Happy New Year's! Our review of 2023 and a look ahead to 2024. Fair Warning: Deflation Ahead.

I wanted to start by wishing everyone a Happy New Year’s and the very best for yourselves, your families, and investment portfolios in 2024. Also thank you very much for reading my newsletters since I started a few months ago. Hopefully the last one of 2023 will be interesting. I wanted to primarily cover the key points to my thesis for 2024 and recap where things stand after 2023. I couldn’t help but share some of my favorite charts of 2023 here and there as well. Looking forward to continue to learn and improve my market understanding from others I interact with here and otherwise. Kicking things off with the US equity market as per usual.

The US Equity Market: A Rollercoaster Ride We Believe is Likely to Get Bumpier

If you’re claiming you had a perfect understanding of what would happen in the US equity market since at least in the aftermath of the C19 pandemic until today, frankly that would be completely impossible for me to believe. Nonetheless below are 2023 final returns for the S&P 500 broken down into 11 segments that make up the composite index, the 2023 returns for 7 major US equity market indices, and 2023 returns for all major global equity markets I could put together. Worth noting the US led the charge by a considerable distance, while China did the opposite and lagged the rest of the world very substantially.

Very clearly it was a fantastic year for mega-caps and large-cap speculative tech in the US equity market. Further to that point, below are the top 20 best and 20 worst performers of 2023 in the S&P 500. Lastly there is the “Magnificent Seven” final returns for 2023, as well as 2022 and 2022-2023 combined, the latter of which not being nearly as impressive as 2023 appears to have been.

 Below is the S&P 500 + 11 market segments highlighting returns from 2020-2023. As you can clearly see, large-cap speculative tech has done well, but it’s certainly not invincible. There’s been quite a drastic variation in returns over the years between different segments to put it mildly. 

For all the talk about how the equity market is so drastically outperforming expectations due to the US Fed’s hiking cycle, we curiously find it’s been performing right on par with historic outcomes.

This is something that truly should be getting far more coverage than it’s receiving but look at how historically excessive the “top 10” companies by market cap in the S&P 500 was relative to the composite index. We’ve never seen anything remotely this close. Perhaps not ironically, the next three years where we’ve seen a high concentration in mega-caps preceding a year of disaster for the US equity market (i.e. 2007, 2020, & 1999). Very interesting how all those are the year before the equity market saw a hard landing.

Another way to show how significant the top 10 was to the broader large-cap S&P 500. The green is the share of performance controlled by the top 10 market cap stocks, while the blue represents the bottom 490. Entering December – before the rally admittedly broadened to end the year – the top 10 controlled (literally) all the gains for 2023 and it looks like the bottom 490 may have been very slightly in the red at that point.

One of a long list of metrics that all seem to point to the same fundamental conclusion: US equity market valuations and high growth in particular is overpriced and due for a downward repricing. The below relationship between the ISM new orders component and S&P 500 YoY index price appears to have very solid correlation and new orders generally lead the S&P 500 price.

This chart is absolutely crucial in my view. Cyclically adjusted P/E (CAPE) is roughly 32. When you say this market isn’t expensive and valuations aren’t anything to get concerned about, bear in mind this is higher than the peak CAPE reached preceding even the 1930’s Great Depression. If you believe in a bullish narrative, you were right this year and we know anything can happen, but to suggest this is somehow a cheap or bargain priced market is borderline disingenuous.

The last few charts imply the bond market is wrong and the equity market is right (VIX charts & QQQ v TLT), or vice versa. There’s also one with the bearish double top for the XLK/SPY ratio having reached this same peak preceding the 2000’s tech bust. Last but not least, maybe it’;s worth rethinking if Apple’s enterprise value is really worth more than the 2022 GDP of almost all those advanced economies. More importantly, whether it’ll be sustainable heading into an economic downturn. We’ve let our opinion be known that we do not believe that to be the case.

