The Safety Of Disbelief

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? ― Alan Greenspan (1996)

In every professional sport, extraordinary players have boosted its popularity. Think about football players such as Pelé, Diego Maradona, Ronaldo, Lionel Messi, or Cristiano Ronaldo. In professional basketball, the rise of Michael Jordan led to a worldwide mania for the NBA. Worldwide viewership numbers skyrocketed, paving the way for the emergence of more talent from around the globe inspired by the players they finally got to see.

However, men's sports receive the most attention. At the same time, female professional athletes often feel they do not get the recognition they deserve or, more precisely, feel underpaid compared to their male peers. While one can argue that these women deserve at least the same respect as their male counterparts from a competition perspective, from a financial perspective, there is a plain reason women do not receive the same pay as men.

For example, the NBA's revenue is about 10 billion dollars, while the women's league, the WNBA, generates only 60 million. In 2022, the NBA Finals averaged 12.4 million viewers, whereas the WNBA Finals averaged 412,000 viewers. It doesn't take a rocket scientist to understand why salaries are lower in the WNBA than in the NBA.

However, things are slowly changing. The WNBA's revenue has been consistently growing; in 2023, it rose by 200%. Additionally, many college stars have entered the WNBA this year, especially Caitlin Clark from Iowa and LSU's Angel Reese. Clark, in particular, has broken several records during her college years, and many reporters have called her a generational talent.

It remains to be seen how the story will unfold. Still, one can spot the similarities to the 1980s when Jordan, Patrick Ewing, Isiah Thomas, Clyde Drexler, Karl Malone, Dennis Rodman, and others entered the league, boosting the NBA's popularity in the 1990s. Similar to Jordan, Caitlin Clark has also signed a deal with Nike, which has caught the attention of several current WNBA stars. Consequently, the competition will likely increase, leading to more exciting games, higher attention, and viewership. Clark might become a new version of Cheryl Miller, arguably the best female basketball player ever, who posted similar stats to Clark despite playing in an era without a three-point line.

A similar phenomenon occurs in the business world. In leading industries, there's often a "role model" company that sets the standard for excellence, innovation, and professionalism. These industry leaders demonstrate best practices and pioneer new technologies or methodologies that others in the sector strive to emulate. They often become synonymous with the highest levels of success and serve as benchmarks against which other companies measure their performance. By setting high standards, these role models help elevate the entire industry, driving improvements in quality, efficiency, and customer satisfaction.

Take, for example, Apple in the technology sector. Apple's commitment to design excellence, user experience, and innovation has set a high bar for competitors. The company's success with products like the iPhone and MacBook has transformed its fortunes and influenced the broader tech industry. Competitors have had to up their game, focusing more on design, user interface, and seamless hardware and software integration to keep pace. Apple's influence extends beyond products to its retail experience, supply chain management, and marketing strategies, all of which are studied and mimicked by other tech companies aiming to capture some of its market magic.

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Currently, NVIDIA is the company that has successfully ridden the wave of AI popularity. Year-to-date, the stock has risen from about $500 to $1,160. At the start of 2023, the stock was worth less than $200, meaning it has increased eightfold since then. Multiple times, several investors called it "irrational exuberance," a "revival of the dotcom boom," and forecasted a dramatic drop in the price. Yet, it didn't happen, and NVIDIA's successful run continues.

To me, NVIDIA serves as another perfect example of why it's a bad idea to short a stock just because it has gone up a lot. I don't want to touch on whether fundamentals justify the price, but regardless, people often overestimate the influence of fundamentals on price developments.

Prices are just the result of supply and demand. Although it might have seemed irrational to buy NVIDIA at $400, one must acknowledge that many market participants didn't, for whatever reason that was. Hence, Keynes was onto something when he once said that markets can be irrational longer than one can remain solvent. In the long term, market prices are definitely driven by fundamentals, as people see that their expectations are not fulfilled. Still, in the short- and medium-term, there are other more influential factors for price action.

