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Last week, 68 teams were selected to participate in the Men’s NCAA basketball tournament, and today marks the conclusion of the first and second round games. Both college basketball enthusiasts and casual fans know that even the most dominant teams can fall in a single-elimination tournament, leading to a few weeks filled with unexpected twists, turns, and excitement—often referred to as ‘madness.’

Like the March Madness on the court, U.S. equity markets have begun their own version of March Madness by dipping into a correction! This week, we’ll review the recent activity in the equity markets and help coach you through the game of long-term investing.

Corrective Behavior

Over the past two weeks, U.S. equities, as measured by the S&P 500, were down 10.4% at their lows since the index reached its all-time closing high of 6,144 on February 19th. This downturn is classified as a correction, which is defined as a decline in the index of between 10% and 20%. Corrections in equities are normal, and all markets experience them regardless of economic recessions. This marks the first technical correction in the S&P 500 since 2022. Psychologically, this amount of volatility is difficult to stomach because of how infrequently it happens. The behavioral temptation to adjust portfolios during these turbulent times is strong. Avoiding that temptation is a crucial aspect of managing long-term investment cycles.

Whether we are in a recession or not, market corrections present a chance for investors to take advantage of fear and lower asset prices. Consider the following chart:

Since 1980, there have been 21 technical corrections in the S&P 500. Regardless of the current economic conditions, the average return of the S&P 500 is positive 12 months after a 10% correction. So, while it can be challenging to click the buy button during falling markets, this is exactly when investors should avoid panic and strategically invest their cash!

Prevailing Sentiment

Teams that advance in the March Madness bracket tend to play their best basketball of the season just as the tournament tips off. In contrast, early upsets are typically those teams caught in a downward spiral. Similarly, we can classify today’s investors as being trapped in a negative sentiment spiral. As we noted last week, investor sentiment is at cycle lows, and this week, that trend continues. Notably, investors have never been this pessimistic about equities for so many consecutive weeks. The AAII Bearish Sentiment index has remained above 55% for the fourth straight week, surpassing the previous three-week record set in March 2009.

Chart #1: ‘The January Effect’  

Many in the industry use technical analysis, which is a term for the evaluation of the trend in price and patterns to forecast future price movements. Ironically, it’s called technical analysis, but it’s also behavioral finance: Market participants make future decisions based on price movements. One of the technical indicators used by strategists is the ‘January Effect’: So goes January market performance, so (typically) returns follow the rest of the year. Historically, a positive January return in the S&P 500 index results in a 12% return for the remaining 11 months 86% of the time. If January returns are negative, the average remaining annual return is 2.1% but at only a 60% hit rate. Of course, no one technical signal is the end-all, but it is helpful context for understanding that market strength often begets more strength on a calendar year basis. With the S&P 500 up 2.7% in January, the case for a positive year has only strengthened.   

Chart #2: Back to the Fundamentals! 

This is a good one. News, fear, and flows guide short-term price action, but it’s underlying corporate earnings that guide long-term price action. A slowing or accelerating rate of change in earnings drives the price. The wisdom here is that time in the market is more important than market timing. There are periods of time where earnings growth outpaces underlying index price growth, and vice versa, but over the long-run, historical earnings matter, and they typically grow over time. 

Chart #3: It’s Still a Bull Market, For Now.

Finally, a historical look at cyclical bull markets and weekly S&P 500 returns therein. As you can see, our current cyclical bull market from the lows of 2022 indicates this bull market is looking historically healthy. Conditions and overall narratives are different across the variety of market timeframes, but the only question is how long this one will last. Yes, cross-sectionally in time, valuations are elevated, and past-performance is no guarantee of future returns, but so far, we are tracking along nicely with previous bull market cycles.  

That is all for this week. Enjoy the rest of your weekend! 

-Matt 

Sources: @Jurrien Timmer, Fidelity Investments, @Ryan Detrick, Carson Investment Research, Bloomberg, S&P Global, YCharts

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. Past performance does not guarantee future results.

