Sleight of Hand

PREFACE

The attack on Israel has so many geopolitical implications that will impact markets, it makes sense to wait a day to see if a path to de-escalation forms. The loss of life puts everything about the markets in perspective. However, for now, aside from the horrible tragedy, some of the moving parts are as follows.

This is likely to be a prolonged conflict. Oil exporters such as Saudi Arabia, Iran, and Russia will benefit from higher crude prices. Netanyahu is now leading a unified Israel, instead of battling his own issues and defending his recent changes in the Israeli Judiciary. The Israeli people, stung by this attack, may want to see a forceful response from the Israeli government. The only hope for a quick resolution is the return of the hostages taken by Hamas.

In 2011 Netanyahu released over 1,000 Palestinian prisoners in return for one Israeli hostage. After Israel pushes Palestinian forces out of Israel, perhaps the presence of the hostages could prevent an offensive into Gaza from escalating.

The clear loser from collateral damage is Ukraine. U.S. aid to Ukraine was not approved in the recent short-term funding resolution and the Pentagon just announced an emergency aid package to Israel. It may not be a coincidence that on Thursday Putin said that Ukraine will fall if the multi-billion dollars in monthly military aid to that country suddenly stopped. Any hope for an end to the Ukranian-Russian conflict is frozen, and anyone hoping for supply disruptions to reverse will need to reassess. Those inflationary pressures will be in addition to the obvious implications of higher energy prices. If the conflict continues as I would expect, investors may worry about how the energy markets could impact a European winter.

Another wild card will be how China reacts to this conflict over time and China’s interpretation of U.S. military readiness in the Asia Pacific region, Taiwan. If President Xi sees a prolonged conflict in Israel and the continued conflict in Ukraine, China may try to use this as an advantage to try and take Taiwan. Additionally, besides U.S. military readiness, there is significant political turmoil in the U.S. that is not going unnoticed around the world. There is no clear resolution to replace the recently removed Speaker of the House, the President has impeachment proceedings against him, and the current Republican frontrunner is under indictment. Additionally, President Biden and his cabinet will be under intense scrutiny for releasing $6 billion to Iran. The Republicans will claim it helped fund the attack by Hamas. Our comments about Taiwan are not our base case, in part because China is in such bad shape economically, but the fear of it happening could be an overhang on the markets. We are watching the Taiwanese stock index closely.

The note below was written on Saturday and was completed when the news first broke. I have not made changes to these comments. The only change I would make is in the Markets section. With the likelihood of increased volatility based on recent events, the JP Morgan put sale at 4150 in the S&P 500 that I wrote about last week could generate a flush to the downside if broken. For tonight, demand will come in above 4295-4300 support in Emini S&P futures and selling pressure emerges below there. Selling could accelerate below 4280 in futures.

 We will have a follow up note on this conflict this week.

”The more you think you see, the easier it will be to fool you. My job? To take your attention and use it against you. The closer you think you are, the less you’ll actually see.”

                                                                            --Now You See Me

There is a need to look behind the curtain.

Key takeaway:  The jobs data released on Tuesday and Friday contained some dazzle and some truth. The markets focused on the dazzle. We will examine both.  

Misdirection Dept:  The market focused on the strength of the JOLTS (Job Openings and Labor Turnover) Survey and the nonfarm payrolls (NFP) headline, but ignored the two more important numbers in each report, the hires rate, and the household survey, respectfully. I do not understand why the Fed, and Chairman Powell in particular, focuses so strongly on job openings (and the ratio of job openings to unemployment) as an employment gauge. The measure is flawed: it has a small sample size and is plagued by a low response rate. However, because it is respected by the FOMC, it is a market mover.

Job openings data are dreadfully distorted, as job openings can be counted as open even though the position is no longer available. Some workforce firms estimate that the likelihood of an opening resulting in a job has dropped by 50% over the past four years. If you are to monitor anything in the JOLTS report, the hirings rate is far more reliable. That series did not move up despite the spike up in the openings data:

 Therefore, the signal with the least noise in JOLTS is showing no change in the hiring environment as of their latest datapoint.

Turning to the nonfarm payroll number, it was a shocker—I am going to focus on the private payrolls number because total payrolls was flattered by a 73,000 increase in government hiring, which was 7x the estimate for September. The consensus for September total private employment was 160,000, with a standard deviation among the estimates of 37,000. The 263,000 that was released by the Bureau of Labor and Statistics Friday was a 3-standard deviation outlier from the median, and above even the most optimistic forecast of 250,000.

 A blowout number by any definition. The strength in the JOLTS job openings data on Tuesday and NFP on Friday sent the markets lower, and then the market sprung back from an oversold condition with a vengeance into the Friday close (more on that in the markets section).

However, if we look at the Household survey, from which the BLS calculates the unemployment rate, the increase was a much less impressive 86,000. Additionally, there is a way to equate the household survey to the establishment survey, and the household number was -7,000 in nonfarm payroll terms. Put the cork back into the champagne bottle?

