Managing Risk in a Risk-On Environment

Darius joined Caroline Woods on Schwab Network last week to discuss the current risk-on Market Regime and its implications for asset markets.

If you missed the interview, here is the most important takeaway from the conversation that has significant implications for your portfolio:

The Market Remains In A Risk-On Regime, And We Believe It Has Room to Run

At the beginning of the month, our Positioning Model flagged an elevated risk of a short-term correction. While some investors point to geopolitical factors as the cause of the correction, we believe the market was stretched thin in terms of positioning and needed a cooling-off period.
We believe the market rally will continue because several fundamental themes, including our “Resilient US Economy,” “China Front Loading Stimulus,” “Green Shoots Globally,” and “Jay and Janet Want A Soft Landing,” may contribute to upside risk in asset markets. Until the drivers causing these themes dissipate, we expect asset markets to perform well.
Although the Fed is discussing rate cuts this year, we maintain that the resilience of the US economy negates the need for cuts, as the economy continues to grow at an at-or-above-trend pace on a real basis and at a well-above-trend pace on a nominal basis. The hawkish repricing of policy rate expectations is bearish, but only to a point in this context. Said simply, the resilient US economy is unlikely to require rate cuts anytime soon.

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What Does REFLATION Mean For Your Portfolio?

Darius joined Adam Taggart on Thoughtful Money this week to discuss the current REFLATION Market Regime, the resiliency of the US economy, the US consumer, and more.

If you missed the interview, here are the three most important takeaways from the conversation that have significant implications for your portfolio:

1. Investors Should Position In Line With The Current REFLATION Regime

Our 42 Macro Risk Management Process simplifies complex market dynamics into a straightforward three-step approach:

Position for the Market Regime
Prepare for regime change using quantitative signals with our Macro Weather Model
Prepare for regime change using qualitative signals via our fundamental research

Currently, we are in a REFLATION Market Regime. In this environment, investors should consider the following key portfolio construction considerations:

Risk Assets > Defensive Assets
High Beta > Low Beta
Cyclicals > Defensives
Growth > Value
Small & Mid Caps > Large Caps
International > US
EM > DM
Spread Products > Treasurys
Short Rates > Belly > Long Rates
High Yield > Investment Grade
Industrial Commodities > Energy Commodities > Agricultural Commodities
FX > Gold > USD

To consistently stay on the right side of market risk, investors should position in accordance with the prevailing Market Regime.

2. The Resilient US Economy Does Not Require Rate Cuts, But The Fed Wants To Cut Rates Anyway

According to the March 2024 Fed Dot Plot, the Fed is guiding to three rate cuts in 2024, three in 2025, and three in 2026.

At the same time, the US Economy continues to prove resilient across various metrics, including income, consumption, and the labor market.

While we maintain the view that the resilience of the US economy does not justify rate cuts, the Fed’s inclination towards cutting rates has served as a positive driver for asset markets.

3. The US Consumer is Resilient Because of The West Village-Montauk Effect

The essence of the “West Village-Montauk Effect” can be summarized as follows: With a substantial stock of savings, there is less pressure to save a significant portion of your disposable income.

We are witnessing this effect in relation to the US consumer. Since the close of 2019, both households and corporations have experienced a boost in wealth:

Household cash reserves have surged by 135%.
Corporate cash reserves have increased by 51%.
Household and corporate net worth have soared by approximately 34%, outpacing inflation.

This notable growth primarily occurred due to government spending during 2020 and 2021, which included COVID-related tax breaks, forgivable PPP loans, and extensions of jobless claims. A considerable portion of this expenditure entered private sector balance sheets. Simultaneously, as household and corporate net worth expanded, the monthly flow of US Personal Savings turned negative, demonstrating the eagerness of US consumers to spend a higher share of their disposable income due to the elevated stock of savings.

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How Long Will The Fed Hold?

Darius sat down with Maggie Lake last week on Real Vision’s Daily Briefing to discuss the recent transition to REFLATION, NVIDIA earnings, China, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. The Market Regime Transitioned From GOLDILOCKS to REFLATION Last Week

We utilize the 42 Macro Global Macro Risk Matrix to nowcast the prevailing Top-Down Market Regime. We do this via scoring the 42 most crucial macro markets globally via our Volatility Adjusted Momentum Signal (VAMS) and GRID Asset Market Backtests. These scores are then tallied, with the regime encompassing the highest number of markets emerging as the Top-Down Market Regime.

As of last week, REFLATION, characterized by a risk-on environment where investors tend to be rewarded for assuming higher risks due to perceived acceleration in nominal economic growth or better than expected economic performance without policy constraints, now holds the largest share of confirming markets.

