Navigating Market Dynamics: Insights on Current Trends and Future Projections

Gene Goldman and Jose Torres delve into the intriguing dynamics of the current market landscape. Despite expectations of a potentially sluggish start to the year, the market has shown remarkable resilience. The conversation unfolds as they analyze factors driving this surge, including shifts in valuation, Federal Reserve policy, and the impact of emerging technologies like artificial intelligence (AI).

Summary – IBKR Podcasts Ep. 144

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jose Torres

Hello everyone. Welcome to the IBKR podcast by Interactive Brokers. I’m Jose Torres, your senior economist. Today, I’m joined by Gene Goldman, the Chief Investment officer at Cetera Financial Group. Hi, Gene. How are you doing today?

Gene Goldman

Hey, Jose, great, how are you?

Jose Torres

Doing great! Looking forward to your outlook on markets, rates, the Fed, everything. Starting with that first question. Stocks had a tremendous run last year and so far, this year, despite rising yields. Some folks thought that after such a gangbusters year last year, maybe this year would start off a little sluggish. Maybe even a little bearish, but it’s been spectacular. Can it continue?

Gene Goldman

That’s a great question, and again thank you for having me on your podcast. One thing that changed, I think changed the environment was October 27th of last year. On October 27th of last year, we had the low point of the correction in the stock market. From that point forward, valuations were much better. Then you combine the fact with the fact that the Fed alluded to the fact that they would be cutting rates in 2024. You take those two together and you’ve seen the stock market rally about 25% since October 27th of last year. It’s been up about 16% over the last 19 weeks. It’s a huge run! With that said, though, valuations are now a little frothy. If you look at the PE ratio on the S&P 500 on forward earnings, it’s about 20.6. You can justify a high valuation with low interest rates and low inflation. But we really don’t have either of those right now. So, the markets are pricing in absolute perfection. Long story short to your question. Is that we do think that likely there will be a pullback in the market, maybe a correction, but the good news is that we do feel that if markets come back, if markets pull back, if there is a correction, it’s going to provide some great buying opportunities. Market breadth has been widening dramatically. Our base case for 2024 is no recession. The Fed, despite some comments from some of our peers out there, we think the Fed will still cut rates, earnings recession is over. Then I think cash on the sideline, there is a lot of cash on the sideline ready to come in. So Long story short, our target coming into 2024 was 5100 on the S&P 500. We breached that already. I do think stocks are ready for a little bit of a pullback, but most importantly it will be short-lived and create buying opportunities.

Jose Torres

Great! One thing that comes to mind there is you have that forward PE up close to 21%, you have rates really high and when you combine those two, you have a really low risk premium. The compensation to invest in risk markets today isn’t as generous as it’s been historically. In fact, it’s probably one of the worst risk premiums we’ve had in history. Sometimes I wonder if increasing retail participation Zero-day data expiry options, more global adoption to markets can support a structurally higher Price to Earnings multiple.

Gene Goldman

Yeah, I think your point is really great. I think the big wild card is earnings and I think that if you look at the fourth quarter, we saw earnings come in around, let’s say, 4.5%, well above expectations. Earnings did well in a deflationary environment. I think the key thing is that we think the earnings recession is over. So, for 2024, earnings are expected to come in at around 11% for the S&P 500. That’s pretty attractive. So, despite the fact that yields are high, I do think that stocks still have an opportunity. We are firmly in the in the camp that the Fed will be cutting rates. One of our big themes for 2024 is the Fed goes from being a foe to a friend. They raised rates last year. We think with inflation rolling over pretty quickly, rates will fall, and the Fed will be forced to cut rates. Which I think will be a boost to equities. I just think the near-term uncertainty and high valuations are going to create a lot of volatility for the markets.

Jose Torres

Another interesting thing is a lot of the market generals have really started to deteriorate when you look at companies like Apple, Tesla, Google, have been replaced by NVIDIA and a lot of the semiconductor names, what do you think about that kind of shift? We think that the laggards catch up or the leaders keep running.

