The Good, the Bad and the Likely Path Forward 

Five Things You Should Know

1. Equity Markets – rose this week with U.S. stocks (S&P 500) up 0.88% and international stocks (EAFE) up 1.4%.  
2. Fixed Income Markets – were mixed this week with investment grade bonds (AGG) up 0.14% and high yield bonds (JNK) down –0.26%.
3. U.S. Jobs Report – Following a soft October the U.S. economy bounced back in November, adding 227,000 new jobs and all but confirming another rate cut at the Fed’s upcoming December meeting. Following the data release traders are now pricing in a 90+% likelihood of a cut this month, up from 70% prior.
4. OPEC Wavers – Despite threats otherwise in previous months, OPEC and its partners are expected to further delay their plans of lifting oil production limits. For many of the participating countries oil prices have dipped too low to cover government spending plans, but are fearful increasing supply would further decrease oil prices and amplify the problem.
5. Key Insight – [VIDEO & ARTICLE] We take a look at the ever-present tug of war between “bulls” and “bear” that often leaves investors torn in two, to analyze the best arguments on both sides as well as the paths forward that investors should consider given current market conditions.  

Insights for Investors

By Tim Mitrovich

The Good, the Bad and the Likely Path Forward 

As we have pointed out before, one of the big challenges to being a successful investor is the constant tug of war between fear and greed, with either seemingly continuously fueled by compelling narratives or actual data to justify letting them guide one’s decision making. The result is that investors often feel unsettled and compelled to make “a call.” 

Such feelings are perhaps particularly pronounced when the Fed is in the midst of changing their policy direction because during such times things like “bad news” can counterintuitively be “good” if it means the Fed will ease monetary policy to support the economy and markets. 

This week we’ll outline the good, bad and ask “what to do now”, framed in large part with some fantastic data/insights from Apollo Chief Economist Torsten Slok, to help you better understand those forces acting on all of us as investors, as well as issue a friendly reminder that letting any of these points compel you to make a big “call” would most likely be the wrong response. 

The Good 

As we’ll touch on below, market valuations and concentration are concerning. However, there some solid reasons to be optimistic about what may lie ahead, especially for those investors willing to diversify their portfolio beyond those stocks and assets that have been the recent darlings. 

One potential positive for markets is the amount of cash/treasuries on the sideline that are likely to seek new “homes” with yields having come down. As you can see in the chart below, when rates rose so did the amount of holdings in consumer Treasury Direct accounts; however, if history is any indicator as rates come down so will the level of these holdings. (see accompanying chart) That money (approximately $10 trillion when you add in the $6.5 trillion in money markets) has to go somewhere with likely homes being higher yielding fixed income, which is supportive of business activity, and/or equity markets. Either could be a catalyst for another leg higher in markets. 

Another key data point that is likely supportive of the US economy and the sustainability of current growth is the financial health/stability of both US consumers and corporations. While the Fed hiked rates at a historic pace in a short-period of time, the resulting strain has been relatively mild. As Torston Slok points out, “The chart below shows that Fed hikes have not had the desired effects on firms. You would normally expect that when interest rates go up, corporates see an increase in debt-servicing costs. But because of locked-in low interest rates combined with strong corporate earnings, net interest payments as a share of operating surplus have been going down, see chart below. The bottom line is that not only have Fed hikes had a limited negative impact on consumers because of locked-in low mortgage rates. Fed hikes have also had a very small impact on corporates because of locked-in low interest rates and rising earnings.” Less debt servicing means more revenue falls down into corporate profits. 

Similarly, consumers are in great shape. He cites, “the debt-to-income ratio looks much better for US households compared with other countries, including Canada and Australia, see the first chart below. At the same time, credit card debt for US households is at very low levels and declining, see the second chart.” 

The Bad 

As we wrote about on October 18^th and again in our video on November 22^nd, US equity markets are getting expensive and while nothing can predict future markets, there is a strong correlation between the price one pays (valuation) and the probabilities around future return levels.  

As Torsten Slok summarized, “When growth is strong, corporate earnings are high. When growth is weak, corporate earnings are low. This makes it difficult to find out if companies are cheap or expensive. One way to analyze if stocks are cheap or expensive is to remove the business cycle by taking the 10-year average of earnings, and doing so shows that stocks are very expensive at the moment. Specifically, the cyclically adjusted price earnings ratio at 38 is near all-time highs, significantly above its long-term average at 17, see chart below.” 

