A Breather or a Hangover?

The new year is less than three days old, but I’ve already fielded several phone calls asking why stocks and bonds have gotten off to a rocky start.  That’s typical – I seem to be more popular when markets don’t go up than when they do.  Frankly, I don’t mind that.  It’s a bit more difficult to explain why things aren’t going as planned or hoped.  Yet the tone of the questions on down days is usually different.  When markets rally, the underlying assumption is that they’re doing what they’re supposed to do.  When markets sink, the questions typically have a “what’s wrong” tone. 

But here’s the rub: markets can, and sometimes do, go up for the wrong reasons.  They can also go down for the right reasons.  And vice versa.  The challenge is determining which.  After a months-long party, that determination becomes more critical.

When we consider the recent rally in stocks, bonds, and pretty much any risk assets, there were plenty of reasons why it was based upon the “right” reasons.  We had gotten very oversold at the end of October.  No one seemed to want to buy 10-year Treasuries with a 5% yield, and stocks were reflecting negative expectations ahead of the November 1^st FOMC meeting.  Some soothing rhetoric from Chair Powell, followed two days later by a decent jobs report, caused us to note at the time (November 3^rd):

Markets are on perpetual watch for an appearance of Goldilocks, and she might have made an appearance this morning. 

Over the coming weeks we worked off our oversold conditions, and markets found a virtuous cycle.  Bond yields fell, which provided an additional impetus to buy stocks, and then momentum did the rest.  The momentum eventually morphed into something self-fulfilling, particularly when year-end considerations came into focus.  By November 28^th we declared,
“FOMO is Back, Baby”, noting that:

While individuals are often perceived as being more susceptible to FOMO, it actually hits professionals more directly.  No portfolio manager wants to underperform his benchmark and peers, so they need to be afraid of missing out.  Momentum has a way of becoming self-fulfilling.

While acknowledging that it was quite difficult to fight strong momentum and year-end bonus considerations, we noted how some of the most optimistic expectations that rationalized the buying might be contradictory:

My concern is that stock traders have become more enamored about the prospect of cuts without fully considering the “why.”   If we do get a soft landing, why would the Fed be willing to cut as early as May?  They would need to see sustained 2% inflation.  Considering we’re not there yet, that seems premature.  And it’s also not clear that the Fed will see the need to lower real interest rates pre-emptively if the economy is chugging along modestly.  Remember, it’s the last few years that have been abnormal in that regard.  The current rate is a bit high on a historical basis, but not out of line with what prevailed prior to the Global Financial Crisis…

Finally, consider also that next year is an election year.  The Fed is historically loath to change rates ahead of an election to avoid perceptions that they are picking sides.

Yet those expectations became turbocharged after the December 13^th FOMC meeting.  The “dot plot” acknowledged the likelihood of rate cuts in 2024, thus confirming the long-awaited “Fed pivot.”  Easier monetary conditions are catnip for asset markets, but even though interest rate futures were already anticipating the median “dot plot” expectation of three rate cuts, markets promptly anticipated six.  The chairman’s enthusiasm was interpreted as an “all clear” by investors, leading us to remark that “Powell Spikes the Punch.”

Those investors were in no mood to listen to the inconvenient rhetoric from a wide range of Fed bigwigs that pushed back upon Powell’s message.  In an admittedly snarky piece, we created a 10-question quiz asking readers to match the statement that urged caution about anticipating aggressive rate cuts with the regional bank President or FOMC member who uttered them.  But the snarkiest question was saved for last:

10. Who said, “Sure, we know that the median SEP, or dot plot, projection is for 3 rate cuts in 2024. So, by all means, project 6 cuts for 2024 anyway.”?

a. Fed Chair Jerome Powell

b. New York Fed President John Williams

c. Chicago Fed President Austan Goolsbee

d. None of the above

The answer of course was “D”.  Having noted that six rate cuts are completely inconsistent with the “soft landing” anticipated by equities, I outlined my year-end thesis in a set of media comments:

“For me, the most important question that we need to resolve is who is correct: equity investors expecting a soft landing that allows for solid earnings growth, or fixed income markets that are implying something worse?

Let’s stipulate that the Fed has indeed announced a pivot, and that the battle against inflation, if not yet fully won, is close to over. Thus, if the economy is decent, two to four rate cuts seems appropriate. Why then are Fed Funds futures expecting six rate cuts? If the Fed needs to cut six times — in an election year, mind you — the reason wouldn’t be a good one. Remember also that we still have a roughly 40-50 basis points inversion between 2-and 10-year yields. Those are screaming hard landing. The fact that leading economic indicators has been below zero for over a year doesn’t help.

So, the markets have to sort this out over the next few months. If the landing is indeed a very soft one, rate expectations need to move higher, putting a headwind on valuations. If the landing is a hard one, it will be hard to justify the ~10% earnings growth that is priced in. If a Goldilocks scenario does indeed come about, then the current rally can continue unabated. If we’re either too hot or too cold, the current ‘everything rally’ will need to take a breather (or more).”

Thus, having enjoyed the spiked punch for several weeks, investors can’t be blamed if they are experiencing a bit of a hangover.  The year-end factors that drove momentum are now behind us, so it is quite fair for investments to take a bit of a breather.  After two trading days, it is far too earlier to know whether we’re experiencing a debilitating hangover or simply taking a well-deserved rest.  In the meantime, I continue to be thinking about a comment that I made on December 14^th, the day after the FOMC meeting:

The contrarian in me is nagged by the feeling that we could be so enthused that we are setting up a situation similar to that of late 2021 into early 2022, when SPX peaked on the first trading day of the new year and sank throughout.

We didn’t peak yesterday, but the overriding idea remains a concern.