Rotation Continues
July 27, 2024
Believe in God the Father, Almighty, Creator, infinitely holy and loving, who has a plan for the world, a plan for my life, and some daily work for me to do. I believe in Jesus, the Christ, the Son of God, as Example, Lord, and Saviour. I believe in the Holy Spirit who is able to guide my life so that I may know God’s will; and I am prepared to allow him to guide and control my life. I believe in God’s law that I should love the Lord my God with all my heart, and with all my soul, and with all my mind, and with all my strength; and my neighbour as myself. I believe it is God’s will that the whole world should be without any barriers of race, colour, class, or anything else that breaks the spirit of fellowship. To believe means to believe with the mind and heart, to accept, and to act accordingly on that basis.
Eric Liddell Olympic Champion, 1924 Paris Games
Good morning and welcome to the Weekender for Saturday, July 27, 2024. As the graph below implies, it was a very uncertain week for equity markets in the United States. As measured by the S&P 500, equity markets were off by -0.93% over the week and lower by -2.9% over the past fortnight.
S&P 500 Index Levels (Source: Bloomberg)
A plethora of data flooded financial markets over the past couple of weeks. Inflation continues to manifest a downward bias, although it’s coming down slowly. Inflation is currently sitting at 2.8%. If the Federal Reserve holds to its target of 2.0% inflation, it may take a while to get there, and something, like the labor market, is likely to be a casualty of the ride. But for the moment, labor markets are stunningly resilient. Economic output continues to clock respectable, but not hot, growth. More on that in a minute.
With approximately 22.1% of US companies having released second-quarter results, no generalizable trends can be divined. Some companies talk about a stressed consumer who is only looking for deals. Others see no slaking in the consumer’s thirst to “buy, buy, buy, spend, spend, spend.” Without any real consensus emerging, markets are feeling a bit schizophrenic. Moves up and down inside a general path lower have driven a recent trend in peak volatility— something we haven’t seen for a while.
S&P 500 10-Day Realized Volatility
1Q 200 - 1Q 2024
(Source: Bloomberg)
Eschewing the Magnificent Seven, the market’s rotation into small-capitalization and value stocks continues. Dominant global financial markets typically hibernate during August while traders, analysts, and investors rush to the Hamptons for their summer respite. In their absence, a slurry of financial and economic data will be released, providing the hard pack needed to build a new foundation for the market
for the rest of 2024 and next year. From the beginning of July, returns for a Magnificent Seven index have significantly underperformed the Bloomberg Small Capitalization cohort.
Cumulative Returns of Magnificent 7 (Gold) and Small Capitalization Stocks (Blue)
July 5 - 26, 2024
(Source: Bloomberg)
Options traders have been the most bullish on small companies in almost twenty years, suggesting that the “great rotation” may last a little longer. However, to make this rotation last, small companies must deliver on earnings; we do not expect that to happen. By their
Small Capitalization Options in the Money
January 28, 2005 - July 26, 2024
(Source: Bloomberg)
nature, small capitalization indices like the Bloomberg 2000 are at least half full of horse thieves who do not make money. Buying into a small company index involves baby and bath water risks. What is more, if a company is profitable and able to generate solid earnings and cash flow growth, its value increases, and it moves out of the small-capitalization classification reasonably quickly.
In our next Weekender, we will begin laying out our forward view for 2025. While we attempt this relatively often, this attempt will be more critical than most. We will be setting up for the new normal for the US economy and financial markets in an environment where government stimulus is largely spent, and the economy will need to forge a path forward on its own steam instead of the kindness of strangers.
Homebuilders
Homebuilders hit a new all-time high. Since their pandemic bottom in March 2020, they have rocketed higher by 397.1%. Despite this gain, the sector trades only at 16.8x the next historical earnings. Recent highs have come because of expectations that mortgage rates will soon decrease. We have been holders of select home builders for some time and expect to continue to do so.
S&P Homebuilders Index
January 2, 2000 - July 26, 2024
(Source: Bloomberg)
Home prices usually react negatively to higher interest and mortgage rates. As mortgage rates re-
main high, from a historical perspective, many of our readers have expressed concern that a residential real estate collapse like that during the 2008 - 2009 period may be in the offing. An unequivocal NO is our answer. At the apex of the Credit Crisis, the supply of new (purple line) and existing (gold line) homes for sale was uncharacteristically high. Since the bubble popped, housing supply has declined precipitously, leading to what could be characterized as a seller’s market over the last fifteen years.
Home Supply Total (Blue), Existing (Gold) and New (Purple)
January 2000 - June 2024 (Source: Bloomberg)
Home prices remain firm. An index of home prices in twenty metropolitan areas hit another record and is
Home Price Index
January 2018 - June 2024 (Source: Bloomberg)
essentially back in line with the historical trend after a post-pandemic adjustment. A general lack of homes for sale continues to support prices, leading to an odd phenomenon. Buyers are finding it cheaper to buy a lot and build a home than to purchase an existing or newly built home.
A two-pronged increase in prices and margins is keeping the sector aloft. We continue to be constructive on the group, although we tend to favor builders with a geographical focus on the south and west.
Economic Narrative
Second-quarter economic output was better than expected, at 2.8% higher than last year. If forward quarters hold close to this headline number, it will likely lead to a soft landing for the US economy. Inside the headline numbers, approximately 1.0% of the growth was due to a buildup of inventories. Higher inventories today reflect products that don’t need to be produced in future quarters. It’s a bit likely paying GDP forward. Third-quarter GDP estimates are hovering around 2.8%.
The point? Economic data continue to suggest the economy is doing just fine. The consumer, in aggregate, continues to spend at a faster clip than incomes justify. Pandemic-related savings have been depleted for lower-income consumers, forcing them to use credit card debt to support robust spending. Credit
Capital One Provision to Loan Ratio
card data continues to highlight a bifurcated consumer. The well-heeled are dropping coins everywhere while those with less are struggling.
Capital One, which caters to a more challenged consumer credit profile, announced that it increased its provisions for loan losses by 45.7% in the second quarter of 2024 compared to the previous quarter. By any objective measure, that’s stunning. When loan losses are tallied as a percent of total loans, the deterioration of the lower-income credit environment stands out. Usually, such increases are reserved for when the economy is on the verge of recession.
China’s economic miracle continues to morph into a nightmare. Last week, the Middle Kingdom’s benchmark 10-year government bond yield fell to a record low, reflecting an economy that continues to struggle despite the stimulatory measures being applied by government programs. We believe strong growth anywhere near its historical levels will remain elusive. Persistent geopolitical instability will likely be a natural extension of China’s troubles.
China Government 10-Year Bond Yield
January 2, 2022 - July 26, 2024 (Source: Bloomberg)
Conclusion
That’s it for this Weekender. In our next Weekender we will begin to lay the groundwork for the new normal. Have a wonderful week.