The common narrative from bulls when valuations get stretched is that earnings will catch up and support prices, the reality is that usually prices are the ones that move to come down in-line with earnings. 

On the topic of valuations, especially in light of the current concentration of the S&P’s market cap in just 10 names, is the fact that those names are trading at exceptionally high valuations with an average P/E of almost 50x earnings. As Torsten Slok asks, “Would you buy a stock in a firm with a P/E ratio of 50?” Many certainly are as they blindly snap-up S&P 500 etfs. Side note highlighted by Slok, Nvidia’s market cap alone is now bigger than five of the G7 countries! 

Another troublesome data point for markets is that sentiment is also getting stretched to the upside with the latest Conference Board data showing a record high 51.4% of households saying stock prices will move higher, similar levels have often appeared before market pullbacks (see gray bars in accompanying chart). One likely reason for this phenomenon is that most buyers are already in, leaving few buyers to push markets higher. 

The Likely Path Forward 

As if what do to with the above wasn’t confusing enough you have recent data that is firmly “in the middle” with respect to its influence in that it’s just “bad” enough to likely justify some additional Fed rate cuts but not so bad that it indicates an impending recession (e.g. ISM Services declining to a still expansionary level of 52.1, Global Manufacturing PMI’s rebounding to neutral levels around the world or the latest ADP payroll data showing an increase in jobs in November by 146,000 but downward revision of 49,000 jobs to last month’s number). 

So, what’s an investor to do? 

One piece of advice we’ve been sharing with investors is to broaden their focus and ask what less followed or even “out-of-favor” assets may improve their potential risk-adjusted returns moving forward as opposed to falling prey to the classic group think of fixating on what has been. 

One area to consider as an investor are the private markets. We touched on this at greater length earlier this year in our Commentary from May 24^th, 2024. Asset classes such as private credit, equity or real estate offer some compelling opportunities for the right investors, especially after the recent rate hike/reset. While many think of private investments as “risky” and public investments as “safe” that narrative is woefully simplistic, especially given the ever-changing nature of markets.  

Whether one is seeking a broader opportunity set and/or to improve genuine diversification among various asset classes, consider that the vast majority of established firms are private not public (see accompanying chart).  

However, even for those investors not yet comfortable with private markets, or for which they may not be appropriate due to liquidity constraints, one should likely address their equity allocation and gauge their exposure to the more expensive parts of the market (see above comments on valuation and Top 10 S&P 500 stocks) versus the rest of the market. 

Beyond the risk of buying expensively valued assets, there is also the likelihood of missed potential returns as earnings growth shifts. As noted by Goldman Sachs, “Fueled by a resilient macroeconomic backdrop and AI enthusiasm, Magnificent 7 companies have driven more than 40% of the S&P 500’s year-to-date return. This outsized contribution has been supported by robust earnings growth, which has significantly outpaced that of the rest of the index. Moving forward however, this gap is expected to narrow, presenting investors with opportunities to find potentially more competitive returns through equal-weighted indices.” (see accompanying chart) 

In Closing 

It is often said that the most dangerous words in investing are “this time it’s different.” And yet, investors often fall prey to such sentiment whether its panic selling during bear markets or chasing after bull markets only to watch things eventually turn against them. 

The price one pays for an investment matters, the lessons of history matter and having the courage to break with the crowd matters. 

How to do this, when to do this and where to do this are all tough questions that require great partners to help answer correctly more times than not. We here at TEN by no means believe we have all the answers which is why we partner with and look to countless industry leaders for their wisdom and insights as part of our process.  

For those that have chosen us to be part of your process, thank you; and for those of you who haven’t or for those you may care about we are always willing to describe how we can to add value to helping clients achieve their goals. 

Have a wonderful weekend, 

Tim and the team at TEN Capital 

Data, Just the Data

• U.S. Jobless Claims – initial claims rose to 224,000 last week for the highest reading in 6 weeks. Continuous claims on the other hand fell by 25,000 to a total of 1.871 million. 

• Eurozone Retail Sales – fell 0.5% month-over-month in October for the first monthly contraction since June. Year-over-year sales for the region now sits at +1.9%. 

• U.S. Manufacturing PMI – saw an increase to 48.4 in November, but still remains in contractionary territory for the 8^thconsecutive month. However, this reading marks the highest since June and suggests the economy may be moving close to expansion once again in manufacturing.  

• U.K. Manufacturing PMI – saw a downward revision to 48 for November’s reading, the sharpest level on contraction since February. Supply chain concerns, weakening demand, and rising costs all weighed on output.