The FOMC will increase the Funds rate at their July 26 meeting by 0.25% to 5.25% - 5.50%. Chair Powell will do his best to convey that every meeting will be a ‘live’ meeting and that the FOMC hasn’t adopted an every other meeting increase format. He will emphasize that the FOMC remains data dependent which means it’s appropriate for each meeting to include the potential for another rate increase. He will note that the FOMC projected GDP growth of 1.0% for 2023, but in the first half of 2023 growth is more than double their target. In the first quarter GDP was up 2.0% and the Atlanta Fed’s most recent forecast is for growth of 2.4% in the second quarter. The resilience of the economy will convince some members of the FOMC that additional rate hikes are warranted since the economy can handle them. For many FOMC members the only way they will have the confidence that inflation will come down and then stay down is if economic growth slows to 1.0% or less for a long time.
Chair Powell will acknowledge that inflation has come down but say it will take a long time to get inflation down to the FOMC’s 2.0% target. He will also refer to the FOMC’s favored inflation metric – the Personal Consumption Expenditures Index – and note that it is still way above the inflation target. In the last year the Core PCE has only dipped from 4.7% to 4.6% in May. The June figure will be released on July 28 and no doubt record another decline. Wall Street will cheer that as great news (it is a positive), but from the FOMC’s perspective the sluggish decline in the Core PCE doesn’t provide the confidence most FOMC members need to truly hit the Pause button.
In his statement after the June 14 FOMC meeting, Powell described the labor market as being ‘very tight’ and that ‘labor demand substantially exceeds the supply of available workers.’ In my opinion this is Powell’s continuing attempt to shift the emphasis of monetary policy from getting inflation down as the top priority to easing labor market tightness as the key in getting inflation down to 2.0% in the long term. This began with his Brooking speech on November 30, 2022. Despite the increase of 5.0% in the Funds rate the Unemployment Rate is 3.6% and hovering near a 53 year low. Until the Unemployment Rate begins to move higher the FOMC’s bias will be tilted toward additional increases in the Funds rate and keeping the Funds rate at the Terminal Rate for a long time. Wall Street has ignored Powell’s emphasis on the labor market and has instead focused on the decline in CPI inflation as being far more important. As monetary policy remains hawkish despite the better inflation news, Wall Street may face an unpleasant wake up call. I will be surprised if Chair Powell doesn’t sharpen the focus on the labor market during his Jackson Hole speech on August 26.
With the economy still growing nicely and inflation falling Wall Street is convinced a soft landing is the most likely outcome. This view has justified the increase in valuations even though earnings have been falling. The Relative strength of the S&P 500 to Treasury bonds has just reached an extreme last achieved in November 2021 (red line). As you may remember the Nasdaq 100 (QQQ) and the Russell 2000 peaked in November 2021 while the S&P 500 topped on January 4, 2022. The S&P 500 also reached intermediate highs in 2022 when this Relative Strength measure hit the upper horizontal line in March and August, and in February 2023.
The National Association of Active Investment Managers (NAAIM) publishes an Exposure Index based on manager’s responses. The blue line is a 2 week average and shows the level of Exposure their managers have compared to the S&P 500. On November 3, 2021 the Exposure Index reached 108.0% since some managers incorporate leverage in their portfolios. When the S&P 500 was approaching its mid October low the Exposure Index was 12.6% in late September and 19.8% on October 12. Last week the Exposure Index rose to 99.0% and the highest level since November 2021.
Financial Conditions are based on changes in the prices for stocks, Treasury bonds, the Dollar, and credit spreads between Treasury and corporate yields. The easing in Financial Conditions since October has increased consumer’s wealth as stock and bonds prices recovered, helped the competitiveness of US international corporations with the Dollar down by 13%, and made it less expensive for companies to refinance lower quality debt. This is making the FOMC’s job tougher, and provides another reason why tighter policy may be warranted.
The Federal Funds rate futures are pricing in a 17% probability that the FOMC will increase the Funds rate at the September 20 meeting and a 31% chance at the November 1 meeting (If no increase in September). We’ll be able to judge Chair Powell success at convincing Wall Street that additional hikes are possible if those percentages increase after his press conference.
