Economic update - "It's different this time"

State of the market and key past trends

Earlier this year I wrote this piece on possible outcomes for monetary policy and what to look for next in the market, and much of this held true.

Here is what we can observe in a current update:

• Local bottoms in risk assets continue to coincide with local bottoms in global net liquidity. Some debate whether central bank liquidity causes markets to move. Correlation is not causation, but omitting a variable strong correlation from a study introduces omitted variable bias. In other words, we can't ignore it.
  
• The end of the last 4 business cycles were preceded by the 2yr treasury rolls over fed funds rate. It looked like this had occurred or started in February near the banking crisis, but has taken several months to show signs of confirmation in September.
  
• Markets can continue to climb 20-40% over 15-30 months after rates roll over.
  
• Markets have climbed 20% in the 10 months following the 2yr starting to roll over.
  
• Without deterioration of real economic variables, continuation is a reasonable expectation.
  
• When a recession does occur, the market bottom is behind us once unemployment has peaked.
  
• In the last four recessions unemployment peaked within 22-37 months of the first of a double top in inflation. I expect this trend to change based upon how low the labor force participation rate was at the start of this cycle. This also suggests that we'll see further continuation.

Overview - "It's different this time"
I expect that we'll continue to see:

• After a 2-3 month seasonal rotation, the largest companies continue to outperform
  
• Consumer strength
  
• Market participants continually caught off guard
  

"It's different this time." I love that phrase for 3 reasons:

1. It speaks to repeated patterns of behavior, but is frequently parroted by people that are biased against technical analysis and cycle theories.
   
2. The phrase is used with a lot of confidence, but we know that trading systems and investment plans are rarely adaptable to all conditions and that panic is more common than composure when recessions arrive.
   
3. There are 13 recessions since WW2. It's a small sample size. They share similarities, but all of them are also unique in some way.
   

This motivates me to remain objective and look for ways that current market and economic conditions will be similar AND different from past experience. Here are two ways that this market is currently unique relative to all prior downturns and recoveries:

The first difference:

The most unique difference has just been resolved this past week: the year long debate about whether we were in a bear market rally or a recovery:
1) All year long we've had the market referenced as bear market rally. If it were, it would have been the longest bear market rally in the markets history and will be the first time that a bear market rally was longer than the bear market itself. Other significant bear market rallies:

• dotcom recession (1 month)
  
• great recession (6 weeks)
  
• 1973-1974 (1 month)
  

2) This tells us that it is likely that this has been a recovery. However, up until this month this was the first recovery without had not included participation from financials and small caps.

What will remain unique to this recovery is that an initial look indicates that this is the first recovery with 3 drawdowns of 7% or more.


What might be the same/different?
What "should" be the same relative to prior down turns:

• Financially strong companies that provide necessary goods/services with real economic value should continue to be preferred. This is important because the broader market outside of the top 7 is expensive relative to treasuries, given their performance. While we will see a seasonal rotation toward small caps and equal weighted, the persistent trend should be for relative strength among the most stable companies.
  
• A risk reward between the safest return (treasuring yield) and total growth (dividend + expectation of growth) should favor either lower risk companies that can outperform inflation + treasury rates, OR higher risk/EXTREMELY high reward speculative opportunities (why we've seeing things like CVNA and BTC perform well all year)
  
• When we reach a downturn it will be sudden, catching nearly all of us off guard. Those with strong investment plans and proper risk mitigation will benefit the most.
  
• Recessions are usually preceded by steep and rapid reversion of the yield curve.
  

Past observations to monitor and where things might be unique:

• Start and end. The tightening cycle starts in an attempt to control inflation and we can typically confirm the bottom of recessions when unemployment peaks.
  
• The consumer is strong. The media is selling fear on the basis of rates of change in credit, defaults, use of savings, etc. It's manipulative and fear mongering. The consumer is strong.
  
• Spending (red) vs implied savings (green). Savings is coming down from extremes but still outpaces savings.
  
  
• Delinquencies among all loans (red), credit cards (pink), and real estate (white). Showing a return to normal levels.
  
  
• Note the rates of change in real income (blue), consumer loans (purple), and credit card default (pink). These have a sequence of going from high to low after recessions. What we see now resembles the trend that follows recoveries.
  
  
• Inflation. We can observe that the decline in inflation begins with a double top. From the first peak in inflation we can see peak unemployment occurring within 2-3 years.
  
• Unemployment. The media reports jobs and unemployment figures, but rarely mentions participation. What's unique to this market is how resilient the labor market has been. Participation never fully recovered from the 2001 and 2007 recessions. It bottomed during covid and is close to returning to a pre-covid level. Increasing participation is favorable for output, productivity, and controlling wage inflation. This is also likely to alter the timing in between inflation peak and unemployment peak.
  
• Job openings (white) falling as participation increases (blue). Participation appears to be leveling off. Total number of employed is at a high (blue), unemployment ticking up (yellow), and permanent job losses flat (red). Note continuing claims in red at the bottom are ticking up, reflecting a tightening job market.
  
  
• Yield curve. During tightening cycles when the 2 year treasury rate rolls below fed funds and stays there the market rallies from 20-40% for 1-3 years. This roll over occurred last year, but both rates are climbing together. This is unique as bear steepening usually occurs as a result of short term rate falling below long term rates and not as a result of long term rates recovering and climbing above short term rates.
  
• Liquidity. There has been strong correlation between market performance and global central bank net liquidity. Correlation of the market pivots to highs and lows in global net liquidity may continue but the future of quantitative easing is likely to be different. We'll like see things like "shadow QE," "quantitative support," or targeted programs like we saw earlier this year to protect the banking system. The market will likely front run announced easing programs, but will continue to lag unannounced movement (similar to what we've seen this fall).
  
• Note the consistent and strong correlation coefficient between the S&P (white) and liquidity (green), as well as a strong inverse correlation to high yield rate spreads (blue). Deviation signals shift in the market.
  
  
• Exogenous shock. If the economy falls into a recession on monetary policy it can likely be resolved with monetary policy. However, an exogenous shock like broadening military conflict or an energy crisis will require re-evaluation.