2024 US Macro Outlook Appears to Heavily Favor Deflation and Subsequent Recession

I’ve tried to really take a step back and contemplate if I am sticking to this position because it’s been my thesis since the very end of 2021 or if the highest probably outcome really is a deflationary recession from the lag at which contractionary monetary policy operates. I don’t see how the below research is biased, but my conclusion is sincerely a deflationary recession is a base case projection for 2024.

Let’s take a step back and understand that while this might sound like an unfunny joke to some, based on historic Fed hiking cycle outcomes, currently we are only slightly behind schedule in terms of metrics commonly used to anticipate recession ETA from contractionary monetary policy. Based on what I’ve read the four current methods to estimate are:

• Interval after 10YR-2YR yield curve inverts

• Interval after 10YR-3M yield curve inverts

• Interval after final US Fed hike

• Interval after initial US Fed hike*

I made the last one bold because that’s the one I personally favor. I think it makes the most sense and it’s also historically proven to have the most accurate range. It suggests we should begin to see deterioration in the US labor market roughly 18-21 after the first hike from the US Fed. It did seem like that’s exactly what would happen, but since rising to 4.0% the US unemployment rate has curiously fallen back down to 3.7%. I don’t take one or two months of data overly serious and I still expect the US unemployment rate to start taking off sometime in 2024. However if we take the average of when a US recession actually occurred from the point after the first US Fed hike, I calculated the average to put us at the end of 1Q24. That’s definitely aggressive given what we’re seeing with the resilience in the US labor market, but I think it’s critical to keep in mind that’s just the average. We know we have a historic labor shortage and an incredibly resilient labor market to this point that will most likely delay that average. However one final point here before moving onto the yield curves: we are still a considerable distance away if using the third method (i.e. taking an average interval after the last US Fed hike). As the final chart below shows, the last 4 cycles had an average of 13 months after the final US Fed hike. That would put the average for this cycle at the very tail end of 2024.

I certainly don’t want to speak for the Fed, but it’s well known the majority – if not effectively all regional Fed’s – are using a yield curve-driven model to predict the probability of recession. Again I’d rather you read the Fed’s explanation on the NY, SF, or Chicago Fed’s websites – I’m sure there are others who have it listed, but those are the ones I’ve read pretty extensively into – for their explanation of why they are using a recession projection model so heavily driven by yield curve dynamics. My interpretation is two-fold. The first is straightforward – if you read the Fed’s short piece on it you’ll see they back-tested it with a very high success rate against former cycles (shown in chart below as well). The second has to do with my understanding of why the inverted yield curve is so successful in anticipating recession: the US Treasury market is the largest liquid funding market in the entire world. Someone can correct me if I’m wrong about that, but I’ve heard that multiple times from reputable sources and it makes sense. I believe a very common misconception is that everyone who buys a 30YR US Treasury bond has the intention of keeping it to maturity for 30 years. Far from it.

If investors in fixed income are that incredibly pessimistic about the future outlook relative to the current one to the point where the 10YR-3M yield curve was well beyond even < -200% inversion still remains deeply inverted. That tells us investors are really beyond hesitant to take any duration risk in the US Treasury market, which has consequently resulted in the awful long-term US Treasury action failures we’ve been consistently seeing. They somewhat quietly started when the TGA needed to and was authorized to be refilled in the summer of 2023 and its continued through year-end. The very last 30YR long-term Treasury auction this past week had another abysmal bid-to-cover ratio (demand proxy).

As if the yield curve inversion wasn’t giving off enough red flags, there’s much more concern to be had in credit markets than the inverted yield curve and frankly that should be worrisome.

It’s essentially inarguable that regardless of what the catalyst to a US recession has historically been and that undoubtably includes credit events, the primary US labor market indicators follow an extraordinarily reliable path into recession. First we should expect to see initial claims begin rising, followed by continuing claims somewhat stalling out before also rising into recession, and lastly the popularized lagging indicator US unemployment rate rising into and all the way through the recession.