Without a doubt, these "other factors" can explain most of the price action in financial markets this year. Take the bond market as an example, where market participants entered the year assuming that several rate cuts were a done deal since the Fed somehow "pivoted" in the fall of 2023, at least verbally. That led to a rally in bonds until it suddenly stopped at the beginning of the year, basically because of two reasons: first, Powell's statement in January that markets shouldn't bet on a cut in the spring, and second, the continuously strong data that did anything but justify a rate cut so far.

I feel like it's time for some acknowledgment before discussing the latest market developments. My view going into the year was that the soft-landing approach wouldn't come to fruition and that we might end the year with more than six cuts because of an economic weakening. While I'm still of this opinion, it's unquestionable that I was way too early, which means I was wrong because I underestimated that the economic strength might persist for longer and that cuts would get priced out first.

Yet, that was exactly what happened. Inflation remained sticky, a bit longer than expected. Stocks continued their rise, supported by these solid economic data. In both fields, stocks and bonds, sentiment remained the driver that drove both higher, as the predominant assumption turned from a "soft-landing" to a "no-landing."

While the sentiment around stocks remained cautious to bearish, it made sense that the market continued to rise. Further, bond investors still haven't capitulated and continue to lean bullish, which could suggest that the latest rise in bonds isn't the turnaround that many hope it will be.

Although we might only know this in hindsight, the rationale behind this could be that slightly slowing economic data could continue to be bullish for stocks for some time. At the same time, bonds might remain under pressure because people will sell bonds to buy equities, and the coming issuances will not attract the needed demand. It still looks as if it's too soon to turn bearish on stocks and bullish on bonds, in my opinion. Though uncertainty remains regarding the long end, the short end seems a lot more attractive, especially since the recent inflation data support the assumption that further rate hikes are off the table.

When we look at currency markets, the recent euro strengthening aligns exactly with what I expected. After all, one should remember that sentiment on the eurozone economy was already very weak, while everyone expected that the strength of the US economy would continue. As it turned out, the US weakened while the eurozone did better than expected.

Meanwhile, the yen continued to devalue against the US dollar, and various currency interventions from the Japanese authorities showed little to no effect despite the increase in interest rates. To fight the yen's downturn, the BoJ either needs the Fed to start cutting or raising Japanese yields, which could mean trouble for the Japanese government.

On the commodity side, one can say that the year has been a good one for precious metal or industrial metal investors so far. However, I think that the run might be close to an end because, like with USD/JPY, sentiment has shifted to increased bullishness, and the trade seems highly crowded. Additionally, when we look at the broader global economy, it appears that the tides are slowly turning, meaning the recent driving force of growth is slowing while the eurozone and Japan show some signs of improvement.

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On Friday, the market received the latest inflation data from the eurozone, Japan, and the US. Early in the morning, Tokyo reported a consumer price inflation of 2.2% year-over-year, slightly up from 1.8% in April. Eurozone inflation numbers were similar, also showing a slight increase to 2.6% YoY, with core inflation up 2.9% year-over-year.

These data points did not help the already rising yields observed in the days prior. It was the PCE numbers from the US that moved markets. To recap, year-over-year Personal Consumption Expenditures remained steady for the headline and core numbers compared to last month.

The miss in the monthly number fueled hopes for rate cut expectations, which stayed slightly below estimates (0.2% vs. the expected 0.3%). Later that day, the MNI Chicago PMI release provided another glimpse of hope for bond bulls, coming in at a staggering 35.4 instead of the median expected 41.6.

Analysts and various chief economists examined the data and examined price increases in all sorts of product categories, each finding support for their own points of view. Once more, no one seemed to suspect that past changes in the broad money supply had already set the path of inflation in stone.

However, moving beyond the topic of inflation, last week's data releases collectively support the thesis that the US economy is experiencing a slowdown in growth. Whether this will sufficiently tip the economy into a recession remains to be seen, but the probability seems to rise.

