Summary

‍

Our models are showing earnings and price momentum beginning to assert themselves. This is beneficial on the way up, but a risk management nightmare when it reverses. Enjoy the music while it lasts, but be realistic about the assumptions propping up this market and hedge below a 5675 S&P 500 weekly close. If the consensus plays out that supportive central banks globally will be successful in boosting consumer and business demand while inflation stays contained, another 5% rally in the S&P can unfold. However, we believe that there are three market misgivings outlined below that could form a long-term equity top sometime this quarter. The August 5^th market unwind may not be buried in our past and may be a preview of what is to come. The Fed is drawing incorrect conclusions regarding the employment situation based off the wrong data. China's stimulus is merely illustrating how massive a problem they are truly facing. To look for a surprising outperformance, small cap outperformance could be it in Q4.

‍

‍

A Parting Thought to Begin

‍

OK, so this is Equity Paradise? Stocks are discounting a utopia with central banks easing, low inflation, and steady economic growth with solid earnings.

What comes to mind is the song “Heaven” by the Talking Heads from way back in 1979. Perhaps you recall the chorus (the part about Heaven being a place where nothing ever happens). However, a less familiar part of the song that may be relevant for Q4 2024 is the second verse:

There is a party

Everyone is there

Everyone will leave

At exactly the same time.

Something to consider as we traverse through the fourth quarter of 2024. Momentum’s resurgence is heavenly, and a reason to party. However, when things reverse, everyone will try to exit through the same door.

‍

‍

The Blank Canvas of Big Questions

‍

Several major questions must be addressed over the next quarter.

• Are economies on the verge of entering a rapid global reflation now that the Fed has joined other central banks by cutting rates?
• Has inflation been tamed?
• Will unemployment start to accelerate? 
• Is Chinese policy putting a floor under its problem?
• Are low credit spreads screaming that there is no Fed restrictiveness?

‍

‍

Unemployment Is Key, and Don’t Forget About Inflation

‍

At the risk of stating the obvious, the direction of monetary policy drives stock market sentiment. Monetary policy will be driven primarily by the unemployment rate and could get surprised by inflation data because it is now off everyone’s radar. The Fed has placed its flag in the ground:

• Inflation is no longer a concern
• Because inflation won’t flare up, we can ease to support the weakening employment picture
• We are going to a terminal Fed Funds rate between 2.5% to 3.5%, so it was time to reduce some of the restrictive policy

Goods inflation appears to be hitting a floor, and tariffs will help push goods inflation higher, regardless of which administration takes over in January 2025. Secondly, if immigration is restricted, a smaller pool of labor supply will push wages up and increase services inflation.

If inflation fails to drop further, the Federal Open Market Committee (FOMC) could begin to question whether it should continue its rate cutting campaign. Secondly, if unemployment fails to rise further, the FOMC may point to low credit spreads and start the “maybe we never were sufficiently restrictive” conversation.

Before the August payroll report and September CPI, I wrote the following:

The FOMC will not cut interest rates at the next Fed meeting (and possibly for December) if:

• At the end of October, the Core Personal Consumption Expenditure Price Index (PCE) does not move below 2.6%

and one or both of the following happen:

• August unemployment rate drops to 4.1% in September

• September unemployment is in the 4.0% to 4.1% range on November 1.

Unemployment peaked in July at 4.3%, went to 4.2% in August and that September report did report the 4.1% mentioned above. Core CPI rose to 3.3% in September and supercore CPI also rose (non-housing core services inflation). The market is aligned with the Fed’s view of another 150 basis points in cuts through 2025. One FOMC voter wasted no time after CPI to say that he prefers not to cut in November. If the market prices in the potential of the Fed removing some of their promised accommodation, that makes further gains in the broad stock indices that much more difficult.

‍

‍

Intermission

‍

If this data-dependent Fed decides to pause, then markets will have to ask themselves what would motivate them to begin to cut again. Another important point to consider is that there will be no more Fed cuts if interest-sensitive spending on homes and autos picks up. This is critical for the stock market rally that has been fueled of late by the hope of six more rate cuts. If spending picks up, it is normally bullish for stock prices and valuations. However, now a stronger consumer may not translate into further stock market gains, because the FOMC will fear that its rate cuts are stoking demand, and they will back off on more rate cuts.

Conversely, a trigger for an even more aggressive rate cut schedule occurs if unemployment hits 4.5%. The September Summary of Economic Projections’ highest forecast was 4.5% for 2024 among all 19 participants. As for 2025, the central tendency (which cuts out the highest and lowest three forecasts) is 4.2%-4.5%. Therefore, expect 50 basis point cuts on 4.5% unemployment prints, but at that point, more accommodation will not help stock prices in a sharply slowing economy.

