Summary of our views is as follows:
- The price of money is a significant driver of asset prices and economic activity. This has been the largest, fastest increase in rates ever in the US. We believe the full impacts are still unfolding.
- While inflation is clearly declining, we doubt it will return to the very low levels targeted by the Federal Reserve anytime soon. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed.
- We caution using a lens from the 2000 – 2021 period as a mechanism to evaluate investments today. A significantly higher price of money, the desire to shrink the Federal balance sheet, and a US Central Bank bias to not cut rates until inflation returns to target are all reasons why the current investing landscape may be quite different than the past.
- From 1968‐82 the equity market experienced multiple violent rallies and subsequent selloffs, and 70% of purchasing power was lost to inflation. We could see a mini period that is similar ‐> choppy markets with multiple large rallies and declines and steady erosion of purchasing power.
- The risk of a credit crunch remains. Investors are no longer willing to accept zero interest from bank deposits and have been reallocating capital into money market funds or other short duration investments. Regional banks have historically been a major provider of CRE, C&I and personal loans. Regional bank business uncertainty could result in tighter lending standards or even an unwillingness to extend credit.
- Demand for downside protection in the US equity markets remains anemic. Put option skew remains low, while market liquidity has been on a general downtrend. Don’t underestimate the potential for either a grind lower or a violent downside repricing in equity indices, followed by significantly reduced potential for a rapid recovery in prices as long as the Federal Reserve is unwilling to aggressively cut rates.
Interest rates, energy prices and the dollar continue to grind higher. Last week the Federal Reserve reiterated their stance to hold rates around current levels – no surprise. However, in their updated Summary Economic Projections, the growth and inflation outlook was revised higher, the unemployment rate expectation was revised lower, and most importantly, the expectation for the amount of rate cuts to come in 2024 and 2025 was decreased, meaning higher rates for longer. Chair Powell predicted pain in his August 2022 address, and we don’t believe the pain for businesses and consumers is over.
Private sector outlooks also indicate more pain is on the horizon. Here is a recent comment from JP Morgan:
US Q2 reporting delivered soft earnings growth and less upbeat corporate guidance, as corporates are seeing demand and prices soften with ongoing margin pressure. The consensus 2024 EPS growth rate of 12% appears too optimistic given an aging business cycle with very restrictive monetary policy, still rising cost of capital, lapping of very easy fiscal policy, eroding consumer savings and household liquidity, low unemployment rate, and increasing risk of a recession for some of the largest economies abroad (e.g., China, Germany).
Consumer savings and household liquidity continue to erode. We remain of the view that lower income cohorts are increasingly coming under pressure with fewer offsets and with little sign of relief from the high cost of capital environment.
It should be no surprise that equity markets have not been able to revisit the previous highs of Q4 2021. It appears to us that much of the equity market rally in 2023 has been from multiple expansion – and not from cheap levels. We continue to believe higher rates and a stronger dollar will weigh on corporate earnings, and that higher energy prices will keep inflation from falling back to target anytime soon.
None of this information tells us to be aggressively long equities here – particularly as there are so many attractive alternatives.
Tactically, seasonals suggest equity weakness into early October. Additionally, the monthly options expiration was 9/15, and coming out of Op Ex, positive gamma has decreased, which implies dealers theoretically have less mean reverting trades associated with delta hedging of option positions on the books. Options enthusiasts note that a positive gamma environment as one where dealers are generally adjusting their delta hedges by selling into rallies, and buying into selloffs, which is a mean reverting flow. But when gamma flips negative, as it did the week after Op Ex, dealer hedging trades tend to be the opposite – buying into rallies and selling into selloffs, which can augment moves in either direction.
We monitor gamma reports, along with multiple indicators of market health to help us determine current market conditions. While we don’t believe any of it is in any way predictive, it does help us understand if the market is in a stable, constructive environment or if it is in an unstable environment with potential fuel for a larger move lower.
Negative gamma, negative McClellan Summation indices, negative net highs, and a negative score from our proprietary market conditions model all suggest caution. This doesn’t mean that equity markets have to fall, but much like the “cone” used in hurricane warnings, the equity market is in the cone of higher risk right now.
