving excessive market volatility in the short run. There is clearly a commonly held fear that the Fed may wait too long to cut rates. This concern amplifies the market impact when receiving disappointing economic datapoints. However, if the Fed begins to cut rates as is expected on September 18th, this could help dispel some of these worries. The recently released Fed Minutes of their July meeting offered some comfort. They noted:
“…several [participants] observed that the recent progress on inflation and increases in the unemployment rate had provided a plausible case for reducing the target range 25 basis points at this meeting or that they could have supported such a decision.”[1]
This statement clearly indicates that there are a few voting members that have already recognized that it is time to start easing. Remember, the Fed’s target rate has been at 5.5% for thirteen months. So, the psychological boost of this first cut should not be overlooked. It reduces the odds of a hard landing…and that is good for stocks!
That said, investors may be getting too optimistic on how many rate cuts to expect. According to the Fed Funds futures curve (see chart below), the market is now expecting the Fed to cut a full two percentage points over the next year resulting in a 3% Fed Funds rate. That equates to eight 25 bps cuts. The hope, of course, is that lower interest rates will stimulate the economy thereby propping up the labor market. But, can this occur without reigniting inflation? This is the Fed’s greatest fear and one that likely trumps their fear of recession. This question may become the next big question for market participants.
Source: Bloomberg
How to Trade this Market
As tactical investors, we do not mind volatile markets. Volatile markets, like the one we are in, are opportunity generators. The key to knowing how and when to buy dips that volatile markets create is to first determine if the pullback is technical or fundamental. A technical market pullback occurs with great frequency. Think about how many times the market pulls back 5-10%. Markets, sectors and individual stocks quite often get overbought and then need to reset lower to find another group of buyers to come in. The AI pullback during the last six weeks is a fitting example of that. Nvidia and several of its AI peers had vastly outperformed the market and reached a point where these stocks simply ran out of buyers. Micron, a memory chip manufacturer, saw its stock fall -43% in July despite no change in its prospects. Because this decline is simply technical, we bought it last week. This is how significant risk adjusted returns are often made.
Fundamental pullbacks are different. They are less frequent and often times much bigger. Fundamental pullbacks are created by concerns that the prospects for the economy, the market or even a particular company have materially worsened. Sometimes these pullbacks are warranted. For instance, the onset of the Covid Pandemic, which shut down the global economy, caused the S&P 500 to decline a massive -34%. The Global Financial Crisis cut stock prices by over half. These were crises. We are often asked how far stocks could fall if we have a normal recession. The answer, of course, is it depends but we would also note that we have not had a normal recession in over thirty years. But, as we have pointed out previously, a number of industries have experienced recessionary conditions in the past few years. Ask any trucker or Home Depot manager.
Sometimes the market gets it wrong. The weak July payroll report, which jolted markets in early August, caused investors to temporarily revisit their economic base case “soft landing” thesis. Concerns that the labor market was failing faster than expected created a chorus of worries that something fundamentally bad was occurring. We have been studying this issue for months because it is the linchpin to the market’s path forward. So far, the labor market remains relatively strong. Strong enough to prevent a recession in the short run. Nevertheless, investors are prone to overreaction and sold the market off. This head fake presented an extraordinary buying opportunity of which we were delighted to take advantage.
Market Outlook
For now, the U.S. economy continues to grow at a decent rate – about 2%. With inflation abating and interest rates poised to decline, these tailwinds will continue to support economic growth. We cannot, however, become complacent. There are cracks showing in lower income consumer spending and in various housing markets. There is also a presidential election in a few months that could yield vastly different economic policies. For instance, the Harris campaign just announced its intention to raise the long-term capital gains rate to 44.6% (up from 20%). This has potentially huge implications for the market later this year. The Trump campaign has announced its intention to increase tariffs on Chinese imports to 60%. These sorts of policies could have significant impacts if implemented. Our job is to avoid these sorts of landmines.
This does not mean that there are not great stocks to own over the next six months. However, careful consideration of which stocks to own is preeminent. Being tactical is also important in navigating this environment. One of the important aspects of this market environment is that high quality bonds are finally behaving like a hedge for portfolios. For the last few years, bonds have lost money for investors. This unusual situation has really hurt fixed income investors. As the Fed pivots towards cutting interest rates, bonds now offer portfolios protection.
Conclusion
What makes Lear quite different from most money managers is our tactical approach. Practically, being tactical means we adjust the risk in portfolios based on market conditions. We are not market timers, but we are acutely aware of changing market environments. In other words, there are times to take more or less risk.
Our first mission is to protect our clients’ irreplaceable wealth, and our tactical approach provides us with the flexibility that increases our chances of doing so. Our investment process is designed for market environments like this one. Could the economy fall into recession in the coming year? Yes. Could the economy benefit from lower inflation and interest rates and the bull market continues? Yes. Whatever the course, our clients can rest easy that we will adjust their portfolios accordingly.
Disclosures
LIM is an Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
This document may contain forward-looking statements based on LIM’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guaranties of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results.
Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-dominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass throughs), asset-backed securities and commercial mortgage-backed securities.
The S&P 500 Equal Weighted Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500 index, but each company is allocated the same fixed weight at each quarterly rebalance.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 Index total market capitalization.