One of the reason economists follow so many data points is because there is no silver bullet. It is like we are trying to map the outlines of a forest while walking within one.

• Large cap stock, especially technology stocks, rallied during June. Small caps fell along with international bonds. Domestic bonds edged up slightly.

• The market reflects the "good news"/"bad news" dilemma we've been wrestling with for about a year now. The good news about lower inflation and lower growth has not led the Fed to cut interest rates. On the contrary, in anticipation of rate cuts, stocks have risen dramatically. In an ironic twist, the higher stocks go, the less likely the Fed will cut rates. This bad news about Fed rate policy and interest rates means more drag on the real economy and potential recession.

• 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. Many of these factors won't be resolved until after the election.

Table 1: Market performance estimate as of 6/28/2024 (LIMW)

The consumer is in a foul mood, but continues to spend, spend, spend

Have you noticed everyone is irritated over inflation?

There are many people comparing today's prices to last year's and those of 2019 before the pandemic. We do not think it is possible for prices to fall to pre-pandemic levels after the massive increase in money supply and stimulus during 2021 and 2022. As in the 1970s, the spending power of our money has been damaged by government policy.

Consumers exhibit mixed emotions over their situation. On the one hand, they are in bad moods about inflation, jobs, immigration, crime, and taxes. On the other hand, they are spending money like crazy and believe the stock market is likely to continue rising.

Part of this phenomena is a bifurcation between the experiences of the wealthy and everyone else. Those with investments have done well these last few years and are spending normally. Inflation has squeezed the poor and working classes very hard because they tend to live on current cash flow. With prices rising, there is less cash for extras.

Here are a few charts on consumer sentiment and consumer spending. We expect the spending numbers to weaken as layoffs increase. This will be the mechanism that slows stocks and inflation: loss of job, less income, lower spending, lower company earnings, and thus falling stock prices. This is the pattern of most recessions.

Figure 1: Consumer expectations of better business conditions compared to expectations of stock prices (Conference board)

Figure 2: Index of consumer sentiment (Conference Board)

Despite a sour mood, consumers continue to spend quite heavily, even after adjusting for inflation.

Figure 3: Consumer spending adjusted for inflation (BEA and Wolfstreet.com)

The Fed can't be happy that inflation is stabilizing at 3%

Headline and Core inflation seem to stabilizing at around 3%. This is not good news for the Fed because their policy target is 2% and they need to see some inflation progress or a weaker labor market to justify rate cuts.

The Fed is caught between a rock and hard place. On the one hand, the financial system is hurting from high interest rates. Commercial real estate is desperate for a normalization of tenant activity and support for building valuations. Banks are carrying large losses on their balance sheets. On the other hand, Congress and the White House are bailing out most institutions as they fail. In 2023, 3 major banks were bailed out in violation of the spirit of the Dodd-Frank financial reforms after the Financial crisis. Bailouts are inflationary.

The key risk for the Fed is that if they cooperate in more inflationary bailouts or stimulus, the bond market slips away and we see much higher interest rates. This would be a direct replication of the 1970s experience.

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

Figure 5: Core PCE inflation v. Federal Funds rate (LIWM)

Let's compare the current situation to the 1970s nightmare. This is the chart that keeps Fed chairman Jerome Powell up at night. Notice that there were 3 giant waves of inflation as the Fed chased inflation up and down through the 3 recessions of 1970, 1974 and 1980. What a disaster!

Figure 6: Federal Funds rate (FF), consumer price index (CPI), and 10-year Treasury yields 1960-1980 (LIWM)

Is the labor market starting to weaken?

There are 3 main data points on the labor market that we follow:

1. Weekly Initial Jobless Claims (reported by the states)
2. Monthly payrolls data (reported by corporations to the federal government)
3. Monthly unemployment (household surveys collected by the federal government)

#1 and #2 continue to show relative stability. #3 unemployment is beginning to breakout to the upside in a way that indicated recession onset.

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

The payrolls employment data #2 is heavily revised each month as the statisticians collect more data. If you look at history, these revisions demonstrate a heavy "pro-cyclical" bias: when things are getting better, revisions are positive (2021-2022); when things are getting bad, revisions are negative (2023-2024). Do you see the pattern? Now look at 1982, 2002 and 2008. The current revisions imply that we are already in a recession.

1986 is interesting because the Fed was raising interest rates. While they did not trigger a recession, they did violently crash the market in 1987.

Figure 8: Non-farm payroll data revisions 1978-2024 (Jeff Weniger)

The real estate market is turning south

Most properties are purchased using debt. Many are familiar with the math on mortgage rates: when interest rates are higher, the cost of the monthly mortgage rises. Because buyers typically are working within a budget, they can only afford to pay a price based on the monthly payment. Higher rates imply lower prices, all else being equal.

In both residential and commercial real estate, we are seeing clear signs of prices falling. After the financial crisis we all learned that property can actually fall significantly in value. It seems quaint that as recently as 2007, the Fed was operating on a policy that assumed the property markets could not fall.

This is important because stable or rising property values are important for the quality of loans held by banks and investors. If property owners begin defaulting, that is bad for the people who lent them the money to buy those properties.

