January 2024 Market Update: A Swift Rebound in Equity Markets at Year End

1. Global equity markets rallied for the second straight month in December.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. The two-month rally was swift and strong. Small cap equities led the way in the U.S. equity market.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

3. Global equities had an excellent year, led by the so-called magnificent seven U.S. mega-cap stocks. China was the big laggard.

4. From a factor perspective in the U.S. equity market, high beta stocks were the outperformers in December and for full year 2023, while low volatility stocks were the laggards.

These charts show the performance of SPY (SPDR S&P 500 Index ETF in purple), SPHB (Invesco S&P 500 High Beta ETF in green), and SPLV (Invesco S&P 500 Low Volatility ETF in red).

5. Treasury yields declined sharply over the last two months of the year, following the historically unusual bear steepening from mid-July through the end of October.

Source: www.treasury.gov, Two Centuries Investments

 6. As we repeated throughput 2023, what lies ahead for financial markets will likely be driven by the path and composition of inflation.

The concern about inflation has likely contributed to the bear steepening of the yield curve. Inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2% above pre-pandemic levels.

7. Despite the Federal Reserve raising the federal funds rate by 5% over the last twenty months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

8. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Over the last several months, United Airlines, American Airlines, and Southwest Airlines pilots were able to negotiate approximately 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years and the UAW (United Auto Workers) negotiated 25% general pay increases plus cost-of-living adjustments over the next four years for the Big 3 auto workers.

9. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy and the multi-month bear steepening of the yield curve.

At year end 2023. high yield bond spreads had settled around 1.5% below long-term averages and well below recent peaks.

10. Overnight reverse repurchase agreements continue to decline. These agreements have served as a source of financial market liquidity. We are concerned financial market volatility may rise once the amount of these agreements outstanding approaches zero.

Checking In

It’s been a while since my last blog. I wanted to check in, and review some topics that I’ve covered in the past.

So much has changed in the year and a half since I last wrote. For example, there is now an “AI” button in my blog editing window that is offering to write this blog for me.

At the same time, so many things are “same as ever”. For example, everyone continues see “a lot of uncertainty in the markets” and things continue to look foggy ahead and clear in hindsight.

Uncomfortable IS PROFITABLE

Unlike the generally agreed upon yet not very useful concept of “market uncertainty”, the much less appreciated and more useful concept that also stays the same is that markets (stocks, factors etc.) continue to move in the direction that is most uncomfortable to predict, because the comfortable direction is already priced in.

For example:

• Last year, it was uncomfortable to predict that inflation will be solved by now.

• This year, it was uncomfortable to predict that a full recession will be avoided.

In September, I had the honor of speaking on Meb Faber’s podcast, where we discuss this idea in more detail. I gave an example that predicting a market doubling is much less comfortable than market halfling. What is comfortable is already priced in and so it’s only the uncomfortable views (if correct) that make money. That’s why forecasters are famously always wrong - even when they are correct, their forecasts are already priced in.

What’s the most uncomfortable view can you have today? - that’s the one to watch out for.

Long-Run Evidence alleviates ABANDONMENT RISK

On the podcast, we also discussed my latest academic paper on long-run asset allocation where I use almost a century of data (building on top of other long-run work of the past 10 years) for many asset classes and factors. I run a horse race between the popular asset allocation approaches from 60/40 to Risk Parity, Endowment Based, Factor Based and Dynamic Asset Allocation. At this point, it’s not news to anyone paying attention that Dynamic allocation historically crushed the other approaches on drawdown protection in traditional growth recessions.

However in 2022, things were different. Both stocks and bonds suffered a drawdown during inflation driven correction, so Dynamic approach came down as hard as the other approaches, in the 20-30% range. Yet the absolute drawdown was still much better than the max drawdowns of 60/40, which ranges from 30-70%.

STRATEGY timing REDUCES RETURN

Unfortunately, most investors continue to ignore historical evidence of crashes and dry spells of their chosen approaches. That leads them to sell out of their allocations when either of these two risks shows up.

Poor timing contributes to the difference between dollar-weighted returns (the ones investors actually get to earn) and the time-weighted counterparts. Watching my own clients add and remove assets from their accounts based on recent deviations from trend return confirms this human tendency. Sticking with a negative deviation is uncomfortable and yet was the right choice when the underlying source of return is reliable. Remaining invested in reliable approaches continues to be the most prudent answer - albeit much easier said than done.

