Is the stock market broken? This is the question I keep asking myself month in and month out for the last three months. In the late 80’s there was a song by R.E.M. that seems to be quite fitting here. The title “It’s the end of the world as we know it, and I feel fine…” should, in my opinion, be the motto for 2024’s US economy, and corresponding stock market performance.
Headed into November 2023 the US stock market rallied on the Federal Reserve’s long awaited pivot from rate hikes to rate cuts. Within days of the November 1stFederal Reserve meeting rates cuts were forecast to start as early as March 2024, with some projections targeting a January rate cut.
To compound the euphoria, headed into December 2023 consumer spending remained strong contributing to a recent report that Q4 2023 GDP came in higher than expected at 3.3%. If the US economy is fueled by the consumer then 2023 was the year post-pandemic growth flourished! That is until you peel back the layers of the economy and start to see serious cracks forming.
If that wasn’t enough, the threat of war in the Middle East, the ongoing conflict in Ukraine, and the ambiguity surrounding the future of Taiwan seemed to be brushed off throughout 2023. If the problem did not involve artificial intelligence then it seemed like the stock market did not care.
Enter January 2024 where the saying “As goes January, so goes the year” became a barometer for measuring whether there would be a potential rally in 2024. The rationale, “since 1953, the year that the current five-day trading week first arrived in the U.S. stock market, when the S&P 500 was up 2% or more in January, its median performance for the rest of the year was a gain of 13.5%.” However, like any other historical data point, I tend to believe past performance is no guarantee of future results.
I would argue the market cap weighted S&P 500 shouldn’t be used as the barometer, the equal cap weighted S&P 500 is a better measure. With this minor switch the barometer’s outcome tells a different story. The market cap weighted S&P 500 finished January up a little over 2.3% whereas the equal cap weighted S&P 500 finished January down 0.93%. So which index is right?
This brings me to attempt to answer the question I first asked, is the stock market broken?
Let me start by stating this is a big question to unpack and one that will most likely not be completely answered by the end of this lengthy commentary. However, the information I intend to present in the detailed section below will showcase my concern over a perpetually expanding market bubble within a select few stocks along with highlighting the misguidance, or lack of guidance, reported by the news. The information will also highlight the continued imbalance between the deterioration of the economy and the irrational exuberance of the S&P 500 & Nasdaq indices. Finally, I will end with three potential outlooks for 2024.
It’s Hard To Breathe At The Top –
The US equity markets, in large part, tend to be characterized by the largest blue chip companies (i.e. Apple, Visa, Microsoft, Fedex, McDonalds, Costco). This is primarily because these companies are the largest companies within the US and some believe are central to gauging the health of the economy. Yet these same companies only employ 17% of the US labor market. That means the health of the US economy sits squarely in the hands of the labor force within small to medium sized businesses.
If large cap companies employ such a small number of the labor force why are they the barometer for the US economy? In a paper written by an analyst at the European Central Bank, “economists say it is because there is a strong relation between the stock market and the health of the American economy.” He goes on to state while “U.S. GDP growth is not an indicator for S&P 500 growth, S&P 500 growth has a predictive power of U.S. GDP time series and a shock in the S&P 500 will shortly be observed in the U.S. GDP growth, therefore S&P 500 growth is a short-run leading indicator for U.S. GDP growth”. This tracks perfectly as stocks rallied throughout 2023, GDP soared to pre-pandemic levels.
However, to say the market cap weighted S&P 500 has a predictive power, as it relates to what will happen with GDP, would seem to imply this group of companies, who employ less than 20% of the American economy, wield a significant amount of power. But that were to assume all 500 companies are equal, or at least contribute equally to GDP. Unfortunately, as seen by last year’s extremely narrow market breadth, and performance, only a select few carried the stock market higher. In fact, the performance of the market cap weighted S&P 500, and in the Nasdaq, relied on the performance of the “Magnificent Seven” to carry the weight of our entire $25 trillion dollar economy, as measured by GDP.
As of today, February 2nd, the top 25 stocks within the S&P 500 account for approximately 45% of the entire weighting of the index. Similarly, the top 25 stocks within the Nasdaq 100 account for approximately 68% of the entire weighting of the index. However, if we drill down into the top 25 stocks within each index to look at the overlap of stocks between both indices we find that there are 12 stocks, or nearly 50%, within the 25 that make up approximately 32% of the S&P 500 and 50% of the Nasdaq. As a point of reference, these twelve stock make up approximately $14 trillion in market capitalization (or enterprise value) out of the entire $40 trillion that makes up the S&P 500. Based on the ECB analyst, this would imply the health of the U.S. economy, along with the success of the respective indices, are beholden to 12 companies.