Based on historic averages I calculated for initial claims, continuing claims, and the US unemployment rate – the historic averages actually differ very considerably. Initial jobless claims, which are always the number one data point we look to for guidance on when the labor market is going under, are lagging historic average. Conversely continuing claims appear to already be in recession territory consistent with prior cycles and given the US unemployment rate has a much broader historic range noted below, we appear to be pretty much on schedule with the US unemployment rate. This is based on where the US unemployment was when the Fed started hiking and the unprecedented historic labor shortage observed this cycle.  

Once the labor market begins to deteriorate in a meaningful capacity, that’s absolutely it for any “soft or no landing” wishful thinking. The rest of the macroeconomic data we’re seeing suggests a severe deflationary recession from the lag at which contractionary monetary policy operates is precisely what we should expect. It starts with this first basic macro concept that respectfully very few people understand at a detailed level despite its enormous importance. Interest rates drive the business cycle. Having them yanked up from a quarter of a percent to five and a half in 18 short months is an unprecedented hiking cycle for the US economy to absorb. Business prices paid, retail sales, money supply, wages, and more all point to future very severe deflation resulting in recessionary economic growth for the US economy.

Regarding labor market deterioration, I wanted to share the below chart with the US unemployment rate calculated at a 6-month moving average dating back to the mid-1940’s. What I see here is that the unemployment rate – ex-mid-1990’s – is very cyclical in nature. More specifically in quite literally every cycle ex-mid-1990’s, we see the unemployment rate start to takeoff and continue through recession. Additionally, the 10YR-2YR yield curve and US unemployment rate have a very closely correlated relationship as yield curves steepen into recession and the UR rises into one, effectively looking like its taking the same path.

The Conference Board’s consumer confidence index is much more closely tied to how consumers feel about the labor market than the University of Michigan consumer sentiment index, for example. It’s not just my belief that’s why subtracting the “present situation” component from “expectations” gives you an extremely reliable path into recession. It actually appears as though right before this calculation sharply rises into recession, it somewhat fluctuates. It’s almost as if consumers are a bit uneasy temporarily and then they are effectively certain they detest the present situations in a recession.

For those who don’t know the Conference Board – it’s an independent think tank that developed a model to forecast a recession a year out using 10 of the most well-known and agreed upon leading indicators of macroeconomic health. We have now seen that same LEI index from Conference Board decline 20 straight months, only surpassed by 22 months preceding the mid-1970’s stagflation recession and 24 preceding the 2008 GFC. Furthermore, every time the Conference Board’s LEIs index was at the current annual level, a recession arrived in 12-months or less. It’s also uncharacteristically went in the opposite direction of annual US GDP growth, which isn’t a good sign for the US economy as the LEI’s index has clearly historically lead annual US GDP percent change.

The 1970’s effectively proved we can’t have high inflation and high unemployment working simultaneously for long, if at all. When economic growth contracts, how is that inflationary? It’s quite the opposite, deflationary. When the US economy needs to be saved and we still have the issue raised in second chart of the highest public debt to GDP in US history, that may bring back undesirable inflation from my perspective.

What are we considering as we look ahead to 2024 and beyond?

Based on a number of factors we put together our outlook below for the S&P 500 in 2024, as well as other global asset classes.

Given the headwinds to the US economy and the hiking cycles having caused recession already in some of our EU trade partners, we feel strongly emerging markets are poised big upside.

Gold miners have been a favorite of ours in commodities for some time now and they were having a very difficult year. Now that gold somewhat took off towards the end of the year, we feel gold miners are underpriced even relative to gold and have a lot of upside potential moving forward.

Especially considering gold went on somewhat of a tear to end the year and we believe silver is underpriced relative to gold, SLV (Silver ETF) remains a deep value idea for us.