‍

‍

White Lie # 1: The One-Day Crash of August 5 is Behind Us

‍

This is supposed to be an outlook, not a review. However, this event, now long forgotten, is now an integral part of the market’s future. Last quarter’s outlook was titled “Sell the House, Sell the Car, Sell the Kids” which was published just before the market peaked on July 16, and was punctuated by the volatility melt-up/mini crash into August 5. And then…empty space. It was followed by a rally to new all-time highs. Japan had more of a shake-up, falling 12% on that chaotic Monday.

The minutes of the September Federal reserve minutes described this “brief incident of elevated market volatility” as being caused by:

A rapid unwinding of some speculative trading positions induced by unrelated events—such as the unexpectedly inflation-focused communications from the Bank of Japan (BOJ) in late July and the weaker-than-expected U.S. employment report in early August—and amplified by technical and liquidity factors.

Well, that is a textbook definition of how the market gets taken down by surprise. The Fed concluded that the unwinding process was contained, with a rapid recovery to a balanced, functioning market.

Oftentimes the market shows its hand on the downside, such as Q2 1987 or Q3 2007, and then a reversal occurs, which creates a sense of invincibility. That does not rule out a 5% rally to 6100 in the S&P 500, but those types of market shocks are rarely isolated events. We are drawing a line in the sand at 5675 in the S&P 500 Index, below which one should place hedges and reallocate portfolios.

‍

‍

White Lie #2: The Dirty Little Secret About the Job Market

‍

People who are currently out of work and looking for jobs are facing much tougher odds than before, and certainly a much tougher environment than what the Fed perceives. If that cohort cannot find jobs, expect a 4.5%+ unemployment rate even if layoffs stay low.

A study out of the Minnesota Fed backs our assertion from our Q3 Outlook that employers no longer fear replacing their current employees, and because of that seismic shift, the demand for labor is falling. As soon as sales turn down, unemployment will rise faster than we have already witnessed. We dismiss the inflated job openings data that the Fed favors. What matters is the hiring rate. We argue strongly against the FOMC’s emphasis on how few layoffs there are. They are missing the point.

The study, based on an earlier 2012 study that came to the same conclusion, turns the Fed’s conventional wisdom about what moves the unemployment rate on its head. It seems logical that the number of people losing a job drives the unemployment rate, as would changes in the number of people without a job who are looking to get hired. However, what drives unemployment up or down is not the inflow to the unemployed, but the number of people who leave the ranks of the unemployed and find a job.

Therefore, the key data series is the job finding rate, or the fraction of unemployed workers getting hired every month, and that level has fallen below pre-pandemic levels. The research found that each job opening is being pursued by 1.5 job seekers, not what the FOMC calculates as each worker pursuing 1.4 jobs.

When looking at it through that lens, all the other data makes sense. We pointed out that existing workers are not quitting their jobs anymore. They are petrified that if they quit, they will not be able to find a new job. Why would that be if, as the Fed believes, there are more jobs available than workers seeking them?

Bulls point to the recently falling unemployment rate and the fact that employers are not laying people off. However, the fact that the employment demand curve has shifted lower means that over time the inability of people being able to move from being without a job to having one will result in a rising unemployment rate. And that hiring rate will accelerate further downward once sales come off.

Can we continue to grow? Yes, but against a backdrop of lower consumer confidence, falling manufacturing, a European continent that seems headed to a recession, and a Chinese government that refuses to commit to sufficient and effective stimulus, the chances of a soft landing are diminishing, not rising.

‍

‍

White Lie #3: China is Going All In and It Will Work

‍

We should know sometime in Q4 if China’s efforts will have only worked to create a stock rally, without a lasting positive impact on the real economy. One problem among many is credit growth. While 8% Chinese credit growth is double that of the U.S., it is the lowest since records were started around 2000. Credit growth rose at a 15% rate for 20 years until the pandemic. If you do not have very high rates of credit, then as the economy slows, the existing debt needs to be rolled to avoid default. The problem with that dynamic is that an increasing percentage of the new credit must service the zombie debt. Even local governments in China, forget about investors, do not want to assume new credit because the country is experiencing deflation.

The solution is what the U.S. did in 2008 and 2020 with the Federal Government borrowing heavily and expanding fiscal policy. China did come in during Q4 2023 to do so, but it was too timid. Beijing offered 1 trillion Yuan of special bonds, and now, there is discussion about whether they will do the same.

