November 2023 Market Update

What a ride November has been. The S&P500 thirty days ago was trading around 4,110, it is now near 4,550. Up 10.6% in four weeks, and year to date up +18.6%. It has been an interesting year for market strategists. Anticipating the effect on future earnings trajectory from regime change at the Federal Reserve has been challenging. There have been many reasons to be bearish risk, but despite these risks the S&P500 has clawed its way back to almost breakeven over the past two years.

It is important to note that the cash return has beaten the S&P500 return over a two-year period, since the anticipation of interest rate hikes began to be priced in.

For markets to be up +10.6% in thirty days one would expect some new information about earnings growth or economic strength to appear. But no. Markets have simply rallied in anticipation of a weakening economy getting weaker and leading to interest rate cuts from the Fed. As if a decline in employment is good for future earnings estimates. Furthermore, if we look inside the S&P500 and peel back the onion of what is driving returns we get a clearer picture of how strong the market really is.

So, let’s dig in. Of the 500 stocks in the S&P500, seven stocks are responsible for the majority of returns year to date. The top seven stocks account for around 30% of the index. These seven stocks on a market weighted basis are up approximately 16%, while the other 493 stocks are only up approximately +3.50% year to date. The cash rate of +4.30% is beating the returns of the other 493 stocks for the year. The equal weight S&P500 is now only up +1.5% as of today. Cash is King. We would not trade cash for the top seven stocks at their current valuations or the other 493 stocks into a potential recession.

Did equity strategists or financial advisers predict this would be the case when they suggested the economy would grow and the stock market would do well? That on an equal weight basis the top seven stocks would rise +88% while the entire S&P500 equal weight index only rises +1.5%. Highly doubtful. This market should be viewed as an anomaly. A narrow market driven by seven stocks is not healthy and is a sign of deteriorating business conditions.

ISM manufacturing PMi is a leading indicator to S&P500 earnings growth expectations (r = 79% with a 4–6-month lead time) which means the ISM manufacturing index leads S&P500 earnings growth by 4 to 6 months with a 79% correlation. ISM has now been in contraction for 12 straight months. Earnings estimates are overstated.

We have been consistent all year in stating that earning estimates for 2024 and 2025 are fantasy. As the long and variable lags from Federal Reserve interest rate policy begin to take hold, earnings optimism should dissipate, leading to a decline in rental prices for primary residences while the unemployment rate begins to rise.

We have seen many historically consistent early indicators of recession ignored by the market so far in 2023, such as temporary help services, leading economic index vs coincident economic index, and commercial and industrial loan demand. Loan demand appears to be entering a troublesome period.

Temporary help services has been a consistent and reliable indicator of continued economic weakening.

Chart credit: Liz Ann Sonders, Charles Schwab, Bloomberg. A read on the LEI vs the CEI suggests economic trouble ahead.

As the effect of the Federal Reserves interest rate policy moves through the economy, commercial and industrial loan demand is contracting at a magnitude consistent with previous U.S recessions.

While economic trouble continues to brew, leading sectors of the economy such as software and finance have seen employment begin to meaningfully decline.

The economic data suggests a weakening economy and the distributions of performance returns suggests the same.

Our recommendation since January has been to position portfolios to endure a recession, in a defensive manor, risk off and in cash, T-bills, money market funds, fixed income duration extended in September from 0-5 year to 0-30-year U.S. Treasury bills and notes, 10-year minus 2-year yield curve re steepening and select low duration U.S. equities.

The U.S. bond market is on track for its best month in four decades. The Bloomberg US Aggregate Bond Index has risen +4.4% so far in November. Best monthly performance since 1985. We feel there is a risk that bond yields move higher one final time and would use a move higher in yields as an additional buying opportunity.

We believe there is value in owning the U.S. treasury market with a 5% nominal yield and 2% or greater real yield in the event of U.S. recession. We remain patient and focused on managing risk.

Disclosure: Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.

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