We anticipate that this risk-on Market Regime is likely to persist until around midyear. For consistent performance, investors should align their portfolios in accordance with the prevailing Top-Down Market Regime.

2. The Tech Bubble Is Likely to Persist At Least Until Around Midyear

In its quarterly earnings release last week, NVIDIA reported a revenue of $22.1 billion, surpassing analysts’ estimates by $1.7 billion, which had projected revenue to be $20.4 billion.

Prior to the release, the 42 Macro Positioning Model indicated that positioning data from commodity trading advisors (CTAs) and market-neutral hedge funds indicated a probability of a further short-term market correction. The earnings release indicated NVIDIA beat their revenue estimates by 8%, and despite a temporary dip in response to the news, the stock surged by 24% over the next two days.

We don’t believe the tech bubble is likely to become unwound at this current juncture, especially if REFLATION persists as the Top-Down Market Regime over the next quarter or two.

3. PBOC Policies This Year Have Largely Supported Asset Markets

Since December, we’ve called for Beijing to implement front-loaded policy support as we entered 2024.

That’s what we’ve witnessed, as the PBOC has been actively implementing monetary policies to support the economy. Its balance sheet is expanding, claims on banks are rising, and it is reducing the loan prime rate while committing to providing additional lending to specific sectors of the economy.

Through these measures, the PBOC is attempting to revive the Chinese economy. Instead, it is positively contributing to global liquidity, bolstering the risk-on Market Regime in asset markets.

That’s a wrap!

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Is There Still A Risk of Recession?

Darius sat down with Anthony Pompliano last week to discuss interest rates, the Fed, the election year, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. Lower Worker Turnover Is Supportive of Economic Expansion

The Federal Reserve is closely monitoring the ratio of JOLTS Total Job Openings to Total Unemployed Workers as a measure of labor market slack or tightness. This ratio currently stands at 1.4, which remains above its pre-pandemic levels, indicating a tight labor market that is still relatively tight.

The Private Sector Hires Rate, holding steady month-over-month at 3.9%, is below the trend observed from 2015 to 2019, suggesting a cooling in hiring momentum. The Private Sector Quit Rate (PSQR) declined to 2.4%, its pre-pandemic level.

Lower turnover rates, as observed in recent quarters, are supportive of economic expansion by alleviating wage pressure within the labor market.

2. The Probability of A Recession Remains Low

At 42 Macro, we have identified five key leading indicators that are most effective in helping investors predict and position for recessions in their portfolios: the University of Michigan Employment Survey, the Conference Board Labor Survey Differential, the Continuing Claims/Total Labor Force ratio, Cyclical Unemployment, and Temporary Employment.

Among the 42 Macro Fab Five Recession Signaling Indicators, only the Temporary Employment metric signals a significant risk of recession. In contrast, three of the indicators suggest a low probability, and one presents a moderate risk level.

As a result, we believe the likelihood of a recession remains low at this current juncture.

3. Asset Markets Are Likely To Generate Positive Returns Throughout 2024

Several positive factors, including a positive fiscal impulse, a resilient economy, and declining inflation, are currently bolstering asset markets. Additionally, stock markets tend to perform well during an election year, especially when the incumbent candidate is from the Democratic Party.

However, the landscape is somewhat different now compared to the beginning of last year, marked by a decrease in both underpositioned investors and companies trading at reasonable valuations.

Consequently, while we do not anticipate the S&P 500 to replicate its 20% performance from last year, we do believe it may achieve positive gains in line with historical average returns.

That’s a wrap!

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Is It Time To Book Gains In Asset Markets?

Darius sat down with Adam Taggart on Thoughtful Money last week to discuss liquidity, investor positioning, the probability of a soft landing, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. Rising Liquidity And Policy Support Are Bullish For Asset Prices

Liquidity is rising both domestically and globally.

Although the recovery since the bottom of the liquidity cycle in the fall of 2022 has not been linear, the overall trend is higher.

Key indicators that typically lead the liquidity cycle, such as the US dollar, currency volatility, bond market vitality, and crude oil, all point towards a growing supply of liquidity from the global private sector.

This environment creates a highly bullish context for asset markets – especially if sustained by these indicators and complemented by potential interest rate cuts from the Federal Reserve

2. Our Positioning Model Suggests The Rally Can Continue

Our 42 Macro Positioning Model tracks a variety of indicators, including:

Non-commercial net length as a percentage of total interest across various asset classes
Year-over-year cash growth rate
AAII bulls and bears %
AAII bull-Bear spread
AAII stock, bond, and cash allocations
S&P 500 realized volatility
S&P 500 price/NTM EPS ratio

Currently, the S&P 500 Price/NTM EPS multiple is in the 80th percentile of readings, a level dating back to the 1990s, often associated with bull market peaks.

