A favorable employment report, not too hot and not too cold, sent stocks higher Friday morning. But profit taking in the afternoon sent stocks lower for the session and the week. One day reversals in a bull market have little meaning without follow through. Although futures this morning point to a softer open, the poster children of speculative activity, namely Nvidia’s stock and the price of bitcoin, both point higher. As long as speculative fever remains intact, the path of least resistance is higher. Bond yields have come down over the past week reflecting confidence that inflation is on the downward path. That only feeds the bullish momentum.
It’s hard to read too much into the employment data released Friday. While the net growth in new jobs was close to consensus, the revisions to prior months’ data was unusually large (and downward) while the unemployment rate shot up to 3.9%. The jump in the rate was a signal of slack building in the labor market. Most of the growth last month came within the health care, government and restaurant segments. Collectively, the rest of the economy saw flat employment. Wage gains were in line with recent numbers, still a bit too hot for the Fed’s liking. The report increased the odds that the Fed might start to cut rates in March, but May or June still seem more likely.
As for speculative fever, a weak afternoon by itself is hardly a sign the fever is breaking. With that said, last Monday’s sharp drop and the sudden reversal Friday afternoon should be taken as warning signs that investors are starting to get a bit nervous that the current rally has gone too far a bit too fast. As a reminder, ignoring the results of the Magnificent 7, the other 493 stocks within the S&P 500 reported lower fourth quarter earnings and declining profit margins. While consensus expectations suggest both should turn around this year, that is predicated on a soft landing and no recession, not even a down quarter. That may be the consensus of the moment, but it’s far from certain. Don’t be fooled by the surprising economic strength of the second half of 2023. Recessions don’t evolve slowly from a gradual decline in demand. They surprise everyone. Sometimes an event such as the collapse in the housing market in 2007 or 9/11 can shock the economy and create a sharp downturn in consumer psychology overnight. But at other times, a recession can evolve from a weight of factors. Unemployment today is 3.9%. Just a few months ago it was 3.4%. Credit card balances are at or near record levels. Housing demand is in the doldrums, EV growth is evaporating, and tech related spending to support AI initiatives may be at a peak growth rate. There are offsets. Infrastructure spending is starting to increase and immigration remains at high levels.
I am not predicting recession, but merely noting that the seeds are still present. Should the Fed keep rates high for too long, those seeds have the potential to sprout. Remember, rates are lowered to boost economic growth. They are lowered because central banks see a risk to economic stability. They aren’t lowered, or at least shouldn’t be lowered, to appease markets. Thus, it is often the case that markets respond negatively to the lowering of rates. Such action is often a harbinger of weakening economic data. Going back to those 493 members of the S&P 500, that would mean a continuation of a period of no earnings growth. Make no mistake, the rally since October is all about AI and declining interest rates. At the end of October, the 10-year Treasury yield was touching 5%. Today, it is a shade above 4%. Where will it be a year from now? The old saw says to add the real growth rate to the rate of inflation as a guideline. Assuming long term inflation expectations remain anchored at just over 2%. For rates to fall substantially, that would imply a very nominal growth rate for real GDP, hardly one that would support meaningfully higher earnings. How much longer can markets advance entirely on the back of lower interest rates and higher P/Es?
Should growth accelerate through 2024 as a soft landing or no landing suggest, the case of lower long-term interest rates becomes a harder one to make. Tomorrow, we get the February CPI report. As you recall, January’s was worse than expected with a jump in a broad range of prices for services. While some point to the all-important shelter component as the villain, a broad range of services experienced price increases of over 6% annualized ranging from pet grooming, to insurance to cruise ship rates. Inflation may be declining as supply chains heal, but getting to 2% may be a bit more difficult than markets are currently anticipating.
And that brings me back to speculative fever. Right now, markets are predicting a perfect landing. I can’t argue against that. But let’s start with a fact. Almost all the time, predictions about the future are wrong. Sometimes they are too optimistic. Sometimes too pessimistic. If you are investing in the overall market using, for instance, the S&P ETF, your focus is to guess which is right. If markets are priced to perfection or beyond, as happens at tops, the risk is increasingly to the downside. The risk is that earnings won’t reach expectations or that P/Es are too high. When investors are most negative, as they were at the peak of the Covid pandemic, then the odds are high that the economy will outperform diminished expectations. Bitcoin provides us a barometer for measuring speculation. Yes, I know about halving and the start of ETF trading in Britain. Those are catalysts feeding even more speculation. But they are short-term triggers. They don’t change the long-term fundamentals which must be fed by a sustained increase in demand. The same can be said for Nvidia. Sure, I and everyone else know that demand currently exceeds supply and revenues are growing close to 200% annualized at the moment. But that won’t be sustained. In the late 1900s, there was a race to lay cable across the Atlantic to support future internet growth. It turns out that cable lay virtually unused for decades. AI demand isn’t going to grow at a 200% rate for very long. When it moderates, supply will catch up. Profit margins will normalize. Determining when that will happen and what growth will look like 2-5 years from now is a very difficult task. Analysts are guessing right now. It’s too early to take any one prediction too seriously. But what I can say is that as Nvidia’s stock keeps rising, analysts who want to stay ahead of the pack keep raising expectations. Eventually, expectations will rise to the point where they become unattainable. A year ago, analysts vastly underestimated Nvidia’s pace of growth. At some point, they will overestimate it. When is that point? I don’t know, but when it happens, markets will react, probably violently. In the end, valuation always matters.
No one can argue that speculative fever is rising. No one can pinpoint the peak. But one could conclude that the odds are increasing that some air needs to come out of the speculative bubble. When you see bitcoin fall and rise by more than 10% in one day or Nvidia drop by over 5% Friday after being up 2% in the morning, those are warning signs. The market may or may not go materially higher from here. But a safer bet is that some cooling of speculative fever is inevitable. Only in the Saturday matinee serials did the hero jump off the train just as it was going over the cliff. Be careful.
Today, Rupert Murdoch is 93.
James M. Meyer, CFA 610-260-2220