February 09 2024

Reading Tea Leaves

And the rip up continues ! Large cap growth companies are now up ~8% for the year, leaving in the dust their small cap nemesis at a painful -4.3%. You may have heard that already, seek refuge in large businesses with higher profitability and strong market position, which should play as better shock absorbers in case the stuff hits the fan.

Of course, there are earnings that partly justify the market craze for bigger and stronger. As the season rolls out, S&P500 earnings still surprise on the upside. Tech and Communications earnings surprise has been below the market average, albeit at a growth rate that is nothing short of flabbergasting, at respectively 13% and 33%.

Yet, market analysts are at a loss what more to say to justify the irresistible ascent of US large cap indices, so they resort to extrapolating the past to guess the future. Bad idea.

It is probably not enough that the mantra of our industry is “past performance is not indicative of future returns”, because every single economist goes out looking at the Shiller Cape ratio, mean reversion, or past SPX returns after Fed rate cut. Everything goes to find a rationale for the straight line increase in large cap performance !

The reading usually goes, like this one from Johanna Kyrklund CIO at Schroders “Our recent analysis, looking at data from 22 rate-cutting cycles stretching back to 1929, has found that the average return for US equities has been 11% in the 12 months following the first US rate cut”. Cool. Besides the jargon, as an investor you are in no better position than taking a bet on heads or tails, knowing the coin has turned heads more often than tails in the past tosses. Spoiler alert: despite your mental bias, you still have a 50% chance of the outcome.

While we are at it, we can even read the stars to guide us on future outcomes. As we enter the lunar new year of the Dragon, I find that quite topical after all. Amusingly, the oil crisis aftermath of 1976, the end of the economic boom of 1988, the dotcom bust of 2000, and the European sovereign debt crisis of 2012 were all Dragon years of turning points. Probably a page to add to Neil Howe’s book “the Fourth Turning is Here”. Joke apart, it’s a good one on a generational approach to economic turning points, worth reading it.

To a point, it is necessary to know your past to master your future. As Mark Twain’s saying goes “history does not repeat itself but it often rhymes”. Allow me to be slightly more conservative here, and also look at what can stop this train.

For one, it seems odd that the US could continue to grow while the rest of the world is on the backfoot. It looks as if the current market spike is grandly fueled by the Fed’s proverbial rate cuts. If the rate cuts do do-happen, it would mean that a shoe fell off in the leveraged part of the small business and consumer economy. As such, it’s not gonna be a good thing.

However, as a market participant, I sarcastically concur that until the rate cut takes place, you are far better off holding pure quality, and pivot into “smaller and lower” as and when the cut is announced.

Where does something break? Domestically, serious delinquencies are rising in credit cards and auto loans, especially for younger folks. Banks are provisioned for this event, but they are similarly hit by rising defaults in Commercial Real Estate. As always, smaller regional banks are relatively more exposed and stand to hold the bucket. As a result, lending standards continue tightening. And so the cycle goes.

Internationally, it is not going so well, is it? China producer prices fell further down in Jan24, de facto exporting deflation elsewhere. Granted, production is shifting to India, Mexico, Vietnam, and we should see the picture of global trade in aggregate. Nevertheless, the production of global goods is wilting, and it shows in deflationary commodity prices.

In my view, the gap is widening, but so far we rejoice in this trade “long immaterial world VS short material world”, where services prevail over manufacturing, semiconductors over oil. US is having a go at the 3rd industrial revolution, while emerging markets choose between grabbing part of the US value chain, or setting a path of their own.

In a world where the average looks fine, but the gap widens, it is unlikely that something doesn’t break at some point. Keep your eyes peeled on the road, and don’t drive looking in the rear view mirror.

Stay safe and I wish you a great year of the Dragon !

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360 Advisory LLC is a Boston-based RIA managing investments