FactorS BOUNCED BUT ALPHA decayED

Speaking of staying invested, my 2020 blog on why value investors should not give up was well timed. The bounce back from the extreme drawdown gave factor investors a short-term relief. However, my other point stands that the long-term “alpha” in traditional factor investing is likely gone. Because factors were not some "reliable premia” as the academics would have us believe, but were basic anomalies that generated alpha by identifying types of companies that were uncomfortable to hold. Proliferation of quants and smart beta, made these approaches comfortable and unprofitable. As a quant, this is hard to admit (and i have dedicated a lot of time to showing that these factors were real over the long run and not results of datamining). But ironically, it is the contrast of the flat return of last two decades vs the positive return of the prior two centuries, that is the most alarming evidence of factor’s decay.

For anyone who still doubts that factors can get arbitraged away just watch how the top hedge funds manage their capacity. Most of the top funds are closed to new investors and have been closed for a long time. These funds are giving up tens (if not hundreds) of millions of fees by not accepting the easily available additional demand. Something that traditional asset managers would gladly accept. Why do they forgo these easy profits? Because additional AUM would eat into their ability to generate alpha and hence their long-term profits. So if a hedge fund choses to close at 50billion to avoid the risk of alpha decay (where alpha is made up of hundreds of signals), how can traditional factors take in a couple trillion of AUM into a small handful of factors and still maintain their alpha?

• What’s is the main antidote to alpha decay? - innovation.

• What’s the main enemy of innovation? - bureaucracy.

ALPHA IN Intangibles

Intangibles are one way to generate innovative alpha as they continue to play a large role in company dynamics. There isn’t a week that goes by, that I don’t see a headline about some company’s culture deterioration causing a crisis or CEO style impacting company culture. These are hard to value assets that are material to the future fundamentals. Just because they are hard to measure, does not mean they are not important. In fact, from the perspective of alpha, this difficulty of measurement makes them even more valuable.

I recently gave a series of talks on intangibles investing at QuantStrats NYC and London, Nuedata, and in this Interactive Brokers webinar that you can watch for free. The webinar is filled with examples of how intangibles can be measured in innovative ways, using language. In one example, I show how we can trace Steve Job’s language in the Apple’s 10Ks. It points to the creative direction in which he took the company when he returned as the CEO in 1998.

Although intangibles investing has proven to be a huge source of alpha over the past two decades, this approach did experience underperformance in 2022. The rise in long-term interest rates affected companies with longer duration assets, which intangibles by definition are.

October 2023 Market Update: The Unholy Trinity Surfaces

1. The global equity market weakness continued in September.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in grey).

2. The unholy trinity of rising oil prices, increasing U.S. interest rates, and a strengthening U.S. dollar is pressuring asset prices.

Since July 13, crude oil prices have risen approximately $12 per barrel (14% price increase), the U.S. dollar has risen approximately 7%, and the ten-year U.S. Treasury note yield has risen 83 basis points. In a world accustomed to low-cost energy, dependent on a cheap reserve currency for facilitating global trade, and addicted to low interest rates for financing, simultaneous increases in the levels of these three financial variables is a threat to global economic activity and asset prices. Stocks, bonds, and gold have responded negatively to the rise of the unholy trinity.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange), WM (iShares Russell 2000 ETF in grey), GLD (SPDR Gold Trust in yellow), TLT (iShares 20 Plus Year Treasury Bond ETF in red), CO1 (Brent crude oil futures contract in black), TBX (ProShares Short 7-10 Year Treasury ETF in light blue), and DXY (U.S. Dollar Index in green).

3. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate has dropped to about 1% above pre-pandemic levels but has risen the last two months.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains 2.5% above pre-pandemic levels. A sticky core inflation rate might compel the Federal Reserve to keep raising short term interest rates in an attempt to dampen economic demand and push inflation back towards its 2% target. More tightening of monetary policy risks a severe economic downturn.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last eighteen months, real economic growth has not collapsed, though it remains muted.

Real gross domestic product (GDP) and real gross domestic income (GDI) have diverged over the last few quarters. GDP data shows the economy humming along, while GDI data  points to an economic slowdown.

The Atlanta Federal Reserve Bank’s GDP Now estimate of 4.9% real economic growth for the third quarter 2023 lends credence to the view that GDI will rise to close the gap to GDP.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. UPS union employees negotiated wage increases near 20% over five years. Currently, the UAW (United Auto Workers) is demanding a 46% pay deal and FedEx pilots are demanding a 30% pay rise.

The unemployment rate remains nears its lows over the last four decades.

6. Credit markets remain sanguine despite the Federal Reserve’s actions to tighten monetary policy.

High yield bond spreads remain near long-term averages, and 2% below the most recent peak of 6% in July 2022.

August 2023 Market Update

1. July was the second consecutive strong month for global equity markets.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in dark grey).

U.S. small-cap stocks were the star performers for the second consecutive month.

