Last week, our outlook was all about the data and trying to eliminate some of the noise. This week, we received the latest input from the Federal Reserve (another raise), jobs (exceeding expectations), regional banks (3 more banks are seemingly in trouble), and earnings (plenty of earnings beats on lowered expectations). There was just so much data.

What matters most? What will be the ultimate impact on the economy? As I was reviewing this past week's voluminous amount of relevant information, I thought to myself, "There are just so many economic variables at work right now." More importantly, how does one appropriately review all of this information to help make better investment decisions?

Then I remembered, "Ah, that is why we have quant-based, algorithmically designed investment strategies." So we can let the strategies do what they each do best: exploit different investment edges.

It is difficult enough to appropriately interpret the constant stream of economic data points, earnings information, Fed actions, geopolitical maneuverings, and policy decisions currently affecting our economy and eventually affecting the stock and bond markets. There truly is a large amount of data, so I thought I would take a stab at interpreting some of it.

The Fed's Continued Hawkish Action

By now, you are probably well aware that the Fed raised interest rates by another 25 basis points. As we said last week, "this was already baked in the cake," with more than 80% futures predicting that it would take place. Although, there was a small group of analysts hoping for a pause due to the banking problems which persist. We are now at 5% after 10 interest rate hikes in just a little more than a year.

A disheveled Jerome Powell took the podium right after announcing the increase. It was what he did not say that startled the markets and caused a downward spike in the stock market for the next two days. The market recovered on Friday, but more about that in a minute.

During his press conference, Chairman Powell made a good case (yet again) for why they should have done nothing. However, he alluded to "elevated inflation" and the need to cool off the economy. He reiterated that "policy is tight," and that "real rates are around 2%, meaningfully higher than the neutral rate."

Chairman Powell also said this week that avoiding a recession is "more likely than that of having a recession." He also opened the door to pausing interest rate hikes following these 10 straight increases by stating "we may not be far off" the level that is sufficiently restrictive to squash persistent inflation.

But what did he not say? Chairman Powell did not use the word "pause" which everyone was looking for. The Fed now plans to "closely monitor incoming information and assess the implications for monetary policy." But he reiterated that the Fed remains data dependent. Which simply means that they will adjust accordingly based on the data that continues to flow in.

He also didn't do anything to suggest rate cuts, or a "pivot," are on his mind, though.

Powell said, “the other end of the Fed's dual-mandate – the job market – is still "extremely tight" with 3.5% unemployment, and that the process of getting inflation back down to 2% has a long way to go... [and] is likely to require a period of below-trend growth and some softening of labor-market conditions. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices over the longer run."

Yet, there are many that believe the Fed will cut interest rates soon. The average period of time from the last hike to a pause to a pivot to a reduction in rates is 108 days. That would put the easing of rates somewhere between August and September. We do not buy it.

The bond market is also following this narrative, as the wide inversion between 2 and 10s has narrowed significantly in the past few weeks.

We are experiencing a credit crunch at the moment, according to Corporate CEOs. Rates have become restrictive for Corporate America and are heavily affecting smaller companies. This has shown up in small-cap stocks. This should weaken the economy further and put pressure on employment.

Regional Banking Problems

Chairman Powell did allude to the strains that rising interest rates have had on the banking system. However, he repeated the same mantra that Jamie Dimon and President Biden stated just days earlier: "Banking conditions have improved since March... the system is sound and resilient."

This was followed by several days of the KRE (Regional Bank Index) falling as 3 additional banks, PacWest Bank (PACW), Western Alliance Bank (WAL), and First Horizon Bank (FHN) were down nearly 50% on Thursday and looked to possibly be taken over by the FDIC or bought by another financial institution.

They recovered a bit on Friday after the positive jobs report and a rally in the stock market. However, the regional banking industry remains problematic, and it may take a long time to resolve or cure the sector. You may recall our previous text about regional banking issues.

With prolonged high rates and the appearance of mismanagement of assets and liabilities, the banking problems have further to go. See some relevant charts below.

We still believe that the Fed was late in hiking rates. These 10 rate increases came on the back of zero interest rates post-pandemic. Hindsight is 20/20, but looking back, the Fed took their decisive action much later than was required. This has led to all types of negative banking issues. Today, rates have begun to roll over, believing that we are in for lower rates in the future.

