The famous game show Jeopardy! had 3 levels; Jeopardy!, Double Jeopardy! and Final Jeopardy!. As players advanced, the rewards and risks doubled increasing the potential gain and loss for the player. Jeremy Grantham uses this analogy to describe today's market.

• Stocks and bonds rose in May despite disappointing earnings estimates knocking down key stocks such as Dell, Kohls and Salesforce.com. The market remains driven by seven key technology stocks, although there has been heavy selling in these names recently.

• The narrative around the Federal Reserve has shifted from rate cuts in January to rate hikes today. Regardless of what is said on TV, our view is that the next move by the Fed will be a rate cut later this year. In the meantime, inflation is stagnating at around 3% while the Fed holds rates above 5%. Based on the post 1970s experience, this could last a lot longer.

• Key leading indicators continue to set records for length of time before recession onset. It is our view that we are going to experience at least a normal recession. Recession severity will depend on Fed policy, Congressional spending and geopolitics. There are many unknowns.

Table 1: Market performance estimate as of 5/31/2024 (LIMW)

Double Jeopardy! and Double Counting

One interesting way to look at the attractiveness of investing in the stock market is to compare market valuation and earnings to historical peaks and valleys. Obviously, we want to buy when the market is cheap and sell when it is dear, but how do we measure it? There are a variety of ways to do this. One of the easiest is to compare stock prices to earnings.

The Shiller P/E was developed by Robert Shiller, a nobel prize winning economist. He postulated that looking at Price-to-Earnings (P/E) ratios over 10-year periods would be more informative that looking at 1-year forward or 1-year trailing earnings reports as many Wall Street analysts do. This method for measuring the market valuation of a stock or benchmark is called a "multiple" (ie a price multiple of earnings: 10x, 20x or 30-times earnings. A stock priced at $25 with $2.50 of earnings would have a P/E of 10.)

Another important factor to consider is whether corporate earnings are at a cyclical high or a cyclical low. Ideally, applying a trough P/E multiple to trough earnings is an excellent time to put money to work in stocks. Selling or trimming exposure when P/Es are high and earnings are at a cyclical high is also desireable.

Jeremy Grantham, an expert on market bubbles, explains today's situation:

Today the market is in the top percentile Shiller P/E of all time, and when you start from this level, you have a very hard time going up materially. You’ve done it once or twice, but you’ve only done it for a while: in the last gasp of 1929; in the last gasp of 1999; and notably and most impressively in Japan, where maybe for two and a half years you kept going. And in each case, they ended incredibly badly. So, the price you paid for bucking that kind of law was a very high price.

In general, if you want to make a lot of money, and you want to have a long bull market, you need high unemployment, depressed profit margins, and depressed P/Es. It’s a beautiful double counting created by multiplying depressed earnings by a low P/E. Multiplying peak earnings by a high P/E, which is what we’re doing today, is also double jeopardy the other way. And the gap between peak P/E times peak profits all the way to trough P/E times trough profits, that’s a big gap. That’s the kind of thing we saw in 1974 and 1982, and to some extent 2009. Yes, it was somewhat higher in 2009 than 1982, but the discount rate, interest rate, everything else had shifted, and it was down an awful lot from its peak.

But it feels good at the top of the spike; it always feels terrific. And people always torture the logic to think, like in 1929, that it’s a “new high plateau.” 1929 – in the most predictive model that I have come across, which is run by Hussman – the only year that is about the same is 2021 (for overvaluation), and a little bit higher, both of them, than today. These are not good times to start a 10-year bull market, and yet, one or two bulls are saying whoopee, this is the beginning of a great bull market.

We have totally full employment, totally wonderful profit margins. All the things you would not want to start a bull market from. This is where you start bear markets from. Great bull markets start with exactly the opposite. But it always feels wonderful. Peak profit margins, getting there takes years, and it feels nice. And so you’ve got a great track record. You can’t get to peak margins without leaving a terrific track record. You’ve got the peak P/E, so you feel wonderful, the stock market has gone up and up and up and up. So everyone feels great, and that’s how you get to a market peak. You feel great about everything. Of course, almost by definition.

When do you start going down? You still feel great. You just don’t feel quite as great as you felt the day before. That’s why it’s so damn hard, at both ends.

Jeremy Grantham, GMO, The Insightful Investor, March 19, 2024

Grantham is using the Double Jeopardy! concept from the gameshow, not the legal theory. On the game show, once the contestant made it to Double Jeopardy! the rewards and risks all doubled. So, in this context when earnings and multiples are high, the risk is the highest with two factors that can both go down. Conversely, when earnings and multiples are both down, the potential reward is the highest, with two factors that can both go up. Thus the concept of Double Counting where there is upside from both valuation and earnings appreciation.

Let's try to quantify some of these important concepts using the peak and trough P/E multiples from the last few cycles.

Table 2: Conceptual comparison of Double Jeopardy! and Double Counting regarding valuation and earnings (LIWM)

Table 3: S&P 500 Peak and Trough Price/Earnings ratios for each major cycle 1990-2020 using Forward 1-year earnings (LIWM)

Looking at these on an XY plot shows us how each cycle transitions from the northwest quadrant to the southeast quadrant of Table 2. This understanding is critical when the end of the cycle is near; up cycles are long and graceful, but markets fall quickly as they transition from expansion to contraction.

You can see that in 2000, 2007 and 2020, both earnings and multiples declined. The 1990 recession was relativey mild and we started with a relatively low P/E multiple that increased as earnings decreased. Notice that there isn't a definitive "peak" or "trough" number across the decades.