Will the banks be a source of credit assuming there is even demand? The banks are being forced to make bad loans to property developers to finish buildings that Chinese citizens have already paid for. Those borrowers have already been paid for those apartments and lost the money, and the Politburo’s stimulus package mentioned strict control of new construction, so these borrowers can’t bring in new revenues. The banks are not guaranteed to be paid back by the local government, they just have implicit backing.

This forced support for zombie credit increases the stress on a shrinking pool of new credit, and it even raises the question of whether the banks are going to lend to corporations to buy back their shares and to financial institutions to lever their portfolios. Are the banks going to aggressively lend to earn a mere 50 basis point margin (borrowing from the central bank at 1.75% to make 2.25% loans) if the collateral is a stock that just got pumped up speculatively by 30%? It was this assumption that started the equity rally in the first place, and what if those loans don’t materialize? Will companies want to borrow to buy stock that is now 30% higher?

Even a 2 trillion Yuan stimulus package may not be significant enough because deflation is rampant, depressing investment demand and incentivizing savings. The risk of not doing enough now is that they will need to do even more in 2025 just to keep servicing the bad debts.

The missing bid for property must be recovered before credit demand can return.

Hopefully, this patient approach of careful deleveraging will work because Beijing may be worried that if they do go in large, it could risk another overleveraging and be back to square one. They are probably concerned by the speed of the stock rally, unless they are hoping it creates enough of a speculative wave that cascades into the property market. No one knows how this will unfold, but for this scenario to be benign, so many things have to fall in place that a successful outcome seems unlikely.

‍

‍

Real Parting Thoughts

‍

Be aware that the markets could be putting in a major top and act accordingly without anticipating it. As with any top it will progress in many stages.

One potential strategy to manage such an outcome would be to use Pave Pro to optimize your portfolios to the Russell 2000 benchmark. Small cap underperformance is in its bottom decile, and the last time it was this depressed was around 2001, which led to a 10-year run of outperformance. Additionally, you could go into Edit Preferences and under Factor Tilts select the “Min Vol” setting under Volatility Preference.

The current momentum cannot last. However, while there is still a tailwind, and if a client is uber bullish, then under the Performance Priority Factor Tilt, you can loosen tracking error targets by moving away from our recommended “Balance” setting into one of the three “Outperformance” settings. We would say this is exactly the wrong time to do this, and would advocate that if a FOMO stance is taken, know it is quite risky at this point and have your finger on the trigger to move to a more prudent “Tracking Error” focus.

Q4 2024 is the quarter to be ready to preserve capital and be disciplined. There are no signs yet to do so but begin to act on a sustained drop below 5675 in the S&P 500 Index. If Paradise is truly here, that support level will not be breached.

‍

‍

Contact Us

If you’re interested in learning more about Pave Pro, please contact us directly at sales@pavefinance.com. We look forward to hearing from you.

‍

‍

About the Author

Peter Corey is the Co-Founder and Chief Market Strategist of Pave Finance, Inc. He spent over a decade on the sell side as head trader of derivative desks in fixed income and foreign exchange. He spent the last three years of this stint at HSBC running a proprietary macro desk before joining Steve Cohen for over nine years as SAC's first macro trader. He then ran a long/short hedge fund using his quantitative models that was ranked number six in the world by Hedge Fund Research, and acted as a strategist to the CIOs of many of the top hedge funds globally before starting Pave. Peter graduated with a B.S. and MBA from Wharton.

‍

‍

‍

Disclaimer

‍

Copyright © 2024 Pave Finance, Inc. All rights reserved.
You are receiving this email because you opted in through our product or website

You can update your preferences or unsubscribe from this list.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.

We take protecting your data and privacy very seriously. Please see our privacy policy here.

Pave Investment Advisors, LLC is an SEC Registered Investment Advisor. Such registration does not imply any level of expertise.

Securities offered through Pave Securities, LLC – New York, NY. Member FINRA/SIPC. You can review Pave Securities LLC with FINRA’s BrokerCheck BrokerCheck.

Advisory Services are only offered through Pave Investment Advisors, LLC., an SEC Registered Investment Advisor which is an affiliate of Pave Securities, LLC.

Pave Securities, LLC and Pave Investment Advisors, LLC do not offer tax or legal advice.

The news, resources and articles available on this site are being presented for educational purposes only and should not be considered specific investment or planning advice applicable to each individual.

Please see ADV Part 2A here and Form CRS here.

For Additional Information and Important Disclosures please click here.