Gene Goldman

Yeah, I think broadly speaking and it’s hard for me to talk about individual stocks just because we have our friends in compliance that are watching everything. So, for me, the big trend that we pointed out late last year was that the market breadth would really widen. If you looked at last year, everyone knows the Magnificent 7 and narrowness in this in the market, the high valuations of those stocks almost immediately though. With the Fed’s seemingly playing to cut rates, you see market breadth widen. You see small caps starting to do a little bit better, although lately it’s been a little bit choppy, mid-caps and then value. One thing I found was interesting was that since the October 27th correction low and I love going back to that point because prior to that point, we were pretty cautious in the markets. The valuation reset and the Fed pivot allowed us to add beta to our portfolios. I think the key point is that since the October 27th low until just recently the number one performing sector is technology, which makes sense. Everyone’s buying the AI related companies, but the number two performing sector is financials, surprisingly. If you look at the top five sectors performing since October 27th of the five three are value oriented overall. The key point is that the market breadth is widening. I think that’s a healthy sign for the market. Again, shifting markets are definitely a good sign going forward.

Jose Torres

Focusing a little more on the Fed and inflation and against the backdrop of a marketplace that’s pricing in around 3 cuts. When the year started, we were pricing in around six to seven January CPI was hot, February CPI was hot. We have Powell next week and the release of the dots. Do you think that maybe we only cut once or twice if inflation continues to settle in above 3% on CPI.

Gene Goldman

That’s a lot of questions in one question. Let’s start at the beginning of the year. At the beginning of the year, the Fed said three rate cuts in their dot plot, which makes sense. The markets are priced in six or seven. And we’ve always said six or seven doesn’t make sense. The economy is still too resilient. You have other people on the side of the. As you said market generals have said maybe one or two cuts. We think that’s still too low because the feds base case coming into 2024 was three rate cuts, and no recession.  The Fed is seeing that inflation is rolling over and we’ll talk about those choppy January and February reports. Overall, if you look at core PCE, as we all say, the Feds preferred measure of inflation. The Fed said in the December dot plot that it would be at 2.4% at year end. We already see core PCE very close to that already, so the inflation is already well ahead of the Fed schedule. Yes, there’s some choppiness and you can use the old phrase. The last mile is difficult, but whatever you want to call it. At the end of the day, inflation is rolling over quickly. I know the Fed has been cautious a little bit lately in some of their comments.

You look at the Fed, the newest Fed speaker, the newest Fed voters, so you have Barkin, Bostic, and Mester. If you look at their comments, they’ve all been very cautious in their phrasing and their phrasing. So, the Fed’s pretty cautious. I think the Fed’s cautious for two reasons. #1 is that services inflation is still pretty high. If you look at PCE and you parse it out between goods and services year over year, goods inflation is -50 basis points. So, it’s in deflation. However, services inflation is around that 3.9% level year over year, which is pretty, frothy right now. The way you reduce services inflation is you put pressure on the labor market. The Fed is cautious because of high service inflation. The other reason is that the Fed is really concerned about a bounce back in inflation. Like in the 1970s scenario where under Paul Volcker the inflation came up the Fed aggressively raised rates, inflation rolled over, they cut rates and then it came back quickly again. The Fed does not want to see this twin peak. I think adding fuel to the fire is what you were alluding to before those January inflation reports were surprising. You saw CPI come in at 3.1% and the market expected 2.9%, then PPI above expectations. Our take on those, those reports for January. We think those were aberrations, and like I said, the case is that if you look at CPI, most of the surprise was an owner’s equivalent rent. If you look at something, we tweeted recently. Take owners’ equivalent rent and rent a primary residence. These two are highly correlated every month. Then in January, owners’ equivalent rent just surged. We think it was an aberration or a bad data point. Then you pivot over the PPI. PPI came in above expectations due to 1 component, hospital outpatient care. That’s a seasonal effect every January it rises dramatically. We do think at the end of the day, inflation is continuing to roll over, but more importantly those January effects were much more aberrations. We did see some of this reverse a bit in February, but its overall inflation has still come in a little bit above expectation. Long story short, we. Remain on the point that the Fed will be cutting rates this year. We think that the economy, though it’s resilient, if you look at the lower income cohorts, they’re really struggling. Today you saw a major retailer that focuses on Dollars. They came out and they said that they are seeing low-income shoppers struggling dramatically. You also see with consumers $1.4 trillion of credit card debt that’s at record levels. You see interest rates for credit card debt at like 22% or 23%, even 24%. That’s kind of a pressure on the consumer. Long story short, inflation is rolling over. The economy is showing some signs of slowing down, but so take all this together. We do believe the Fed cuts rates three times as they said they would. I think the report that came out yesterday for CPI suggests that June is probably the first time they cut rates.