In all cycles the Fed played a major role by slowing down the economy, as they are doing today. Each cycle was preceded by a yield curve inversion, as we have today. Inflation is the wild card this cycle because in all the cycles since 1990, the United States experienced secular deflation (ie falling interest rates.)

Figure 1: Comparison of Double Jeopardy! and Double Counting in the four cycles since 1990 (LIWM)

The key takeaway is that while P/E multiples are not at record highs, they are certainly historically high along with cyclically high earnings. Both factors are vulnerable to decline in a recession and the Fed inverted yield curve is predicting that to happen sometime in the near future.

Here is a depiction of the Shiller P/E 1900-2023. Notice that periods of high inflation were awful for stock P/E multiples in the periods during WW1, WW2, and the inflation of the 1970s. Periods of falling or low inflation are best for keeping stocks expensive.

Figure 2: Shiller Price-to-Earnings (P/E) 1900-2023 (LIWM, Robert Shiller)

Early indicators still warning of trouble

Our favorite leading indicators are still predicting trouble. The Conference Board's Leading Economic Indicator and the Federal Reserve's Inverted Yield Curve have correctly anticipated recession in the past and may continue to do so today.

Other indicators show potential problems, but no recession. Some of these are the Purchasing Manager Indexes (PMI) from the Institute for Supply Management (ISM) and S&P Global. Each survey indicates weakness, but not a current recession.

Figure 3: Service and manufacturing PMI surveys weak, but not disasters (LIWM)

Inflation is stabilizing at 3%

While not falling to the Fed's 2% target, at least inflation is well below the recent high of 9% we experienced following the pandemic. The critical question is whether the Fed will be satisfied with this situation or keep policy tight hoping for further declines in inflation.

The Fed is caught between a rock and hard place. On the one hand, the financial system is hurting from high interest rates. We had major bank failures in early 2023. On the other hand, massive government spending is supporting economic growth and inflation. It is unlikely the Fed will cut rates without a major stock market sell-off or another large bank failure.

Figure 4: Federal Funds rate (FF), consumer price index (CPI), and 10-year Treasury yields (LIWM)

Surveys of consumer inflation expectations are subdued. This is important because there is a behavioral aspect to inflation. The belief that inflation is rampant causes workers and industries to expect and demand new higher prices. Subdued expectations lower the probability of runaway inflation in the near future.

Figure 5: Federal Funds rate and consumer inflation expectations 2000-2024 (LIWM and University of Michigan)

Recently, the Federal Reserve has kept its policy interest rate below expectations to stimulate demand and growth. That was in an environment of stable and low inflation.

Clearly, we are in a different environment today. In the 1980s when the Fed was actively trying to suppress inflation, they kept their policy rate wayyyy above inflation expectations. This is not a prediction of the future, just an observation of how the Fed has behaved in the past.

Figure 6: Federal Funds rate and consumer inflation expectations 1978-1985 (LIWM and University of Michigan)

The labor market continues to gradually weaken

The unemployment rate is creeping higher and is almost to the point where we can confirm recession onset. Unfortunately, this data gets revised, so we may be in a recession and not know it.

Figure 7: Household unemployment rate versus Initial Jobless Claims 2021-2024 (LIWM)

One of the reasons the labor market is so tight today is that many folks are retiring earlier than expected. Over the last 10 years, the ratio of those expecting to work past age 62 has fallen dramatically.

A tight labor market encourages higher wages; higher wages support inflation.

Figure 8: Share of workers planning to work beyond age 62 (Yahoo Finance)

It's a narrow market

When the stock market's movement is driven by fewer and fewer names, we call this a "narrow market". A narrow market is not necessarily a healthy market. Sustainable bull markets need all stocks to participate to a greater or lesser degree.

Since the pandemic, the technology sector has been the standout sector compared to all others. In the last two years, 6 tech names have dominated market performance because of their size and high correlation. In recent months, only one stock, Nvidia, has been the driving force behind the market. This pattern exemplifies the narrow market concept.

The problem of course is that once these market leaders weaken, there must be some other group to pick up the baton to run. Unfortunately, companies like Apple, Microsoft, Tesla, and Nvidia are so large, there really isn't any alternative. If they go down, the market will likely fall with them.

All eyes are on Nvidia.

Figure 9: Narrow markets are driven by a few stocks (LIWM)

Final thoughts

What are we to make of the markets?

1. Stocks are acting as if Fed rate cuts are cancelled.
2. Oil prices are falling like we are in recession.
3. Gold prices are falling like rate hikes are imminent.
4. Bonds are falling like inflation is rising.
5. Natural gas declining as if demand is decreasing.

Our view is that inflation is tamed for now but risks rising if the Federal government keeps spending heavily. The Federal Reserve is trying to figure out a way to suppress inflation and interest rates to help the banks without hurting the economy. These are mutually exclusive goals, in our opinion. Corporations began layoffs several months ago and the unemployment rate bottomed last year.

It looks like we are gradually slowing into a normal recession. The bond market has partially accepted this; the stock market is hoping spending on artificial intelligence will save the day.

If you'd like to discuss any of our research, please feel free to reach out to us.

Rob 281-402-8284

Chris 281-547-7542

Rob Lloyd, CFA^®

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-402-8284

Robert.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

Christopher Lloyd, CFP ^®

Vice President and Senior Wealth Planner

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-547-7542

Chris.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

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