Nestled within the household survey is the number of reentrants to the labor force. It has been increasing, breaking its downtrend, which has tended to be a leading indicator for recessions:

While there is more forecast error in the Household survey due to its smaller sample size than the establishment survey, it does catch turns faster. That rule of thumb has never been more dependable than now. The following chart explains why:

There have never been more full-time multiple jobholders than right now. That means the potential for double counting errors in the establishment survey has never been higher. So don’t watch the hand that is waving, watch the other hand, where reality lies—the household survey.

Private payroll growth measured by the ADP report was extremely disappointing, showing only an 89,000 increase in employment and large establishments (those with over 500 employees) experienced a drop of 83,000. While that survey is deemed unreliable by many economists who expected a 160,000 increase—the same estimate as the nonfarm private payrolls forecast—ADP reported the largest increase of 92,000 was in leisure and hospitality. That statistic was consistent with the 96,000 increase that was reported in the establishment survey. Leisure and hospitality alone represented 37% of the employment gain in private payrolls for September, and more than 100% of the gain in the headline ADP number.  

Additional clarifying information will be available after the Conference Board’s Employment Trends Index (ETI) is broadcast on Monday. Job openings is one of the eight indicators comprising the ETI, but the big jump for August should not carry too much weight given how the Conference Board calculates monthly changes in those eight timeseries. Technical Note: The Conference Board applies a “symmetric monthly change methodology” rather than a simple percentage change to account for wide swings when they calculate the impact of an indicator on the entire ETI. Job openings dropped 700,000 in the prior two months and then whipsawed back up 700,000 in August to return to the May level of 9.6 million openings. This outsized move will have a smaller impact due to their approach.  

The ETI has been falling all year, and my favorite component, the percentage of Conference Board respondents finding “Jobs Hard to Get” just hit a two-year high. We will take a good look at the components when they are released at 10 a.m. tomorrow.

Markets: Big Round Numbers and the Clarity of the Yield Curve

Three big numbers came into play this week:

·         150 in the USDJPY (U.S. Dollar Yen exchange rate). Important? The currency pair has reversed hard off that level in the past, and USDJPY has not seen a monthly close above 150 in 33 years.

·         5% yields were seen in U.S. Treasury 30-year bonds; a level that has not been seen since it reached that plateau on a monthly closing basis in June 2007.

·         The S&P 500 index came within 10 points of its 200-day moving average just above 4200 on Friday, sparking a violent short-covering reversal.  The Russell 1000 and 3000 tested their respective 200-day moving averages which marked their lows on Friday.

As far as the dollar is concerned, its recent strength has been driven by the increase in interest rates. However, Japan’s weakening economy has not helped the situation: Japanese consumption expenditure per household was 2.5% lower in August on a year-over-year basis, the sixth straight month of annual declines.

The interest rate increase at the long end of the U.S. yield curve has been extreme and has accelerated after Chairman Powell discussed the “heat in GDP.” While we closed at new highs in the 30-year, I find it important fixed income traders did not push yields above Wednesday’s highs after the blowout NFP headlines Friday. Market tone is important, and action around the psychologically significant 5% level needs to be monitored.

Equity Market:

The 200-day moving average certainly carries weight, and normally causes a bounce up when price approaches it from above and the moving average is rising, as it is currently. It is important to watch for any close below that level now that it has bounced, because the large volume spike that accompanied the reversal on Friday signifies that the consensus believes that will be the only test of the 4200 support level.  

The conditions for Friday’s bounce were set by the prevailing negative sentiment that caught the market leaning too bearish:

Last week, the CNN Fear and Greed index hit 17, which was a bullish signal that almost matched the low reading of 16 coinciding with the major October 2022 lows. Furthermore, the number of NASDAQ stocks trading above their 50-day moving average also hit a low for the year on Tuesday.

The washout in Nasdaq breadth is what helped the index close the week at 14,973, a hair below my bullish trigger. I had written last week that “This is a potentially very bullish look with a sharp risk/return ratio. Use the following short-term trading rules to manage exposures—be defensive below 14,400 and bullish above 14,980 with a target of 16,750.”

When I looked at the S&P 500, I listed one caveat regarding a bearish pattern in the S&P 500 “that requires Friday’s high of 4335 to be broken on the upside. That is a critical level that must be exceeded early this week followed by confirmation above 4400.” That 4335 level has yet to be broken, and with the news out of Israel, we will not be seeing bullish follow through to Friday’s rally in Asia Sunday nor in the U.S. on Monday.

I would take advantage of bullish action above 14,980 in the NADAQ 100 index and above 4400 in the S&P 500 to add to exposure, but we are still on thin ice as of this writing.