And yet, four of these companies recently released subpar earnings, revenue, or guidance expectations. Typically, this would lead to stock price declines as valuations and price targets are reset. Not this time. Any price volatility was short lived as investors shrugged off the weak news and raced to buy more exposure on the dip.
Does this mean 2024 will be a repeat of 2023? Time will tell, but it makes much more sense why there is a massive disconnect between the health of the economy and the rally in the U.S. stock market. It feels a lot like a window dressing, in my opinion. But let’s dive deeper and look at the deterioration of the economy as the cracks begin to grow bigger, as recently seen with the announcement from New York Community Bank.
Banking Crisis No One Cares About –
I’ve said it before, and I will say it again, I am not a glass half empty type of person. I try to see the brighter side of everything I analyze. I firmly believe there is more money to be made in the long run when you invest for growth and opportunity. That said, it becomes more challenging to see the rose colored future through the mountain of debt ahead of us (i.e. credit cards, auto loans, commercial real estate, and government).
In the lead up to the 2008 Great Financial Crisis bank lending became very loose, regulations had eroded over decades, and banks were not prepared for the toppling of the financial system that ensued. In the wake of the financial crisis new banking regulations, capital requirements, and lending standards were established to prevent those deemed “too big to fail” from collapsing in the future. Unfortunately, there were a group of banks that were left out of these requirements; or stated another way, they were not viewed as materially significant and therefore did not need to abide by the same standards as the bigger banks.
Then came the Federal Reserves rate hiking frenzy as a way to control inflation. In many cases this shouldn’t have presented a problems for banks IF they managed their underlying bond and loan portfolios correctly. However, fast forward to March 2023 when Silicon Valley Bank, Signature Bank, and First Republic bank closed their doors due to poor management decisions. While in the moment they were not seen as systemic to the broader economy, they did serve a critical part of the economy… small and medium sized businesses. It was in the wake of this mini banking crisis that new regulations were proposed for regional banks. While these regulations and capital requirements should address future contagion concerns, these restrictions will have an effect on lending standards for small and medium sized businesses.
So if these new regulations were supposed to provide safety to the regional banks, what happened to NY Community Bank? Well “NYCB posted an adjusted loss of $185 million due to a chunky $552 million provision for credit losses.” It was reported that the bank’s purchase of assets from the now defunct Signature Bank in 2023 along with another acquisition in 2022, coupled with the tighter capital requirements, were the main drivers of the loan losses. However, when you pullback the layers further you see a lion share of the losses were related to their commercial real estate portfolio.
GFC 2.0 –
If the 2008 residential collapse was a byproduct of loose lending standards then the 2024/2025 commercial collapse will be a byproduct of the Federal Reserve’s interest rate frenzy. Why? The speed at which the Federal Reserve raised interest rates, coupled with commercial loan terms being five to ten year terms, forces businesses to refinance their real estate at higher rates which makes it a challenging time for banks. But which banks?
“Banks hold about 60% of loans associated with nonfarm, nonresidential properties, such as office buildings, hotels, retail stores and warehouses; two-thirds of those loans are held by community or regional banks. For U.S. banks as a whole, CRE loans make up about a quarter of total loans outstanding. But for the universe of community banks—banks with assets of less than $10 billion—they account for nearly half of all loans.”
What does this mean?
When interest rates increase and commercial loans have to be refinanced, the underlying value of the assets have to be repriced downward. Essentially, for every 1% increase in interest rates results in a 5% to 10% decrease in real estate value. If commercial loan rates climbed 4% to 5% over the last two years then commercial loan portfolios should drop 30% to 50% depending the starting interest rate.
If regional banks like New York Community Bank, or even smaller community banks, own approximately 50% of commercial real estate loans and these banks are set to reprice their commercial real estate portfolio over the next two years then it would reasonable to expect additional credit losses will continue to weigh on these institutions. As credit losses mount the mini banking crisis of 2023 will look like an opening act to a larger banking crisis.
