Get Real

1934 words – a 5 minute read.

Wow, one has to admit that external validation, especially from a well respected source like the Fed, sure feels good. Better than that, it sure makes the model portfolio go POP. Here is Bespoke: “The small-cap Russell 2,000 made a new 52-week high today after hitting a 52-week low just 48 days ago. That's the shortest turnaround time in the index's history to go from 52-week low to 52-week high dating back to the 1970s!”

What great timing, coming at the holiday season when all around one are exhortations to buy, spend and buy & spend some more.. it feels good. Given the strong start to the holiday shopping season, we are clearly not alone in that feeling!

From a portfolio POV though the question is: buy what? Markets have broadened out from the Magnificent 7 to the most new 52 week highs in over two years as the equal weighted S&P crushes the market cap weighted version. We have the most overbought condition for the broad US equity markets in years if not decades; the laggards, bio tech, small caps, fin tech, even some climate names have been shot out of a cannon the past 2-3 weeks.

Jefferies reports: “HF long/short spread is -10% over two days. That's the 2nd worst two day move ever. Stating the obvious, but max pain/chase. 3+ standard dev moves all over the place...pain/chase levels are 10 out of 10.” Here’s BofA: "Leveraged funds are not bullish and continue to fight rallies on the SPX."  These funds increased their net SHORT positions while $SPX has rallied 10% since late October.” Ah yes, the smart money.

To answer the question, we take today’s title & say get real as in buy real assets, like Commodities. The clear laggard asset class, far from overbought (GSG ST RSI 34), the commodity complex seems like one of the big winners from the positive feedback loop developing across markets.

Get Real also refers to how to navigate today’s very distorted landscape between what folks say and what they do. This is true across survey data, across hard vs soft data and across opinion polling vs real activity. Here’s Paul Krugman: “Moody’s, the rating agency, has looked at surveys of businesses, like the one conducted by the National Federation of Independent Business. As Moody’s notes, these surveys include both “hard” indicators like hiring and capital expenditure plans, and softer questions, for example what people say they think about the business outlook. Sure enough, the hard indicators — which tell us what businesses are actually doing — are consistent with a strong economy, while the soft indicators are what you’d expect in the midst of a severe recession.”

The gap between feelings or vibes and reality is oceans wide & miles deep. Its easy to get lost or confused. As investors that is a very dangerous place to be, one we want to avoid at all costs. Here’s Conor Sen of Bloomberg: “People today say they feel much worse about the economy than they have felt about objectively far worse economic situations in the past. Consumer sentiment was lower in Nov. than it was in April 2009, at the depths of the Great Recession. That's vibes.” Its also nuts & the inverse of what folks are doing, as seen in yesterday’s retail sales data. People may not sound good, but they are sure spending like they feel good. Watch what they do, not what they say.

At TPW Advisory we remain focused forward, focused on real life, not reality TV. And hey real life is actually pretty darn good. Just like real economic activity in the US is pretty darn good – falling inflation, stable job market, signs of a manufacturing pick up, continued robust consumer demand etc.

Much of what we have been pointing towards and writing about these past few months seems to be falling into place. When we published our 2024 outlook  now some 6 weeks ago, we noted our 4 for 24 macro and market surprises. We are a bit surprised that several are already manifesting and we haven’t even turned the calendar page yet.

Perhaps we shouldn’t be that surprised – after all we I’d SPEED as a market concept back in 2020 (Covid Speed). Well, things sure do move fast and so this week we saw signs of validation for two of our four macro surprises.

Our #1 macro surprise: lower than expected inflation, sooner than expected, has clearly manifested across both sides of the Atlantic. We expect that to continue as EU energy prices  (Nat gas) continue to plummet while we continue to expect falling US shelter costs to serve as a tailwind for lower inflation prints well into 2024. Here’s REDFIN: “The median U.S. asking rent declined 2.1% year over year in November to $1,967—the biggest annual drop since February 2020”.

As we have seen over the past few weeks, inflation is the driver to both the cross asset space & investor positioning. That’s another macro surprise that has started to be validated: #3, the return to macro stability. We have been on this one for months – first writing about it exactly three months ago when we talked about the $1Trillion reward unlock – highlighting the flood of cash into US MMF and the potential for that cash to reverse into risk assets as it became clear that macro stability was manifesting. The first signs of just that are starting to appear with this one catching our eye: Fintwit reporting that XLK took in the most inflows Tuesday of any day in the past 5 years.