A Simple Yet Difficult Demand

It wasn’t the first thing mentioned during Thursday’s speech, but eventually, Trump quipped that he would “demand interest rates drop immediately after the price of oil comes down.” We can talk later about tariffs, but Trump understands that lowering interest rates is the only meaningful lever to reduce the government deficit (outside of raising taxes on the American people). The US Treasury publishes monthly statements—here’s a chart on the income (receipts) and expenses (outlays), of the US Treasury for fiscal year 2024:

A deficit of over $1.8 trillion. For Trump to reduce the expense side of the budget, it’s very hard to find where the cuts are going to come from. Social security, Medicare, defense spending? Nope. The low-hanging fruit in Trump’s mind here is the net interest expense. Do you remember T-bill and chill? Yep, as interest rates rose in 2022-2023, so did the weighted average interest rate on US government debt. This year, the CBOE projects this line-item expense to be almost 1 trillion dollars (!). This is why Trump is so adamant that interest rates come down. He wants to increase defense spending to over $1.3 Trillion, and cuts to social security and Medicare are non-negotiable because he will need congressional support to lower the corporate tax rate, but more on that later.  

Powell Vs. Trump

Trump had his ‘return to glory’ last week, but this week the focus will shift to Jerome Powell’s response to Trump’s demand on interest rates. The Fed will convene on January 28-29^th, and with Trump’s demand for lower interest rates, it pits him squarely against Jerome Powell and the Fed, who actually hold the power of setting the target federal funds rate. Powell will surely not budge at the President’s call for lowering interest rates. Fighting Trump on interest rate policy could suit Powell’s fancy, thereby setting off a more hawkish Fed. This would put pressure on US equity valuations as long-term interest rates trudge higher under higher-for-longer Fed interest rate policy. Trump has long held an affinity for the stock market and thoroughly enjoys having US equities at all-time highs, and he even rang the bell at the NYSE just last month! However, a fight on interest rates and Fed policy will only intensify from here.

Finally, (No) Tariffs

Considering that the expense side of the federal budget will likely increase, let’s look at the income side of the ledger. Trump ran a re-election campaign on the back of tariffs, but so far, there’s been more bark than bite. During his speech at Davos last week, he mentioned his desire for trade with China only to be more equitable and not necessarily overtly in favor of the US. With a week gone by and no additional tariffs levied, it’s increasingly likely that tariffs will be more of a negotiating tactic.

This dovetails with Trump’s call for the US corporate tax-rate to be reduced to 15% from 21%. Trump understands he needs more economic activity to grow both the consumer and corporate tax base. By further lowering the corporate tax rate, Trump’s pitch to company executives is: make your product in the US, where you’ll pay a 15% corporate tax, or continue producing elsewhere and face increasing tariffs. But with no additional tariffs levied last week, it’s more of a negotiating tactic at this point. Trump will rely on companies bringing production facilities to the US, adding jobs and income, and increasing GDP while not passing on price increases to the US consumer through overbearing tariffs. The end game is likely a long and variable lag of increasing productivity and enough corporate onshoring to offset the decrease in the corporate tax rate through sheer volume and the incremental increase in individual tax receipts from the new jobs created.  

This Generation’s Arm’s Race

Most interesting to investors, Trump announced the launch of the Stargate Initiative—a $500 billion private-sector collaboration targeting the expansion of the artificial intelligence infrastructure in the United States. Executives from OpenAI, Oracle, and other leading companies believe the investment will position the US to lead the race in artificial intelligence and quantum computing. The initiative initially will build ten data center facilities, each 500,000 square feet. These data centers and the energy that powers them are crucial to the expansion and acceleration of AI. Without the energy capacity to fulfill the ever-increasing demand for power, a limit is placed on how quickly we can accelerate AI’s growth. A single Chat-GPT search requires 10x the computing power of a simple Google search. You can see how the power demand exponentially grows as the usage increases. Enter the US Government. Trump facilitating the deal amidst a light-handed regulatory environment allows for the energy sector expansion needed to power the arms race, bringing some private sector jobs along with it to construct and manage the data centers.

Have a great week!

-Matt

The 90’s!

Comparing different market cycles is a lot like the arguments about the greatest athletes of all time in their respective sports. In basketball, most often this becomes Michael Jordan or Lebron James, but the disagreement often ends with each side firmly entrenched in their belief with the mutual understanding that they played in different eras; in other words, agree to disagree. The same, too, can be said of comparing market cycles—but it’s fun to do it anyhow!

The Fed’s Playbook: 1995 vs. 2024

A close comparison to this market cycle is the mid-1990’s. Of course, there are inconsistencies and differences, and although history does not necessarily repeat itself, it often rhymes. I won’t tell you how old I was in 1995, but at the time, Fed chair Alan Greenspan kicked off a rate-cutting cycle in response to signs of deteriorating economic growth after having tamed a slight rise in inflation in the years prior. Cue the comparison!