Unfortunately, if regional and community banks have to provision for additional loan losses then these banks will either be forced to restrict lending further or to push to diversify their lending portfolio. However, to expand their loan portfolio they will need small and medium size businesses to increase their borrowing which will be a challenge as small business deliquency rates continue to rise. While these community banks could look to broaden their consumer loan portfolio, the consumer debt crisis would further damage their financial stability as the consumer debt wave ripples throughout the U.S. economy when the unemployment rate rises.
Let’s bring this home…
At the start of this letter I asked the question, is the stock market broken? In short, in my opinion… Yes. If twelve companies can make up one third to almost half of the U.S. stock market and investors are led to believe the U.S. stock market is healthy then we have a problem.
In prior letters I have highlighted the deterioration of the U.S. consumer’s finances, how small businesses are struggling to grow beyond their cost of capital constraints (i.e. interest rates on debt), and now the potential implosion of the commercial real estate market. These trends have nothing to do with the top twelve companies that seem to make up the U.S. stock market. These are the topics that are glossed over when you watch the news. Why? Simple… no one wants to hear about doom and gloom. Last year people were shouting from the rooftops “the sky is falling” or “a recession is coming”. The rhetoric is old, it’s tired, and people want to move on. Chicken little, it’s time to go home…
And yet, things are getting worse. In my year-end wrap up I stated I wouldn’t be surprised if layoff announcements started to increase during earnings season, and even throughout the first quarter of 2024. Sure enough, layoff announcements have been coming in hot and fast. While some announcements from larger companies seem relatively small (i.e. 2,000 employees from a 200,000 employee company) small and medium size company layoffs are quite large on a relative scale (i.e. 1,400 employees from a 7,000 employee company).
According to the Small Business Administration, there are over 33 million businesses in the United States. “Small businesses employ 61.7 million Americans, totaling 46.4% of private sector employees”. This means as bank lending standards tighten, consumer spending declines, and small businesses cannot afford (or qualify for) new debt, small businesses will resort to laying off more people. Layoffs will contribute to consumer debt delinquencies and defaults. Layoffs will prevent small business expansion as fewer workers will be able to fulfill on the company’s growth plans. That is until artificial intelligence begins replacing the productivity of lost labor.
These are the cracks that are not given enough attention through various media channels. These are the cracks that put the American economy on the brink of some major financial problems. And while the cracks articulated in this letter are troublesome, they are only just a few that could dramatically hurt the American economy. Add in the concern for government debt getting out of control, or the start of a Middle East war which would lead to oil prices spiking, or China and North Korea invading their respective neighbors (i.e. Taiwan and South Korea) and it’s not to hard to see why the doomsday clock is 90 seconds to midnight.
- The economy reaches the Goldilocks outcome it has been dreaming of for the last 12 months. Health, wealth, and prosperity should follow.
- The economy limps along at a 1% growth rate. Stagnation and volatility abound.
- The economy goes off a cliff and a global recession follows. Chaos in the streets ensue but this gives rise to a reset so artificially inflated assets can adjust, poor performing companies can go to the junkyard, and consumer debt problems can be fixed through a wave of personal bankruptcies.
It is difficult to know which of the three scenarios would be the most ideal outcome.
The potential obvious answer is the first one, but eventually the economic cycle catches up to everyone making the first outcome the worst. I would liken it to a rollercoaster climbing the mountain before the first drop. The higher the economy goes without an economic reset the farther it has to drop when it eventually does drop.
The second outcome sounds like torture. No one wants to live is a world where things move sideways.
The last outcome would be the worst at the outset but in time it would become the best option. During the 2007 to 2008 crisis the pain for many was unbearable. So many people lost so much. And yet, those same people eventually pulled themselves up and rebuilt what they lost over the following years. In fact that crisis led to 15 years of prosperity.
So they question I continue to ask is, if the stock market is supposed to be a leading indicator of where the economy is going over the coming six to nine months… why does it keep flashing all clear signs?
My only answer is… the stock market (i.e. S&P 500 and Nasdaq) is no longer a market of stocks, it is a market of twelve. The true representation of the stock market, is the small cap market (i.e. Russell 2000) which has been in a bear market for the last two years.
Therefore, the “stock market” is broken…
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. You cannot invest directly in an index. Asset allocation is no guarantee of risk reduction. Past performance is no guarantee of future results.