Bank Lending has Slowed Dramatically

Smaller banks are being scrutinized much more closely now since Silicon Valley Bank went bankrupt. Bank loans have seen a dramatic slowdown, with some major markets reporting as much as 25% fewer loans being underwritten.

Higher short-term interest rates, however, have helped to attract investors seeking a risk-free way to acquire attractive rates of return. These are 2-year fixed income duration instruments. The amount of movement out of banks and into short-term Treasury bills has undoubtedly caused an exacerbated run on the banks and helped to weaken those depending on stable deposits from their customers.

The Friday Jobs Report

After all of the Fed's rhetoric about the economy, the jobs report came out on Friday and smashed expectations that the employment market was cooling off. Employers added an unexpected 253,000 jobs for April. This brought the unemployment rate back down to a historic low of 3.4%. The expectations had been for 185,000 with unemployment ticking up to 3.6%

Perhaps the biggest surprise was wage gains of 0.5% for the month as compared to the expectation of 0.3%. Year-over-year, the wage gains were 4.4% versus expectations of 4.2%. Our guess is that the Federal Reserve was acutely aware of this increase, and it led to their unanimous vote to raise the overnight lending rates an additional 0.25% on Wednesday. Employment is just not cooling off as they would have expected from 10 previous rate hikes.

The one good data point was that March's employment was significantly revised downward. Employment gains in March, were revised lower to show 165,000 jobs were created during the month 71,000 fewer than previously reported. February's job report was also revised lower — to 248,000 from 326,000 — making job growth over that two-month stretch lower than previously reported by 149,000.

With these revisions, job gains over the last six months have averaged approximately 290,000. I believe it was the downward revision that helped the stock market to celebrate on Friday (along with Apple's earnings holding up). Otherwise, the robust job creation from April should have sent interest rates higher and stock market prices lower, figuring the Fed had more work to do.

The chart below shows a map of the US indicating where April's job growth came from.

Rates May Go Higher

Federal Reserve Bank of St Louis President James Bullard said policymakers will probably have to push rates higher to cool inflation, but he also said he would wait and see what the data show before deciding what move to support in June.

"The aggressive policy we pursued in the last 15 months has stemmed the rise in inflation, but it is not so clear we are on a path to 2%,” Bullard told reporters following an event in Minneapolis on Friday. He said he is willing to assess the economic data as it comes in, but he would need to see "meaningful declines in inflation" to be convinced higher rates aren't necessary.

Bullard also said he thinks the US central bank can still achieve a soft landing, with inflation returning to the Fed's 2% target without triggering a significant downturn. "Yes, the economy could go into recession, but that's not the base case," he told the Economic Club of Minneapolis. "I think the base case is slow growth, probably a somewhat softer labor market and declining inflation."

"I think all of you should put most of your weight on that scenario," he said, adding he did not think a surge in unemployment was needed to cool inflation.

Our Take

We are now faced with Stagflation. The dreaded economic condition that causes consumer prices to stay elevated, a tight employment market, and basically slow or no growth for the economy.

We believe that it is likely interest rates will stay higher for longer and we will see no pivot anytime during 2023. In fact, given where inflation is today and how "hot" the employment market is, it is highly conceivable that the Fed hikes 1-2 more times during the next six months.

We prescribe to the notion that Jamie Dimon suggested late last year, when he said that we could possibly see short-term interest rates rise to 6% or greater if inflation stays elevated. Our near-term concern is that oil may have bottomed, and with geopolitical risks rising, we could see oil prices spike to above $80, which puts continued pressure on inflationary forces. Additionally, food costs do not seem to be subsiding much.

Earnings Update

According to FactSet, 85% of S&P 500 companies have reported their Q1 2023 results, with 79% beating their earnings estimates and 75% reporting revenues above estimates. From the looks of it, it appears that this earnings season is better than expected. Please remember that earnings estimates were brought down significantly over the past few quarters.

On Thursday, Apple reported its earnings. Apple is a mega-cap stock that has a huge weighting in the S&P 500, Dow Jones Industrial Average, and the Nasdaq 100. As expected, they came out with earnings that beat expectations.

However, their earnings were flat for the past year. Due to the fact that they beat their lowered earnings expectations, surpassed their sales projections for the IPhone 14, increased their dividend, and announced a $90 billion share buyback, the market celebrated, and it lifted all other related stocks.