As the chart of the NAAIM positioning illustrates sentiment and positioning has changed significantly since last October. This change reflects professional investors believing that a recession will be avoided and increasing their exposure to benefit. What is known is that the stock market has rallied as those who were concerned about a recession in 2022, or after the regional bank dust up in March, have moved money back into the stock market. In other words the S&P 500 has already benefited from last year’s mistake when a recession was ‘top of mind.’ Additional gains may be possible in the short term as long as the economy reinforces the no-recession narrative. Currently, any sign that the economy is slowing is overlooked, but that’s going to change as more data comes in. On July 24 the S&P Global Flash US Composite Output Index for July fell to 52.0 from 53.2 in June and the Services Business Index dropped to 52.4 from 54.4. The expectation has been that the economy will show more signs of slowing in Q3 and this report is supportive of the outlook.
Sometimes markets display a measure of equilibrium that is fascinating by trending up and down for the same amount of time. From its high on January 2, 2022 the S&P 500 fell for 283 calendar days until bottoming on October 14, 2022. If the S&P 500 rallied for the same amount of time it would top on July 24.
As discussed last week the rally in the S&P 500 since the low in October may be the middle part of a much larger bear market. “The risk for investors is that the decline from 4818 to 3492 is Wave A (blue) of a large bear market. The rally from the October low would be Wave B (blue). The price targets suggest a potential stopping point for Wave B is 4500- 4550.” This week there is a lot of news that could enable the S&P 500 to briefly trade above 4600 or not. The FOMC, ECB, and Bank of Japan will make rate announcements and the largest number of big name companies will report earnings this week. Irrespective of this week’s price gyrations, there are two reasons why the S&P 500 is at or approaching an inflection point.
If I thought the economy was likely to strengthen in the second half of 2023, I would pay less attention to the Wave B interpretation in the S&P 500. The opposite is true as the economy buckles before the end of 2023 under the weight of higher interest rates and tightened lending standards. The second reason is monetary policy. The FOMC won’t lower the Funds rate at the first sign of slowing before year end, since they want the economy to slow down. Chair Powell has said the FOMC has only one chance to get this right and FOMC members don’t want to repeat the mistakes of the 1970’s, which eventually caused Paul Volker to raise the Funds rate to 20% and push the economy into a deep recession. The FOMC’s confidence that PCE inflation will drop toward 2.0% will remain low, as long as the Unemployment Rate is below 4.0%. Historically, the largest declines in inflation have occurred during a recession. Members of the FOMC know this which is why the decline in inflation isn’t the primary determinant for monetary policy in coming months. The key is the labor market and an increase in the Unemployment Rate. That’s why the Median projection for the Unemployment Rate is 4.5% in 2024.
Valuation, Sentiment, Positioning, Time, and the outlook for the economy suggest a correction in the S&P 500 is coming. The economy will determine whether it will be -5% - -7% or something worse. The one thing the market has going for it is momentum and an improvement in market breadth. As investors have become more confident that a recession will be avoided more cyclical sectors have begun to rally. The NYSE Advance - Decline Line broke out above the previous highs reached on April 4, 2022, August 16, 2022, and February 2, 2023. As the S&P 500 made a new high on January 2, 2022 the A/D Line made a lower high which is common at an important top. This negative divergence provided a warning of the weakness to come. This move above resistance is a positive as long as it is maintained. The only reason I’m not willing to take it at face value is that it occurred because investors don’t think a recession will develop. That view is expected to be challenged but in the near term this is positive.
The 21 day Advance – Decline Oscillator measures how strong rallies and declines are and helps to identify when the market has become overbought or oversold. Often a price reversal develops after the Oscillator makes a lower high (top) or higher low (bottom). A divergence occurs when upside or downside momentum is running out of steam. The Oscillator has notched a modest negative divergence with the Oscillator making a second lower low. A more convincing signal will be provided when the Oscillator closes below the blue uptrend line.
Since turning positive on June 5 the 21 day average of net Highs minus Lows (black) has trended higher and held above the blue 13 day EMA. When the S&P 500 rolled over after topping on February 2, the H-L % fell below the blue EMA. The black line has become flat which is a sign of lessening upside momentum but not a turn lower.
The S&P 500’s 5 day EMA (red) is above the green 13 day EMA which indicates the price trend is up. The 13 day EMA is at 4503 so the S&P 500 will need to fall below 4503 to pull the 5 day EMA below it and render a short term sell signal.