2. While the year-to-date outperformance of U.S. large cap equities remains intact, U.S. small cap and emerging markets equities have closed the gap over the last two months.

This chart shows the performance of SPY (SPDR S&P 500 Index ETF in purple), EFA (iShares MSCI EAFE ETF in blue), EEM (iShares MSCI Emerging Markets ETF in orange) and IWM (iShares Russell 2000 ETF in dark grey).

We would not be surprised if U.S. small cap, non-US developed markets and emerging markets equities continue to outperform U.S. large cap equities. Over the last five years, U.S. large cap has outperformed both U.S. small cap and non-US developed markets by around 50% and has outperformed emerging markets by over 70%.

3. What lies ahead for financial markets will likely be driven by the path and composition of inflation.

The level of inflation has historically impacted equity valuation multiples. High inflation has led to lower multiples and thus lower investment returns. The composition of inflation will also impact earnings. The last few decades have been a period of low growth in labor costs and low energy costs, both major drivers of rising corporate profit margins.

The headline inflation rate is now only 1% above pre-pandemic levels.

The concern is the “core” inflation rate (excludes food and energy) has proven stickier and remains almost 3% above pre-pandemic levels.

4. Despite the Federal Reserve raising the federal funds rate by 5% over the last sixteen months, real economic growth has not collapsed, though it remains muted.

According to the "advance" estimate from the U.S. Bureau of Economic Analysis, real gross domestic product (GDP) even picked up from its recent trend, increasing at an annual rate of 2.4% in the second quarter of 2023.

Real gross domestic income (GDI) data for the second quarter is not yet available. The GDI data diverged from the GDP data in first quarter and pointed to an economic slowdown. These data series will converge, the question is in which direction.

5. The challenge the Federal Reserve faces is how to balance its dual mandate of maximum employment and stable (2% target) inflation.

In the current economic environment. the Federal Reserve cannot achieve its inflation target without risking a significant rise in unemployment and a recession. Because of structural supply shortages, most notably in the labor market, tighter monetary policy is less effective in reducing inflationary pressures. Tighter monetary policy operates by increasing the cost of debt capital and thus, with a lag, puts downward pressure on the demand for goods and services. The dilemma is the Federal Reserve may have to risk crushing real GDP growth (the volume of goods and services being transacted) in order to crush inflationary pressures (price of goods and services being transacted).

While the Federal Reserve Bank of Atlanta data shows wage growth across all industries continues to slow, there are many industries facing supply shortages. Recently, United Airlines and American Airlines pilots were able to negotiate 40% wage increases over the next four years. Currently, the UAW (United Auto Workers) is demanding a 46% pay increase deal and FedEx pilots are demanding a 30% pay rise.

Adding to the challenge facing the Federal Reserve is the demand for mortgage loans is contracting at a much slower pace. The rapid rise in mortgage rates in 2022 crushed mortgage loan issuance and appeared to be putting the brakes on housing construction. As housing construction remains an important driver of economic activity, any sustained strength in construction activity will contribute to inflationary pressure.

Lastly, crude oil prices have risen recently. Continued strength in oil prices will put upward pressure on headline inflation, potentially make core inflation stickier, and further complicate the Federal Reserve’s balancing act.

6. Corporate earnings growth in the second quarter 2023, while better than expected, was still the weakest growth in almost three years.

With 84% of the companies in the S&P 500 Index having reported quarterly earnings, earnings declined 5.2% and revenues declined 0.6%, year over year.

7. While most of the world is dealing with inflationary pressures and many central banks are still raising short-term interest rates, in contrast China is facing the risk of a credit crisis and deflation.

This chart shows the People’s Bank of China one-year medium term funding rate versus the U.S. Federal Reserve’s federal funds rate (overnight rate)

China’s central bank, the PBoC, once again cut its one-year medium-term lending facility (MLF) rate, to 2.50% on August 15th, as it seeks to support economic growth weighed down by a deepening property crisis and muted consumer spending.

Country Garden, a real estate developer with $194 billion in liabilities at year end 2022, missed payments of $22.5 million on two of its offshore dollar bonds. Trading in eleven of its onshore bonds was suspended. A default appears to be a foregone conclusion.

China Evergrande, once China’s largest property developer by sales, filed for Chapter 15 bankruptcy in New York on August 17. Its meltdown began in September 2021 and triggered a chain of failures across the Chinese property sector, which is estimated to represent as high as 30% of China’s GDP. We discussed Evergrande in our December update (December 2021 Market Update).

How the Chinese government navigates the real estate crisis bears monitoring for two reasons.

• The Chinese economy is a significant source of demand for commodities.

• Any large depreciation of China’s currency, the renminbi, could have a large impact on global trade and financial flows.