Feb. 21, 2023
Editor’s Note: What follows in the introduction to the February issue of Foundational Profits. It addresses if there is going to be a soft landing for the economy and if a new bull market in stocks has begun. The full issue reveals my current positioning for my retirement accounts, including what assets I own and in what percentage. Click here to access the full issue.
Is there going to be a “soft landing”?
Has a new bull market begun for stocks?
These are the questions everyone is asking.
To hear the bulls tell it, the S&P 500 bottomed last October and we’ve been in a new bull market for nearly four months now. Inflation is coming down. Wages have ticked up. Job creation is well above expectations. Look, they say, even crypto and meme stocks are catching a bid again.
The bears, naturally, see it differently. To them, we’re in an overextended bear market rally. Inflation remains near 40-year highs, offsetting any wage growth. Sure, new jobs are being created, but people are working two or three jobs just to make ends meet. And the fact that bankrupt companies like Bed Bath & Beyond can see their share prices rise so rapidly shows there hasn’t been the true capitulation needed to usher in a bottom.
The truth, as with many things in life, is somewhere in the middle of the two extremes.
Your agnostic editor is never permanently in either camp, instead choosing to objectively consider all the data and trends to make his investment decisions and allocations. Let us bow our heads and seek it.
Yes, stocks have broken out from a technical standpoint. Whether looking at stochastics, moving averages, or simple trend lines, what we’re currently seeing in the S&P is different from what we saw in all of 2022. Stochastically, stocks are not overbought and are in fact somewhere in the middle of their range. The 50-day moving average on the S&P has crossed over the 200-day — a so-called ‘golden cross’ — for the first time since stocks staged a massive breakout that began in early 2020. And the index has also moved above its top-end trend line for the first time since the bear market began.
Looking at that chart, I can see where the bulls are coming from. I even get a little tickle of FOMO (fear of missing out) in some deep part of my lizard brain.
And that’s when I start hearing the voice coming from my other shoulder.
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It says that the yield curve remains significantly inverted and that means a recession is inescapable, particularly because the inversion is now being driven by a weaker 10-year yield as opposed to a rising 2-year yield — the former of which takes its cues from economic growth and the latter of which takes cues from the Fed’s interest rate policy.
The slowing growth bucket holds water. US gross domestic product for the fourth quarter of 2022 came in at 2.9%, slowing from 3.2% in Q3.
What’s more, consensus estimates for Q1 and Q2 2023 growth are in negative territory, which of course would confirm another recession. According to The Conference Board, as of January 10:
The US economy, and the US consumer, have been defying expectations. US consumer spending continued to support GDP growth despite the dual headwinds of rising interest rates and high inflation. Additionally, upward revisions to Q3 2022 GDP data show stronger economic momentum in H2 2022. However, we still expect that the US economy will fall into recession soon. We currently anticipate three quarters of negative GDP growth starting in Q1 2023. However, this down turn will be relatively mild and brief, and growth should rebound in 2024 as inflation ebbs further and the Fed begins to loosen monetary policy.
Corporate earnings are corroborating the slowing growth narrative. As of February 3, with about half of the S&P companies reporting their Q4 numbers, earnings growth was at -5.3%.
For Q1 2023 and Q2 2023, analysts are projecting earnings declines of -4.2% and -2.9%, respectively. That would be three consecutive quarters of negative earnings growth for the S&P.
How can stocks be rising in the face of slowing economic and earnings growth?
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Enter ‘Zero Days to Expiration’ options (0DTE), a fairly new options mechanism that has kept volatility artificially low and has perpetuated buying. According to derivatives-analytics firm SpotGamma, in early 2022:
... the Chicago Board Options Exchange (CBOE) launched expirations every single business day for SPX Index Options. The week of 11/14/2022 exchanges then launched daily expirations for both SPY and QQQ. While 0DTE volumes for SPX were typically around 30% of total SPX volume to start 2022, they have increased recently to 50% of total SPX volume.
This has led to two things.
First, the significant call option buying has created a self-fulfilling feedback loop of more buying, thereby driving stocks higher. I would say artificially higher, but the last price is always the right price and Mr. Market is never wrong.
Second, it has made volatility all but disappear. The S&P volatility index (VIX) is a classic fear gauge that is calculated by combining the weighted prices of the index's put and call options for the next 30 days. But it only uses options that mature between 23 and 37 days for the calculation.
How can the VIX be accurate if over half the options being traded — with a notional value of some $500 billion per day — aren’t being included? The answer is that it can’t be and therefore isn’t reflecting the true underlying volatility in this market, which could be perpetuating even more buying.
What would change that? Some shock to the current complacency that would calm the bulls and reinvigorate the bears. My contention remains that it will be the reality of slowing growth and earnings outlined above.
As such, we remain defensively positioned, still with a significant portion of cash, as we patiently await the coming recession and likely concurrent selloff in stocks — at which point we can more seriously consider more long exposure to broader equities.
Click here to see exactly what we own and why.
Publisher, Daily Profit Cycle