However, this signal is not supported by other indicators like the AAII Stock, Bond, or Cash allocations.

This suggests that while the market appears overvalued based on the S&P 500 Price/NTM EPS multiple, it may become even more so as investors are forced to chase positive stock market returns by increasing their allocation to equities.

3. There Is A Rising Probability of A Soft Landing in The Economy

Over the past two quarters, many economic indicators have evolved in a manner that increases the probability of a soft landing.

Among these, the acceleration in Nonfarm Productivity stands out, rising to 2.4% on a YoY basis, which is roughly 50 basis points higher than the long-term trend.

This uptick in productivity growth lessens the pressure on corporations to cut labor costs through workforce reductions or offset these costs by raising consumer prices.

Furthermore, our corporate profitability model suggests we will likely avoid a deep earnings recession.

This reinforces our views that corporations will not need to resort to mass layoffs or above-trend price increases to protect profit margins.

That’s a wrap!

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How Should Bitcoin Fit Into A Traditional Portfolio?

Darius sat down with Anthony Pompliano last week to discuss our KISS Portfolio Construction Process, the outlook on interest rates, Bitcoin, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. We Believe Investors Should Keep Their Investment Process Simple And Systematic… And It Should Include Bitcoin

In January, we made a strategic shift to our investment approach to our KISS portfolio construction process, transitioning to a long-only strategy.

The new process is designed to help traditional investors, RIAs, family offices, and other money managers outperform the conventional 60/40 portfolio in the long run by integrating trend-following strategies and a consistent allocation to Bitcoin.

The portfolio follows a 60/30/10 allocation, comprising 60% SPY, 30% AGG, and 10% BITO.

For serious investors considering adding a Bitcoin allocation, we emphasize the importance of systematic risk management to navigate this process and achieve smoother returns.

2. There Is A Significant Amount of Policy Rate Easing Priced Into 2024

The market is currently pricing in a 90+ percent chance of a rate cut by the end of Q2 2024.

This expectation is reflected both in overnight index swaps and federal funds futures, where a considerable amount of policy rate easing is priced throughout next year.

Moreover, we believe the concurrent rise in both stocks and bonds is fueling expectations of a disinflationary ‘soft landing’ in the months ahead.

3. Our Models Indicate Only A Low-To-Middling Probability Of A Near-Term Recession In the US Economy

At 42 Macro, we monitor several key indicators that give our clients the ability to spot a developing recession in real-time.

One of these indicators has crossed its recession-signaling threshold, suggesting a low-to-middling probability of a near-term recession.

However, it is important for investors to maintain perspective.

Our research indicates that stock markets typically peak around the same time as a breakout in jobless claims and the unemployment rate. Our research also indicates the stock market is typically very buoyant in the months leading up to that peak.

Therefore, there is no urgency for investors to put on a recession trade prematurely at this juncture.

That’s a wrap!

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Will Santa Claus Bring Gifts For Investors This Year?

Darius appeared on Schwab Network last week to discuss the US economy, the probability of a recession, the US consumer, and more.

If you missed the interview, here is the most important takeaway to help you navigate upcoming trends in asset markets:

Both Technicals and Economic Data Suggest The Market Should Continue to Rally Well Into January

The conditional seasonality research we conduct at 42 Macro suggests the dip will likely be bought until late January.
This sentiment aligns with the recent economic data, which confirms the market’s consensus for a soft landing. We believe the market has fundamental reasons to continue rallying.
We believe that the Federal Reserve has completed its rate-hiking cycle. While we think that market expectations might be slightly ahead of themselves regarding when the Fed will begin cutting rates, we do not foresee this having significant negative implications for the stock and bond markets at the current juncture.

That’s a wrap!

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Where Are Asset Markets Headed?

Darius joined Charles Payne earlier this week on Making Money to discuss where markets are likely headed.

If you missed the interview, here is the most important takeaway to help you navigate upcoming trends in asset markets:

Over The Next Few Months, We Believe The Stock Market Will Continue to Rally, And Dips Will Be Shallow.

