Mid-Year Market Outlook: Hidden in the Noise

The market conditions that typically precede economic recession and significant stock market declines have been present for some time now, ...
Hidden in the Noise_Option 2

...leading CWM to take a conservative approach in actively managed asset models. This stance was validated in 2022 when markets fell sharply, but 2023 and now 2024 (at least through the first half) have been decent market performance years. This invariably begs the questions: was the market low in 2022 “the low” of the cycle? Is near future economic recession and/or a strong market decline still likely? And what does the path forward look like? As 2022’s market performance and the continued mixed economic data has shown, there was reason for caution; however, some factors did make it different this time. It remains to be seen if the market can continue to push higher. High interest rates limit borrowing and spending at both corporate and government levels, while current high valuations historically portend a low return environment for the stock market. While it is always tempting to chase market valuations as they move higher, tested disciplines suggest that conservative positioning is still warranted even though it can be discomforting to leave money on the table in hindsight.

The TL;DR (Too Long; Didn't Read) Executive Summary

Since late 2022, the stock market has risen strongly. However, underlying economic indicators point to significant weaknesses, hinting at a potential stealth recession. The contrast between stock market gains and struggling economic indicators raises concerns about the sustainability of current market performance. Some additional factors supporting this performance include lingering pandemic stimulus effects and locked-in low interest rates, which could be concealing deeper economic issues. Outlier high stock valuations and strong investor confidence suggest lower future return potential and the possibility of sharp downward market corrections. Additionally, the dominance of major tech companies is driving market strength, and the impact of massive government deficit spending continues to shape the economic landscape, posing future risks if current supportive trends shift. Caution remains the strongest recommendation, which will be expressed differently based on the investment strategy utilized.

Has a Stealth Recession Already Happened?

While there has been an undeniably strong stock market valuation recovery since the Fall of 2022, this has not been the case in the overall economy of the United States or globally. For instance, while showing some signs of recent improvement, the U.S. Manufacturing Purchasers Index has been in contraction (meaning fewer goods are being made) for most of the last two years. The global picture, as seen below, is not much better with contraction occurring every month from September of 2022 until February of 2024. While stock market valuations have held up, the underlying economy has been struggling. At the very least, there has absolutely been a recession in manufacturing activity.

1. Global Mfg PMI

Additionally, leading economic indicators (things like building permits, hours worked, unemployment claims, yield spreads, etc.) have been negative on a year-over-year basis to levels never seen outside of a recession. While still negative, it should be noted there has been some marginal improvement. Being “less bad” is an important piece of information.

2. YoY change in LEI Q2 2024 John Hancock

The above data indicates that widespread economic weakness has persisted and continues to do so. However, this trend has not yet been reflected in headline stock market valuations in the time since 2022’s sharp market sell off. Stock market weakness typically follows weak economic data, but it has truly been different this time in that economic weakness did not morph into a fully recognizable recession or sustained market decline.

Why “It’s Different This Time” and Why That Could Change

“It’s different this time” are famous last words on Wall Street, often uttered by those seeking to justify why a current outlier market move can continue despite all evidence to the contrary (and usually famously just before major reversals). In the post-pandemic environment, there are unique factors that haven’t been present in previous recessionary environments. Mitsubishi UFJ Financial Group, a large Japanese-based global bank, put out an excellent two-point synopsis (see below) on why stock markets and the economy have been largely immune to negative economic data and a sharply higher rate environment. Put simply, they claim it’s the lingering ripple effects of massive trillion-dollar COVID-era stimulus and the fact that much of the U.S. economy took advantage of the pandemic’s low-rate environment to lock in low rates of interest on debt. These locked-in rates effectively immunized a large swath of the economy from the historically fast rate hikes that the Fed used to combat the highest inflation decades. In the past, sharply higher rates would have greatly and quickly impacted the economy.