Jose Torres

Interesting points on the consumer, corporate earnings estimates remain buoyant, but as you point out, there’s, some headwinds with the consumer. How do you reconcile, corporate earnings increasing? Is it going to be more of a revenue growth story or more of a margin expansion? For the last 15 months or so, we’ve seen a pickup in layoffs across corporate America, albeit it hasn’t really made it to the official government data in arrogate. But we’ve been hearing a lot about these anecdotal layoffs.

Gene Goldman

Yeah, that’s a great point. Is it going to be earnings related, margin related, or even revenue related? I think earnings are going to be driven by the combination of all three. Our base case is that the economy is not going to have a recession in 2024. But let’s say I’m wrong and let’s say that we have a recession. We think at worst case scenario it’s going to be a mild recession because we would envision a so-called sector recession. Where sectors of the economy that are in recession today are going to start to stabilize in other areas in the economy and not struggling, like the consumer, are going to start to weaken a bit. So, if you look at what’s struggling today. Housing, autos, manufacturing. These areas are starting to recover a bit. You look at building permits are up 33% year over year. That’s a sign, the housing market is starting to come back a bit. If you look at manufacturing, we’ve been in recession for what, 15 straight months, but new orders for manufacturing are picking up pretty quickly. So, we do think areas in the economy that are struggling are starting to do a little bit better. On the other hand, the consumer will be impacted by, as you said, all these major headwinds. If there is a recession, it will be a very mild recession. I think that because the economy is more resilient than people anticipate given this whole sector type recession, we do expect that earnings will be a little bit better than expected. We do think revenues will be a little bit better than expected. I know that last quarter it was a good overall quarter from an earnings growth standpoint, but it was really driven from revenues. I thought it was interesting, revenues rose quarter over quarter despite the fact that we were in a disinflationary environment. That’s really good news. So, we expect inflation to roll over a bit.

Companies are doing a good job because they’re actually driving growth by increasing profit margins. One thing that you can look at is a simple way of looking at profit margins where they’re headed, or a data point is you compare CPI relative to PPI. If you use CPI as a proxy for business sales and PPI as a proxy for business costs. PPI has fallen at a much faster clip. That’s very profit margin positive. Long story short, I think revenues are going to be okay. They will slow down a bit given the inflation is running over, but proper margins, while they did take a backseat last year, they should bounce back, especially as PPI continues to fall faster than CPI.

Jose Torres

To deliver earnings growth in the medium to long term, a huge focus for this market of course has been artificial intelligence. Some folks think that it’s revolutionary. Others think that it’s a lot of hype, how the EV rally went on in 2021 and how the in .com we had some, some things that we thought would be revolutionary that weren’t. What is your view on artificial intelligence?

Gene Goldman

I think AI is going to be like electricity back in the late 18th century, early 19th century. It’s just going to be big. We just don’t know how big it will be. I mean, in theory, we’ve been using AI for a long time. I mean, we’ve been using AI in terms of with computers with systems, but lately we’ve been able to transition AI into some more products and more services. I think the fundamentals for AI are pretty strong. My wife, for example, is a is a nurse. She’s studying to be a nurse and I know that when she graduates with her degree in nursing, she’s going to be able to go and get data quickly from AI and look at that and then be able to review a patient’s information. Just think about as a lawyer today and being a lawyer in the old days, you have to go through all those books. You can watch old Law and Order episodes where they go through all those big books and go through all the documents and so on.

Today they can just run a couple of buttons and they can get all this information or even portfolio managers today. They can go in and scrape data quickly. I think AI is going to be huge. The fundamentals are very, very strong. I think I saw a study from McKinsey that said that by the end of 2030 AI should add about $1.7 to $4 trillion of annual global productivity. That’s like the size of the UK economy, it’s huge. I think the fundamentals are strong. What does worry us are valuations. Valuations have been pricing in near absolute perfection as we learn from the .com bubble, which I lived through. Not everything is going to survive. There will be some random companies that are in AI that won’t survive. So, I think what it points to you and your listeners is. AI fundamentally strong, but it’s going to be very much of a stock pickers environment. There’s only a certain number of big companies that are going to do well. Not every company will do well.

Jose Torres

Moving on to the banking sector and the lending environment, spreads have been really well behaved, which is so tough to imagine given the really tight monetary policy. The banking sector, though, is under some significant direst, particularly regional. Are you concerned about commercial real estate and the lending environment?