While we are not forecasting a financial crisis driven by debt defaults similar to 2008, it is good be aware of these potential aggravating problems in real estate.

Figure 9: Residential property prices are falling (Wolfstreet.com, NAR and Commerce Department)

Figure 10: Supply of homes for sale increasing dramatically. Look familiar? (NAR and Commerce Department)

Figure 11: Home price relative valuation compared to rent and interest rates. Yikes! (Federal Reserve)

Figure 12: Example of desperate selling in commercial real estate (LIWM)

Figure 13: Commercial construction starts plummets

Leading indicators and the timing of the next cycle

Our favorite leading indicators still are pointing to recession and not expansion. The Conference Board's Leading Economic Indicator has been saying "recession" for 29 months; the bond market Yield Curve Inversion signal has been saying "recession" for 19 months.

Massive stimulus from the federal government keeps moving the economy forward. Of course, it is not sustainable. It is also unclear when and if the bond market will revolt and we see another spike in interest rates. So far, Fed policy has calmed bond investors with promises of restraint. We will see.

Here is another analysis that compares yield curve inversion with a slowdown signaled by the ISM Services PMI indicator (the Institute for Supply Management Services Purchasing Manager Index). The United States is primarily a service economy and service economies do not respond to central bank interest rate policies quickly. Notice the 33 month lag between yield curve inversion and PMI trough: 33 months in 2008! We are only 19 months into our yield curve inversion. By this metric, the bottom in economic growth can be a year away.

Figure 14: Yield Curve Inversion compared to ISM Services PMI (Jeff Weniger, ISM, Refinitiv)

Fed rate cuts are the tease that keeps giving

It seems like the stock market keeps rising on the same narrative month after month: "The Fed will soon cut rates and that is ALWAYS great for stocks!"

Except that this statement of common knowledge is not true. The Fed doesn't cut interest rates to stimulate stock gains. The Federal Reserve cuts rates in response to market failures or recessions. All the large rate cutting cycles of the last 40 years occurred in the middle of recessions: 1990, 2000, 2008 and 2020.

What IS true is that after the market selloff and recession, after interest rates have fallen, eventually the markets recover to new gains.

Figure 15: Fed rate cuts compared to S&P 500 year-to-year performance (LIWM)

Here is a helpful illustration of the Circle of Life for investors. There are four parts to each economic cycle: Recession, Recovery, Expansion, and Slowdown.

Each stage has a profile regarding interest rates, earnings, employment and inflation. Today we see falling inflation, falling employment, OK earnings, and high but stable interest rates. That places us squarely between Slowdown and Recession.

The stock market will react when earnings begin to get cut; earnings will cut as employment weakens and consumers stop spending.

Figure 16: The Circle of Life (for investors) (LIWM)

Valuation hints at where we are in the cycle

Valuation metrics cannot be used for market timing. However, it is very helpful to understand when the market is at valuation extremes and vulnerable to sudden changes to to the interest rate policy of the Federal Reserve.

This chart shows blue lines for S&P 500 earnings times various multiples (25x or 25 times 1 year forward earnings, 20x, 15x, and 10x). You can see how expensive the market was in the lead-up to the 2000 top and low valuation in the trough earnings of 2009.

Please notice that each major earnings and valuation cycle was coincident with Fed tightening policies and an inverted yield curve. What do we have today? An inverted yield curve and Fed tightening policies.

Figure 17: S&P 500 index, forward earnings multiples 1985-2024 (Ed Yardeni and Datastream)

The stock market is dominated by a few names

The stock markets are dominated by a handful of stocks. Nvidia itself has done most of the heavy lifting pushing up the markets this year as investors bet heavily that artificial intelligence will change the world.

Currently, the top ten stocks are 31% of the S&P 500 and the technology sector alone weighs 29.5%. What that means is that broad market performance is going to be driven by the behavior of a handful of names.

For those carrying these names remember technology stocks are heavily cyclical and the current top names have historically high valuations.

Figure 18: Six large tech companies driving the S&P 500 (LIWM)

Figure 19: The S&P 500 with current support lines (LIWM)

Regulators take a heavy blow

Regulations and court opinions can heavily impact the business world. Last week, one of the most important doctrines behind the modern regulatory state was overturned at the Supreme Court.

The concept of Chevron Deference was a legal doctrine that came out of the 1984 Chevron versus Natural Resources Defense Council case. This principle of administrative law required the courts to defer to administrative agency interpretations of laws. This concept allowed an enormous growth of regulations as regulators wrote rules that were essentially laws. This doctrine no longer holds.

This is important because a whole raft of cumbersome regulations are now at risk and may be overturned. This will likely lower costs for businesses, encourage entrepreneurship and energize our economy.

Final thoughts

The markets are not always logical and each cycle is driven by different circumstances. In this cycle, the Federal Reserve is trying hard to slow things down at the same time Congress has opened the spending flood gates. As we saw in the 1970s, recessions can still happen even when the government is spending heavily, but inflation becomes an ongoing issue. Let's hope we don't relive that difficult decade.

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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