3. End of an Era MUFG

In addition to the above items, large amounts of government spending at levels not previously seen outside of recessionary environments has kept the party going. While government spending can help propel an economy forward, it does tend to have diminishing returns past a certain point. The chart below shows government spending as a ratio to gross domestic output, which has rarely been higher than it is now, and never outside of known recessionary environments. The yellow dotted lines represent above 21.4% and below 17.9% government spending as a percentage of nominal GDP. As the table shows, high levels of government spending tend to be associated with lower future rates of economic growth and higher inflation pressures than in periods below 17.9% of GDP. While this may have kept the market’s greedy animal spirits flying the last year or so, it portends a weaker environment for the future once the sugar high wears off.

4. Deficits, Debt, and Markets Charles Schwab

One problem with the large amounts of government spending is a large chunk of it is coming from borrowed resources with the U.S. debt level rising at roughly $1 trillion every 100 days.That will add up eventually, especially at higher rates of interest. According to the Congressional Budget Office, just interest on the debt, not repayment, will eclipse every other government spending item by 2034. It should be noted that entitlement spending (e.g. Social Security and Medicare) will still be a larger items and are not included here. If interest rates remain higher for longer, government debt will be a bigger problem sooner.

5. Net interest will exceed key programs in 2034

Another factor that makes it different this time for the major indices, like the S&P 500, is the high concentration in large technology companies that, unlike the smaller company earnings shown earlier, have boasted strong earnings growth thanks to the artificial intelligence (AI) boom. These results have been largely concentrated in the seven biggest technology stocks (frequently referred to as the Magnificent Seven or Mag-7) and that group’s ability to maintain near all-time high profit margins and rates of growth, and reasonably pointed to as a sign for optimism. The returns in Mag-7 stocks have been impressive, but if you remove those companies from the S&P 500 index, both earnings and value growth are far less impressive for the stock market overall. The chart below shows the returns since the beginning of 2021, but if the start date shifted to the end of 2021 (the hash mark above ’22 on the x-axis), outside the Mag-7 companies, market valuations have barely budged as have earnings.

6. Guide to Markets 6.12.24 JP Morgan_Resized

Despite the strength of large technology companies, as stated earlier, a near term recession cannot be ruled out because of significant underlying economic weakness. There is some evidence that a recession has already happened in at least portions of the global economy and that weakness was papered over by lingering COVID stimulus, ongoing massive government spending, and the emergence of AI. Factors that are likely to decline in strength and effect outside of the continued AI build out. Whether those factors have prevented a recession or simply delayed it is a significant question. As the performance of the Mag-7 stocks dwindles, how long big tech companies can continue to support the global economy and market values all by themselves remains to be seen.

7. NVDA and the Entire Global Economy

The CWM Data Model Response

The CWM Factor Wheel below shows an improving Economic category (compared to was discussed in April’s Market Outlook), but data remains mixed with some strongly negative readings. Price Momentum is the most positive factor while Valuation, Behavior, and Interest Rates categories all report negative outlier data, suggesting caution for risk managed models. To take on more aggressive stances in the actively managed CWM investment models, these areas will need to see improvement along with continued economic progress. This could slowly resolve over time if a "soft landing" or no recession scenario comes into play. However, this improvement would likely be gradual due to high current valuations, suggesting low future return potential for stocks based on a history of similar levels. Thus, rushing into stocks may not be necessary while income (e.g. bonds) assets provide reasonably comparable return expectations and the best yield (income) levels in over a decade.

While the CWM team would never cheer the idea of a recession and a sharp market price drop, as that can cause a great deal of harm to real people, it would be the fastest way to get valuations back to reasonable levels, eliminate greedy investment sentiment, and likely lead to lower interest rates and normalization of the yield curve. All changes that would enable greater confidence in portfolio risk taking.

8. CWM Factor Wheel 6.18.2024

High stock valuations likely represent the greatest risk in the current environment. As the old saying goes, “price is what you pay, value is what you get” and by most measures, investors are not getting very good deals on stocks right now compared to history. High valuation levels are also where the largest and fastest market drawdowns tend to emerge from. One prominent measure, the Shiller Price-to-Earnings ratio, is at a valuation level rarely seen and historically related to major market tops. While the 2000 Dot-Com boom and bust era demonstrates it could go higher still, longer term return expectations should be tempered because of this unfavorably high buying level.

