Long-Term Investing Ideas in a Volatile Market
Simon recently spoke with a $35 billion global asset manager about how they're navigating the market volatility. The key takeaways are to think long term, tune out the noise...
Invictus Research founder Mike Singleton shares his thoughts on the macroeconomy and leading indicators investors should be aware of.
April 11, 2023 – By Simon Erickson
All eyes are on the Fed these days. And for good reason, too.
There’s a high degree of correlation between the stock market and the American macroeconomy. Many investors are impatiently watching Jay Powell’s every move and are obsessively analyzing every word he says.
Yet the Fed’s actions are actually just one piece of a much larger puzzle. Equities as a whole tend to follow a broader business cycle, which includes periods of growth, inflation, and policy that spans for several years and even decades. Each phase within the business cycle has implications for companies and also their equity shareholders.
What exactly does that mean? And what exactly are those implications for us, as investors?
To answer those questions, 7investing CEO Simon Erickson recently spoke with Mike Singleton, who’s the founder and senior analyst of Invictus Research. Invictus’ business cycle analysis helps retail and institutional investors make more-informed financial decisions.
Simon and Mike began the conversation by discussing the business cycle — including what it is and how to measure it. They discussed why several leading indicators such as industrial manufacturing, CPI inflation, and the housing sector are worth monitoring to predict upcoming investing cycles. Specifically, layoffs within the manufacturing sector could indicate a shift in the business cycle — especially in service-heavy economies like the United States.
In the second half of the conversation, Simon asks Mike if he believes the Fed will ultimately reach its stated goal of 2% inflation and what a period of lower inflation would mean. Mike believes American will, in fact, see disinflation through the second half of the year. He also predicts an uptick in unemployment rates and a high likelihood of a recession. For investors, now could be a good time to consider defensive sectors such as consumer staples and health care.
No individual publicly-traded companies were mentioned in this interview. Cryptocurrencies mentioned include Bitcoin. 7investing or its guests may have positions in the stocks or cryptocurrencies mentioned.
This episode of our 7investing podcast has been sponsored by Stockscurrent. As a listener of our 7investing podcasts, you’ll get an exclusive offer a 10% off an executive membership by visiting stockscurrent.com/signup/podcast10. Their membership comes with a 30 day 100% money back guarantee no questions asked.
Simon Erickson 00:01
Hello everyone and welcome to this episode of our 7investing podcast where it’s our mission to empower you to invest in your future 7 investing founder and CEO Simon Erickson you can learn more about our 7investing research and our seven top ideas in the stock market each and every month at 7investing.com/subscribe.
Simon Erickson 00:19
Now there’s a lot of factors that impact stock prices, including the business cycle itself, and there’s quite a bit going on in the American macro economy right now. That’s why I’m very excited to introduce our guests for today’s show. Mike Singleton is the founder and senior analyst of Invictus research. He joins me today from the Great Northeast between Baltimore and Washington, DC Mike, glad to have you on the podcast.
Mike Singleton 00:42
Thank you for having me, Simon, it’s an honor to be here.
Simon Erickson 00:44
You know, Mike, we represent typically individual investors here with 7investing, there’s certainly gonna be interested in what’s going on in the economy right now the impact and implications that will have on equities, we’ll talk a little bit about stock valuations, we’ll talk a little bit about the housing market as a leading indicator for asset prices. But maybe it’d be best for you to start with some of the research that you’ve done into the business cycle. Can you talk a little bit about how things tend to follow cycles somewhat predictably over long periods of time, and the research and things that you’ve found?
Mike Singleton 01:14
Sure. Thanks, Simon. So first of all, I would say at Invictus, we’re pitching our own book a little bit because we are business cycle analysts. So what do we mean by business cycle, really, we mean three sub cycles, the real growth cycle, the inflation cycle, and the monetary policy cycle or interest rate cycle. And the reason that we care about those three sub cycles, which we sometimes shortened as just the business cycle more broadly, is because the business cycle drives between 60 and 80% of the price action for individual stocks. And if you look at the sector level, it drives a lot more than 60 80%, maybe as much as 100%. And when you look at the broader market, or asset classes as a whole, it’s just more and more macro each level you go up. And so if you if you care about why stocks are moving, and you don’t want to be confused by Mr. Market, so to speak, you don’t want to be you know, waving your fists at the you know, what happen, when your portfolio is going up and down. For reasons you don’t understand, I think studying the business cycle is a very good idea. And I think it can help enhance almost anyone stock picking process by overlaying a little bit of macro understanding of a shadow, the broad the components of the cycle, right?
