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Aug 04 2022

The Active/Passive Performance Cycle Second Quarter 2022 Update

  • Aug 4, 2022

The performance derby between actively-managed portfolios and passively-managed index funds is a topic of ongoing interest for Leuthold clients and the investment community at large. Therefore, we are providing an update to all charts and tables of our Active/Passive performance analyses.

As inflation rages and real economic growth decelerates, investors share legitimate concerns about the direction of company earnings. Undoubtedly, profit growth will slow; businesses are simultaneously dealing with declining unit sales and margin pressures. In the coming year, the question is, will corporate earnings significantly collapse or simply moderate to a sluggish (but still positive) growth rate? That is, are profits poised to “Poof” or “Purr?”

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Read this week's Major Trend update. 

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Who’s correct? The Federal Reserve is talking tough on inflation, indicating its fight is far from over and multiple rate hikes are yet forthcoming. The bond market, though, has turned decidedly dovish: The 10-year Treasury yield peaked in mid-June near 3.5% and has subsequently eased by about 75 bps. Moreover, the one-year breakeven rate (the bond market’s embedded one-year-forward inflation expectation) collapsed from 6.3% in March to 3.0% today. Indeed, the recent decline suggests the inflation outlook could soon be back near the Fed’s 2% target.

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Old timers will recognize our title as a twist on Ronald Reagan’s clincher in the final 1980 presidential debate with Jimmy Carter.

We recalled Reagan’s line while preparing for today’s 40th anniversary of the great 1982 secular stock-market low. Investors in the S&P 500 have earned an annualized total return of +12.4% since that trough, about two percentage points above the long-term average.

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An early mentor told me, “When your management style starts to reduce productivity, apply less management!” Fiscal authorities should consider that advice.

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Both the headline and core CPI are better (lower) than expected. We see more signs of peak inflation as oil prices, supply chain issues, wage pressure and capacity utilization start to moderate.

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Not all sectors are created equal. Some influence the direction and thrust of the stock market more than others. The Technology sector, however, has historically had an unparalleled impact on the overall performance of U.S. stocks.

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At the beginning of the year, we liked the chances for the “Donut Portfolio” to break its 10-year losing streak against the S&P 500. As a refresher, the Donut holds six of seven key assets in equal weights. The S&P 500 is excluded—a decision probably only suitable for allocators who are self-employed. 

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Many technicians contend that the rebound off June’s lows triggered a bear-market-killing “breadth thrust.” Several gauges we monitor to capture this phenomenon contradict that claim. None has reached a threshold that is extreme enough to qualify as a thrust.

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The theory of “contrary opinion” is important to market analysis, but so is an understanding of its limitations. When investor-sentiment surveys dipped sharply in late January, we warned that the declines (which are usually signals to “buy”) might instead mark the beginning of an important trend change. 

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Our recession indicators have continued to deteriorate. Given the stagflation backdrop, the Fed’s tightening cycle is very likely to end in a recession.

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While our breadth measures do not consider this rally to be thrust-worthy, when based on nothing more than performance, it’s difficult to distinguish between the “first up-leg” in a new bull market and a bear-market rally. The vital signs at present appear to be more in-line with the latter (although making that conclusion based on price action, alone, is hardly better than a coin toss).

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Now that the yield curve has inverted, its dynamic is apt to change from bear flattening (higher rates, flatter curves) to bull steepening (lower rates, steeper curves) fairly soon.

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One of the problems with the bear market this year is there have simply been too many investors playing defense. Well, that has finally changed. Investors are again on OFFENSE, perhaps giving the stock market its best chance, yet, to ultimately put the bear to bed.

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The goal of decelerating real economic growth (demand destruction) has been achieved. The economy is not likely in a recession because job creation rose at an annual pace of nearly 3.7% in the first half of this year, real personal consumption increased by 1% in the second quarter, the ISM Manufacturing Survey is at 52.8, and profits, dividends, and capital-goods orders continue rising.

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Sometimes, trends get so extreme that it is best to bet on a reversal. Such is the case for a few critical factors underlying the health of the U.S. stock market. Because they have been stretched to exaggerated positions, there are currently three favorable forces for the stock market: real liquidity growth, private sector confidence, and valuations.

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Tomorrow’s meeting conclusion will be the “lucky 13th” since the start of 2021. Count me skeptical, but what is the rationale for having these glitzy Fed Pressers? Do we really ever learn anything on "Fed Day" that we didn’t know before the event started? 

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Read this week's Major Trend.

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Here are a few morsels to start the week...

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To paraphrase that great market historian Leo Tolstoy, “each bear market is unhappy in its own way.” Recession, interest rates, valuation bubbles, inflation, war, credit cycles, oil prices, manias & panics: the tipping point that triggers each bear market is always different. However, bearish forces ultimately manifest themselves in just two ways; declining earnings and/or declining valuations. June’s Of Special Interest report detailed how the current bear market has been fueled entirely by collapsing valuations, with the largest P/E compressions occurring in companies with the highest starting valuations.