Fixed Income:

A quick note on Japan: Given how expensive it has been to hedge the currency risk of holding U.S. treasuries for Japanese institutions, Japanese portfolio managers have not added to their U.S. fixed income holdings. During this period where U.S. short rates have exceeded those offered in Japan, Japanese Government Bonds (JGBs) have appreciated relative to U.S. 10-year notes on a currency-hedged basis. This dynamic is displayed in the chart of the ratio between Japanese and U.S fixed income prices since 1990

: 

 If the U.S. yield curve steepens, the 10-year becomes more attractive to Japanese portfolio managers. Therefore, I am wondering if the huge wave of capital repatriation will occur to the extent the consensus believes when the BoJ’s yield curve control (YCC) is eliminated and JGB yields rise. While JGB yields will offer more value to Japanese institutional investors post-YCC, they need to make a bet that the high valuation of JGB’s relative to U.S. treasury notes will continue rising and make 20-year highs. This JGB/10-year treasury chart will be important to track when the BoJ reverses course. 

The U.S. yield curve, as defined here as the weekly spread between the 10-year and 2-year treasury notes, is perched at a pivotal level. The colored area in the chart below is the Ichimoku cloud, and I have circled the areas over the past 10 years that illustrate the interaction between the cloud and the 2s 10s spread. It is fairly evident that the cloud sets up very good directional trends. A break above -20 basis points (meaning the 10 year is inverted relative to the 2-year by 20 basis points in yield) could usher in a period of further steepening.

As seen in the next chart below, after the yield curve broke above the Ichimoku cloud in December of 2000 and May 2007, it rapidly steepened. Those dates coincided with recession and an equity bear market. While some who remember 2007 could object, arguing the stock market rallied until October of that year, banks, consumer discretionary, healthcare, and telecom sectors all hit highs on a monthly closing basis in May 2007

.In 2007, energy stocks continued to rise thanks to a rising price of oil for another year, and tech stocks appreciated another 10% into November 1, 2007, two weeks after the S&P 500 peaked. There are some parallels to 2007; perhaps this will be the roadmap for our current period.

Of course, the 10-year minus the 2-year yield has not broken out above its negative 20-basis point resistance level. However, we are seeing the 2-year through 30-year yields hit levels not seen since Q3 2007, and 3-month bill yields at their highest since Q1 2001, which reinforces the potential for a move lower in economic activity and stocks, analogous to 2001 and 2007. 

Final Comment—is the yield curve pointing to timing a period of small cap outperformance? The Russell 2000 has severely underperformed the Russell 1000 and underperformed the NASDAQ 100 even more dramatically during 2023. Curve steepening is normally a good environment for small caps, although it can occur with a long lag, specifically during a rising rate environment (a bear steepening). Just as there is a stretched move between stocks and fixed income but no trigger to act, overweighting small caps has no trigger. However, we are monitoring both in our asset allocation discussions.

Peter Corey

PavePro Team

© Copyright 2023 Pave Investment Advisors, LLC (“Pave”). All Rights Reserved Pave is an SEC registered investment adviser. Such registration does not imply any level of expertise by the registrant. Pave provides services on a discretionary and non-discretionary basis. The enclosed material is for educational purposes only, any client subscribing to Pave’s advisory services will need to accept the Term of Service and execute, by accepting, the Investment Advisory Agreement in the Pave application. Investing is speculative and involves risk, including the possible loss of principal. The information contained herein is provided for discussion purposes only, is only a summary of key information, is not complete, and does not contain certain material information about Pave or any of Pave’s affiliates and is subject to change without notice. The distribution of the information contained herein in certain jurisdictions may be restricted, and Pave may not be available in all jurisdictions. 

Unless otherwise indicated, the information contained herein is believed to be accurate as of the date it was produced. No representation or warranty is made as to its continued accuracy after such date. This material is not intended to be, nor should it be construed or used as an offer to sell, or a solicitation of any offer to buy, any securities or investment advice. No offer or solicitation may be made prior to the delivery of an Investment Management Agreement, which will contain additional information about Pave, including disclosures relating to risk factors and conflicts of interest. Clients will also receive ADV Part 2A, 2B and Part III (Form CRS). You should review all the material provided about the advisor. In the event of any discrepancies between the information contained herein and the Investment Management Agreement, the Investment Management Agreement will control. You should make an independent investigation of the investment described herein, including consulting your tax, legal, accounting or other advisors about the matters discussed herein. Pave’s investment methodology may not be suitable for all investors. There can be no assurance that any investment objectives will be achieved. Investment losses may occur, and investors could lose some or all of their investment. No guarantee or representation is made that Pave’s investment methodology will be successful. Nothing herein is intended to imply that Pave’s investment methodology may be considered "conservative", "safe", "risk free" or "risk averse”. Economic, market and other conditions could also cause Pave to alter the investment methodology. Certain information contained in this material may constitute "forward-looking statements," which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "target", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of Pave’s methodology may differ materially from those reflected or contemplated in such forward-looking statements. Pave believes that the information contained in this material to be reliable but does not warrant its accuracy or completeness.