Inflation and sentiment with Richard Excell

The outlook for the economy is sitting at historic lows, leaving investors with a pessimistic view and without a clear idea of what move to make next. Today Richard Excell, clinical professor of finance at the University of Illinois Gies College of Business joins The Yield to discuss key drivers in today’s market, especially those that are under the surface.

Key Takeaways:

[1:31] Key drivers in recent market evolution.

[15:18] Insights from earnings in Q2. 

[18:55] Is the market finally bottoming out? 

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The last couple of weeks since the 4th of July holiday have been full of a lot of information that we, as investors, need to internalize. We are still trying to determine whether we continue in the mode of higher inflation, or transition into the oncoming recession mindset, because the FOMC reaction function could be meaningfully different in each case. As a result, both stocks and bonds (and other assets too) will see different potential drivers. As with most data, I think the market reaction to news is more important than the news itself. This is what I have been watching over the last couple of weeks. 

If you are a poker player, you know that everyone at the table has a tell. The markets have a tell as well. It is impossible for us to know what every person is thinking, however, we can read the price action of the markets, the reaction to the news, to get a sense of where the softer side may be, to get a sense of when too many people might be on the same side of the boat & looking over. In “Reminiscences of a Stock Operator”, it is said that when Jessie Livermore was given a tip to buy a stock, he would immediately go out & sell it to see what the price reaction was. If the mkt could hold up in the face of his sell, he knew there was a legitimate bull trend. If it could not, it probably meant he was the last person getting into the trade. Never a good place to be.

As such, I want to walk through some of the bigger events of the last week or so and talk about the reaction to the news as much as the news itself. First, President Biden was in the Middle East last week, among other things, to speak to the Saudis about more producing more oil.


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Source: White House

Oil was weak heading into this meeting for fears of new supply coming online & hit a bottom during it but has bounced more than $12 off the lows. Think about that for a second. The Saudis agreed to increase production levels 50% above what was planned, yet oil bounced more than 10% from the lows after the meeting. This appears to be a case of too many people positioned for lower oil. We have an OPEC meeting coming up in early August which could really help set the tone for all markets for the rest of the year. I say this because energy and food are directly affecting the inflation numbers and expectations we see. As such the economic data last week was extremely anticipated. The market has been worried about inflation but thinking a slowing economy could pull it lower. The non-farm payroll number give some sense of alarm that maybe inflation wouldn’t come lower as quickly as hoped. Last week saw both CPI and PPI prints. In the Treasury bond market, many had started buying in anticipation of the recession. After the jobs number we saw some weakness leading into the inflation data.  We got a historic CPI print on Wednesday (7/13) that hit bonds. Then another from PPI on Thursday (7/14). The bond market has recovered from both shots better than Rocky against Drago. Have we seen the lows in bonds? It is interesting that as much as the bond market increased the expectations for rate hikes in July and September, it also accelerated the expectation of rate CUTS in 2023. A Fed policy error is expected.

It isn’t just economic data driving the markets, though. Another strongly anticipated set of data has been corporate earnings. This is the last shoe to drop before the impending recession in the eyes of many. I have said many times that the economy leads earnings and earnings leave stocks. I am not the only investor that has been anxiously awaiting this earnings news. The big banks are always some of the first big names to report earnings and those came out last week. The early news wasn’t good as it wasn’t expected to be. The stocks sold off but recovered during the day. Jamie Dimon, of ‘economic hurricane fame, put out his message for the economy. While there is clearly some negative news in there, between the lines, there was also some hope. News from the other money center banks such as Bank of America, Citi, Wells Fargo, and US Bank was much more upbeat, on loan growth, on net interest income and on the economic outlook. Since banks extend credit to the economy, a better sentiment from banks is good economic news. As such, over the subsequent days, financial stocks have moved to levels above those from before earnings.

From my days as a hedge fund portfolio manager, I know these early reports from banks, and importantly the reaction to the news, can be a big driver for other sectors. We have seen a strong S&P 500 futures market as a result. This culminated on July 19, when we saw a major short squeeze in the market, where the most-shorted stocks outperformed the headline index by almost 3%, with shorts outperforming in every single sector. While I do not think this price action is indicative of a market bottom, it should not be surprising either. The same day, the BAML Global Fund Manager Survey came out which showed historic levels of pessimism on the economy and on earnings, with positioning in cash and extremely defensive. 

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This all tells me that investors had gotten too pessimistic. However, in my myriad of interactions on various social media platforms, I keep hearing from others that the market won’t rally because people are too optimistic. I pushed back on this because no matter where I look in the data, I see no optimism at all. Let me give you a few examples.  Are people optimistic? Ask them. The University of Michigan & the Conference Board do exactly that.  You can see the results. In the case of Univ. of Michigan, it is worse than 2008. The bias in each of these surveys is that the Univ. of Michigan is more slanted toward inflation questions and the Conference Board is more geared to jobs. This makes sense that the Conference Board is holding up better, but it doesn’t look optimistic to me. What about small businesses. They employ the most people in the USA. Their optimism index is approaching 2008 & their outlook index is lower than 2008. Again, does this look optimistic to you? How about Individual investors. While some suggest that the American Association of Individual Investors (AAII) data may no longer be representative, I still find that at extremes in the Bulls minus Bears, there is a good signal for markets. If I look at how many Bulls there are minus how many Bears, we are at 2008 levels & more bearish than the 2001-2002 tech bubble & 9/11. Does the economy feel that bad to you even if we are in or about to go into recession? Back to that BAML Fund Manager Survey. Their indicators are in extreme pessimism. I like to try to corroborate with the CNN Fear & Greed Index. It uses a variety of market indicators to measure the fear or greed in markets. It reads extreme bearishness as well. 

Why is everyone so bearish? If we go back to the BAML Global Fund Manager Survey, we can see that the expectation for profits is at an all-time low. Earnings drive stocks, especially in a period of Fed rate hiking which limits any multiple expansion. 

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Finally, in my classes I told my students that the fiscal and monetary stimulus we saw in 2020 was unlike any other US period except WWII. What if we then look at CPI and the SPX in the post WWII era? What you can see is that the market sold off before the big spike in inflation, just like this year. Once inflation peaked, stocks then went sideways for a while as policy worked through the economy. Eventually, this laid the groundwork for a rally in stocks as inflation was brought under relative control. Again, this doesn’t mean stocks go straight up. Inflation hasn’t peaked yet. Even when we do, it would suggest some sideways price action for an extended period of time. Let me ask you this: if we were to end the year with an SPX that is down in the 10-15% range, with a forward P/E for the market of 15x or less, with a Fed Funds and 10 year yield in the 2.75-3% range, and inflation slowly falling, would you be happy? Does that set a table for some level of optimism in 2023? Is anyone expecting that?

As I have said before, history doesn’t repeat but it rhymes. A sideways market that allows us to work off excesses may be exactly what the doctor ordered. Risky assets may be inflecting, but in the event it is to work off too much pessimism, it would be short-lived. There is still a lot of negative news on the economy. However, it is the right time to do your homework on what you want your portfolio to look like so you can begin to position for that. 

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