Euphoria Has Returned
Investors,
I hope that everyone had a wonderful Thanksgiving, if you celebrated! It’s always great to be around family & enjoy great food, but I’m always disappointed to have a holiday-shortened trading week (slightly joking). I’m currently running a free 7 day trial for premium memberships to Cubic Analytics, as a way to celebrate Black Friday.
As a reminder, I am available for 1-on-1 meetings! I had four private meetings this week with subscribers and we had extremely productive sessions, ranging from my expectations for monetary policy, asset price valuations, Federal Reserve resources, technical analysis, crypto projects, inflation, and portfolio allocation strategies. If you’d like to check my availability and schedule a meeting, please use the link below:
Book a meeting with Caleb Franzen
Macroeconomics:
My macro attention was primarily focused on two aspects this week:
The S&P Global U.S. Composite PMI data.
The FOMC minutes for the November 1-2 meeting.
The PMI data was very underwhelming in terms of the results, indicating that manufacturing & service industries both contracted at a faster pace relative to the October data. The November data came in below estimates, indicating that the trend is even worse than expected:
The Composite index was 46.3 (vs estimates of 48.0 and previous results of 48.2).
The Manufacturing index was 47.6 (vs est. of 50.0 and previous results of 50.4).
The Services index came in at 46.1 (vs est. of 48.0 and previous results of 47.8).
A result below 50.0 indicates that the U.S. output and business activity is contracting, so this was a very disappointing result across the board. Within the report, there were key aspects that stood out to me, notably:
The month-over-month decline was the second-fastest decline since May 2020, “as inflation, rising borrowing costs, and economic uncertainty weighted on demand.”
The Flash U.S. PMI Composite Output Index (graph above) fell at the fastest pace since August 2022 and was “among the quickest since 2009”.
Inflationary pressures eased in November, with private sector input costs softening for the sixth consecutive month. The data indicates that inflation is still rising, but at the slowest pace since December 2020. In particular, firms noted price decreases in lumber, steel, plastic, and freight costs.
Interestingly, “firms reported a pick-up in output expectations for the coming 12 months”, indicating that businesses expect for demand conditions to improve over the coming year. It seems that business outlooks & optimism are improving.
All-in-all, this wasn’t a report of optimism. It provides further evidence that the underlying economy is weakening in terms of production, output, and business activity, not something that occurs in the midst of an economic boom. This “late-cycle” behavior, as I refer to it, is what we would expect to see at the onset of a recession or the depths of a recession. After two consecutive quarters of anemic GDP growth, where real annualized growth was negative in Q1 & Q2 2022, the U.S. economy decisively rebounded in Q3 at an annualized growth rate of +2.6%. The Federal Reserve of Atlanta is now expecting Q4 real GDP growth of +4.3% as of their latest update this past week. With the unemployment rate at 3.7% (near historic lows) and job openings at 10.7M, it’s hard to argue that we’re in a recession. While these are backward looking data points, they haven’t even deteriorated by a considerable margin to even suggest that we’re in a recession right now. Are we trending towards a recession? I believe that we are. But that’s very different from saying that we’re in one right now, or even that we’ll be in a recession in the next few months.
According to the latest report from The Conference Board’s Leading Indicators, the rapid year-over-year decline in leading indicators is foreshadowing a much steeper decline in YoY real GDP growth:
Switching to the release of the FOMC meeting minutes, investors were keen to identify any clues about the future path of monetary policy. In particular, investors wanted to hear that the Fed is going to be reducing the pace of rate hikes and that the consistent +0.75% rate hikes are likely in the past.
That’s exactly what the market heard.
Specifically, investors focused on these three sentences:
“A number of participants observed that, as monetary policy approached a stance that was sufficiently restrictive to achieve the Committee’s goals, it would become appropriate to slow the pace of increase in the target range for the federal funds rate. In addition, a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate. A slower pace in these circumstances would better allow the Committee to assess progress toward its goals of maximum employment and price stability.”
In other words, the Federal Reserve is officially contemplating a reduction in the speed & magnitude of their future rate hikes. Considering that monetary policy operates with “long and variable lags”, according to Milton Friedman and the Fed, they are hoping to observe the impact of their prior rate hikes in order to avoid over-tightening. Importantly, this doesn’t mean that the Fed is outright pausing, or pivoting for that matter. They have front-loaded their rates hikes, raising the FFR by +3.75% in eight months! By reducing the pace of tightening, they can attempt to acutely steer the economy towards simultaneously reducing inflation & maintaining smooth-functioning financial markets. In other words, they are still on a mission to engineer a soft-landing.
Even if the Fed reduces the pace of tightening, market participants must acknowledge one simple fact: the Federal Reserve is still tightening.
When I published “The Earthquake Effect” on November 12th, I wrote how monetary tightening was draining liquidity from the market & the financial system. In turn, this was exposing over-leveraged investors, bad actors, and even outright scams. This general dynamic is why I invoked the famous quote from Warren Buffett, “you don’t know who’s swimming naked until the tide goes out.” In that publication, I warned that investors shouldn’t get ahead of themselves simply because the pace of rate hikes is potentially going to decrease:
“Even if the Federal Reserve reduces the pace of their rate hikes, they are still raising rates. In turn, this will reduce liquidity, force the ‘ocean water’ to recede further, and potentially expose more naked swimmers.”
