I’ve Got A Fish Story To Tell You
Equity markets continued to press higher last week with the Nasdaq Composite hitting a new high on Friday (up +11% ytd) and the S&P 500 gaining 2.4% on the week (+8.5% ytd) – the latter up a whopping 28% off the Liberation Day lows in early April. This move in equities is attributable to a combination of factors: negative overreaction to the tariff levels announced on Liberation Day that were walked back within days, sentiment evolving from extreme fear to greed, positioning moving from underweight to overweight, economic growth holding up, inflation staying tame, growth positive fiscal policy and expectations of the Fed moving towards rate cuts.
But in my view, the most significant driver of equity performance since April has been earnings and multiple expansion. Through Friday, we’ve had 90% of S&P 500 companies report Q2 EPS, which is tracking +11% year-over-year (the third consecutive quarter of double-digit growth). While many companies have expressed caution about tariffs and ‘weak demand’ in the future, we are not seeing the analyst community cutting estimates. Supporting the strong earnings story is the ravenous pace at which U.S. companies are buying back their stock, with $984 billion in repurchases so far this year, led by the tech titans and big banks. Don’t underestimate this powerful bid propping up both share prices and earnings numbers, because the economic backdrop has been sluggish at best.
Looking at Q1 and Q2 in their entirety, the net contribution from the consumer to real GDP was the lowest since Q1 and Q2 of 2020 – quarters that encompassed COVID and an economy in lockdown. When you strip out inventories and net exports, real final sales cooled off to a stall speed of +1.1% at an annual rate in Q2 after an almost equally tepid reading of +1.5% in the first quarter. That is a pretty feeble showing for an economy that depends on the consumer for nearly 70% of GDP. Imagine where we’d be if we didn’t have the gigantic AI capex contribution from big-cap tech.
Still, even with earnings (in the aggregate) being very strong, the S&P 500 has seen its 12-month forward P/E ratio rise from 18x to 22x – a nearly 40% premium above the long-run norm of 16x. Keep in mind that this remains principally a mega-cap/AI-related rally. The headline averages continue to make progress, though the rally has again begun to depend on a relatively small number of large-cap names. The small-cap indexes are far more reflective of what is happening in the real economy, and they are lagging well behind – woefully underperforming to close out the past week. The S&P 500 equal-weight index is lower now than last November, which tells you a lot about the narrowly based nature of the rally.
I remain of the view that caution is warranted at the moment, with the VIX closing last week just over 15 (far below the long-run mean of close to 20), valuations stretched, the economic impacts from tariffs dead ahead, a softening labor market, inflation marking out a near-term trough, and seasonality not in investors' favor (August and September are two of the weakest months historically speaking).
Speaking of inflation, this week we’ll get the July readings on CPI and PPI. CPI comes out on Tuesday morning with the consensus looking for a +0.2% print on the headline (lower gasoline prices and used car prices in July), but the core is seen coming in at +0.3%. The uptick in core prices to +0.3% will be poor optics for a Fed that is looking for reasons to support cutting rates, as it would take the YoY rate to a five-month high of +3.0% from +2.9% (+3.0% is a full point above target). As for producer prices on Thursday, the markets are looking for similar readings on headline and core, and like the CPI, the core YoY trend would rise to +2.9% from +2.6% in June.
I don’t think this dissuades the Fed from cutting at the September meeting, but to do so, they may need to see another soft jobs report for August. A recovery in the August jobs report will definitely add intrigue to the September confab, force markets to reprice the 90% probability of a cut, and push out future rate cuts for 2025 from 3 to 2. We round out the week with the July retail sales report on Friday, with consensus expecting a +0.5% MoM print on the headline and +0.4% for the ‘control’ group that feeds into the consumer spending segment of the GDP accounts.
One thing I’ve been trying to wrap my head around over the next 6-12 months is the impact tariffs will have on future inflation prints. Both the administration and the broader economics community believe tariffs act as a one-time level shift in inflation, and as a result will not filter through as a persistent force on inflation (“tomayto, tomahto” but at the end of the day someone/something is paying more). Furthermore, it appears to me that an unhealthy dose of complacency is setting in because we have yet to experience any negative consequences from trade actions.