Simon Erickson 02:22
You’ve broken it down to the growth side growth cycle, excuse me the inflation cycle in the policy cycle, perhaps you call that the interest rate cycle, but break each of those data points, or what kind of we were we typically see in each one of those steps.
Mike Singleton 02:33
So I guess, wow, that’s, that’s a long, complicated question. But I guess we could maybe start with how the growth cycle and the policy cycle and inflation cycle interact and sort of go through the sequencing, because I think that provides some really helpful context. So when a normal business cycle, what you’ll see is I’ll start with inflation, let’s say inflation is running hot, the Fed sees that inflation is running hot. So what do they do? How do they react? What’s their tool for bringing inflation back down to target, they raise interest rates, right. And when the Fed raises the Fed funds rate, which is their policy rate, it’s the benchmark rate that that influences everything else. When the Fed raises the Fed funds rate, it increases rates for the entire US interest rate complex and has considerable global influence as well. So what does that mean? It means when the Fed raises the federal funds rate, short term, government bill rates go up. So you know, three months, six months, one year, two year, there’s about a 98% correlation between short rates and the Fed funds rate. But then what a lot of people don’t understand is if you go out on the curve and look at the 10 year, or 20 year or the 30 year, the correlation is extremely high as well. The R squared for the relationship between the Fed funds rate and the 30 year treasury bill, bond yield is point eight, right? So 80% of the price action in the long bond is explainable by what the Fed is doing at the short end, right. So a lot of times people talk about the bond market, discounting economic conditions or growth prospects for the economy. And that’s true, it does. But the overwhelmingly most important factor is what the Fed is doing. Even moving into private interest rate markets like mortgage rates, the Fed has an incredible amount of control over that market. So when they raise the the Fed funds rate, they increase the mortgage rate as well, something like a 93% correlation between the 30 year fixed rate mortgage and the Fed funds rate. So moving away from all that bond market jargon, when the Fed raises the mortgage rate along with all the other rates, what happens well, demand for new homes goes down really quickly. And you can see that in the mortgage applications data. There’s a very strong inverse correlation between mortgage rates and mortgage applications. So essentially, what the Fed does when it raises the mortgage rate is it stuns the housing market and the good cycle tends to correspond to the housing market pretty closely. When people were buying new homes. They’re oftentimes spending more money on their homes. They’re buying what are called durable goods, think cars which go in your Roger your driveway or furniture or home appliances, big, expensive financial items, right. And so the durable goods cycle tends to correspond to the manufacturing cycle because of course, these durable goods have to be manufactured. So when the Fed raises rates, it slows down the housing market. It slows down durable goods consumption, manufacturing companies have to respond to that reduce demand by producing less, right. And that’s why we talk about industrial production where the isn manufacturing PMI. And these these production growth time series tend to have a very close correlation with the stock market. So if you look at the isn, manufacturing PMI, and the s&p 500, and you look at them over time, they look very, very similar. So we want to track that data really closely. In any case, if consumer demand for durable goods stays down long enough, and manufacturing companies have to suppress production for long enough, obviously, that’s bad for their businesses, it eats away at their margins. And so they have to begin firing people. So that’s the next step in the policy cycle. That’s the next step in the Fed slowing down growth in order to slow down inflation, right. And last in the manufacturing sector, are typically the end, you could also say residential construction or goods producing industries more broadly, that’s kind of the next step in the transmission of monetary policy, which eventually bleeds into services. So that was a very long answer. I’ll maybe pause there. But that’s typically how growth inflation and policy interact in sort of a qualitative conceptual sense.