Asset markets recently transitioned to a Goldilocks regime, where stocks typically perform well. As a result, we believe the path of least resistance in stocks is higher over the next couple of months.
Investor positioning remains light going into year-end, as many investors are under-exposed to equities. We believe any dips are likely to be shallow as many investors are forced to chase positive performance.
The AAII Investor Sentiment Survey shows the % Bull-Bear spread, a metric that represents the difference between the percentage of investors who are bullish and those who are bearish. It moved from an extremely bearish reading in the 4th percentile to an extremely bullish reading in the 91st percentile, the largest four-week move in history. This does not indicate that the bull market has peaked; rather, we believe it suggests a continuation of the recent consolidation over the near term.

That’s a wrap!

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Get Ready For ‘Markets Gone Wild’

Darius sat down with Adam Taggart, founder and CEO of Wealthion, last week to discuss Bitcoin, the stock market, the probability of a recession, and much more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. The US Equity Market Still Has Significant Right Tail Risk Over The Next 3-6 Months

The stock market has historically performed well heading into a recession:

The median Return of the S&P 500 in the year leading up to the peak around recessions is +16%, with an interquartile range of +14% to +20%.
More than half of the median return comes in the final three months leading up to the recession.

Our research currently indicates a blow-off top in equities in the months ahead given – especially given the starting point of severely depressed investor sentiment.

2. We Believe The Most Likely Path Forward Is For The Economy to Devolve Into A Mild Recession

Prior to deep recessions, credit typically increases as banks extend credit to less credit-worthy borrowers.

Then, when the economy experiences a tightening of monetary or fiscal policy, the effects are amplified by the large amount of credit present in the financial system.

Today, we have limited credit cycle vulnerabilities, indicated by:

The Private Sector Credit to GDP ratio of 152%. This ratio has declined throughout this business cycle.
The Private Sector Credit to GDP ratio trailing five-year z-score of -0.7.

These indicators suggest the recession will likely be moderate because the economy has not experienced the rapid build-up of credit that usually occurs before deep recessions.

3. Bitcoin Will Underperform Stocks Until A Recession Or Sovereign Debt Crisis Forces Central Banks To Pivot

We expect Bitcoin to struggle over the next few quarters until we find a bottom amidst the recession.

If stocks experience a drawdown of 24%, their median drawdown in a recession, Bitcoin will likely fall orders of magnitude further.

Our 42 Macro Global Liquidity Proxy, measured by the aggregated sum of the global central bank balance sheets, global broad money supply, and global FX reserves minus gold, has been trending lower and will likely decline further over the medium term.

Still, we believe Bitcoin will trend significantly higher in the coming years. But we likely will not see a meteoric rise without a recession or significant problem in the sovereign debt markets that causes the stimulus to put Bitcoin on that path.

That’s a wrap!

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RT this thread and follow @DariusDale42 and @42Macro.
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Stocks To Surge & Bonds To Sell Off Before Recession Hits By Early 2024

Darius sat down with Adam Taggart, founder and CEO of Wealthion, last week to discuss inflation, the labor market, the probability of a recession, and much more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio:

1. A Resilient US economy Leads to A Resilient Labor Market

The labor market has remained relatively resilient:

The Private sector employment experienced a three-month annualized growth rate of 2.3% for August.
Private sector wages are growing at a three-month annualized rate of 3.9%.
Private sector labor income is growing at a three-month annualized rate of 6.2% and is above its pre-covid trend.

Labor market conditions are likely to remain robust until the spring of next year.

2. “Immaculate Disinflation” Will Give Way To “Sticky Inflation” In The Coming Months

We believe the Immaculate Disinflation that has occurred will likely run out in the coming months. Historically, the US economy has always required a recession to bring inflation back to a below-trend level.

Our HOPE+I framework looks at how unique baskets of indicators representing the housing, orders, production/profits, employment, and inflation cycles have historically behaved around recessions.

The framework shows that inflation typically breaks down 6 – 8 months after a recession starts.

There is no historical evidence to anticipate anything other than inflation exhibiting a similar pattern in this business cycle.

3. The Spread Between Labor Demand And Labor Supply Will Likely Remain Positive For Several Quarters

The most recent US Total Labor Force SA reading was 168 million people – a value below its 2009 to 2019 trendline.

Conversely, Gross Domestic Income recovered its trendline approximately two years ago and remains above it.

Looking at the spread between labor demand and labor supply, we found that labor demand outpaces labor supply by approximately 2.5 million workers.

This spread will likely take a few quarters to return to zero and has sticky implications for workers’ bargaining power for their wages because the spread has historically been correlated to the annual change in the Private Sector Employment Cost Index.

That’s a wrap!

If you found this blog post helpful:

Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
RT this thread and follow @DariusDale42 and @42Macro.
Have a great day!