Now macro stability remains a distinctly minority view as virtually any 2024 outlook one picks up will tell you. We note Nataxis’s survey of 500 institutional investors whose #1 risk for 2024 was “geo political bad actors”; we also note that history suggests geopolitics are not a significant driver of risk asset prices over any meaningful time period. We are not blind to these risks but rather see them as being fully discounted and in the price of risk assets. What’s clearly not in risk asset prices, especially outside of big cap US stocks, is a return to stability.

That return to stability is already being flagged by risk asset indicators like the VIX and MOVE indices which have plummeted back to pre Covid levels. Another set up is the constant chatter about how stocks have really not gone anywhere for two years. We see the past two years as a digestive period as risk assets took on board all that has occurred from Covid, to inflation spikes, to Fed & Central Bank rate spikes, to supply chain confusion, the great job market tumult and on and on. 525 bp of Fed rate hikes in under 18 months & more are now in the rear view mirror.

What lies ahead is open field – economically, policy and market wise. The Fed has validated the soft landing (our Middle Path scenario first enunciated back in summer 2022) and taken out the recession call, replacing it with the expected ability to lower rates not because of impending recession but because of falling inflation leaving real rates higher than they need to be (normal real rates is roughly .5%, currently well over 2%).

Market history (something that begins to have utility as we exit the ahistorical period & return to stability) makes it quite clear that its not WHEN the Fed cuts but WHY it cuts that moves markets.  The Finom Group notes that rate cuts to lower real rates  generates SPY returns of roughly 10% pa; rate cuts to fend off imminent recession – SPY falls 15% on average the following 12 months. We are set up for the former not the latter.

As we see it there is a positive feedback loop developing where the Fed can cut rates because inflation is falling; today, it is using its signaling power to let the markets do its work in advance vie easing financial conditions (record easing last month) thus supporting the real economy & providing fuel for laggard rallies in stocks. Housing and mortgage rates are a prime real world example: mortgage rates have fallen from well over 8% to under 7% sending XHB to the moon.

At the same time the market is starting to sniff out that it is in a win win state because if rates back up they will do so most likely because growth is stronger than expected. Consensus 2024 US GPD growth is around 1.5%, even as the Atlanta Fed GDP Nowcast has Q4 at 2.6%.

So, rates fall because the Fed has room for insurance cuts; rates rise because growth is stronger than expected. Who is the big winner here – the same group that has yet to really run – Commodities and to a lesser extent EM equity. I say lesser because ex China EM has had a good run.

Our investment mantra remains: inflation down > rates down > USD down = non US equity and Commodities up.  Here’s Fintwit: “At 44%, the percentage of stocks that are overbought in the S&P 500 $SPX is at its highest level on record. The only other readings above 40% were in June 2003 and June 2020. It's not bearish...both times mkts were just starting to break out”. Pullbacks are to be expected; it's not about whether we make new highs, it's about whether the pullback, which will happen at some point, makes a higher low; we expect so given all that cash on the sidelines.

Thus, those fortunate to be already exposed to much of this scenario, those such as TPW model portfolio clients, should now look to the commodity space for the next up leg. We have been & remain OW Commodities across the complex from energy (fossil to renewable and on to uranium) to miners both precious and industrial as well as to the Ag space.

We note indicators like the historic unwind of net speculative positions in oil or recent Dallas Fed surveys suggesting under $70 WTI and US driller break even levels start to be hit or  COP28’s historic pledge by roughly 20 countries to triple nuclear capacity by 2050 or the numerous 2024 copper production cuts noted by StoneX  or hedge funds with their largest short corn position in years even with corn down roughly 50% over the past 18 months.

Here's StoneX on oil positioning: “Hedge funds reduced net length and speculative length in WTI is now near its 3-year historical net length low (3rd percentile). Speculative positioning could go further to the downside, however, there is a lot more dry powder if prices get moving upward.” We like that.

Our EM equity exposure is as aggressive as it has been in years with equity positions across the Tri Polar World given our view that certain EM countries will be the big winners from the regionalization of supply chains, countries like Mexico, Poland etc. Brazil offers exposure to both the rate story –  10 year nominal rates have fallen over 260 bps over the past year, the most of any major market while ST rates are forecast to fall another 300 or so bps in 2024 & the commodity story as a commodity powerhouse with roughly 36% of EWZ commodity related

Bottom line: Markets can get extended (SPX/VIX at record extreme)…machines don’t know how to sit on their hands & enjoy the ride but we do… so enjoy the ride… take some off when you want but this ride could go well into January with minimal interruption.