Mean Reversion (Part 4)

February 13, 2023

If you have read anything that I’ve written to you over the past number of years, one of the common themes that I quote is Mean Reversion.  In fact, after looking back through my articles I found 3 other articles with the same heading (Mean Reversion).  The market, which ever one you look at (stocks, bonds, currencies, commodities etc.) overshoots and undershoots.  Last year’s dogs, often become this year’s darlings. And vice versa. 

I really enjoy studying trends and movements in the market and this particular move is fascinating, not just in the markets, but some economic data points.  Let’s start by looking at the markets.  At the time of this writing the S&P 500 is up around 7.7%, and since the most recent low in October up around 15.5%.  Where did these returns come from?  Yep you guessed it, from those positions that were totally unloved in 2022. 

Source FactSet

How quickly things change.  This enforces my phrase I’m never wrong, just early.  This highlights graphically how giving up, or chasing what worked can do to you.  Reversion to the mean is a thing and will likely always be a thing while we have free markets. 

OK, let’s touch on the Fed.  This is a group of men and women who would be the ones showing up holding the balloons after everyone else left the party.  The fed (as expected) raised the short term rate another 25 basis points, and commented that given the strong labor stats released last Friday that further tightening is likely.  You would think this body made up of some of the best and brightest, who have access to data far superior than what I can find, would be able to see past the end of their nose.  I’m beyond disappointed or surprised at this point.  Firstly, labor stats are the biggest lagging indicator of all the economic data points.  If I’m a business owner and thinking about hiring or firing the government receives that data months after I made the decision.  Secondly, average hourly earnings is what ultimately affects inflation, not necessarily the number of new jobs.  Wage growth has been declining since last October.

Of the 519,000 new jobs published, a great percentage were for lower paying hospitality industry, and layoffs occurred at the higher paying tech and transportation jobs.  Lastly, the jobs being added are part time as opposed to full time, a trend that reversed in mid-2022.

All that again leads me to believe that inflation will be tipping over quickly this year and the Fed is likely to cause the recession by being too restrictive for too long.  Ultimately, none of it matters as we are invested long term, we will just need to ride the volatility.

My next graph below is one of my favorite graphs.  It’s the difference between the 3-month treasury yield and the 10 year treasury yield.  If you’ve seen it before, its likely that you see it on TV and the commentator will tell you that it’s a great indicator of a pending recession.  Think about it.  If we are talking about loaning money to the US Government, it would make sense that you get a bigger return for loaning them money for a longer term.  Right now however you get more for loaning the Government money over 3 months than you would loaning them money for 10 years.  We call this the yield spread.  It’s been negative since October. 

Now considering the Fed controls the short end of the yield curve (Fed Funds Rate) and the market controls the long end, to me the yield spread is a sign of just how wrong the Fed is in positioning their rates.  Right now the Fed is telling you that the economy is way too robust and the market is telling you something different.  I know who I’m betting on.

Good news however is the market is able to look longer term than the Fed and price things accordingly.  Longer term there is confidence that inflation won’t be an issue, fiscal policy will stay status quo (at least till after the next election), and the environment is good for companies to invest longer term to increase growth. 

In the relative short term I think we may have moved to far to quickly, and there are a few areas that look a little lofty, but longer term I feel we are positioned well to start the next bull market later in the year.  My thoughts are that we are likely in for a little consolidation in the coming weeks, and this will provide the opportunity for the repositioning into those areas that are historically cheap. 

The US Dollar has assisted emerging markets to outperform this year to date.  Small caps have outperformed but are still historically cheap, and we can soon look forward to a market trading on fundamentals rather than momentum. 

In summary, we may be in for a pull back after a good 5 weeks.  If I’m right, there is likely to be some nice opportunities for the rest of the year.

As always should you have any questions or concerns, please don’t hesitate to call.

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