We firmly believe that while the Fed may talk tough with respect to inflation on occasion, their hiking cycle is over. As soon as rates are cut, bond yields will fall. I think this is still a very dangerous long-term position considering many really challenges on the public debt and systemic financial crises viewpoints. But in the meantime, we feel it’s as straightforward as the US Fed cutting will lower bond yields on the short and long-end – more immediately on the short-end – therefore consequently the fair market value of US Treasury bonds should be higher than today.

We have recently warmed up even more to Utilities not only because of the valuation, but they are the segment most likely to outperform in favorable rates conditions. This makes sense as to why they’ve been the laggard this year and really the only segment unable to generate any kind of positive momentum all year. We believe it’s prudent to buy low and sell high if that opportunity presents itself.

Below are 18 of what I believe are the most popular commodities in the world and their clearly unimpressive 2023 returns. We’ve shared some research on this previously and we are certainly not ruling out a commodities supercycle that gets traditional 60/40 funds to ponder a new approach. We already know what a disaster bonds have been since the hiking cycle began and now if we see something similar in the equity market, that at least seems like it’d set the stage for commodities to thrive. The research below mainly points to commodities historically outperforming when inflation was high and when manufacturing activity declined, both of which we have in the US macro setup today.

Our "Top 3" Chart Picks to Close 2023

While many of us understandably feel like we could have had a better understanding of how this year would pan out for the US equity market, let’s not forget both consensus and all major investment banks I could dig up price targets faired too. As noted below, not one major investment bank called how high the S&P 500 would finish at the end of 2022. Ironically Deutsche Bank generally doesn’t seem bullish to say the least and they were the closest by missing only -270 points. It’s probably a good idea for all of us to rethink everything we were so sure about after a year like this.

Second is just an interesting chart I recently made that dispels the notion Republicans are historically better for the S&P 500. According to data going back to 1929, Democrat presidencies are far superior to that of Republicans on average when it comes to S&P 500 performance. Democrat administrations averaged +90.93% while Republican administrations averaged just +34%. Looking at the average month for the S&P 500 under a Democrat vs. Republican – Democrats are doing more than twice as good averaging +1.05% with Republicans stuck at just 0.50%. Not that I ever seriously engage in conspiracy theories, however this should really dispel the notion that the economy might get artificially propped up to re-elect the current POTUS. The 2008 GFC attributed to GW Bush doesn’t seem to corroborate that narrative either.

Last but most certainly not least: the US recession ETA tracker I created back around 2Q23/3Q23 when we started to see bear steepening and I ascertained the historic labor shortage needed to somehow be factored in. This factors in when the 10YR-2YR yield curve began steeping and the US unemployment rate crossed its 6-month moving average. Back testing that logic in prior cycles, I found a 14 month recession ETA on average from the point at which those two things occur. In this cycle, that would put the average recession ETA May-end/June-start 2024.

Happy New Year’s again thanks so much to everyone for reading, supporting, and interacting with me in 2023. Looking forward to a lot more fun discussing markets and sharing my thoughts with you in 2024. 

Thank you so much as always to anyone who took the time to read and participate in my weekly markets’ newsletter. Hope you enjoyed my market update and if you have any questions, feedback, concerns, etc., please don’t hesitate to email me at:

[email protected]

Best of luck to all market participants this upcoming week & year!

Disclaimer: The information and publications are not meant to be, and do not constitute, financial, investment, trading, or similar advice. The material supplied is not intended to be used in making decisions to buy or sell securities, or financial products of any kind. We highly encourage you to do your own research before investing.

Disclaimer: Returns from ETFs do not match the index they’re meant to track on a 1:1 scale. ETFs contain shares of securities comprising a given market metric an ETF is tracking and the composition of the ETF is often not identical to the index its tracking. For example, SPY (SPDR S&P 500 ETF) tracks the S&P 500. A committee ultimately agrees on the companies from the S&P 500 included in the ETF, using guidelines including liquidity, profitability, & balance.