Have you ever been late to catch a train or flight? The urge to run can be overpowering. We all know logically that there will be another train eventually, so our stress is not logical. It's about emotion. Markets are rarely logical nor are they machines; they are driven by millions of investors making emotional decisions about money. That is why we have massive moves up and down. Even algorithms designed to trade automatically are programmed to analyze human behavior, thus reinforcing the behavioral aspect of the market. In our view, October 2022 wasn't "the" low. For this cycle, the low is probably still ahead of us.

• Stocks and bonds rallied in November as the bond market mood changed from fear of higher interest rates to anticipation of Fed rate cuts in 2024. Stocks are betting that the Fed will panic and cut rates at the first sign of trouble. Bonds are hoping that the inflation problem is resolved.

• Many leading indicators of economic activity are displaying clearearly-recession types of signals. Earnings, employment, tax receipts and new home prices are all weak.

Table 1: Market performance estimate as of 11/30/2023 (LIMW)

Leading indicators stink

Most of our leading indicators show weakness and suggest that a recession is imminent. However, the paragraph title refers to our mindset after looking at all these leading indicators that show problems: Where is the recession?

This is the dilemma with looking at leading indicators. They are leading by design and show the potential for problems long before they appear. Today, everything seems ok: GDP is positive, the stock market has not fallen much, employment is good, profits are generally ok and on some things the consumer is spending like crazy.

Yet, there is a troubling list of data points that resemble periods prior to notorious recessions:

1. Central banks around the world are shrinking their balance sheets (ie. pulling back prior stimulus).
2. Yield curves are inverted in most major markets such as the US, UK, & Europe (ie. short-term interest rates are higher than long-term interest rates).
3. The US unemployment rate has moved up significantly from its 2022 low.
4. As in with many prior recessions, the ISM manufacturing index has fallen below 50 for 12 months.
5. The Conference Board's Leading Economic Indicator (LEI) has fallen for 19 consecutive months, a trend only observed prior to the 1973 and 2008 recessions.
6. Stock market leadership has narrowed to a handful of names, just like lead-up to the 2001 recession; the S&P 500 itself peaked nearly 2 years ago.
7. Banks have gigantic unrealized bond losses on their balance sheets. While all bond investors have lost money, the banks have done so with enormous leverage.
8. The US Federal Reserve is now 21 months into its rate hiking cycle.
9. Federal tax receipts have declined for seven months, a sequence usually observed before recessions.
10. Bank credit is starting to contract, starving the economy of capital.
11. Trucking employment is falling faster than the 2000 and 2008 recessions.

We could add more bullet points, but you get the idea. The amazing thing is how well employment and the stock market have held up in the face of these problems.

Ironically, the longer the stock market and labor market perform well, the longer the Federal Reserve will hold up interest rates, increasing the odds of an eventual hard landing for the economy and creating trillions in interest expense for the Federal Goverment. Our leaders have landed us in a real pickle.

Let's look at some of the most interesting leading indicators and then conclude with an analysis of the equity and bond markets.

Leading economic indicator down 19 months

There are many indicators designed to forecast different things. The Conference Board's Leading Economic Indicator (LEI) is designed to forecast economic growth and recessions. It has been negative for 19 months, matching the pattern before the 1973 and 2008 recessions. If you remember, both those recessions were very difficult.

Figure 1: Leading Economic Indicator index down 19 months (Conference Board)

Manufacturing and service indexes are weak

The Institute for Supply Management surveys business activity and generates a variety of indexes. In particular, the manufacturing index has a very long track record. While we are not a manufacturing economy any more, it is helpful to see where the cyclical industries are at. Service economies like that of the USA tend toward stability, but are still affected by the cyclicality of the global economy.

Figure 2: Institute for Supply Management indexes for manufacturing and service sectors (LIWM)

Federal Reserve surveys turning down

Each month, the Federal Reserve performs surveys on their component regions and assembles a book of anecdotes to describe local business conditions. Naturally, those with an analytical mindset want to aggregate and analyze the data to tease out a trend. We decided to analyze the headlines as reported for each region.

You can see in the month of November, the phrases all tended to say something worse than in prior months. This is another "soft" indicater telling us the economy changed for the worse in October.

Table 2: Federal Reserve Beige Book Economic Activity Title Phrases (LIWM)

Headline inflation continues to fall

For most of the last year, headline consumer price inflation (CPI) has fallen. The Core PCE inflation figure followed by the Fed just fell to +3.5%, so there is a well recognized decline in inflation. This doesn't mean prices are falling, just that they are increasing at a slower rate. Unfortunately, the pre-pandemic price regime is not coming back and our high prices are likely to stay.

Inflation falls for a variety of reasons: supply chain improvement, innovation, efficiency, and falling demand (ie. recession).

Notice the Federal Funds rate of 5.3% is well above the 10-year Treasury and CPI level. The Fed is pressing HARD on the economy's brake pedal by holding their policy interest rate above CPI and the US 10-year Treasury bond yield.

Figure 3: Headline consumer price inflation (CPI) (LIMW)

The Fed has hinted at a "higher-for-longer" interest rate policy to suppress inflation. During the 1980's, this was exactly the policy implemented by the Fed.

The markets generally believe the Fed will cut rates at the first sign of trouble. Since the 2000's, this has been their game plan for any market turbulence.

As we move through recession in 2024, we will see which policy the Fed will pursue. The "higher-for-longer" policy may help avoid a 1970's inflationary episode and has historical precedent.

Figure 4: Federal Reserve interest rate policy, inflation and 10-year yields 1980-2000 (LIWM)

Much ado about "Sahm"-thing

Claudia Sahm is a Federal Reserve economist that documented the connection between rising unemployment rates and recession onset. Once the 3-month moving average of unemployment rose 0.5% from its recent low, the economy was either in or commencing a recession. This has occurred in every cycle she studied.