Intermediate indicators are flashing red but as long as momentum is positive the S&P 500 can work higher. Once the short term momentum reverses lower, the degree of weakness will tell us a lot about whether the uptrend can resume after a -5% to -7% pullback. If the S&P 500 declines in a 5 wave manner, a more important high will be confirmed. The primary message is based on the indicators discussed, at the current price level it’s better to do some selling than increasing exposure.
The S&P 500 has rallied a bit more than the 4520 I expected, and could push higher until momentum signals a high. The S&P 500 is still expected to pullback to 4200 – 4230 to test the recent breakout and possibly 3950 in the third quarter. Traders are 75% short the S&P 500 after buying the inverse ETF SH at an average cost of $14.442. (SH paid a dividend of $0.175 on June 21 which lowered the cost basis from $14.617) Traders were advised to sell half of the SH position on the open of July 11 at $14.00, and reestablished this position on July 14 at $13.71. The actual amount of exposure is determined by each subscriber as some will be comfortable taking a 30% short position which would amount to 22.5% of their portfolio (75% X 30%). Others might have a 7.5% position since their comfort level is 10% of their portfolio being short.
As noted last week, the 10-year Treasury yield quickly fell to 3.761% after the CPI report and tagged the black up trend line. “To show further improvement the 10-year yield needs to close below this line and the lime green 55 day exponential moving average.” To date the 10-year Treasury yield has not been able to break below this resistance.
In terms of what comes next I’m still on the fence. PCE inflation has only dipped from 4.7% to 4.6%, GDP is running twice as strong as the 1% the FOMC projected, and the Unemployment Rate is near a 50 year low. With those numbers it’s easy to see why many FOMC members have little confidence that inflation will fall to 2.0% without additional rate increases. Chair Powell certainly has the justification for being hawkish as will FOMC members when they give speeches in coming weeks.
TLT was expected to decline below 98.88 before a rally took hold. On July 10 TLT traded down to 98.85 before closing at 99.21, so it’s possible that TLT completed Wave B (red). Two weeks ago TLT was expected to bounce to 102 – 103.50 and it reached 102.98 on July 19. TLT is still below the blue trend line connecting the last two highs so the intermediate down trend remains intact.
It has become fashionable to talk about the Dollar losing its status as the Reserve currency of the world. This view gained some traction after Brazil, Russia, India, China, and South Africa said they were working to develop a non-Dollar currency for cross border trade. This prospect has led to a large short position in the Dollar. Extreme positioning in the Dollar has proved helpful in identifying important trading lows and highs.
In January 2017 positioning was long in anticipation of a rally just as the Dollar topped at 103.82. By February 2018 the Dollar had fallen to 88.25 which coincided with an extreme short position, and by October 2019 the Dollar was trading above 99.20. In early 2021 traders were convinced the Dollar would fall and established a big short position. In June 2021 I thought the Dollar would rally from 89.50 to above 100.00, as the FOMC moved to increase rates and the large short position caused short covering. The Dollar jumped to 103.92 in April 2022 before soaring above 114.00 in October 2022. The current extreme short position against the Dollar suggests the downside in the Dollar is likely limited.
In recent weeks I expected the Dollar to drop below the March low of 100.78 after forming a triangle pattern. The Dollar quickly fell from 104.01 to 99.58 after the CPI report. The sharp drop left the Dollar oversold which was why a rally to 100.75 – 101.00 was forecast. The Dollar rallied to 101.42 on July 24 and the extreme positioning suggests a rally above 104.01 may follow in coming weeks, especially if Chair Powell is hawkish.
As the Dollar fell below its lows of the past 6 months, Gold only managed to rally to $1987 and well below the May high of $2059. The poor price action suggests Gold will subsequently drop below the June 29 low of $1894. The first leg of the correction was $165 and an equal decline from $1987 would bring Gold down to $1822. The 50% retracement of the Wave 1 rally from $1616 to $2059 is $1837 so Gold has the potential to drop to $1850. Once this correction is complete Gold is expected to rally to a new all time high above $2070.
