Flip Flop

1880 words – a 5 minute beach read.

We wrote about the speed of things last week in just the latest piece we have written about how speed is accelerating in life and especially in the markets. Not just the speed of change but the scale of the moves can leave even this near 40 yr. veteran of the markets feeling a little whip lashed.

Across the cross asset space, assets are flip flopping around like a fish out of water – maybe that’s it – maybe it’s the post AI nirvana vibe that has left us gasping for air. A prime example is the equity breadth expansion over the past month or so vs the index implosion of the past few weeks.

 Here’s All Star Charts: “And in case you didn't notice that the list of new 52-week highs on the NYSE just hit the highest levels this entire bull market, and in case you didn't notice that the % of stocks on the NYSE above their 200 day moving average just hit the highest levels this entire bull market, now you're seeing the NYSE Advance-Decline line closing out the week at the highest levels in HISTORY.” Talk about flip flop, from one week to the next.

We remain AI believers and note that the big tech stocks have plenty of $ and plenty of opportunity to prove out their thinking on AI. We continue to believe the pick & shovel approach we have employed here – with a focus on semiconductors and the AI – power nexus, will pay off over time. That doesn’t make the SMH selloff feel any better but up fast and down fast doesn’t just happen on rollercoasters. Barchart notes mega cap tech is the most oversold since 2017.

The economic data is another thing that has been flip flopping around; from good data on US growth (Q2 much better than forecast) inflation and productivity (the latter of which should flow into EPS support) to bad data from the US ISM Manuf report & on to the weak US jobs # today which has certainly added some gas to the risk asset selloff. 

The ISM survey data really shocked folks given how weak it was; we suspect it’s a head fake, perhaps Beryl related given that the employment # was last seen at the Covid and GFC low – we are nowhere close to either scenario. On US manufacturing BofA notes: “we see inventory destocking trough, new orders to inventory starting to rise, & 2nd longest manufacturing recession since 1960s coming to an end ( longest run without 2 M of ISM manuf above 50).”

On the jobs front the flip flop is from one data source to the next. Fintwit notes lots of volatility in construction industry job cut announcements ... June saw largest increase since September 2007; July saw largest decrease since March 2007. FInom reports that Challenger Layoffs (25k) hit their lowest level since July of 2023 – expanding participation rates are positive for growth even if it means higher UER.

The net result seems to be that the equity rotation out of tech into more economic sensitive sectors has been arrested by growing concerns over the viability of continued economic expansion both in the US and globally. This results in the tech selloff we have seen over the past few weeks broadening out to the rest of the market including Small Caps. The shift from aggressive small cap OP over the past month to sharp selloff could be just some profit taking but it reinforces the flip flop, whiplash nature of the current set up.

Here's the Carson Group: “Russell 2k (small caps) were up more than 10% last month, for only the 21st time ever. Looking at the other times, stronger forward returns are perfectly normal.

One year later up 15.8%% on avg isn't too bad if you ask me.” Finom adds: “Small-cap A/D Line made another multi-year high yesterday and highest level since Feb 2022. Breadth leads price; anticipate higher small-cap prices ahead”. We agree.

All this suggests one needs to be careful to not read too much into any one data point or stock, sector or asset reaction. We continue to believe the rotation will win out over the correction impulse and that the US and global economy remain far from recession territory. Furthermore, investors now have the Central Banks behind them rather than a head wind in front of them; Central Banks that have plenty of room to cut rates given the continued easing of inflation.

Perhaps most importantly from an equity risk POV is that earnings continue to come in with a solid reading. JPM reports that with roughly 65% of US and European companies having reported, Q2 earnings continue to surprise with US earnings running at +12% Y/Y rate and EU EPS + 1% both significantly better than expected ( +5% and + 3% respectively).  The same holds true in Japan which is a market that has taken a sharp tumble the past few days.

Going a step further because as we know markets are forward looking; Fintwit notes that 12 month forward EPS across the US, Europe and the Asia Pacific continue to rise and now are solidly double digit in both the US and Asia Pacific with Europe running +8%.

Earnings are coming in BTE and forward earnings are continuing to expand while valuation improves and sentiment tanks (a plus). Credit remains in good shape; while credit spreads have widened its more due to the sharp UST rally than credit weakness itself (HYG). 