Simon Erickson 06:30
They certainly are interconnected, Mike. And you know, we have seen now you can call it maybe a 12. year bull market, right, since the great financial crisis, you know, 2008 2009, we basically gone into 2021. With equities being very attractive options, right? zero interest rate policy, you know, money was very cheap step on the accelerator, go for the growth very, very good for companies in the growth part of the cycle. But there are some people that would say, you know, this is a different market that is not as correlated to the ones in the past, we had a COVID global pandemic in 2020, we have a crisis right now going on in Eastern Europe, with Russia and Ukraine, we’ve got supply chain problems with China. Is this time different? Or do you think that this is highly correlated still to what you’ve typically seen with all the cycles? And if it is similar to the previous cycles? We’ve seen? What are some of the leading indicators that you’re looking at right now?
Mike Singleton 07:20
So it’s a good question, I would say that business cycles tend to follow self repeating patterns, which means that you can learn about what’s likely to happen in the future from looking at the past. But we haven’t really had a full business cycle since the great financial crisis, really, we’ve had the COVID recession. But the COVID recession did not follow the typical sequencing of the business cycle, because in some sense, it was artificial, or it was caused by an exogenous shock. So I would say that if you want to learn about where we might be going in terms of the US economy, you’re better off looking at the great financial crisis or the.com, bust or 1992, or other historical recessions. In terms of what might happen next, leading indicators we’re looking at, it’s almost hard to explain some of our leading indicators without using slides. But this is this is what I’ll say. People talk about interest rate shocks, or the long and variable lags of interest rate policy on the US economy. We saw what by all accounts should be a considerable interest rate shock. And in 2022, right, the Fed raised the Fed funds rate 450 basis points or something like that the 10 year Treasury yield increased 322 basis points between 2021 and 2023. So the question is this big spike in interest rates? How and when does this flow through the US economy? And we’ve run countless different back tests on this. And our answer, and this is one of the primary inputs into our forecasting models, is in the back half of 2023. That’s where we see the interest rate shock, really hitting the US economy. That’s where you’ll see the pain start to affect the labor market, right up to now the labor market has been very strong. So because stocks typically trade atop the growth cycle, and recessions are more or less called on the growth cycle, we can get more into the specific details of what a recession is, and when the NBR will declare one officially. But essentially, what we’re saying is the the big risk off is in the back half of 2023. Right now our models are saying usually the way people delineate it is when does the labor market break? When is there a big nonlinear spike in the claims data or the unemployment rate? Our expectation is November December of 2023, or maybe even January of 2024.
Simon Erickson 09:45
So we’ve seen layoffs in the tech industry. You think the unemployment rate is going to increase even higher from that though, because that was maybe a little bit ahead of the rest of the economy, which is going to follow suit later this year.
Mike Singleton 09:56
Right so so these tech layoffs actually represent a relatively small for action of the overall economy. So while there have been considerable layoffs in tech, and we hadn’t really seen this many layoffs in taxes the.com bubble, if you look at the overall labor market, all of the industries and sectors of America put together either through something like the unemployment rate or the claims data, they’re actually pretty close to secular lows. Right? The unemployment rate is still 3.6%. It wasn’t that long ago that economists thought the natural rate of unemployment was about 5%. Right? Right. That was, that was kind of the common most common knowledge, so to speak, five or 10 years ago, and an initial jobless claims are not only at a cycle low, they’re also at a secular low, very, very low relative to history. And if you take initial jobless claims, and you divide it by the size of the labor force, which is an adjustment that you really need to make to get an apples to apples comparison for today versus prior business cycles, because the US population, and therefore labor force has grown over the last six years or so. initial jobless claims are lower than they’ve ever been going all the way back to the beginning of a time series in the 1960s. So we do expect weakness in the labor market and the back half of 2023. But we also have to acknowledge that it’s not happening yet. All of our coincident measures of labor market health still look pretty strong.
Simon Erickson 11:18
And we agreed Mike not not to have slides for this podcast is audio only. So there’s not going to talk to you on the screen right now. But can you tell me a little bit about how you guys follow the industrial markets? You know, manufacturing PMI? How important is that to the analysis that you do? And I know that you said that some of the indices that you’re looking at, I’ve actually turned negative in recent months.