GDX was expected to rally to $31.50 and maybe a bit above $32.29 as the Dollar declined and Gold rallied. GDX rallied to $31.40 on July 14 and I thought it might briefly pop above $31.40. GDX traded up to $32.92 on July 18 before falling to $31.04. GDX became overbought as measured by its MACD on its RSI and is expected to become oversold before the next trading low takes hold. The 61.8% retracement of the rally from $21.52 to $36.25 is $27.15.
Tactical Investment Advice in 2023
In October the 21 day Advances minus Declines Oscillator became deeply oversold and supportive of a rally. I thought the S&P 500 would rally to above 4000. I recommended selling as the S&P 500 rallied above 4009, 4029, and 4100. The S&P 500 topped at 4101 in December.
In late December the Oscillator was modestly oversold and I expected (“Looking for a rally’) the S&P 500 to rally above 4101. The S&P 500 rallied to 4195 on February 2.
In the January 17 WTR I noted that the economy was still OK in the fourth quarter, which suggested Q4 earnings would be decent and help the S&P 500 rally above 4101 and potentially to 4250. On February 23 the Bureau of Economic Analysis reported that GDP grew by 2.7% in the fourth quarter. In the February Macro Tides I discussed why the economy was likely to hold up until mid year. “Most Consumers are in good shape. They still have a healthy cushion of Pandemic savings, wage growth is solid, the labor market is resilient, and the Unemployment Rate is historically low. According to the Labor Department, Median weekly earnings for all workers were up 7.4% in 2022. The increase in wages is helping consumers stretch the Excess Savings they accumulated during the Pandemic.”
In the February 13 WTR I discussed how bullish sentiment had climbed to a high level. “Sentiment has changed significantly since the low in October. For instance, in October the allocation to equities by the National Association of Active Investment Managers (NAAIM) was less than 20%. Last week the allocation exceeded 80% which is higher than at any time in 2022.” The expectation was that a pullback to “could bring the S&P 500 down to 3980 – 4015 (January 30 low).” As the Regional bank crisis erupted in early March the S&P 500 dropped to an intra-day low of 3808 on March 13, the 21 day Advances minus Declines Oscillator became deeply oversold. In the March 20 WTR I thought the market was set up to rally. “The Nasdaq 100 (QQQ) has been holding up much better than the S&P 500 because Treasury yields have been falling. Traders remember that last year QQQ was smashed as Treasury yields rose, so it’s only logical that QQQ rallies with yields coming down. On Wall Street this is deep analysis. As long as QQQ holds above 294.50, QQQ could rally to near 325.00 in the Goldilocks narrative, and the S&P 500 could move above 4195.”
Many on Wall Street believed a recession had begun in 2022 after the first and second quarter reports for GDP showed a contraction. (I didn’t think a recession would develop in 2022.) When the economy rebounded in the second half of 2022 and gained strength in the first part of 2023, Wall Street adopted the No Landing narrative. On April 27 the Bureau of Economic Analysis (BEA) confirmed that growth continued in the first quarter as expected. “Although GDP dropped to 1.1% from 2.6% in the fourth quarter, the level of demand was actually stronger. Real Final Sales are a good metric to measure demand and in the first quarter, Real Final Sales were up at an annual rate of 3.4% compared to just 1.1% in the fourth quarter.”
Since a recession didn’t materialize when expected, Wall Street now (first quarter 2023) thinks a recession will be avoided. I don’t agree as discussed in the April Macro Tides. “The inverted yield curve, the Leading Economic Index (LEI), and the big increase in lending standards in the second half of last year are the most reliable recession indicators to watch. Each has reached a level in the last 6 months that has signaled a recession with 100% accuracy over many decades. The inverted yield curve has an average lead time of 19 months. The Leading Economic Index has an average recession lead time of 10 months and it turned negative 6 months ago. No one should be surprised if the lag time in this cycle is longer than the average since consumers have never had so much excess savings going into a FOMC tightening cycle. By most estimates consumers still have between $1 trillion to $1.5 trillion in Excess savings. This has clearly played a role in sustaining consumer spending. The extension of lag times has duped Wall Street. When the economy slows more than expected after mid-year, Wall Street will be surprised which shouldn’t be a surprise to anyone with some common sense.” Based on three reliable recession indicators Wall Street is likely to be wrong about the No Landing outlook.