Tightening is tightening, regardless of the pace! From my perspective, the release from the minutes was a “non-event”, meaning that it doesn’t change my overall position on market dynamics, asset prices, or financial conditions.
Stock Market:
Holiday-shortened trading weeks are typically low-volume, with many investors on vacation and unwilling to commit to substantive portfolio decisions. Generally speaking, markets shrugged off any economic data that was released during the week; however, investors certainly celebrated upon hearing that the Fed was considering a reduction in the pace of rate increases. Equities launched higher on Wednesday’s session after the release of the minutes, with each of the indexes posting sizable gains.
Financial markets were closed on Thursday in observance of Thanksgiving, and Friday’s session was shortened by closing at 1pm ET instead of the typical 4pm cutoff. Despite the shorter trading week, the U.S. indexes generated strong weekly returns:
Dow Jones Industrial Average $DJX: +1.78%
S&P 500 $SPX: +1.53%
Nasdaq-100 $NDX: +0.68%
Russell 2000 $RUT: +1.06%
Since the market lows on 10/13, when each of the major indexes produced new YTD lows, the Dow Jones has been accelerating like a rocket ship. In my 9 years as a market participant, I can’t recall any rally that matches the current magnitude and pace of the uptrend, aside from the immediate recovery from the March 2020 lows. From the lows on 10/13 to the market close on 11/25, each index has returned:
Dow Jones Industrial Average $DJX: +19.8%
S&P 500 $SPX: +15.3%
Nasdaq-100 $NDX: +12.6%
Russell 2000 $RUT: +13.9%
The leadership from the Dow Jones is extremely impressive, but simultaneously worrying from my perspective. During a market-bottoming process, we typically see the riskier segments of the market (like technology, biotech, fintech, or recent IPO’s) lead the market higher. Typically, the riskier assets bottom first and rise the fastest. That’s the exact opposite of the dynamic in the market right now, where the Dow Jones is leading the way higher. As we look at market internals over the past week and month, we can see that the defensive sectors of the market are having the strongest relative performance:
After a “normal” market bottom, tech, communication, and consumer cyclical stocks outperform the rest of the market. In the current environment, each of these segments are lagging behind, while utilities, materials, real estate, financials, and industrials generate the strongest levels of relative performance. The outperformance from these defensive sectors gives me reduced confidence in the sustainability of the current rally.
As of Friday’s close, the Dow Jones has broken above the mid-August highs and generated a YTD performance of -5.8%:
From a price structure perspective, analysts will recognize this as a bullish breakout. I’m not so quick to celebrate, however, and believe that investors should exercise caution above this level. If/when the index falls below the teal range, that would be potential confirmation of a downtrend reversal and would indicate a “risk-off” signal.
Bitcoin:
Plagued by ongoing uncertainty from FTX and Digital Currency Group, two unrelated but significant concerns to the crypto ecosystem, Bitcoin has been unable to partake in any of the upside being produced by equities. Despite a historic selloff in the U.S. Dollar and declining yields, crypto is struggling to generate momentum in either direction. I continue to be fearful of more crypto-specific downside & broader risk asset downside in the market, meaning that I foresee more headwinds for Bitcoin in the short-term. As a long-term investor, my fundamental conviction in the asset is the same as it was last year.
As such, my primary focus for Bitcoin is centered around identifying downside targets & potential levels of support where I would be interested in dollar-cost averaging. In June 2022, I warned investors about my outlook that Bitcoin would fall to $13.9k, which was the monthly close from December 2017.
Why was this level so important? Because it was highest monthly close (long-term analysis) from the prior cycle peak, which also acted as resistance in 2019! As we continue to inch closer towards this level, I’m reiterating my outlook that we fall to $13.9k, but I’m now expecting a slightly adjusting my outlook based on this chart:
I’ve merely extended the potential support zone by including the monthly close from June 2019, when Bitcoin produced a local peak. This new range provides a potential purchase/support zone of $10.7k - $13.9k, based on the monthly closes from the respective highs from 2017 and 2019.
Bitcoin drawdowns have historically been -85% from peak to trough, which is roughly what happened in the 2014-2015 collapse and the 2017-2018 collapse. Considering that the peak from 2021 was $69,000, an -85% drawdown would imply a price target of $10,350. This is generally in-line with the target range above, so I genuinely wouldn’t be surprised to see price fall in this range. As I mentioned in June, my intention is to fade rallies & DCA.
Best,
Caleb Franzen
DISCLAIMER:
My investment thesis, risk appetite, and time frames are strictly my own and are significantly different than that of my readership. As such, the investments & stocks covered in this publication are not to be considered investment advice and should be regarded as information only. I encourage everyone to conduct their own due diligence, understand the risks associated with any information that is reviewed, and to recognize that my investment approach is not necessarily suitable for your specific portfolio & investing needs. Please consult a registered & licensed financial advisor for any topics related to your portfolio, exercise strong risk controls, and understand that I have no responsibility for any gains or losses incurred in your portfolio.
Great work!
As for the macro perspective: I think you’re pretty much spot on with your assessment of late-cycle behavior. With the recent performance of bonds it looks like the market is finally about to price a recession.