A Time For Vigilance And Prudence
Markets are coming off a rather dull week, where all the major averages traded modestly lower. Interest rates nudged higher as the probability of two more rate cuts this year slides (odds of a December cut are down to 65% from 90% before the last Fed meeting), but that didn’t stop gold from pushing above $3,800/oz to a new all-time high. We’ve been a long-term holder of gold in client portfolios going back years, and I anticipate that will continue to be the case for some time to come, but the near-term setup is becoming quite crowded and technically overbought (see chart below – Gold price in yellow, Relative Strength Index in blue). As the price/oz approaches the $4,000/oz level, discipline dictates that some rebalancing and profit-taking are warranted. No need to get greedy up here, and for those that are late to the party – I’d advocate dipping a toe in and building a position over time rather than diving in headfirst after this push higher. Don’t get me wrong, I still see a strong secular case for gold to move higher with the price reaching $5,500/oz before this bullion bull market is over, but I don’t expect it to play out in a straight line.
This week is loaded with a slate of economic data set to be reported, headlined by Friday’s jobs report. However, before that, we’ll all be standing by to see if a federal government shutdown can be averted as of October 1st. If we do get a shutdown, then we’ll have to rely more on private sector economic reports (ADP, ISM…) to gauge the health of the labor market, as the BLS jobs report won’t be released on its usual first Friday of a new month. Depending on how long the BLS could be absent, the FOMC may have large blind spots ahead of its 29 October meeting. It is worth noting that the FOMC can still meet during a shutdown, as it is self-funded.
As for the shutdown, both sides look to be digging in and playing what has become an all-too-common game of who blinks first. The White House warned that Democrats must abandon their demands for health-care subsidy renewals and Medicaid cut reversals, and predicted a shutdown was likely if they do not. Vice President JD Vance said on Fox News Sunday,
“We don’t want to shut down the government, but if Democrats refuse to just pass this clean continuing resolution, that’s exactly what’s going to happen, and I think the Democrats are going to bear the responsibility for it.”
The Trump administration’s refusal to make concessions to Democrats heightens the likelihood that the standoff will result in a prolonged and difficult-to-resolve shutdown — something with which they have experience. Recall that the record-long 35-day US government shutdown from December 2018 to January 2019 stemmed from President Trump’s $5.7bn demand for border wall funding. Markets, for the most part, have become numb to this recurring drama, as there have been 14 shutdowns since 1981, lasting from one day to 35 days. Assuming this one comes and goes as was the case with all prior iterations, then there is nothing for investors to get too excited about. Spending-driven shutdowns are less severe than a Debt Limit breach and default, which has never occurred despite the US nearly missing payments in 2023.
Back to markets, where it is becoming difficult not to draw some parallels to the late-90s tech bubble and mid-2000s housing bubble, given the everything rally we’re experiencing in asset prices. As it pertains to the late-90s environment, there are similarities in terms of investor exuberance over a shift in the innovation curve, elevated valuations, bullish sentiment, and market concentration. It’s not a replica of that era, but it is similar. As for comparisons to the 2007 housing bubble, there are parallels, but once again, we need a heavy degree of nuance since the banks are so much more regulated and better capitalized today. I think a valid argument can be made today that the bubble resides in the market for private debt and equity (private credit is now a $1.7 trillion industry). This area of the market is not regulated, has a ton of leverage, and is as opaque as mezzanine CDOs used to be. Beyond private credit, it's Federal government debt that is in a bubble which is likely why we are seeing gold perform as it has and at the same time levies an explanation for why investment-grade spreads have tightened to their lowest levels since 1998 (+74 basis points… AAA spreads are down to only +30 basis points and Microsoft bonds now trade at a discount to Treasuries). Why lend to Uncle Sam, who continues to run deficits at 5-7% of GDP, when the likes of the MAG7 have fortress balance sheets and earn ample free cash flow year after year?
The most significant difference this time is that the median age of the baby boomers is now over 60, not 36 when the bubble popped in 2000 or 43 back in 2007. Demographically speaking, there is much more at stake this time around, especially because this aging and, yes, now aged, population profile collectively has never been more exposed to the stock market. Sadly, time will not be on their side if the tide rolls out. It’s not just individual investors loaded up on the bullish side of the equity boat. Strategists at State Street recently noted that institutional investor exposure to equities has hit the highest level since November 2007 (the S&P 500 peaked that cycle in October 2007). And as we have noted, the American household allocation to stocks is also at a near-record share of 72% (only 7% in boring bonds). All the while, the S&P 500 dividend yield has collapsed to 1.2%. We haven’t seen such a puny yield in the S&P in a quarter century.
This is where my caution stems from, in that investors are acting as if expected returns from stocks are assured, but when you perform some simple back-of-the-envelope math based on a time series that goes back beyond the past fifteen years, you’d be hard-pressed to find a less favorable setup for stocks relative to bonds. Yeah, yeah, yeah, I can hear it already. Things are different today, Corey. I’ll concede that point, but only to meet the ‘this time is different’ crowd halfway in those major structural forces (passive flows, sovereign debt levels, fiscal dominance, global demographics, trade, AI…) all meaningfully alter present-day comparisons to the past, but human behavior (fear and greed) remains constant. Investors shunning a reasonably secure 4 -6% nominal yield (2.5% – 2.75% real yield) in favor of the S&P 500 trading with a 4.13% earnings yield ($275 EPS/ 6,660) or a 1.2% dividend yield is an indication of bullish exuberance.