As always, there are still ways to interpret the data to fit one's narrative, whether bullish or bearish. On Monday, PMIs from the eurozone showed a mixed picture, with signs that the latest gain in economic strength might not lead to expansion. The worst data came from Italy, where the Manufacturing PMI dropped from 47.3 to 45.6, contrary to expectations of a rise to 48.

If one wants to speculate about my thesis that the recent uptick in eurozone economic activity was a result of the continuous strength of the US and that a slowing US economy might halt the eurozone's recovery, the US ISM Manufacturing index published after the eurozone PMIs supports this view. The Index dropped into contractionary levels, disappointing those who expected an upward surprise.

Prices paid also dropped more sharply than expected, and new orders surprisingly fell as well. However, ISM Employment still points to labor market robustness and vigorously beat estimates. Bears immediately interpreted the ISM Manufacturing numbers as signs of an imminent recession.

Additionally, other indicators, such as consumer confidence, paint a grim outlook for the US economy. However, it's important to note that these indices consist of hard economic and survey data. While survey data is very negative, the hard data components suggest a slowing economy but not one in trouble.

The disappointing data on Monday led to another drop in the Atlanta Fed's GDP, now estimated to be 2.6% annualized (up from 1.8% on Monday). This is a significant drop from the 4.1% estimate from early May that suggested a strong, booming US economy. The question arises whether this indicates a substantial slowdown in economic activity or just a statement that the economy continues to grow but not as fast as before.

Furthermore, the services ISM on Wednesday contradicted the weak manufacturing numbers from Monday. According to the ISM Services, the services sector is still on a solid expansionary path. The S&P US Services PMI supported this picture, although it has stalled at the previous month's level. Still, the number was enough to raise the composite PMI from 54.4 to 54.5.

In conclusion, the US economy still shows a very mixed picture that supports bullish and bearish arguments. Despite the strong ISM and PMI numbers on Wednesday, the S&P 500 and the Nasdaq climbed to another all-time high. Yields continued their recent drop but remained in a downward trend.

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One can argue that rising expectations regarding rate cuts serve as a tailwind for stocks because investors interpret sooner cuts as supportive. This is not unusual at this stage of the interest rate cycle, and hence, one could expect that equities are currently in some sort of melt-up phase. Nevertheless, history also tells us that “since 1970, 50% of the Fed's first cuts were followed by declines of more than 20% in the S&P Index.”

Despite some weakening data, there is still no compelling reason for the Fed to cut interest rates. If one ponders what could change the FOMC's opinion, the answer is clearly the labor market. Powell and others have repeatedly mentioned this as a reason for the Fed to act.

Although one can argue that there are some signs of a cooling labor market (for example, the latest Beige Book mentioned a "normalization"), jobless claims and other labor market data remain solid and do not point to a need for imminent action. ADP employment numbers slightly disappointed on Wednesday, probably contributing to rising bond prices, but there have been multiple occasions where hotter-than-expected NFPs contradicted weak ADP numbers, so one has to wait for Friday's number for additional conclusions.

At this point, I need to refer to the dispute among several analysts about the accuracy of NFP data. Recently, it has not been unusual for strong NFP numbers to be quietly revised down in subsequent months, something I've noted before by citing Bloomberg economist Anna Wong.

This week, Wong published another interesting piece about Nonfarm payrolls, where she estimates that NFP numbers in 2023 were overstated by 730,000 jobs. According to Wong, it is even possible that total job growth was negative last year and that a recession already started in October. However, as she notes:

Unfortunately, the true state of the economy won't be known until well after the fact. The BLS will provide a glimpse of the QCEW dat for 1Q24 in late-August, which allows a guess of the ultimate benchmark revisions due early next year. The QCEW is typically a quiet affair, but the potentially large downward revisions expected in the August report - coming during a presidential election campaign, and with the Fed on the fence about rate cuts - could show the kind of "unexpected" labor-market weakening Powell flagged as a potential trigger for rate cuts.