We are not certain that Apple can retain its lofty price to earnings multiple now that revenue and earnings have gone sideways for the past 12 months.

How Has the Stock Market Held Up?

As discussed in this column last week, we have seen a sideways market (S&P 500) and if not for the preponderance of a few of the mega-cap stocks, it is unlikely the market would have gone anywhere year-to-date in 2023. Yet the Nasdaq is up around 21%, and the S&P up over 7% through Friday's close.

However, performance numbers can be deceiving. We offer a comparison (from Stock Charts) of the different indices, to provide a more realistic look. Note that small-cap stocks (IWM) is flat on the year. Higher interest rates have had a material effect on the smaller capitalized stocks. These companies are more dependent on low interest bank loans to operate their businesses.

Additionally, take a look at this chart from this past Thursday.

As you can see from a much bigger (and longer period) picture, the S&P 500 continues to move sideways and is, for the moment, range-bound.

And for a more close-up perspective of the market uncertainty and grinding behavior, we offer this chart for the period beginning December 2021.

What's Next?

We have no idea. We could make a positive case, and we also could certainly provide a negative narrative. We have offered up our views on valuation in last week's outlook. It is conceivable to us that the markets, given a recession, could see a 10-15% correction.

You should be aware that we have entered the worst six-month period for stocks (May-November). We suggest that, given all of the factors above, investors stay patient and remain vigilant of the risks. This is why all of our strategies employ risk management with stops and targets.

Here are a few charts from one of our favorite analysts (and CMT), Ryan Detrick.

And now here a few market highlights from the past week.

Risk-On

• Major market indices recovered sharply on Friday with positive economic news after looking like a potential meltdown was in order. The key highlight is that QQQ closed on new yearly highs.
• The McClellan Oscillator for the Nasdaq Composite is in much stronger territory than it is for the S&P 500, indicating a significant leap for QQQ outperforming SPY.
• Risk gauges were extremely volatile, but they still closed the week positive.
• The 1-month vs 3-month volatility ratio closed the week in positive territory.
• Growth stocks (VUG) continue to outperform value stocks (VTV), with VUG making a new yearly high close.
• Large-cap foreign equities continue to outperform the US market, with established foreign equities (EFA) closing at new highs for the first time in over a year. Both EEM and EFA are back in bullish phases.
• Both soft commodities (DBA) and copper (COPX) mean reverted back to their 50-day moving averages and bounced nicely, confirming their continued bull phases.

Risk-Off

• The Russell 2000 is in a Bearish phase on both the daily and weekly charts.
• Volume patterns are down almost across the board for the key indices, with the possible exception of QQQ which did have an accumulation day on Friday to end the week strong. However, there are far more distribution days than accumulation days for the 4 key indices over the past two weeks.
• The yield curve has inverted even further with the Fed raising rates another quarter of a percent.

Neutral

• Consumer staples (XLP) and consumer discretionary (XLY) were down on the week, while transportation (IYT) was the only major market sector to improve at all this week as it shifted back into a bullish phase.
• Even with a big selloff to end the week, gold (GLD) and silver (SLV) were the clear market leaders this week.
• After getting moderately oversold on Thursday, market internals, according to the McClellan Oscillator for the S&P 500, bounced sharply to finish the week.
• There is a mixed read at low levels for the new high/new low ratio for the S&P 500.
• The number of stocks above the 10-, 50-, and 200-day moving averages are hovering around a neutral level for the S&P 500, and seem to be recovering on a shorter-term basis for the IWM.
• At the moment, interest rates (TLT) are stuck in the middle of a five-month trading range, but they are closing in a recovery phase.
• Semiconductors (SMH) recovered its bullish phase while regional banks (KRE) has a potential island bottom pattern in play after a big spike down this week.
• Gold closed at new highs but is potentially overbought once again, which means it may be subject to a bit of mean reversion.
• Oil (USO) failed an attempt at a major breakout and got fairly oversold, but has now technically bounced and is back into the lower end of its six-month trading range.

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More By This Author:

Lots Of Noise, But What Is The Data Telling Us?
The Fed’s Actions Appear to Be Working…. Or Are They? What Could Be Their Next Moves?
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