{"id":193935,"date":"2023-07-25T11:00:00","date_gmt":"2023-07-25T15:00:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=193935"},"modified":"2023-07-25T11:12:23","modified_gmt":"2023-07-25T15:12:23","slug":"above-the-noise-making-sense-of-a-bizarre-market-cycle","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/macro\/above-the-noise-making-sense-of-a-bizarre-market-cycle\/","title":{"rendered":"Above the Noise: Making Sense of a Bizarre Market Cycle"},"content":{"rendered":"\n

Key takeaways<\/h2>\n\n\n\n

Recession<\/h3>\n\n\n\n

We\u2019ve been anticipating a recession for some time, but I believe the US economy is too strong to experience one this year.<\/p>\n\n\n\n

Inflation<\/h3>\n\n\n\n

Core inflation has been stubbornly high, but I expect it to fall as the impact of flattening home prices makes its way into the Consumer Price Index.<\/p>\n\n\n\n

Stocks<\/h3>\n\n\n\n

It\u2019s difficult to predict the market bottom in this bizarre cycle, but I believe US stocks hit bottom back in October 2022.<\/p>\n\n\n\n

When you do what I do for a living, you keep adages and statistics in your back pockets to bring out whenever the right situations arise. Then you repeat them in all settings and hope that you don\u2019t end up looking like the one-trick ponies who get lambasted on the \u201cAnd Now This\u201d segment of Last Week Tonight with John Oliver. My go-to statistic over the past 12 months has been this: \u201cStocks have advanced, on average, by 17% over the one-year periods following historical peaks in inflation.\u201d<\/em>1<\/a><\/sup><\/p>\n\n\n\n

Admittedly, there have been moments over the past year that have tested my faith in this rudimentary analysis. A 9% decline in the S&P 500 Index in September alone will do that to you.2<\/a><\/sup> However, the \u201chot take\u201d culture frowns upon people who don\u2019t stand by their provocative comments. Plus, I believed stocks were heading higher because, well, that\u2019s what typically happens as inflation improves.<\/p>\n\n\n\n

June 2023 marked a year since inflation peaked. The price return of the S&P 500 Index was +17.6% through the end of last month!3<\/a><\/sup> Good call. As John Oliver would say, \u201cCool.\u201d<\/p>\n\n\n\n

A \u2018keep it simple\u2019 strategy<\/h2>\n\n\n\n

We start with three simple questions.<\/p>\n\n\n\n

1. Where are we in the cycle?<\/strong><\/p>\n\n\n\n

Not all calls are prescient. The much-anticipated recession eludes us. The US economy looks too strong to enter a recession this year. I expect this cycle will end as all others do, with too much policy tightening. I just don\u2019t see it happening in 2023.<\/p>\n\n\n\n

2. What\u2019s the market telling us about the direction of the economy?<\/strong><\/p>\n\n\n\n

Risk appetite, believe it or not, has improved significantly over the past month. Stocks have been outperforming bonds.4<\/a><\/sup> Credit spreads have tightened.5<\/a><\/sup> The magnitude of this reversal in market sentiment has historically signaled an improvement in growth expectations and a subsequent improvement in economic data.6<\/a><\/sup> It\u2019s reminiscent of late 2022 into early 2023 when a rebound in cyclical markets rightly challenged the notion of imminent recession.<\/p>\n\n\n\n

3. What will be the policy response?<\/strong><\/p>\n\n\n\n

One more rate hike? Are we tired of talking about this yet? The US Federal Reserve, after letting inflation out of the bag, is committed to restoring its credibility.<\/p>\n\n\n\n

Our view is that a tactical recovery trade has emerged, favoring cyclical, smaller-cap, and value-oriented stocks. The trade is reflective of the ongoing resilience in the US economy and recent improvements across various sectors. However, it does not ignore the likely impact of policy tightening on the economy that is still forthcoming. For now, we make hay while the sun shines. How\u2019s that for another adage from the back pocket?<\/p>\n\n\n\n

How\u2019d we do?<\/h2>\n\n\n\n

Speaking of cooling inflation, let\u2019s revisit an Above the Noise concept from October 2022. Back then, our crack team of advanced mathematicians (ok, it\u2019s just me) calculated that if US inflation remained at its then 0.3% three-month run rate7<\/a><\/sup>, that the year-over-year percent change would be 3.2% by the June 2023 reading. Inflation is now at 3% on a year-over-year basis.8<\/a><\/sup> That was some near-Nobel Prize winning math.<\/p>\n\n\n\n

It may be confirmation bias, but \u2026<\/h2>\n\n\n\n

\u2026 I expect core inflation, which has been remained stubbornly elevated, to follow the Consumer Price Index (CPI) lower. Shelter is a large weighting of the core CPI (which excludes food and energy), but unfortunately, shelter costs are calculated in a manner that causes them to significantly lag current conditions.<\/p>\n\n\n\n

The Bureau of Labor Statistics (BLS) can survey tenants and update the CPI when their rents change, but that only tends to happen when leases expire. By then, the BLS is telling us what we already know. We know that US home prices have already flattened9<\/a><\/sup>, and that the apartment rental market is soft.10<\/a><\/sup> As shown in the chart below, CPI Owners\u2019 Equivalent Rent has tended to peak roughly 10 to 12 months after the peak in the S&P Case\/Shiller National Home Price Index. And the home price index peaked in April 2022.11<\/a><\/sup> I\u2019ll take the under on core CPI in the coming months.<\/p>\n\n\n\n