Gene Goldman

Let’s take a step back. I think banks are struggling a lot and that’s why valuations are down. So, if you look at a bank, the one big thing overhanging them is the inverted yield curve. Let’s just simply say we take the 2 and 10 year. In theory as we all know the two years should be below the 10 year for the long term because the 10 year you’re locking money in for an additional 8 years. The yield should be less on the 2 relative to the 10. What we’re seeing, the 2 above the 10 at one point it was up 130 basis points, the 2 above the 10. Right now, the 2 above the 10 is about 40 basis points. So why is this important? You think about us as savers, putting money into our bank accounts. Let’s just say we do that. Banks are borrowing money at a bit higher rate from us, whether yields or whatever, just to borrow money. Then they’re also lending money at a lower rate. So, in theory, if short term rates are above long-term rates, this basically suggests that every transaction a bank make on a mortgage, on a car loan, they’re actually losing money. I know I’m exaggerating a lot of different assumptions I put in there. However, in theory think about that. Short term yields are above long-term yields, it makes it less profitable for a bank going forward.

With that said, one of our favorite sectors is financials. We do believe that, loan loss reserves for banks were a little bit too aggressive, too bearish. Basically, we think the economy is going to be fine. So that’s going to help financials also, you’re seeing the M&A activity open up, you’re seeing capital markets open up, you’re seeing IPO’s and so on. So, to your question though, for the commercial real estate sector, the area that worries us are those small regional banks and you’re seeing them pop up here and there. Because they don’t have the infrastructure, they don’t have the ability to grab as much capital as the larger banks. I think commercial real estate, we put a blanket, statement in all commercial real estate doesn’t look great, but it’s just the office space. Warehousing looks phenomenal; other parts of commercial real estate are okay. I saw something from the FDIC in their quarterly report recently and said that only about 103 basis points, so about 1% of gross U.S. bank loans in the real estate category is not paying on time. Just 1.03% and I think that’s pretty close to the long-term average. Yes, it’s going to weaken a bit and we understand this. The good news the Fed is aware of this and part of the reason why we think the Fed will cut rates sometime this summer because, yes, the economy is resilient, but there’s also things that could break that the Fed is worried about and the Fed got a little bit of a taste of this in March of last year with the failures of those banks.

Jose Torres

Interesting. One thing about the regionals, too. Gene is that their cost of funds is much higher. When you mentioned the 2 and 10 year, the big banks are a lot of times they’re in a position where they actually don’t even really want deposits. They pay really low, zero to 0.5%. However, the regionals because they don’t have the technology, the marketing spend, television, and radio notoriety, they have to pay 2%, 3%, 4% and then sometimes they in order to compensate for those, those higher cost of funds, they end up in the riskiest segments of lending where large banks actually don’t want to be.

Gene Goldman

Exactly. You don’t see regional banks doing commercials during the Super Bowl, so they don’t do that.

Jose Torres

Yeah. I think overall I think you’d agree that it just points to just more consolidation in the sector. I worked at the FDIC for about 3 years and that’s just a trend that we continuously watch was just the bigger banks getting bigger and the smaller banks consolidating and getting acquired and merged and all that kind of stuff.

Gene Goldman

Yeah, and that’s a great point. So, as part of my team, we also have a recommended list of mutual funds and money managers. We’ve talked to a lot of small cap value managers and small cap value managers usually diving into regional banks. I’ll ask. Well, why are you? Why do you even have any positions and a lot of them are still buying them because they have to own them to be closer to the benchmark? So, I do worry about regional banks. The only counter argument you can look at is that we’ve seen a lot of insiders buying of executives at regional banks buying in. If you think that executives are a leading indicator, that suggests that maybe the worst could be over for regional banks. But again, Jose, as you and I are talking about, there’s so much information out there. There are so many ways that this could pivot, and I think this is what the Fed discusses behind the scenes. They know that this is a concern, especially the office space of commercial real estate and they are worried about what could take place if they keep rates higher for longer.

Jose Torres

You mentioned small cap value, I was wondering how you’re envisioning equities overall? Any particular categories that you see more favorable than others in terms of large cap, mid, small, or sectors value growth, tilts that you think are the most appealing?