Mike Singleton 11:35
Right. So manufacturing is important for a lot of reasons. I guess. The first and most obvious reason that we think it’s important is it just has a very close correlation with the stock market and also market internals. So again, if you take the year over year rate of change in the s&p 500, and paste it right on top of the isn manufacturing PMI, which is a very widely cited measure of manufacturing growth, they look really, really similar. So that’s one reason to care about it. Because we care about the performance of stocks, and Victus. We are market strategists, we’re not policymakers, right, we’re not academics. So the reason we study any of these variables is is to make better investment decisions. Right. So when any time series has a super close correlation with the performance of the markets, we’re going to anchor to that time series we’re going to look at it a lot right so that’s a big reason that we care about the the isn manufacturing PMI. Another reason is that market internals tend to correspond to it really closely as well. So if you took cyclical sectors over defensive sectors as a ratio right, and measured it over the last 20 years or so, it looks just like the isn manufacturing PMI. So when the manufacturing PMI is increasing cyclicals virtually always outperform and when it’s declining, signifying slower manufacturing growth, defensives almost always outperform right. So if we have a view that the manufacturing PMI is going to decline until the middle of 2024, which, you know, not coincidentally, is our view right now, then we should be overweight, defensives, it doesn’t mean you have to take all your risk off the table. Everyone has their own investment objectives. But it does mean that it’s time to be it’s time to be playing defense, not offense, so to speak. And then the second part is that manufacturing the manufacturing sector, even though it’s a small, relatively small portion of the US economy, you know, relative to other economies, globally, manufacturing goods spending is only about a third of total consumer spending versus services, which is about two thirds of the US is very service centric. But manufacturing tends to lead services. So it’s a good leading indicator. And then like I said earlier, it’s also the transmission mechanism for monetary policy into services. Right. When manufacturing layoffs happen. People spend less money on services, and therefore services companies tend to lay people off as well. So, you know, when we look at the labor market data, when we look at the employment data, what are we looking at most specifically, what are we focusing on the most, we’re looking at the manufacturing data, right? Because when layoffs start to happen in the manufacturing sector, that’s kind of our signal that the next step of the business cycle is starting to take place.
Simon Erickson 13:59
I do want to drill down into the implications and the decisions that the Fed faces here in just a minute. I do want to give just one moment for a sponsored read. Our sponsor for this episode is stocks current stocks current is your investment companion and guide. It’s helping individual investors just like you on their investment journey. They help new and seasoned investors alike by conducting research providing analysis and making recommendations. By joining stocks current you’ll get access to their recommendations, watchlist and real money portfolio, you receive real time mobile notifications and email alerts of their activities in the real money portfolio. As a listener to our 7investing podcasts, you’ll also get an exclusive offer a 10% off as an executive membership. Using a unique code to take advantage of this special promotion will include the text in our written piece for this podcast, but it stocks current.com/sign up slash podcast in this membership comes with a 30 day 100% money back guarantee no questions asked. Join stocks current today and let them help you make the most of your investments back to Mike Singleton, who’s the founder and senior analyst of Invictus research on like we talked with little bit about the implications about what to expect with stocks it sounded like right now is a time to get defensive. Some people might call that value investing some people might say staying away from cyclicals but bigger picture is that your your take on the stock market and equities right now that you tend to stay away from things that would move along with that kind of decline a lot of the production and manufacturing and industrial indices that you look at.
Mike Singleton 15:22
Right, that’s about it. And it’s important to understand too, that all stocks are cyclical, right? So if you were to take the different there’s 11 equity sectors, right, if you were to take the performance of the 11 equity sectors and do a correlation analysis with the isn manufacturing PMI, which has to do with the growth cycle, all of them have positive correlations with the economic growth cycle, but some tend to be more correlated and some tend to be less correlated. So cyclical sectors tend to be like consumer discretionary technology, industrials, energy, basic materials, financials and defensives tend to be what you’d expect, right? Healthcare, large cap, healthcare utilities, consumer staples, again, they are exposed to the business cycle, if you go to the grocery store, during a recession, you might buy hamburger instead of steak, but you’re not gonna stop going to the grocery store entirely. And so we also do some multi asset work at Invictus. And one of our favorite allocations right now, as it has been for a little while is, is treasury bills, which is sort of the cash alternative, or at least that’s the way we think about it. And we’ll take a nominally risk free four to 5% yield right now, given our economic outlook, we think that’s not a bad trade off to make.