 

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VOLATILITY has wreaked havoc in the financial markets this year. The median stock-market CBOE VIX Volatility Index® is 26.7 compared to only 18.6 in 2021 and is higher than 86% of the time since 1990. Because Treasury yields recently returned to some sense of normalcy, bond market volatility has also been challenging. For example, the median ICE MOVE Index (a yield-curve-weighted index of implied Treasury-option volatility) is at 111 versus just 61 in 2021—this is higher than 80% of the time measured back to 1990!

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Read this week's Major Trend update. 

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After a promising start, year-to-date, international stocks are now trailing the S&P 500. At mid-year, despite a strong U.S. dollar, the MSCI ACWI ex-USA and MSCI EM ex-China indexes essentially matched the S&P 500. Indeed, through June, the developed markets index was ahead of the S&P 500 nearly two-thirds of the time, while EM ex-China surpassed the S&P 500 more than 90% of the time. Recently, as global recession fears have intensified and the U.S. dollar has soared, both international indexes now slightly trail domestic stocks. Nonetheless, we are sticking with a tilt toward global stocks—particularly EM ex-China—primarily because we expect the U.S. dollar to soon dive!

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Despite an obvious slowdown in real economic growth this year, and insatiable talk of recession, it is curious that S&P 500 EPS estimates continue to climb.

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The Federal Reserve has regular meetings and fancy press conferences, but like the rest of us, it is usually directed by its boss. The Fed’s board of directors comprises the character of the economy, both inflation and real economic growth, and bond vigilantes. This group of bosses primarily dictates whether the Fed is a hawk or a dove.

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Energy has solidified its spot atop the GS Scores; it’s by far the highest-rated sector and counts three underlying groups among the top-ten industries out of all the sectors. Valuations have only improved amid steady outperformance, and renewed capital discipline looks to remain for the foreseeable future.

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The late 2018 policy error and subsequent pivot of Chairman Powell’s rookie year is probably the best case-study for today’s pivot debate. Here we evaluate the current status of key pivot triggers and compare them to the readings of late 2018. Given the political environment and backward-looking nature of the Fed, we think the bar is higher for a pivot than the market hopes.

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Remember the good old days (like even a year ago) when one didn’t need to mentally tabulate investment results in inflation-adjusted terms? For a blissful couple of decades, nominal and real returns were so close together that the latter figure seemed irrelevant.

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We previously promised to limit the amount of comparisons to Y2K, but the paths that a number of the usual suspects are taking look more and more like “something we’ve seen before”—in some cases down to the percentage point.

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Based on a short-term perspective, stocks may be ripe for a bounce. However, the S&P 500 has not reached “oversold” territory since early 2016, and it is still a long way from doing so. Of the major indexes, only the Russell 2000 is now positioning to soon claim a “low-risk buy” signal. 

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The 2022 bear market has been driven entirely by a collapse in P/E ratios. Last month, we noted that the other potential driver of market declines—falling earnings—had yet to raise its ugly head. Now we examine past episodes to consider how the stock market might react when the “other shoe” (EPS) drops.

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Read this week's Major Trend Index. 

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The 2022 economic backdrop is nothing like the near-Goldilocks environment accompanying the first few innings of the Y2K Tech bust. However, the action to-date in the former Growth stock leaders has followed the 2000-2002 path very closely—and almost on a point-for-point basis, when it comes to some  indexes. With the stock market “weight of the evidence” still negative, we wouldn’t be surprised if the Y2K analog holds for a while longer.

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Recession mania has gripped Wall Street: Surveys consistently show a high percentage of respondents expect that a recession is inevitable. That is true for investors, company leaders, and consumers. These fears are understandable because fighting against rapid inflation often ends in recession.

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The fight against runaway inflation is intense, and recession fears are rampant. The stock market has collapsed while bond yields have surged, and the panicked Federal Reserve is rapidly catching up with 75-basis-point fed fund hikes. In addition, Putin’s invasion of Ukraine shows no end in sight, and the U.S. Supreme Court is now at war with the Executive Branch.

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Read this week's Major Trend update. 

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High inflation continues to dominate the headlines, but it is only one piece of the “weight of the evidence” that’s stacked against the stock market. Still, in ironic fashion, stock-market action itself suggests that inflation is set to peak.

 

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“Quantitative Policy” by the Federal Reserve is a very recent addition to the monetary tool kit, and we are still learning about its significance. For example, does QT directly and consistently impact the money supply? Is it equivalent to raising the fed funds rate? Is QT really another substantial tightening force—or is its impact overstated? Unfortunately, nobody yet knows the answer to these questions. They will become understood only after many more years of data becomes available.

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