We must remind ourselves that because companies had so much time to prepare in advance, imports and inventories soared earlier this year, and bought time for manufacturers, wholesale importers, and retailers alike. They have continued to buy time by selling off their lower-cost pre-tariff stockpiles of goods, but that process has an expiry date before margins get really crimped. Tariffs, when imposed, are inherently an additional cost that did not exist prior to their implementation. As a result, this cost has to be borne by someone: the foreign exporter, the domestic importer, and/or the final consumer — the degree of price-elasticity of demand will trigger whatever type of inflation households will end up seeing.
What I’m concerned about is how this filters out into the data from today forward, with tariffs now in effect on as many as 90 countries. Over the last several months, there have been so many reprieves provided that most of the tariff increases have been delayed. Then there are sectoral tariff threats ahead on pharmaceuticals, consumer electronics, and chips. So far, many small countries have faced the initial tariff hikes, and then there are the big ones like Japan, the EU, and China, which have had theirs suspended as they move to do “deals” to avert steep reciprocal increases
So, the worst has yet to come, and that is the point. We are at the very early chapters of this tariff file. The question of inflation is how consumers will respond and the extent of any pass-through costs – these are unknowns. The claim that tariffs are just a one-time price level shift loses traction when you see that tariffs are being implemented in a staggered fashion. How tariffs are being implemented represents a sequence of moves over time that may work its way into future inflation prints in a similar manner. This is what makes the job at the Fed that much more frustrating. Even the latest round that took effect last week does not apply to goods that had been loaded onto ships before August 7th; those products in transit won’t be subject to new taxes as long as they enter the United States before October 5th. So, what will this likely accomplish? Basically, to incentivize importers to accumulate even more inventory before the new tariff schedule impacts their bottom lines.
Maybe it’s my propensity to fear bad outcomes more than I carelessly embrace good outcomes, but the rise in the U.S. effective tariff rate to 18% (per the Yale Budget Lab) from 2.5% at the start of the year is a big deal. This is akin to a $2,400 de facto tax hike per household and a -0.5% trimming off of this year’s GDP growth trajectory. Ladies and gentlemen, this is the classic economic definition of ‘stagflation’ – low growth with rising inflation. This puts the Fed in a box between its two mandates, with or without the growing number of policy doves.
The archives of financial history suggest that investors favor exposure to real assets, businesses with low exposure to variable costs / high exposure to fixed costs, businesses selling highly inelastic goods, and low cyclicality. Easier said than done. This humble analyst has no problem admitting that he thinks the path ahead will be much less forgiving than it was four months ago, where all you needed was some courage, a policy walk back, and fundamentals to deliver in order to garner a nice return on your capital. The setup is the polar opposite today, which doesn’t mean the decent returns can not be achieved, but rather that they will likely be harder to come by and will occur in a manner of a 2 steps forward, 1 step back type of fashion.
This brings me to my fish story. You know, the kind you talk about at the bar among friends or at a family gathering after taking down a few confidence-building cocktails. Let me say from the beginning that this isn’t a real story for me, but one all investors have played out for themselves in their minds. The ‘what could’ve been’ or ‘it was so obvious’ with hindsight acting as the guiding light. With Bitcoin trading near a new all-time high as I type, I want to take you down ‘imagination lane’ – mapping out what a $100 investment back in February 2011, when Bitcoin last traded at $1, would be worth today.
Here goes: a $100 investment in Bitcoin in February 2011, where you bought 100 Bitcoin at $1 is worth more than $12 million today.
Within four months of your initial $100 investment, it would have increased to $3,300 by June 2011, and seeing the exponential pace of appreciation, you would have had to do nothing.
Then over the following three months, you would have watched $3,300 plunge to $200 by October 20, 2011 – still doubling your money since February, but again, you would have had to do nothing.
Over the next two years, your $200 ripped to $104,400 by November 2013, when Bitcoin first crossed $1,000 – still, you would have had to have done nothing.
From there, you had to watch as $104,400 fell to $75,422 by January 2014. Once again, you were still doing nothing.
Over the next three years, your $75,422 in January 2014 exploded to $1,918,800 by December 2017. Keep in mind that you did nothing during this appreciation phase and remained unwavering in cashing in on your initial $100 investment.