Simon Erickson 16:34
Yeah, you got a great four block, you know, some of the research that you put out there was kind of breaking it down based on the inflation rates, you know, relative inflation rates and year over year comparisons, and also the growth of the economy. It sounds like if I hear correctly when the deflation bottom left quadrant, where it seems like consumer staples of healthcare are going to outperform at least in the research that you’ve shown, whereas the underperforming sectors might be financial and energy. Right.
Mike Singleton 16:55
Right. Right, exactly. And to be clear, when we say deflation, that Invictus, we don’t mean negative inflation year over year terms, we we mean something very specific, we mean slower real growth and slower inflation and rate of change terms. So if inflation goes from 9.1%, in June of 2022 to 6% today. That’s, that’s not deflation, technically, because it’s not negative, but it’s disinflation and combined with slower real growth. That’s what we mean when we say deflation.
Simon Erickson 17:25
Yeah, absolutely. Thanks for the clarification, Mike. And maybe that’s a perfect segue for kind of a final topic I wanted to chat about right now, which is the decision that Jay Powell and the Fed have got in front of them. Right. Powell has been saying for, at least since I can remember that his target inflation rate was 2%. We are still far above that right now, you know, CPI core inflation here for us. But he’s aggressively raised Fed funds rate, like you said, you know, it seems like this has been more challenging to get down to 2% inflation than maybe it was originally considered, especially at a time we’re like we said it’s after COVID, we’ve had a lot of free money going into the system. We saw from Silicon Valley Bank, you know, a lot of the banks were flush with cash, and they put it into long duration bonds that turned on them here recently with the yield curve inflation or your trade inversion. Other things. What do you make of kind of the Feds policy right now? Or are we getting back to 2%? Inflation? Do you think that there’s more Fed Funds increases here in 2023? And what are kind of some of the options you see that are on the table right now? And then what are the implications for asset classes based on each one of those options? I know that’s a huge question. That’s probably a three hour discussion right there. But kind of what do you think of the Fed? The decisions that are fed faces right now look like?
Mike Singleton 18:37
So I’ll answer the first question. First, are we going to 2% back to 2%? Inflation? I think the answer is, yes, at least over the next 12 months or so called next nine to 12 months. Why do I say that? How can I be confident about that? Well, it’s a really simple thesis, right? If we see a recession, recessions are virtually always disinflationary events. Why? Because price is the price of consumer goods, the price of whatever is always the intersection of supply and demand, right? And recessions mean, the aggregate demand curve is moving in, and so almost equal, that will bring prices down. And if you look at the last 20 recessions, we have data going back to 1910s, on inflation and NBR recessions. Inflation, pretty much always goes down whenever there’s a recession, and frequently it goes down very, very quickly. So we think Tibet, Tibet on something like an inflationary recession, which is something that we’ve heard before is countered economic history and economic logic, unless you expect a coincident major supply shock at the same time, which Invictus is pretty much impossible to forecast but it’s certainly not in our base case. So 2% inflation, why? Well, because we think there’s going to be a recession. Your second question, will the Fed continue to hike? That’s a more difficult question. So for a while, for a long time, we’ve been saying our outlook and monetary policy is hawkish policy is going to get tighter rates are going higher. And for a long time, that was a good call. Right? We were right about that. Our outlook for the last monthly market outlook that we did for April or monetary policy view is switched to neutral. And the reason we say that, first of all, I fully acknowledge that economic conditions still suggest that the Fed would hike, right. Why do I say that? Well, services inflation, which represents about two thirds of consumer spending, like I said earlier, is still running at between six and 8%. annualized, depending on which numbers that you’re looking at. And durable goods inflation, which has really been the primary driver of disinflation, since June, has shown signs of beginning to rebound a little bit. At Invictus, we don’t think that that is really going to culminate in anything material. But it’s a policy risk, the Fed sees it, the Fed doesn’t want it to happen. So you would think if two thirds of the US economy is doing flooding and 68%, and the primary driver of disinflation seems to be picking a 10 