How Did We Get Here, and Where Are We Going?

• Valuations for market-cap-weighted US large caps were rich: the top decile of the past 20 years.
• While aggregate earnings are coming in good, earnings revisions breadth enters a period of seasonal weakness, and commentary from many companies suggests there is limited visibility on a 2H reacceleration.
• VIX is in backwardation – very rare
• Defensives have been outperforming cyclicals since April, coinciding with deterioration in economic surprise indices (the cake had been baking for a while).  Remember that most of the market returns were driven by Mag 7 stocks – not healthy.
• Over 100bps cuts priced into the curve going into today (this is moving around quickly)
• Friday’s NFP has challenged the soft landing view, plus downward revisions in the last 2 months.
• The Conference Board Employment Trends Index is a more comprehensive measure, and it’s been in a clear downtrend now for over 2 years.
• It’s worth noting that the area of greatest slowing in the July jobs data on Friday was services, where hiring fell to 72k from 125k jobs created in June.
• We think the market is quickly shifting from a growth slowdown to the odds of a recession dramatically increasing. The yield curve is finally starting to bull steepen; the resteepening is being led by the front end.
• It’s not all gloom and doom.  The market continues to reward both revenue and EPS beats in a more significant way than what we’ve seen over the prior 4 quarters.

• The S&P 500 was up 20% from the beginning of January through July 16th.  For historical context, this is 3x the historical average, so the S&P 500 was overextended and a bit rich from a valuation standpoint.
• In general, Astoria tends to own stocks that are cheaper than the market (we are value investors and lean on quality).  So, our ETF portfolios tend to have a lower PE ratio by design and hence offer some downside protection.  Jerome Powell mentioned in his press conference a reluctance to acknowledge a potential 50bps rate cut, which has since spooked the markets along with some recent poor macro data.
• The sell-off started with high multiple PE stocks being sold and has culminated across most market segments declining.  Also, the Bank of Japan had a surprise interest rate hike despite Europe and the US entering a rate-cutting cycle.
• We had a barbell approach in our portfolios.  We owned gold and long-dated bonds, which have performed well in this selloff to offset our tilts across our US and international equities and our real asset tilts.
• Is our US policy rate higher by 100-150bps compared to the normal rate at this level of unemployment and a decline in inflation?  Yes.  Hence, why the bond market has repriced significantly, and there are calls for an emergency rate cut.
• I would say that the Fed has a lot of levers to pull, with Fed Funds at 5%.  They can easily cut rates by 150bps to jump-start the economy.  This is very different from, say, 5-6 years ago when rates were at 0% and we were entering a recession.
• It’s important to acknowledge that everything written and said on TV this week will be about an emergency rate cut.  We would rather focus on building a well-balanced portfolio for the next 1-2 years.  We were never all in on the Mag 7, but we think that the rotation away from these stocks and into the broader market (when markets stabilize) will continue.  Warren Buffet has sold a big chunk of his technology holdings, and he is considered one of the greatest value investors.
• There is value coming quickly in US markets.  I expect volatility to continue as markets are relatively illiquid, many are on vacation, and we are in a bit of a macro news vacuum. While earnings are coming in better than expected, it won’t be enough to offset investors’ perception that the Fed recently made a policy mistake.

Listen to the video here.

Best,

John Davi

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