By December 2018, you’ve watched $1,918,800 evaporate into $370,900 – still doing nothing but wallowing in your sorrows at the 80% plunge in Bitcoin over the past year.
Oh, but your fortitude pays off. Your $370,900 worth of Bitcoin went on a tear and, in November 2021, was now worth $6,900,000. Still, you do nothing.
Over the next 14 months, you experience another gut punch as $6,900,000 falls to $1,662,552 by January 2023. I'm sure you're sick to your stomach, as you’re not focused on $100 turning into $1,662,552, but rather $6,900,000 turning into $1,662,552. Still, you do nothing.
Here we are today with Bitcoin at an all-time high, and your $100 investment in 100 Bitcoin back in February 2011 worth more than $12 million.
Now what do you do?
Outside of being a founder of one of the fastest-growing and most successful companies in history, a child of the founder, or Warren Buffett, I don’t know of any investor who has achieved returns like those illustrated in the above Bitcoin example.
What’s your point, Corey? My point is that 99% of investors don’t have the patience, fortitude, attention span, foresight, and/or personal tie (like a founder) to hold through the volatility that is necessary to garner the returns generated by companies like Tesla, Oracle, Meta, Amazon, Google, Nvidia, Microsoft, or Bitcoin. Moreover, these companies are the anomalies, not the norm. These are the best of the best, and while rightfully garnering the attention they deserve, they are the exception, not the rule. For every Amazon or Google, there are 1,000 companies that you’ve never heard of that started with the same hopes and dreams, but things just didn’t pan out in the same way.
Also, most individuals tend to act on the outcome of a life-changing amount of money. We’re emotional beings and lack the attachment to an investment like a company's founder. Where she/he has poured his/her entire life into said investment, and for them, the money becomes a byproduct of the investment's success.
Before signing off on this week’s missive, I want to briefly revisit some thoughts on last week’s jobs report, particularly on the process behind revisions. First off, there is nothing political at all about the revisions, no matter how large. The problem lies with the depleted business response rate in the first payroll survey (58% currently – was over 80% pre-COVID), which then rises to the normal 94% by the final revision. That’s the story. The data are only as reliable as the sample size, and that has nothing to do with the BLS but rather the tardiness of the U.S. business sector in getting its updated staffing levels to the Bureau on time.
This is why the first release of nonfarm payrolls should be treated with a giant grain of salt. The only number you can rely on with reasonable confidence is the month of the second revision. Perhaps a better solution than firing the head of the BLS would be for the 42% of businesses that don’t send in their updated payrolls to the BLS in time for the first release, the government should impose a financial penalty. That will incentivize them to be timelier in their response. By the time we get the final revision, the response rate expands sharply to 94% from 58% on the first release. As a statistician, no matter where you are, your numbers are only as good as the sample size.
One last thing on this file: before COVID-19, when the response rate was well over 80% at the time of the first release, the average nonfarm payroll gap (in absolute terms) from initial release to the second revision was 57k. Since 2020, when the response rate began to plunge and never recovered (it obviously is too cumbersome for the small business sector to get their numbers in on time), the average revision has soared to +133k. If you read the BLS reports, you will see that its confidence interval is 15% wider today than pre-COVID. The Bureau has not hidden at all from the fact that the error term has widened these past 5+ years – it's not their fault if no one is paying attention to what they are telling us.
Maybe the BLS should simply stop publishing the payroll data so quickly. Think of the first release as nothing more than an incomplete snapshot of the labor market because it is no easy task to get it right in the days that follow a month in a market as complex and as large as a 170- million-person labor force, not to mention all the churning that goes on beneath the surface. What we gain in speed of putting out the initial estimate, we lose in accuracy.
If you spend the time doing some real analysis of the current situation regarding the labor market, what you see is that firing rates are still very low, but what has happened is that the collapse in hiring rates is starting to converge, and that is why the data have been weakening on a net basis…the churning in the labor market has declined markedly and you also see that in job openings and voluntary quit rates. A new BLS commissioner cannot change the reality of what is going on. The labor market is weakening both on the supply side (immigration outflows) and the demand side (we can see that domestic demand growth has been cut to around +1% from nearly +3% a year ago).
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