9. Schiller P_E 6.10.2024

The current Shiller P/E of ~35 is in the top quartile of historic valuations and previous similar valuation environments see a low return of just ~2% annually over the following 10-year period (see left chart below). Note that the cheapest valued quartile typically provides solid returns of over 10%. Comparatively, the 10-year treasury yield, at the time of writing, is 4.39% the 2nd quintile, which is associated with ~3.5% annual return for treasuries. A better return, with historically less volatility than stocks. That is not a stellar outcome either. The point here is that assets like treasuries, because of their yield, are likely to outperform extremely expensive stocks and their low return potential based on a history of similar conditions.

10. Big Picture Bigger Risks

On top of valuations, the treasury yield curve is still inverted, where longer term debt yields less than shorter term debt, now for the longest period of time on record. Economic recessions have followed every inversion period since the 1970s. While there is no guarantee a recession will follow this time, that’s a track record that probably shouldn’t be ignored.

11. Longest Yield Curve Inversion in History

Greedy investor behavior is also evident in the current market scenario through the observance of high stock exposure as a percentage of cumulative investor asset allocations. The current exposure is even higher than the Dot Com top in 2000, showing investors are increasingly confident and willing to be exposed to the stock market’s gyrations. Investor overconfidence has a strong history of being regularly corrected by negative mean reversion in the stock market.

12. US Equity Market Update May 2024

Investor sentiment, as expressed in recent polls from Ned Davis Research, is also at a very high level. Similar to high valuations, high sentiment is historically associated with future low return environments.

13. Quarterly Chartbook

To top off this discussion, interest rate policy must also be considered, as the last few years saw the most aggressive rate hiking regime since the early 1980s at 5.25% or 525 basis points (bps). The chart below demonstrates just how much higher and faster the latest rate hiking regime has been this time compared to other Fed hiking cycles in the last 40-years.

14. Peace Love and Understanding September 2023

The next table demonstrates just how rare it is for a soft landing to occur rather than a more damaging hard recession after rate hiking cycles. It should be noted that a soft landing has not occurred in any scenario where rates have been raised more than 300 bps (3%). However, as stated earlier, the U.S. economy is less sensitive to higher rates as a whole (subgroups are definitely feeling more pressure from it), so perhaps it will be different this time.

15. End of an Era MUFG May 2024

The rate hikes of the last few years were done to combat inflation, and a significant economic debate this year has been around future Federal Reserve (the Fed) interest rate policy now that inflation levels have come down, with most of the conversation centering around how many cuts the Fed will make rather than if it will cut rates. A reacceleration of inflation pressures this year has all but quashed any hope for substantial rate cuts, as Core CPI (removing food and energy prices from the inflation calculation due to their volatility) has moved upwards and away from the Fed’s stated 2% target inflation level. The Federal Reserve’s own current forecasts estimate just one cut by the end of 2024, with futures markets pricing one to two rate cuts. It is doubtful that one or two quarter point cuts is enough to make a meaningful difference to borrowing decisions and economic activity, but it would be a start.

16. Monthly Core CPI Inflation Slows to 33-Month Low

Though the recent reacceleration of inflation is a problem that should give the Fed pause when it considers rate cuts, the actual inflation path lower over the last year plus has been about as good as could be hoped for. So far, it could be argued that the Fed has handled the problem well, though cynics would also claim it is largely to blame for sparking the issue to begin with.

17. The Last Mile Deutsche Bank

While data still suggests caution is warranted, there are several CWM strategy options for clients to establish how that caution is expressed. For example, CWM’s Risk Adjusted Models are strongly risk off since they are designed for clients with capital preservation as a primary goal. In contrast, the Wealth Accumulator Models remain statically long exposed to markets, to a greater or lesser extent depending on the model selected, regardless of the current market data. The extent to which any of the CWM strategies are used (or not) is completely up to the client’s personal goals, risk tolerance, and time horizon- with a blended strategy approach available because no single strategy works in all markets. The below section provides a brief statement on each model group that designates who each model is primarily designed for (CWM clients have access to every model) and how the model is responding to the above information among other datapoints.