Current Fed chair Jerome Powell began a rate-cutting cycle this past September across a similar backdrop of relatively loose financial conditions, with US equity markets at very-near all-time highs:

It’s a noisy chart, but you’ll see, as marked by the vertical orange lines, that both Greenspan and Powell started cutting interest rates under a similar set: loose financial conditions as measured by the Chicago Fed National Financial Conditions index, and newly minted all-time highs in US equity markets as measured by the S&P 500 index. Of course, after Greenspan’s cuts in 1995, we see what happened thereafter: the S&P 500 continued its run under relatively loose financial conditions until 2000.

Why Financial Conditions Matter

Why do financial conditions matter? In simple terms, they are a measure of relative liquidity available in the marketplace. Typically, excess liquidity ends up flowing into investment assets, thereby boosting asset prices. On the other hand, as financial conditions tighten, asset prices typically come under pressure as liquidity exits the system. You can see this on the same chart as conditions tightened into 2000, 2007, and 2022.

A Stronger Dollar: Echoes of 1995

Like financial conditions and equity prices, the direction of the USD has taken a similar path to Greenspan’s1995 rate-cut cycle:

The dollar index, as measured by DXY, ramped almost 50% from 1995 to 2000, following Greenspan’s first cut in 1995. The DXY index is a relative value, meaning US dollar strength is also a function of the strength or weakness against other currencies. Fast forward to today, and since Powell’s first cut in September, the dollar has appreciated almost 10% in a few short months. We will be keen to watch if this trend continues or reverses course.

What’s Different This Time?

As is the case in comparing anything, it’s important to highlight the differences as well. The US federal debt to GDP is almost twice as high now as it was in 1995, and the Fed’s behavior changed dramatically after the Great Financial Crisis in 2008. Across the current cycle, as the Fed began raising interest rates in 2022, the US Treasury countered this Fed financial tightening by issuing short US Treasury Bills, as opposed to longer-dated maturity notes and bonds, to finance the US Government. Ultimately, as we can see in the Financial Conditions Index, it’s ended up loosening financial conditions, providing a tailwind and support for US equities.

Following the Cycle’s Path Forward

As we move forward from this particular point in cycle time, we will closely monitor financial conditions, as they can be a helpful indicator in the future direction of US equity markets.

Have a great week!

-Matt

Sources: YCharts, SIMFA Research

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. Past performance does not guarantee future results.

Before we look ahead to the remainder of 2025, let’s look back at the year that was in 2024. As the saying goes, hindsight is 20/20; just when you think an asset should zig, it often zags!

The Trend Is Your Friend—Until It Isn’t!

I’m a big visual learner. One of my favorite ways to digest asset class returns is through a quilt chart like the one below. Of course, this does not represent the entire investing universe, but it does provide helpful context through color:

Much like in 2023, large-cap US equities led the way again in 2024, producing a 25% return—over double the closest competitor. Similarly, cash assumed invested at the fed funds rate earned a 5.3% return, beating traditional fixed income and even international, developed equities at 1.3% and 4.3%, respectively. However, the “quilt” nature of the chart shows why we diversify portfolios across different asset classes, and it provides a valuable lesson as we kick off 2025.

Both Winners and Losers

If you look at the top left of the quilt, you’ll see that, coming out of the Great Financial Crisis in 2009, REITs led the way in returns for three straight years and for five of the first six years that kicked off the 2010s decade. For those who recall the sentiment at the time, an allocation to REITs was necessary and borderline foolish to underweight inside of portfolios.

On the bottom of the quilt, you’ll see just the opposite. Commodities ranked near the bottom for almost the entire decade. They were the laughingstock of asset allocators, bringing forward the question of why anyone would ever invest in commodities. Amazingly, they awoke from their performance slumber and had fantastic performances in 2021 and 2022.

Looking back at various outlooks for 2022, likely very few, if any, had commodities at the top of the buy list. So, reallocating your hard-earned capital into REITs after their strong run or dumping commodities after their difficult decade would have proven costly thereafter. But that’s what makes the ”quilt” essence of the chart so informative. It is a humbling reminder that being in the prediction business of calendar-year returns is a difficult endeavor.

Looking Ahead

Fast forward to the present, and we find ourselves in the middle of another leadership streak after US large-cap equities continued to flex their return muscle in 2024. Of course, owning US large-cap stocks has been a lot like picking the Chiefs to win the Super Bowl in recent years. When the trend is your friend, it’s silly to pick the time when that trend will end. However, we do know from history that it will likely end at some point.

