With the 10-year T-note yield sliding this week to 3.44 per cent, and now down nearly 100 basis points from the peak, Mr. Bond has been neither shaken nor stirred from the latest string of hawkish United States Federal Reserve rhetoric as he thinks “just bring on the recession.”
And with lower market rates and a weakening U.S. dollar tone, gold continues to perform marvellously, with the price breaching US$1,900 per ounce on Jan. 12 and on track for the fourth weekly advance in a row. The bond-bullion barbell is up six per cent for the year and 13 per cent since the end of October. Not too shabby.
In the equity market, silly season is back with prices rising sharply even as earnings and earnings estimates decline. Anyone notice how U.S. homebuilder KB Home missed both its earnings and revenue targets? The forward P/E multiple has widened to 17.3x from 16.7x at the start of the year, which is a 5.7-per-cent yield and simply not enough to justify it over the level of risk-free rates, let alone what you can garner in the corporate bond market.
A proper accounting of earnings, using an overlay from reported profits and the broad data from the National Accounts profit numbers, shows the forward P/E multiple is north of 20x, which means you can actually do just about as well in T-bills now on a yield basis than equities without even accounting for the capital and volatility risk in the latter.
We saw no fewer than eight bear-market rallies in 2022 that caused the same sort of excitement we have on our hands right now and yet the overall market was still down almost 20 per cent for the year and the cyclical sectors were down more like 30 per cent (and banks were off 24 per cent).
Such a pullback in economic-sensitive stocks amidst a Fed tightening that inverted the yield curve this much for this long has generated a recession a year later fully 100 per cent of the time in the past. Why fight those odds? And why on earth fight the Fed? Weren’t we told to not fight the Fed in the 2020-2021 doubling of the stock market by all the bulls, who somehow have turned silent on this strategy in recent months? I wonder why.
Bonds are fighting the Fed, that is for certain. The futures market does not see the funds rate going to five per cent and yet the Federal Open Market Committee is telling us we are going north of that number. Then again, the Fed told us this time last year that we would finish 2022 at 0.9 per cent and we ended up in the 4.25-4.5-per-cent range.
The swaps market is pricing in 90 per cent of a 25-basis-point hike at the next meeting, one more after that (leaving the peak at 4.9 per cent) and then 60-per-cent odds that we see at least one cut before 2023 is done.
Since we see inflation down to three per cent and the unemployment rate piercing 4.5 per cent by the summer, the trail will be blazed for the Fed to begin reducing the level of policy tightness (remember, the neutral rate is still estimated to be 2.5 per cent, so anything north of that level still represents policy restraint, even once the Fed inevitably pivots).
Meanwhile, the drop in hours worked and the surge in multiple job holders means the jobless rate is really at four per cent, not 3.5 per cent, when accounting for the shift to part-time work. This is why wage growth is starting to cool off; there is more labour market slack than meets the eye. Just as when you adjust for the skew from rental rates, there is much more disinflation in the consumer price index data than meets the eye.
We must keep in mind that interest rates naturally are cyclical … they move with the economy. Even in soft landings, the Fed historically cuts at least 75 basis points; in recessions, more like 500 basis points.
The biggest inflation dragon slayer of all time, Paul Volcker, turned out to be the greatest interest rate cutter of all time, too, slicing the funds rate 1,200 basis points in the second part of the 1981-82 double-dip recession, and he didn’t wait for inflation to fall to some holy grail of two per cent, either. And remember, Fed chair Jay Powell has compared himself to Paul Volcker this past year at every opportunity.
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Meanwhile, one concern I have in the stock market beyond the still-excessive valuations is that sentiment has become far too complacent again. Investors Intelligence showed the bull camp expanding to 41.4 per cent last week from 36.6 per cent, while the bear share dipped to 32.9 per cent from 33.8 per cent. The VIX is at a crazy low of 18.8x, which is near the low established in April 2022 — recall that within a month, we had a 17 per cent drawdown in the S&P 500. Note that every time the VIX fell below 20x last year, the stock market rolled over.
The Nasdaq short-term overbought/oversold oscillator is at a level that in the past saw the market peak and roll over as well. This happened last January, April, June and August and the ensuing weeks did not serve up a very pleasant meal.
The CNN Fear/Greed index closed has jumped to greed terrain at 57 from 42 last week as well. It is clear that this rally in the opening weeks of 2023 is not really built on active buying activity as much as the shorts covering their positions, with the basket of the most shorted S&P 500 stocks up 18.7 per cent this year versus the 3.5 per cent gain for the S&P 500.
This year’s rally is akin to a castle built on sand. More tests of the lows are likely, especially if the S&P 500 fails to decisively clear the 200-day line, where it’s hit resistance multiple times this past year. A pause or pullback at this point is highly likely and I suggest that for those investors kicking themselves for missing a two-week bounce, don’t bother chasing the market at this point. Wait to see if it pauses, pulls back or whether a new base has been formed.
If this rally is for real, there will be plenty of chances to play catch-up. If it stalls out, as it did so many times in last year’s bear market, you’ll be happy you didn’t follow the herd.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.
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