Gene Goldman

If you take a step back, if you think what our broad perspective is, our broad perspective is, long term we’re optimistic on the markets. Near term given what we talked about with valuations with increasing risks that we do think could pull back a correction is likely. And with this in mind. We are positioning our portfolio a little bit more cautious right now than we traditionally would be. So, what that means is that we have liquid alternatives. So those are those investments that zig when the rest of the markets are zagging. We’re also much more diversified than we usually are. With that said, if you look at how we’re positioned today, we’re overweight value versus. Growth, I think a lot of people look at the look at the economy right now. They say, “well, the economy is growing. So, you buy growth.” Well, that’s actually the opposite. When the economy starts to slow down, you want to buy growth because usually investors are searching for earnings growth. So, they buy growth in the slowing economy. We like value so value you get exposure to the materials, industrials, healthcare. Great sectors we think will do well. I think also with value by overweighting value you may get some of the risk that the benchmarks are overweight growth right now and then we do this analysis where we look at our portfolios. Where significantly overweight value. But then if you run a cross analysis of your holdings based, we’re overweight growth. I know I’m getting to the weeds, and I apologize, but we try to mitigate some of that exposure. We also like small caps. I think small caps are super cheap right now. Lots of concerns about the economy for small caps, but again, the economy in our opinion, is better than expected.

However, valuations are extremely cheap. If you look at earnings for 2025, small cap earnings should exceed large cap earnings and eventually the market will price these events in, six to nine months in advance. Then the area we’re underweight is we’re underweight international today, but we’re starting to look at those potential areas, especially if the dollar weakens. Europe is a little attractive, and I know that the valuations are high right now in Europe. Again, they were cheaper, they’ve gotten better despite having a recession in Germany, but you’re starting to see a little bit of a pickup in some of the data. Especially in Europe, especially in Germany and then Japan, we like Japan a lot and from a non-us standpoint. So, with Japan, you’ve got inflation coming back haven’t seen this in like, decades. You also see less crossholdings ownership, and you see, decreased regulations. All this together suggests that Asia and non-us should do well. Right now, we’re still underweight until we get a little bit more clarity in terms of what the Fed is doing and this will help us in terms of the dollar weakening, which should drive international investing.

Jose Torres

Final question. One thing that the Bears have been talking about The Bank of Japan, the BOJ going against negative rates and shifting them back into positive territory. Perhaps next week, as you mentioned, the Nikkei, the Japanese benchmark is a pretty much a hit like a double top just exceeded its 30-year high or something like that. If Japan goes into positive territory, what impacts do you think that will have overall? Specifically, if you can shed a little bit of light on China and emerging markets, which have really suffered at the expense of developed markets. Rallying sharply.

Gene Goldman

We’re underweighting non-us, but we are finding opportunity. We’re just looking for a better entry point, I guess. I think the trigger will be the weaker dollar. Overall Japan is benefiting from Friend-Shoring and they’re also benefiting from some structural changes to their economy. In terms of workers, in terms of infrastructure. Japan is still a very attractive area, especially as you see companies moving to Japan to avoid China. I think Japan has opportunities now if you look at China, I think China, is a concern to us. I think at one point China was what like 40% of the emerging market index and today it’s at 26%. I think China the problem is that you’ve got that speculative property bubble. You have aging demographics with their old one child policy from 1980 to 2015, all this taken together just creates a lot of risks in China although they won’t admit it, they were probably in the recession. The good news is that you’re starting to see some Chinese data starting to improve a bit. Like you saw, inflation turned positive in China just recently. I think just last month. That’s good news because, they’ve been in such a deflationary environment, having a slight uptick in inflation is good, suggesting there’s a greater demand. I think in February, I think Chinese exports rose sharply. So, the Chinese economy is out of favor but it’s starting to come back. If you take a look at emerging markets overall, It’s not just China anymore. One thing I always point to is Mexico. Mexico right now, if you look at Mexican exports to the United States and Chinese exports to the United States, we are now importing more from Mexico than we are from China for the first time in two decades. It’s not just China as the emerging market, it’s other parts of the economy for emerging markets. Emerging markets are pretty attractive, but we’re watching carefully because again, things are starting to everything is changing so much and so quickly.

Jose Torres

Was great. Ladies and gentlemen, thank you so much for listening and thank you to our guest, gene Goldman, Chief Investment Officer at Cetera Financial Group. It was a great talk. Thanks so much for being here, Gene.

Gene Goldman

Thanks, Jose. Thank you for having me on your show. I really appreciate this.

Jose Torres

Thank you everyone for joining this great conversation. Don’t forget to rate us and subscribe and I look forward to next time. Thank you.