What about the economic outlook? Here we continue to utilize our 4 for 24 globe macro surprises as guideposts.

 Macro surprise #1 lower inflation, sooner than expected, remains on track and provides the underpinning for CBs to continue to cut rates; as noted JPM expects a full 80% of the world’s CBs to be in rate cutting mode by Q4, resulting in the most synchronized global rate cutting cycle in 40 + years. This is a major positive and puts us in a much better position to take risk than a few years ago when CBs had no room to cut bc rates were already so low.

Macro surprise #2, better productivity growth, is also manifesting especially in the US where data is more readily available. Q2 productivity growth came in well above expectations, leading to much lower than expected unit labor costs (Q2 lowest since 2019) which should support continued EPS growth and robust margins. This is a key to our global macro blue sky outlook for the 2023 -2027 period.

Macro surprise #3, return to stability, has been a key support for the positive risk asset return profile YTD. We have noted it in the context of sharply lower global inflation volatility coupled with the heretofore low VIX and MOVE readings YTD. Of course, the current flare up (reminds of my grill session the other night) has put the VIX back over 20 for the first time since the Fall of last year. Its important to note that over the past decade or so VIX has averaged 19 so even a 20 reading is quite low relative to history – it’s the speed and scale of the algo driven selloffs that create the sense of much higher volatility.

Macro surprise #4, early cycle global economy, is one that has had us pointing in the right direction of being OW risk & Commodities but is now being called into question. One example is the 9 day win streak for lower UST bond yields and higher bond prices – a streak last seen at Covid’s onset. We struggle to see how the current environment lines up with Covid given the Atlanta Fed Q3 GDP Nowcast at 2.5% and with GS and others forecasting 2.4% GPD growth in Q3.

We also note that the global manufacturing recovery while not evident in the very weak US ISM # does show up in continued Asia Pacific Manuf PMI expansion which is running at its best levels in well over a year and up for the 7th straight month as demand conditions strengthen and new orders expand.

Another piece of background noise that has really flip flopped is the US Presidential race with betting sites such as Predict It now forecasting a Harris win vs Trump. This is key for our blue sky outlook given the likelihood that a Harris presidency would continue and sustain the Biden – Harris economic policy mix that has made the US the envy of DMs while a Trump return to orifice would likely result in a very poor economic policy mix that could threaten a USD crash.

The fly in the ointment that continues to worry us lies in the commodity space, particularly the weakness in industrial metals like copper which is setting off lots of commentary re the copper/gold ratio etc. Dr. Copper has had a major selloff after a sharp run up, similar to many other assets over the past year or so. The fundamental supply – demand picture has not changed from our reading; what has changed is $20B in speculative money selling since May according to StoneX. In addition, the absence of massive stimulus post China’s 3rd Plenum has not helped sentiment (we never expected it to).

Speaking of China, we do sense a growing recognition that the need to support consumption from both a ST and LT POV is being embraced – most recently by an expansion of migration from rural to urban areas complete with central Govt support to assist that transition which could help absorb the excess property build out and all that one needs to furnish a new apartment. 

China growth is not imploding (its PMI Composite remaining above 50),  Japan is making headway in its return to macro economic normality (BOJ raising rates is a good thing notwithstanding the $/Y selloff). Europe is also picking up as better than expected Q2 GDP growth suggests, even with Germany playing the sick man again. The sharp rally in long rates coupled with the selloff in Commodities does call this view into question.

So where does all this leave us? Still believers in rotation rather than recession, in the US and globally. Does double digit earnings growth, above potential GDP growth and Fed rate cuts ahead sound like a bad combo for risk assets? We don’t think so.

A sharp pullback like this ( from recent highs, Nasdaq down 10%, Semis down close to 20%, SPY down 6%, testing it 100DMav, Japan off 12% with today being worst day since Covid, ACWI & ACWX down 6%) is unnerving, especially given the speed and scale of the moves – it strikes us this is the new normal and one either rides it thru unless the macro underpinnings have changed or one tries to trade it. 

We are in the former camp; focused intently on earnings, the USD (broke under 200dmav), the commodity space and the impact of lower rates (10 yr. UST under 4%, 2 yr. as well) on parts of the economy that have been weak like RE ( 30 yr. US mortgage rates back to Spring 2023 levels), financials, Small Caps etc. which in turn should support the broadening rotation to sustain the global equity bull market.