- The S&P 500 and Nasdaq remain in a secular (long-term) bull market cycle.
- Economic growth and inflation are temporarily decelerating together.
o The FED’s hope for a soft landing is fading away. - A rate cut in September is highly anticipated.
o And then, what? - Inflation may reaccelerate in Q4 2024 and early 2025.
I continue to be bullish long-term (6-12 months). However, to reach the long-term target, we have to go through mid- and short-term periods first, which I expect to be volatile. The purpose of this article is to explain why.
In my last article (here) on July 1st, I wrote, “If the trends in the Consumer Discretionary and Technology sectors remain positive, it should be challenging for the bears to regain control of the stock market.” Technology represents about 32% of the S&P 500 and 50% of the Nasadq 100. Consumer Discretionary represents two-thirds of GDP. Therefore, the importance of these two sectors. Guess what? The trends in Consumer Discretionary and Technology are changing, which is part of the reason for the market selloff. The rotation of capital out of growth and into defensive sectors is usually an indication of a weakening economy and stock market ahead. The other part of the problem is the Central Bank (FED). From Wednesday’s statement, the FED is now concerned about the economy (employment) and inflation (pricing), not just inflation. They want the latter to be on a clear trend to their 2% target to cut rates. However, the FED failed to signal to investors the timing for the expected interest rate cuts after September, while they still bet on a soft landing of the U.S. economy.
Additionally, a Kamala Harris (KH) administration means higher taxes and more regulation than a Trump administration proposing lower taxes and less red tape. Democrats are considering imposing taxes on unrealized capital gains. If KH wins the White House and Democrats manage to pass such a law, it may kill investor’s interest in Venture Capital and Private Equity investments. These two investment forms are like blood flowing through the country’s aorta for the real economy. KH stands much further to the left than Biden. Therefore, if she wins higher taxes are possible. I’m not suggesting this is the reason for the selloff, but investors grew comfortable with Biden trailing Trump. Everything is changing now, and investors must reassess the new political scenario. Although I keep politics in mind and heart as an individual, from a strict portfolio management perspective, I don’t pay excessive attention to the presidential race yet because it is too early to quantify and assess.
However, the economy and the stock market behavior are quantifiable. Let us focus on it. Aside from the latest news regarding Tesla and Google’s earnings disappointment, economic reports show signs of deterioration. If inflation reaccelerates in this type of economic environment, even marginally, the FED may not continue cutting rates as expected after the September cut. Only a couple of weeks ago, the stock market was priced to perfection regarding earnings, inflation, and monetary policy, ignoring even the slightest probability of inflation reaccelerating or the lack of ability of the FED to properly and timely implement interest rate cuts to successfully manage a soft landing of the economy. Our forecast indicates that inflation may reaccelerate during the last quarter and into Q1 2025 before it decelerates again. If our assessment is correct, we shall experience more volatility in the short and mid-term. The S&P 500 Index lost about -5.70% from the closing on July 16 to the closing on August 2. The Nasdaq 100 lost -9.50%.
We expected the economic cycle to remain in Phase III, where growth decelerates, and inflation accelerates during Q3. Although the stock market does not collapse in Phase III, the current rotation of capital (out of growth and into defensive sectors) combined with the inversion of the yield curve, which now seems to be initiating the flattening process at -0.15 bp on July 24 (in early July, was -0.50 bp), may indicate that the economy is now (hopefully temporarily) entering Phase IV instead of Phase III. The problem with this scenario, where both inflation and growth decelerate, is that the stock market collapses in Phase IV while the yield curve is flattening, the FED cuts rates and investors begin to dump large-cap growth stocks (META, GOOGL, NVDA, etc.) and commodities. Although the FED is concerned about the economy and inflation, after Powell’s statement on Wednesday, my conclusion is that they don’t seem to realize that the economy is entering Phase IV in the economic cycle and the probability of entering into a recession instead of a soft landing, increases. As has happened in the past, the FED is not looking at the bond market, which is telegraphing the problem, or even worse, they may not understand how the bond market works.
A 10-Month Portfolio Review: Following our quantitative indicators, as last year was coming to an end, we increased the capital allocation to risk to benefit from the uptrend that started in October 2023. However, the increase in risk was achieved with low volatility due to narrow stock participation in the uptrend from the very beginning and in anticipation of the flattening of the yield curve and the increasing probability of an economic recession evolving throughout the year. So far, we haven’t had a recession, but history shows that a recession always results in a bear market. This is the risk investors are finally realizing now. It could be cyclical or secular, but a bear market nonetheless. Thus, throughout this period, your Financial Cycle Portfolio (our balanced portfolio) has had low exposure to risk and volatility while still outperforming the benchmark.
Conclusion: We’ve been waiting for this pullback to happen. Now, we shall increase the allocation of risk in pursuit of higher returns whenever our quantitative process indicates that the financial cycle anticipates the economy is entering Phase I or at least, is rotating out of Phase IV. In Phase I, GDP growth accelerates with no inflation, which creates the perfect environment to take on risk in anticipation of higher returns and performance without interference from inflation and higher interest rates.
It remains to be seen if the weakening trend in the economy continues and the U.S. finally hits a recession. However, when the financial cycle enters Phase IV, anticipating an economic slowdown or recession, much of the outcome depends on the FED’s actions and economic reports. At this point, we believe it is prudent to reduce the beta and volatility in your portfolios by increasing exposure to safer assets such as utilities, 2-year Treasury Notes, and T-bills while waiting for the cycle to exit Phase IV. Even if the selloff continues, we expect it to be a short-term event—perhaps a sharp selloff, but clarity should arise after the presidential election on November 5 th.