up again, that should be an environment where the Fed is likely to hike, especially since the employment data remains very strong. Right? So they’ve got their dual mandate, you know, price stability and full employment employment is, you know, for right now, it’s it’s, as it says, title labor market, as we’ve seen in a long time, and inflation still hot. You know, it almost seems like a no brainer, the Fed should be hiking. The reason that I say that we’re not hawkish on monetary policy right now, even though the economic, the economic conditions, say that we should be is really based on our back tests. So there are a number of leading indicators that we look at probably the simplest is just looking at the two year yield, the US two year yield tends to lead the Fed funds rate by about three months with a 98% correlation. So that is not a correlation that we generally want to bet against. That’s as you know, as close a correlation, as you’ll find in financial markets, generally. And the two year yield has broken down really since. I guess it was the Silicon Valley Bank debacle on March 8, that was the I think that was the peak in the two year yield. And we saw four sigma move lower in the two year yield, we saw it make a new, lower low, we saw it break down below support below 4.1 to 4.2%. And what that suggests is, given the relationship we just talked about that the Fed will be cutting in the next three months or so. Now. Could the two year reprice higher? Sure, certainly right? Is that a bet that we necessarily want to make at Invictus. Given that that historical 98% correlation? No, not really. And if we are going to see a recession in the back half of 2023, due to hikes that have already that are already sort of flowing through the economy. I don’t know that it makes sense to position your portfolio for higher rate for higher rates in this in this just given the the weight of the evidence in the in the economy in the financial markets right now. So it’s a tricky situation. We don’t think getting super short duration right now. Make sense? We don’t need to make a bet on this one way or the other. There’s not a high risk reward. Making a bet either way right now.
Simon Erickson 23:12
Yeah, absolutely. And then one last question, Mike, you know, I’m thinking about I don’t mean to open up an entire new can of worms on this, but something that we didn’t have to compare to in the past was cryptocurrencies, right. We there’s a lot of headlines out there about Bitcoin right now. But this is another asset class that, you know, some people are saying it’s going to replace gold. Some people say it’s gonna be an alternative, you know, for 401 K plans, retirement accounts to take to cash or money market funds. Some say it’s a very, very high risk investment, as we certainly seen the last couple of years. Do you think that cryptocurrencies has any impact on your models? Or your expectations for how you’re planning things going forward? Is or is crypto just completely not at not a factor in in all the modeling that you’re doing right now?
Mike Singleton 23:50
So we do look at crypto, we spend a decent amount of time on and we probably spend more time on the traditional asset classes. So I’d say we’re equity focused, but we also do bonds, commodities and currencies, and a little bit of crypto, it’s really pretty simple. With crypto, I think crypto does incredibly well and economic environments where one the Fed is easing into real economic growth is accelerating. Right. And historically, you’ve really just needed one of those to see crypto do pretty well. So what’s happening right now, are we seeing any of that? Well, growth is still slowing, and we expect it to slow for a while. So that’s a big red mark against crypto policy, we’re neutral on right, we could see it start to ease, you know, at some point in the next three to six months, but we think it’s a little bit early to make that high conviction bet on crypto because crypto is so heavily leveraged to those factors, right. So we’re probably neutral to bearish on crypto, I think it’s probably fair to say that for an asset that’s as high beta as Bitcoin or certainly anything that’s it’s, you know, underneath Bitcoin in the crypto universe, if there’s a recession is probably not gonna go up. And so, you know, we would love to buy, you know, buy the dip in crypto at the right time, but our model suggests that now is not the right time.
Simon Erickson 25:10
Absolutely once again like Singleton. He is the senior analyst and the founder of Invictus research. You can learn more about them at Invictus i and Vi C T U S dash research.com. Mike, a real pleasure having you on the show. Thanks for joining me on the 7investing podcast today.
Thanks for having me, Simon.
And thank everybody for tuning into this edition of our 7investing podcast where we are here to empower you to invest in your future. Have a great day, everyone!
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