Peering through the hourglass of 2025, will US large-cap stocks lead the way? Maybe, but maybe not. Consider the below chart of historical US asset class valuations against the rest of the world:

Going back thirty years, US assets are expensive compared to the rest of the world. Past performance is no guarantee of future results, and as we can see in the quilt chart, a trend might continue, but it also might not. There is no necessary reason that US vs. Global valuations should mean revert, but we know from history that they often do at some point in time.

So, before ditching the underperforming asset classes in your portfolio, it’s important to remember why we own a collection of assets instead of one or two. The collective pool of diversified, un-correlated asset classes helps generate portfolio returns with lower levels of volatility or, in essence, smoothing out the ride in the growth of the portfolio over time.

Have a great weekend!

-Matt

Sources: JP Morgan Asset Management, Topdown Charts, LSEG

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. Past performance does not guarantee future results.

On Wednesday, Jerome Powell and his fellow committee members cut short-term interest rates by 0.25%, but saw their summary of economic projections increase their 2025 expectations for inflation, GDP, and the Fed funds rate. This induced a correction in US equities and a small rise in the 10-year treasury, but it’s important to understand the correction in the context of other asset classes, specifically treasury bond volatility, oil prices, and credit spreads, all of which barely moved alongside their US equity counterparts!

And the award goes to…

Madden’s tradition of giving out turkey legs began back in November 1989 when Eagles fans enjoyed a 27-0 win over the Cowboys. Then Eagles lineman Reggie White sacked Troy Aikman once and led the defense to earn the first-ever Madden turkey leg award. With it, a new tradition was born. This year, the inaugural W&A Thanksgiving Turkey Leg award winner is… the US economy! Let’s review the recent data and the stat lines, which suggest a healthier and more robust US economy than expected. Last Monday, Atlanta Fed estimates for Q4 GDP ticked up to an annualized 2.6%, following what has been a steady rise in the estimate throughout November:

Further, the Conference Board Leading Economic Index® (LEI), which tracks a range of economic indicators to predict future economic activity, is no longer forecasting a recession for the first time since early 2022! No one indicator is perfect, but this shift reflects stronger-than-expected economic resilience, including robust consumer spending, steady labor market conditions, and a normalizing yield curve. While risks remain, the updated outlook suggests a more stable economic trajectory in the near term:

Next, you might remember reading about the ‘Sahm Rule’ back in July and August. Economist Claudia Sahm created the metric to help identify the onset of economic recessions in real-time by monitoring short-term trends in unemployment rates. Historically, a reading above 0.5 and rising has been a reliable indicator of ongoing recessions. The Sahm Rule was triggered in August when it reached a cycle high of 0.57. This sparked attention in the financial media, with many quickly pointing out its significance, and predicting a concurrent, ongoing recession. However, since most financial media won’t revisit previous play calls that went sideways, investors should know the two Sahm Rule readings since August have dropped to 0.5 in September and now 0.43 in October! 

Additionally, Friday morning saw a big upside win in the US Services PMI, reading a 57 handle versus 55 in October, the prior month. As a refresher on PMIs, a level of 50 indicates no change over the prior reading, while readings above and below 50 indicate an acceleration or deceleration, respectively.  As you can see in the chart below, this month’s reading represents the largest number since March 2022.

Lastly, a quick peek at the Citigroup Economic Surprise Index reflects the current assessment that the recent US economic data has been improving and surprising to the upside. All told, the US economy continues to recover, evolve, grow, and most importantly, has not yet descended into a recession even with restrictive fed monetary policy.

Congrats, US economy!

Have a great week!

-Matt

Sources: Yardeni, FRED, S&P Global, Federal Reserve, The Conference Board

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. Past performance does not guarantee future results.

Earning our candy!

As David mentioned in last week’s blog, it is Q3 earnings season, and further equity market upside will need to be supported by accelerating earnings growth. So far, third-quarter earnings growth for the S&P500 sits at 3.4%, taking year-over-year earnings growth to 12.4%. Of the S&P500 constituents, the magnificent seven are expected to lead the pack this quarter and in the foreseeable future, even accelerating their earnings growth into the second half of 2025. The positive earnings momentum is constructive for further equity market price appreciation, but companies will still need to deliver.

