Above the Noise: Calm after the storm

“Boy, that escalated quickly. I mean, that really got out of hand fast.” I can’t help but quote Anchorman’s Ron Burgundy when I think about the market sell-off in early August. Investors were in a “glass case of emotion” as the S&P 500 lost more than 8% during the downturn — perhaps forgetting that 5%–10% drawdowns occur in most years.¹ Sell-offs may feel different each time, but they tend to occur as policy uncertainty heightens and abate as policy clarity emerges. The US Federal Reserve (Fed) has typically stepped in to calm markets in times like this, although the Bank of Japan (BOJ) played the starring role this time. No sooner did the BOJ signal that multiple interest rate hikes were not in the offing, than the market found a bottom. More on this in a moment.

As for the so-called US growth scare, we need to be careful what we wish for. The Fed’s tightening cycle was designed to moderate economic activity in order to return inflation to its “comfort zone.” Inflation appears contained² while leading indicators suggest that the economy is slowing but not crashing.³ As Ron Burgundy might say, “Don’t act like you’re not impressed.”

Phone a friend (revisited)

In my February 2024 edition, I asked my colleague Alessio de Longis what he believed could end the sizeable outperformance of the “Magnificent 7” stocks relative to the rest of the broad market. His response, highlighting a reversal in the yen carry trade, was remarkably prophetic:

“Many catalysts can break these market dynamics, and of course, we think about the usual suspects such as interest rates, growth, and inflation. Often, these catalysts can be unexpected, however, and even unrelated to the market in question. Therefore, it’s worth thinking outside of the box to consider the potential impact of other markets and economies and understand that markets are globally connected.

Here’s a thought. What if the Bank of Japan begins raising interest rates for the first time since 2007? For nearly 20 years, investors have grown used to borrowing Japanese yen at low interest rates to invest in other assets that promise higher returns. A reversal in rates could spark margin calls and unwinding of positions, resulting in investors having to sell the winners, such as the ‘Magnificent 7.’ The Bank of Japan could still manage this gracefully, but if you’re asking for an underappreciated catalyst, then an unwind of the yen carry trade is a reasonable candidate for unexpected market volatility.” 

With apologies to Donald Trump, I know the best people. Thanks, Alessio. Are you available to help with my fantasy football draft?

It may be confirmation bias…

…but markets have generally performed well following mass sell-offs like the one in early August. The average time to recovery following 5%-10% drawdowns in the S&P 500 Index is three months.⁴

My apologies, but I’m about to get technical. The Relative Strength Index (RSI) is a technical indicator that measures the speed and magnitude of recent price changes of a security or index to evaluate overvalued or undervalued conditions in its price. The RSI oscillates between zero and 100. Traditionally, an index is considered overbought when its RSI is above 70 and oversold when it’s below 30. The relative strength of the S&P 500 Index fell to 30 on August 5, 2024, representing an oversold condition.⁵ The average next 12-month return of the S&P 500 Index when the RSI is at 30 or lower is 11.5%.⁶

Going back to the Anchorman well one last time, “Sixty percent of the time, it works all the time.”

It’s that time again?

There’s a fear the market will be more volatile in the weeks leading to the November election than at other times during the presidential cycle. It sounds like a reasonable concern, but it isn’t supported by the facts.

• Market volatility, as represented by the CBOE Volatility Index (VIX), has been below or near average during six of the past eight election months: November 1992, 1996, 2004, 2012, 2016, and 2020.⁷
• The two election-year Novembers when volatility spiked, 2000 and 2008, were associated with recessions.⁸

As always, the direction of the economy will matter more than the potential outcomes of the election.

It was said

“If we were to see inflation moving down...more or less in line with expectations, growth remains reasonably strong, and the labor market remains consistent with current conditions, then I think a rate cut could be on the table at the September meeting.”

– Jerome Powell, Chairman of the US Federal Reserve

Powell’s ifs are likely to be candy and nuts, at least at the September meeting. The market is currently pricing between one and two rate cuts in September.⁹ A 25-basis point cut seems reasonable. It’s less clear, however, that the Fed will provide investors with a Merry Christmas. The expectation of four rate cuts between now and the end of the year seems incongruous with the relatively resilient US economy. I’ll take the under unless an unforeseen emergency arises.

Since you asked (part 1)

Q: Why is no one concerned about geopolitical risks?

A: I’m concerned, but not necessarily with regard to the broad markets. Ask yourself this: Has the Russian invasion of Ukraine or the growing conflict in the Middle East meaningfully impacted the direction of the US economy or the expectations for US monetary policy? If your answer is no, as I would suggest it should be, then the conflicts will likely continue to play out in the background with regard to the market. It also doesn’t hurt that the US is currently producing more oil than any nation at any time, rendering it less susceptible to overseas shocks.¹⁰

Since you asked (part 2)

Q: Is the steepening of the US Treasury yield curve indicating that recession risk has lessened?

A: Alas, no. Historically, the initial normalization of the yield curve has been nothing to celebrate. The US Treasury yield curve tends to steepen before the formal starts of recessions as short rates fall amid rising expectations for easier monetary policy.¹¹

A recession doesn’t appear imminent. Our tactically focused portfolios, however, with the US economy poised to slow, are positioned more defensively for the near term with a focus on higher quality stocks and bonds. (Learn more in our monthly Portfolio Playbook.)

Automate my job?

Each month, I pose a question to ChatGPT — the artificial intelligence-driven chatbot — and assess the response.

Q: When do small-cap stocks outperform?

A: Small-cap stocks often outperform during economic recoveries or periods of strong economic growth. This is because they typically benefit from increased consumer spending and business expansion. Additionally, small-cap stocks might outperform during times of lower interest rates, as they can access capital more easily and are more agile in taking advantage of new opportunities.

Good answer, ChatGPT. It’s a good explanation for why the great “small-cap rotation” perpetuated by the media hasn’t proved sustainable. While it’s true that interest rates are likely to fall, the market’s focus over the next months will likely be on slowing US growth.

On the road again

My travels this month took me to Pittsburgh, Pennsylvania, for a meeting with financial professionals and their clients. Having arrived in the city early, I enjoyed time at The Terminal with a beverage of my choice. The beautiful Art Deco, five-block long, former produce distribution facility was among the hippest places in the country to spend an afternoon. It served as a great example of urban renewal and was indicative of Pittsburgh’s decades-long revival from urban decay to a city driven by high tech, health care, and higher education.

I’ll see you in September, a month that, in recent years, has lived up to its reputation of not being ideal for the US stock market. Or maybe in the lyrics of Green Day, “I’ll wake you up when September ends.”