Good morning and welcome to a week where we remember D-Day and a founding father’s discovery of electricity. Last week the market continued in traditional fashion to ascend the “wall of worry” despite some of the ugliest days the country has seen in a while. It is ironic this is on the 31st anniversary of the student-led protests in China that led to the Tiananmen Square Massacre. In the last 48 hours some cities vowed to reduce funding for local law enforcement, which is applauded by both protesters and investors. But we are still in a recession and municipal finances are far from healthy. Coming from a town with two police departments, there are many municipalities that ought to reduce law enforcement budgets beyond just NYC and LA. Yes, it is symbolic of what the protests are standing for, but it seems plausible this was already being considered.
Economic uncertainty at all-time high
This note is part of a weekly series where I attempt to digest current economic and market data to help asset allocators gauge the macroeconomic environment.
Newspapers started competing with social media starting in 2018. High competition among media outlets is leading to more partisan reporting and even more superlative headlines to retain viewership. However, consumers are now using social media for real-time news instead. For example, Black Lives Matter protests have over 20mm posts using #BLackLivesMatter on Instagram alone. That is more than the circulation of the top 10 national newspapers combined.
Russell 2000 outperforming, small businesses to follow?
Keeping with current events, the global recovery is anything but equitable thus far. China is sporting the highest manufacturing PMI among G20 countries at 50.7 - barely in expansion territory. Meanwhile, the remaining three “BRIC” countries’ manufacturing levels are still deep in recession territory. Fortunately, the US showed its recovery is already underway through a blowout jobs report. Perhaps a sign of optimism for small business specifically is the Russell 2000 ETF (IWM) (an index measuring the smaller third of stocks) was among the top performers of the last month. A bullish confirmation would be a rebound in the NFIB Small Business Optimism survey on Tuesday, keeping pace with small-cap stocks. Any deviation from their historically strong correlation could be a poor sign for small-cap stocks, especially ahead of the Russell rebalancing at the end of the month.
Money Market AUM as % of S&P 500 Market Cap
So while small-cap stocks are leading off the market bottom, less promising for equities broadly, is the small amount of cash "on the sidelines" as compared to prior recessions. Bear markets usually see investors sell stocks for cash, which is left in money market funds that pay interest.
In past recessions, high money market AUM became a large source of buyers for stocks. This time around, investors preferred bonds over money markets, which now only make up ~20% of the stock market value (low compared to prior recessions). This is confirmed by the $78bn inflows to fixed income ETFs this year.
For equities to take their next leg higher, the fixed income market seems the likely source of funds. This would imply higher yields, which has been a losing proposition the last 40 years.
Dividend yields higher than treasury yields = double-digit returns
Most treasury bonds are paying investors less than 1%, yet the S&P 500 ETF (SPY) is paying closer to 2%. Although the dividend yield is based on the last twelve months and is not forward-looking, this has only happened in 21 months since 1990. The higher yield makes equities more attractive to income investors and is often seen ahead of strong periods for stocks. The below chart shows the relationship between relatively high dividend yields and forward returns for equities.
It is noteworthy the yield differential never went positive until quantitative easing in November 2008. Still, it is intuitive that equities now present a real alternative for income investors and the historical data shows that. Since 1990, every month when the yield differential was positive, as it is now, saw a double-digit positive return over the next five years.
Yes, the highest five-year return occurred in the 90s when treasury yields were consistently above dividend yields. But it was a period that also saw the lowest return. At the very least, this supports the notion that high interest rates are associated with volatility of returns, and quantitative easing leads to more consistent returns.
Data sourced from FactSet.
Waking up this morning we have OPEC members conspiring to elevate energy prices, which should buoy stocks on Monday; but investors will soon be getting ready to discount the next big risk - politics. A few weeks ago we presented the correlation between the opposition party winning the election and weak equity returns in the 3 months prior.
Biden is now the favorite in the polls and an overbought market may prove that indicator right once again. On an even shorter horizon, a NY Fed survey shows consumers are expecting increased benefits for assistance programs. They are also expecting a second stimulus check that requires a lot of agreement among political parties to pass through Congress this week.
So strategists are becoming more optimistic just as markets finish a historic rally. From a contrarian perspective, low volatility and less bears make the overbought market ripe for a pause just as outlooks are changing. One last ode to the bulls: if we recently had a period where bad news was good news for monetary policy, what happens at next week’s FOMC meeting if we have been getting so much real good news (data)?
This week's economic data releases:
- 6/7 China import/exports, China FX reserves, Japan bank loans
- 6/8 China new yuan loans, German industrial production, Japan M2
- 6/9 NFIB Small business, JOLTS job openings, China loan growth, China M2, China CPI, Japan core machinery orders, German exports
- 6/10 FOMC meeting, Consumer price index
- 6/11 Producer price index, jobless claims
- 6/12 Michigan consumer confidence, import/exports, China FDI, Japan industrial production, German foreign investment