Price movement, past and present

One of the most interesting yet boring things I like to read and talk about is market structure. How markets operate is both a function of the rules of the game and the players playing. Knowing and understanding the dynamics of all players and their decisions can help investors navigate and understand short-term price movements.  

Let’s break down the volatility setup as it relates to the Q3 earnings season. Equity volatility can be quoted in realized and implied terms—t­hese are fancy Wall Street terms for what volatility has been in the past, i.e. realized, and what the market is expecting volatility to be in the future, i.e. implied. This is a vital part of market structure. Big traders like hedge funds and institutions utilize short-term options contracts to hedge their positions against future moves in price. So, in advance of events where there is a higher probability of a larger range of price movement, institutions buy protection in the form of put options against positions in their portfolios. Did I mention it’s earnings season?

Single stock price moves post earnings announcements can vary wildly. However, as of Friday, of the S&P 500 companies that have released Q3 earnings, their respective share prices have moved in +-3% range post-announcement, and importantly, it’s the options market that prices the expected volatility of the underlying share prices in advance of the release. But who cares, and what can we do about implied volatility?

“Be greedy when others are fearful.” – Warren Buffett

Capitalize on the fear! An important part of market dynamics is understanding when market participants are inefficiently expecting more volatility than what is likely to materialize from a statistical probability perspective.

Let’s look at this past week. Throughout most of the week, the 30-day implied volatility of the S&P500 index sat around 18.7, while the 30-day realized volatility sat around 9.2. This represents a 100%+ premium of expected to actual volatility. Over the last three years, that amount of premium is over two standard deviations from the mean, which, in a typical bell curve, we know only occurs about 5% of the time. An outlier!

All told, by understanding short-term volatility structure and the premiums paid by institutions to hedge their portfolios from Q3 earnings announcements, investors can capitalize in the short-term by deploying capital on irrational downward movements in price, like the middle of last week:

Have a great weekend!

-Matt

Sources: Factset, YCharts, Hedgeye Risk Management, TradingView, Cboe Exchange

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. Past performance does not guarantee future results.

“Am I still in uniform? Then I ain’t retired.” – Pete Rose

In last week’s blog, we highlighted the latest US payroll data, which showed nonfarm payrolls adding 254,000 jobs in September—almost 70% more than expected. This week, we received the latest jobless claims data, which increased by 33,000 over the previous period. However, seasonal trends and two life-altering hurricanes are the culprit in what amounts to noisy data. Overall, US job creation and employment gains have been healthy, and notably, the number of unemployed per job opening is normalizing and only returning to pre-covid levels:

“I’d walk through hell in a gasoline suit to play baseball.” – Pete Rose

The other “job” of the Fed is to achieve stable prices, so let’s read through the latest CPI data from this week. The good news: year over year headline inflation is now down to 2.4% as of Thursday’s data, closing in on the Fed’s 2% target. However, inflation ex-food and energy showed an acceleration year-over-year of 3.3%. If you look at the numbers behind the headline percentage change, you will see that although inflation is lower year-over-year, it comes with the tremendous help of falling gasoline and oil prices in August and September:

Why is this important? Well, since Brent Crude Oil prices approached their cycle lows on September 10th, prices are back up almost 16%! This comes alongside a breakout in other commodity prices (though not directly captured in the CPI calculations) which will be felt throughout markets and investor pockets. In sum, what has been a helpful offset to headline inflation numbers might now be additive going forward.

7^th Inning Stretch

A lot of times, we can lose ourselves in the middle of an inning and lose sight of the score of the game. In investing terms—dive too deep into the day-to-day and lose sight of the longer-term secular trends. With all the noise last week about the upside surprise employment data and similar surprise this week in inflation data, US equity and bond markets day-to-day have been more volatile than usual.

For example, the MOVE index is a measure of US bond market volatility. Since the fed rate cut on September 18^th, the MOVE index has ramped almost 30% (!), one of the largest moves since 2020. Similarly, US equity market volatility measured by the VIX remains at near 21, which is elevated enough for markets to remain choppy.

Let’s drown out all the noise and take the score of the game with year-to-date returns of major asset classes:

US equity markets led by the S&P 500 are well ahead as we enter into the final earnings season of the calendar year. It’s a good reminder that annual US equity market returns are more often greater than 20% than they are negative!

Have a great rest of your weekend,

Matt Gentzkow, Investment Strategist

Sources: FRED, Bureau of Labor Statistics, Trading View, YCharts, FactSet, S&P

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. Past performance does not guarantee future results.