The NFP numbers this Friday might indicate whether the real state of the labor market is as bad as Wong suggests. Needless to say, if NFPs remain strong, bears will likely shift the debate to questioning the accuracy of the BLS's data. Although they might have a point, it's doubtful that this will influence short-term price action because the market will primarily focus on the official BLS number.

Furthermore, it seems unlikely that Friday's NFP number will be so terrible (median estimate is 185,000) that it will ignite a strong sell-off in equities. After all, a slightly lower number could be interpreted as further normalization of the labor market and hence support the stock market.

This scenario also has implications for the yield curve, suggesting that the latest drop in long-term yields is just another countermove and not a change in trend. For a record amount of time, the yield curve has remained inverted, meaning interest rates are higher on the short end than on the long end.

As long as the data remains as it is, there is no real reason to assume that the Fed will start to cut interest rates on the short end. As a result, it is possible that the demand for long-term bonds will remain dampened and that the yield curve will bear-steepen instead of bull-steepen, pushing long-term bond yields up again. The coming 30-year bond auction next week will provide more clarity on this, and even if the Fed surprises everyone with an interest rate reduction, it does not contradict the possibility that long-term yields could test their October 2023 lows again.

Furthermore, the consumer seems to be running out of steam, pointing to a continuing weakening of the US economy in the months ahead. Real income growth has fallen in recent months, and several earnings calls suggested that consumers are switching to cheaper alternatives, implying that the reliance on credit card spending to keep consumption stable could end in the months ahead. A recent FOX poll supports this assumption: "73% reported that they lack the necessary funds for vacation."

Again, the coming NFP print on Friday will clarify whether the latest drop in consumer spending was mainly due to disinflation. Several other news items also suggest that the consumer is not the only one potentially facing future trouble. Neil Kashkari recently said at a conference in London that there is a possibility of a big loss in commercial real estate, and a Chicago Fed report found that:

US life insurers are piling into higher-returning but illiquid and opaque privately placed debt, raising concerns about what happens should they suddenly need to sell the securities.

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Despite all these indicators of potential problems building up, one should not become outright bearish. Market participants are masters at dismissing bad data and focusing on sound data; sentiment is also an essential aspect of price action.

As I have already mentioned, fundamentals are an important driver in the long term but a relatively poor indicator of short-term price movements. After all, expected real growth of 2.6% and unemployment still at record lows are not characteristics of an economy close to contracting. However, it's noteworthy that these numbers are not unusual close to a recession.

As long as expectations remain bearish for stocks, there is still room for them to go up until most bears have thrown in the towel. The opposite is true for the bond markets, where many still expect a bond rally in the year's second half. This assumption is not impossible, but with all the discussed points and current positioning, it is a valid argument that bonds will drop to another year-to-date low first and that the bear-steepening will continue.

Whether one views the current stock market rally as a bubble or a sustainable uptrend, market prices remain as they are, independent of personal beliefs. No matter how exaggerated earnings expectations might be, the simple fact that these expectations exist causes stock prices to go up, reflecting George Soros's quote that it's better to ride the wave than to fight it.

Pessimism within our expansionary financial system might sound intellectually superior but often comes with the downside of missing out on many opportunities. Recently, the question of whether the level of US government debt is sustainable has become a topic of discussion. Still, even if one tends to agree, one must remember that this discussion started when Ronald Reagan took office.

In conclusion, despite increasing signs of a slowdown, financial markets continue to behave as they do, and the more one reads about a "potential stock market crash," the more one should be able to fade it. Things do not happen when everyone expects them to but when most people think they won't. Observing bullish price action in the safety of disbelief instead of taking advantage of it turns one into a perma bear without making money.

I can never be all that you want from me
And I am broken
I will fail you constantly
Return to the safety of disbelief

Light The Torch- The Safety of Disbelief

Have a great weekend!

Fabian Wintersberger

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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.