So our first unemployment chart is the one used to apply the "Sahm" rule. We are in month #1 of the unemployment rate rising +0.5% over the low earlier in the year.

The other important labor chart relates to permanent job losers. Permanent job losers are economically important because their lost jobs paid well and they received health and retirement benefits. Loss of a permanent job significantly affects a consumers spending. You can see from the chart this job loss rate is moving up significantly, just like each recession over the past 30 years.

Figure 5: Unemployment rate at recession turns v. S&P 500 (LIWM)

Figure 6: Permanent Job Losers 1995-2023 (LIWM)

Bond market to banks: "Stop Lending!"

Interest rates matter a lot. Here is an update on the difference between long-term and short-term interest rates. When short-term rates set by the Fed are higher than long-term rates set by the market, banks are discouraged from lending. This contracts the supply of credit and the overall money supply, slowing economic growth.

We can see the cause and effect in a handful of charts. First, there is the cause (short rates > long rates). The second and third charts show the effects as bank lending behavior slows.

Figure 7: 10-year minus 2-year Treasury spread v. S&P 500 (LIWM)

Once the bond market reduces the incentive to lend, banks begin to tighten credit and slow their lending by only extending loans to their most reliable borrowers. Of course, this directly affects the economy because many people borrow money to buy houses, go to school, buy cars, expand businesses, and finance large projects.

Figure 8: Percentage of banks tightening or loosening lending standards (tighening means banks make it harder to borrow) (LIWM)

Figure 9: US Commercial and Industrial Loan growth 2000-2023 (LIWM)

Equity market: "The train has left the station!"

The stock market is a mish-mash of conflicting signals. Let's set aside the recession evidence and examine what the stock traders see on their screens:

Bullish stock investors say this:

1. Markets successfully tested the 200-day moving average.
2. The uptrends from 2020 and 2009 are still in play.
3. If the market breaks out to new highs (ie. SPX > 4800), the sky is the limit. Potential for a parabolic move higher.
4. These investors believe the Fed will cut rates at the first sign of trouble.
5. The historically reliable Coppedge indicator says the market will not retest the October 2022 low.

Bearish stock investors say this:

1. The 2020 uptrend was violated in October 2023.
2. The 200-day moving average was clearly broken before bouncing.
3. SPX and NDX are extremely over-bought, especially the Magnificent 7 (AAPL, MSFT, GOOG, FB, NFLX, AMZN, and NVDA).
4. The overall market is mirroring other bear market rallies from past bear markets.
5. These investors believe the Fed will hold rates "higher-for-longer".

Because we are long-term investors, we are obliged to look at all the evidence when making a call on the market. While we recognize there are some compelling bullish aspects to the current stock market, the weight of the evidence leads us to a bearish conclusion. In particular, the fundamental evidence for recession is compelling and will create difficult times for stock bulls. The Fed wants to slow the economy and we don't think fighting the Fed is a good investment strategy. The bulls are fighting the Fed.

Figure 10: S&P 500 weekly 2019-2023 (LIWM)

Our LIWM Bear Market Indicator still shows a very high probability for a continuation of the current bear market. Its factors are different than that of the Conference Board's LEI; the Conference Board is trying to predict economic recessions, while we are trying to predict bear markets.

Here are the 5 key variables we capture in our indicator:

1. 10yr-2yr Treasury bond yield spread (yield curve inversion)
2. ISM manufacturing index (slowing economy)
3. Inflation (Core Personal Consumption Expenditure inflation)
4. Cyclically adjusted SPX Price/Earnings ratio (stock valuation)
5. Unemployment rate (headline monthly household survey rate)

Figure 11: LIWM Bear Market Indicator 2000-2023 (LIWM)

Bond market: "Did we just become best friends?"

After inflicting deep pain on investors for nearly 2 years, interest rates seem to have peaked at the end of October. This was the best monthly performance for bonds since 1985. The real question is why did rates peak and are they likely to continue declining?

One of the dominant narratives on bonds this year is the profligate spending by the federal government. In terms of dollars, we are seeing record budget deficits and interest expense on the national debt. The current spending trajectory seems to be an unstoppable train. We addressed this in September with our deep dive on the national debt and concluded that in the short-term, the national debt and spending are sustainable.

Yet, something changed in late October 2023. As 10-year Treasury yields crested 5%, the debt-meltdown prophets went into high gear claiming this was the end of the dollar-based trade system. There seems to have been a mood change as the fear peaked, however. On trading desks, rumors spread of large institutional accounts (ie. pension funds and insurance companies) willing to buy all the long-term US Treasury debt effectively yielding over 5%. Yields quickly collapsed after prominent hedge fund manager Bill Ackman announced he had closed his Treasury short position and expected the Fed to start cutting interest rates in early 2024. Perhaps investors started to believe that the Fed would successfully defeat inflation.

A decline in trading volume coincident with a price bottom is precisely the market profile we discussed last month when looking for a bond market bottom scenario. It looks like that is playing out below.

Figure 12: 20-year Treasury bond ETF TLT 2017-2023 (LIWM)

Final thoughts

It is our view that the stock market completed a bear market rally in July 2023 and is resuming its downward path. The bond market, after showing signs of capitulation selling in October, rallied sharply in November indicating a potential bottom for bond investors.

After being deeply over-sold in October, the equity market has reversed to an over-bought position in November. The combination of over-bought charts and recessionary fundamentals suggest to us a very difficult environment for stock bulls in December.

We enjoy discussing our research and how it relates to your situation. Feel free to give us a call if you want to talk. It is important to consider your portfolio allocation as interest rates peak and the economy slows down.

We look forward to hearing from you!

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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