Or perhaps I’m overanalyzing it, and it really is just the mindless recurring bid of investors buying index funds to play the market. After all, FOMO is a very powerful emotion, and while we see plenty of speculation in individual names by retail investors (don’t confuse gambling with thoughtful analysis), passive investment in terms of AUM has overtaken active share. This makes me nervous in that just as little thought can go into selling as it has with buying.
My point isn’t to call a market top or even suggest it's going to end, but rather to highlight that for the boomer crowd that’s made a pile of money over the past several years riding the wave to these all-time highs, you likely don’t need to take as much risk today. As a consolation prize, you can rebalance some of your gains into a reasonably secure 4-6% fixed income instrument, preserve some of your capital, while living off the interest income that should cover a decent chunk of your spending needs. My point is to make it known that we’re at a juncture in this bull market where prudence, discipline, and vigilance shouldn’t be ignored. None of us know what the future holds, no matter how smart us talking heads make the bull or bear case sound. Understand your financial goals and objectives. Understand what you need, and work backwards. That doesn’t mean you shouldn’t take any risk – all portfolios should be long a well-diversified portfolio at all times – but there are times when the setup favors running with a higher risk profile and times to run with a neutral to lower risk profile, and we’re in the latter.
We have now gone 108 trading days without a -2% drawdown in the stock index. All the while, President Trump ended up taking the effective tariff rate from 2.5% to 17.5%, the highest since the 1930s. But the AI boom has kept the economy from slipping into a contraction, and the expectation that a reacceleration in growth is right around the corner has been enough to keep this bull market going. Valuations are extreme across any measure, and sentiment is resoundingly bullish: the bull share in the Investors Intelligence poll rose this past week to 58.5% from 56.6% while the bear camp steadied at 17% — we are back to more than a +40-percentage-point spread, which in the past was a danger zone. But nobody sees the danger inherent in the herd mentality, as the bears have been beaten into submission to such an extent that the most-shorted stocks in the Goldman Sachs basket have surged +10.8% this month alone, which has far outpaced the +2.2% move in the broad market.
It seems strange that the stock market could be so white knuckled in early April with the flurry of tariff announcements, and then gleefully rally to new highs as the de facto taxes kick in. But what we see coming through the data (Q2 GDP was a perfect example) is the degree to which the AI capex investment boom is carrying everything else. Time will be the ultimate arbiter on whether all this investment generates a return for corporate bottom lines, but it may be a case of ‘what is normal for the spider is chaos for the fly’ in that AI used for productivity enhancement to boost earnings and maintain elevated profit margins is great for corporate America, but it likely comes at the expense of labor markets. In the end, it further reinforces our K-shaped economy, where those with exposure to asset prices benefit relative to those relying on wages (a job).
We are seeing signs of this in an array of labor market data, like the recently released Q3 Business Roundtable CEO Outlook Survey, where hiring plans declined in the third quarter to a level consistent with the last two economic recessions. The Q3 Conference Board CEO Confidence Survey revealed that the share of companies looking to cut staff loads jumped from 28% in Q2 to 34%, which is the highest share since the fourth quarter of 2020. The share of respondents in the Manpower Employment Outlook Survey seeing higher employment has dialed its way back to a four-and-a-half-year low. As per the latest NFIB survey, only 32% of small businesses have a job opening right now, down from 40% a year ago and the lowest share since December 2020. It’s no surprise that the Fed has made the pivot to focus more on the labor market than inflation, but you have to wonder if monetary policy will be effective in counterbalancing what may be a structural change taking shape.
As for my closing thoughts on markets, I’d say I’m rather sanguine about the setup in most assets at the moment. I don’t like or dislike the S&P 500 right here at 6,650 and think it's highly likely, notwithstanding an exogenous event, we trade within a 5-7% band through the remainder of the year. That implies we potentially get to 7,000 or as low as 6,150 where at the upper end of the range I’m likely to be trimming while at the low end of the range I’ll be adding to areas we like.
My mindset is not much different in the bond market where I think bonds have priced in a heavy dose of Fed cuts into the middle of next year which likely leaves them susceptible to disappointment, but the yield curve is realistically priced with Fed guidance and what incoming data will call for. I don’t find the 2-year T-bill at 3.63% all that enticing, and feel the same about the 10-yr T-note yielding 4.14%. Given the strength in corporate profits and an expectation that economic growth will reaccelerate into mid-2026 I like parts of the corporate credit market, mortgage backed securities, and foreign sovereign debt which should benefit from a global interest rate cutting cycle. I shared my thoughts on gold above (decisively neutral near-term, still bullish long-term), and continue to like parts of the commodity market (power grid related industrials, nuclear/uranium, copper, and warming to natural gas), but these too have moved a long way (except nat gas).
In a nutshell, I’m back to being decisively neutral on most things, which means I’ll hold the core of where our capital is allocated while making modest adjustments around the edges until things change that warrant a more meaningful adjustment.
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