In the April 17 WTR I reiterated the expectation of a rally above 4195 on the S&P 500. “A rally above 4195 remains likely. If Wall Street pushes the pause button as being bullish, the S&P 500 could approach the August high of 4325. The 61.8% retracement of the decline from 4818 to 3492 is 4311.” In every WTR in May, the S&P 500 was expected to rally above 4200 as economy held up, the Debt Ceiling was increased, and the FOMC signaled that it would pause after hiking the Funds rate to 5.0% to 5.25% at the May 3 meeting. In June investors were advised to sell into the rally above 4250 in anticipation of a decline once it became clear the economy was slowing after mid-year. The S&P 500 has rallied more than I expected, initially on Artificial Intelligence speculation and subsequently on Wall Street’s view that if a recession is avoided it’s time to buy cyclical stocks. Ultimately, I think that view will prove wrong. In the July 10 WTR the S&P 500 was expected to rally above 4500 in response to the CPI falling to near 3.0%. Traders were advised to begin establishing a short position in stages and above 4510 on July 14.
The Major Trend Indicator (MTI) generated a Bear Market Rally Buy (BMR) signal on January 11, when the S&P 500 closed at 3970. On February 1 the MTI climbed above the green horizontal line which confirms a bull market began at 4119. Fundamentally, I’ve been skeptical of this signal, since the S&P 500 has rallied on the expectation that earnings will grow in 2023 and that no recession is on the horizon. The MTI closed below the red moving average on February 22, which represented a short term sell signal with the S&P 500 at 3997. On March 28 the MTI generated a short term buy signal when it crossed above the red moving average with the S&P 500 at 3971.
The three most reliable recession indicators (Yield Curve inversion, Leading Economic Index, Lending standards) have each reached a level that has developed before every recession in the last 60 years and suggest the economy will slow after mid-year. I’m relying on those indicators.
At a minimum, the economy is likely to experience a sharp slowdown that increases the concern that a recession is indeed occurring. There is likely to be at least 1 quarter with a decline in GDP. That should create a correction that provides a better entry point below 4119 (MTI Bull signal), even if a retest of the October low is avoided. That said a recession before the end of 2023 is still the most likely outcome. A recession would lead Wall Street to cut earnings estimates for the second half of 2023 and 2024, and create the potential for a retest of the October low at 3491 or a decline to 3200. The 61.8% retracement of the rally the March 2020 low of 2190 and high of 4818 in January 2022 is 3195.
Recession Watch – No Soft Landing
After the FOMC increased the Funds rate for the first time on March 16, 2022, Chair Powell emphasized that the central bank he leads could succeed in its quest to tame rapid inflation without causing unemployment to rise or setting off a recession (Soft Landing). “The historical record provides some grounds for optimism.” During his press conference he provided a chart showing that no recession developed in 1965, 1984, and 1995 after the FOMC had increased the Funds rate (red circles on chart). The Fed tightened monetary policy by increasing the federal-funds rate significantly in 1965 (from 3.4% to 5.8%), 1984 (9.6% to 11.6%) and 1994-95 (3% to 6%) without precipitating a recession. In each of these episodes, the Unemployment Rate fell from 5.1% to 3.6% in 1965, 7.8% to 7.5% in 1984, and in 1995 to 5.8% from 6.5%.
Although the FOMC increased the Funds rate significantly in those Soft Landing years, banks didn’t increase their Lending Standards. Consumers and businesses weren’t denied access to credit and were able to borrow what they needed. This is why those three Soft Landings occurred despite the increases in the Funds rate.
As I noted in the March Macro Tides, a recession has followed whenever more than 20% of banks have tightened lending standards since 1990. At the end of the first quarter, 46% of banks tightened their lending standards and more will once the economy slows. Investors who are banking on a Soft Landing are likely to be disappointed. At the end of 2022 Lending Standards were already tight enough to cause a decline in lending in 2023. The Regional bank crisis will only make it worse as small banks cut lending.
The Leading Economic Index (LEI) fell for the 14th month in a row which is the longest streak since 2009. Since 1960, a recession has developed whenever the LEI has declined this much.
The Daily Shot
A number of charts in this letter were from The Daily Shot. https://thedailyshot.com/.
Linked In Jim Welsh - Twitter @JimWelshMacro