Counteracting all of the negative market indicators are the positive seasonals and flows starting around mid‐ October. Those seasonals are also historically even stronger in years where the equity market is up through September.
We distill all of this information into the following expectation: Equities are in a window of elevated downside risk until Q4 seasonals kick in, which should keep the market positive for the year. However, once January 2024 comes, conditions have a higher potential to swing negative again.
Longer term, we continue to expect the equity markets to generally trade sideways, not break out to new highs and be volatile until there is a clear picture of if and when inflation will return to the Fed’s target. Until then, tighter financial conditions, higher rates and a shrinking Fed balance sheet most likely continue to bring pain.
Monthly Podcast Recommendation:
Meb Faber Podcast: Episode #497: Ulrike Hoffmann‐Burchardi, Tudor Investments – AI, Digital, Data & Disruptive Innovation
Lots of timeless content in this one, and a thoughtful look at what AI can and can’t be expected to do in investing.
As a reminder, our Sundial Dynamic All‐Weather Portfolios attempt to achieve positive returns regardless of the macroeconomic regime, such as positive or negative growth, or an inflationary or deflationary environment.
This is achieved through a few key principles:
- Utilize multiple asset classes and strategies, beyond traditional equity and fixed income markets
- Utilize both active (tactical) and passive (buy and hold) strategies
- Recognize that some investments are stability seeking (short volatility bias) and others are instability or dislocation seeking (long volatility bias) and it is critical that a portfolio contains both.
The desired result is a portfolio of non‐correlated revenue streams, that exhibits attractive asymmetry through tactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive in constructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: Our tactical equity strategies have pared back equity exposure over the past month and are again lightly invested. While these strategies have generally underperformed the S&P 500 in 2023, they are doing exactly what we want them to do – increase risk when market conditions are constructive and reduce risk when market conditions deteriorate. We expect them to outperform again when market conditions do revert back to a strong bull market, and since we never know when that period will begin, we let these strategies do what they do best – protect capital from large losses and capture the upside outliers when they appear.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range. These positions are mostly in ETFs and other diversified exposures. We see little reason to tinker with the positions until the macro and central bank outlook is more favorable, as discussed above.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects both our defensive stance and the attractive opportunity set. There are so many strategies that can generate a high single digit and even mid to high double digit annual returns with modest risk. We continue to utilize mostly alternative yield generating investments and our Government and corporate bond exposures are limited to short maturities where yields of around 5% are quite attractive. Over the past month, we have initiated multiple new investments. The number of commercial real estate deals arriving in our inbox has exploded higher, and while we view most of them as marginal, some of the deals look to have very attractive risk‐reward. We are always looking for “optionality and arbitrages” in our CRE deals and a few of the deals we have come across are right on the mark.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: Trend following strategies are starting to perform again, which is no surprise with the trend higher in rates, the dollar and energy. We continue to believe the uncertain macro environment continues to be constructive for “dislocation seeking” trend following strategies. Now more than ever, we embrace this uncorrelated stream of returns, particularly as they have the potential to help protect the overall portfolio if equities resume a downtrend. We were never believers in the stock and bond only portfolio, and we continue to hold the view that owning government bonds will not act as much of a portfolio hedge as long as inflation remains above target. Trend following strategies are a far better portfolio diversifier.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: We continue to maintain maximum exposure to these strategies, and when we take on a new portfolio, this is also one of the first positions we initiate. The cost of tail protection (skew) remains extremely low, the potential for a left fat tail is elevated in our opinion, and we are strong proponents of this exposure in all portfolios.
CHARTS & TABLES:
NYSE Composite Index Weekly Candle Chart
Markets Haven’t Reached Extreme Oversold Levels Based on Advance – Decline Values:
But it Is getting there in terms of % of Stocks above the 20 day and the 50 day Moving Average
The Length of the yield curve inversion has been historically correlated to length of subsequent recession. This has been a long inversion. So, it is reasonable to expect a drawn‐out recession.
US Treasury 2Y – 10Y Yield Curve Spread:
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