How Much Risk Management is Needed or Wanted

Risk Adjusted Models (RAM):

General Philosophy: Never risk what you have and need for what you don’t have and don’t need.

Who’s It For: This model is generally best suited for persons in or near retirement where capital preservation is a primary goal.

    Current Portfolio Positioning: RAM is significantly underweighting risk exposures compared to the normal biases of each sub model. Recent trading activity has reduced interest rate sensitivity and slightly increased the correlation with the overall stock market while giving a nice boost to portfolio income.

    Global Allocation Model (GAM):

    General Philosophy: There is always a bull market somewhere, even in a bear market.

    Who’s It For: This model is generally best suited for clients who want to enable the CWM team to utilize data models to invest in the highest confidence investment categories regardless of the macro investment environment and without being constrained to a certain percentage of stock or bond/market neutral assets.

    Current Portfolio Positioning: GAM is majority (55%) invested in income and market neutral assets. The equity (stock) allocation is comprised of international stocks, precious metals, and technology stocks, which your CWM team believes is a strong mix of defensive and aggressive equity positions. Portfolio changes in the first half of 2024 have slightly reduced stock exposures and decreased portfolio interest rate sensitivity in favor of market neutral assets and liquid alternatives.

    Tactical Allocation Models (TAM):

    General Philosophy: You have something to protect, but you are still short of your goals and require greater portfolio growth to achieve them.

    Who’s It For: This model is generally best suited for clients who are established in their careers, have established a sizeable nest egg that would be difficult to rebuild based on their ability to make new account contributions, and are still short of their required portfolio size.

    Current Portfolio Positioning: TAM is statically allocated to either stock assets or bond/market neutral assets depending on the macro allocation selected by the client during the planning process. This model type will not "go anywhere” like some other CWM models but will seek to maintain its predetermined static exposure to either stocks or bonds/market neutral assets. Those subgroups will be actively managed via CWM’s proprietary data models. If no suitable assets (stock or bonds/market neutral) can be found in the current situation, money market positions will be utilized until that changes. In the current situation, because so many stock categories are unfavorable due to high valuations, recent portfolio changes have reduced stock exposures in favor of a significant positioning in money markets yielding over 5% in annual income. The bond/market neutral portfolio has reduced interest rates sensitivity and sought to responsibly increase portfolio income.

    Wealth Accumulator Models (WAM):

    General Philosophy: Your future success is more dependent on your rate of saving rather than your short-term rate of return.

    Who’s It For: This model assignment is generally best for those with a strong income but small relative account balance or those who just want static low cost exposure to markets based on a predetermined allocation.

    Current Portfolio Positioning: WAM portfolios are CWM’s version of the traditional buy and hold strategies common at most advisory firms. The goal of this model is to build an allocation with strong historic success in most market long-term environments. The discipline of this model is to invest, periodically add new funds, and not make allocation changes as a result of changing market conditions. These models continue to be long exposed as designated during the planning process. The model is monitored for portfolio deviation, where it will be rebalanced if position balances deviates too far from the original target weightings, and remodeled at least annually, which most recently happened in May of 2024.

    If you are interested in a deeper dive into the current market data or a more tailored conversation regarding CWM's investment models, please Contact Us or call the office at (425) 778-6160 to schedule an appointment with your CWM advisor.

    Know someone who could benefit from a clear financial plan with proactive investment management? Please keep in mind that we are always looking for more great clients, just like you!


    P.S. Election season is upon us and I encourage you to participate and vote in the democratic process. May we all keep cool heads in what is sure to be a contentious election season and remember we are all Americans (well most of the CWM community anyway) who want the country to succeed and prosper for ourselves and the next generations. For those who need a good laugh, I highly recommend the Non Sequitur.

    1Fox, M. (March 1, 2024). The U.S. National Debt is Rising by $1 Trillion About Every 100 days. CNBC.

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