Blueprint for a Bear Market:

How I’m Navigating My Capital Now (and why)

I saw a recent poll of market participants about their outlook for the stock market for the remainder of the year.

A third were bullish. A third were bearish. A third were neutral.

It’s easy to see why people are so confused. The data and price action has been confusing for  the duration of our last trip around the sun.

Economic growth has been low and continues to stagnate while the stock market has moved higher.

Oil’s going up while copper’s going sideways.

Consumer sentiment is near 2008 levels, yet they keep on consuming with retail sales remaining relatively strong.

The data of late has no bounds to how much it confounds, making our job separating the signal from the noise particularly challenging.

Yet separate we must, and separate we have.

Through my monthly premium research letter, Foundational Profits, I have been largely bearish since December 2021, when we last sold out of the energy sector and began positioning more defensively.

It was the right move.

We handily beat the market with our closed portfolio in 2021, selling our long oil and long tech positions. Yes, we were long tech in 2021! No permabears here.

We beat the market again in 2022, selling the bullish run in gold and uranium in the first half the year while they were running hot and the mouthbreathers were talking about “going to the moon.” Both the precious metal and uranium complexes finished the year much lower.

August 2023 saw stock price action more in line with the economic reality that I’m seeing in the data. It was the stock market’s worst month since February.

Where did Goldilocks go?

She’s probably out climbing the hills left by the dollar and short-term bond yields, which have sped significantly higher since mid-July. When bond yields and the dollar go up, the stock market and commodities typically — not always — correlate inversely.

Those are big short-term moves for such large asset classes.

What does it mean?

It means the Fed’s not done hiking yet, which I’ve been saying for over a year now.

Investors — perhaps a third of them — who’ve failed to break the zero-interest Pavlovian response to buy the dip made out ok in 2023. But the current downside risk in the S&P is greater than its upside potential, and they are now truly picking up pennies in front of a steamroller.

I have outlined for my Foundational Profits readers many times the recessionary cascade of H.O.P.E. — housing, orders, profits, employment — as a general order of the way things break heading into an economic slowdown or recession. It was developed by Michael Kanrowitz at Piper Sandler.

Housing already broke and is now trying to deal with our current “new normal” high interest rates. Mortgage rates for 30-years are now near 8%, up 165% from the 3% we knew for so long. This killed housing affordability and the refinance market. People with 3% mortgages simply aren’t willing to sell as it means they would have to take on a higher-interest loan to move. This has pushed would-be buyers into new homes, which has been great for the homebuilders. But the negative outcomes outweigh higher share prices for homebuilders. The grinding to a halt of the refinance market will have compounding and lagging effects on the economy as home equity is the main way Americans finance their consumption. What of those who can’t afford to build a new home? You can increasingly find them living in cars and tent cities.

Orders, too, have collapsed as the Institute for Supply Management's New Orders Index has fallen for eleven straight months and remains contractionary.

Profits. What profits? For the second quarter, S&P 500 companies reported a year-over-year earnings decline of -4.1%, according to FactSet.

That leaves employment, which, as most people know, has remained “relatively strong.”

And like the economy itself, employment has an order to how it breaks down. Temp work is the first to be cut. Then overtime hours. And then pink slips.

Right on cue, Reuters was out in September 2023 with a report titled, “Fewer US temp jobs may flag longer lasting concern,” that noted:

A steady drop in the temporary worker employment is a concerning blight in an otherwise steady U.S. labor market. Despite adding another 187,000 jobs in August, short-term positions such as event staff declined for a seventh consecutive month, to about 2.9 million, according to data released on Friday by the Bureau of Labor Statistics. The trend has been an ominous sign before.

Companies that recruit and place temps tend to cut payrolls when the first signs of an economic slowdown emerge. Employment in the sector peaked 11 months before the 2000 and 2007 recessions, per BLS data. The crest, at 3.2 million, occurred 17 months ago, in March 2022, signaling that weakness could be ahead.

So where does that leave us in Macroland?

It leaves us still with a higher chance of recession than not.

The US GDP for Q3 will see positive economic growth, but will get dangerously close to flat or negative growth in Q4 of this year and the first two quarters of 2024.

And I would suspect with inflation back on the rise, thanks largely to sticky high crude oil prices that we get higher interest rates for longer. Expect 3% to 3.5% inflation over the next few quarters, which will keep the Fed hawkish or else risk losing its credibility even more than it already has.

Slow growth with reinflation is a classic stagflation scenario.

Credit will come under pressure, particularly in the commercial real estate space, which will tighten lending in general and put further pressure on the regional banks that we haven’t heard from in a few months.

And whether or not that comes with a stock market crash is not the point. The point is that the risks outweigh the upside in the broader markets, and so we remain overall bearish and defensive.

 

Positioning for a Bear Market

The S&P as a whole is up 13.5% for the year as of October, propelled largely by what have been dubbed the Magnificent Seven: Apple, Microsoft, Alphabet, Amazon.com, Nvidia, Tesla, and Meta Platforms. But if you equal weight the index, it’s flat.

So what’s next?

The recession has been delayed until next year thanks to government spending that kept GDP relatively buoyant this year.

From where I sit, the Fedspeak is becoming less relevant even as Bloomberg and CNBC hang on to every members’ coo. Dovish or not, the market has raised rates for the Fed, with the US 2-year yield topping 5% in the second half of 2023, its highest since 2006. That has kept the dollar strong, with the US Dollar Index (DXY) at 11-month highs near 106, which is why dollars with that 5% yield remain my largest position.

Higher yields, by the way, are what caused the regional banking crises earlier this year that has seemingly been erased from the collective memory. No one is talking about the fact that rates are higher than they were in the spring and bank stocks are weaker, with a breakdown in the SPDR Regional Banking (KRE) in the second half of 2023 as rates have moved higher.

My next largest holding is gold via the SPDR Gold Trust (NYSE: GLD), which, in addition to the dollar, is a classic bear market hedge.

I also own some energy stocks and a few dividend-paying positions that I expect to insulate my portfolio a bit from any coming volatility.

In Foundational Profits, I routinely show readers how I’m positioning my long-term retirement portfolio. You can get access to the latest issue and current portfolio by following this link.

Call it like you see it,

Nick Hodge
Publisher, Daily Profit Cycle