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Source: StayVigilant.Substack.com, Bloomberg |
Today I want to build on the concept of intermarket analysis, where we look at economic indicators, fundamental data and prices from other markets to help us assess the market that we invest in. We discussed the outlook for growth and inflation yesterday and ended with the FOMC rate cuts and the economic soft landing being priced into the market. The first chart today tries to anticipate why many in the market think the FOMC needs to cut rates in 2024. For this chart, I have created a custom index called ‘Restrictive’ which is simply the difference between CPI and the Federal Reserve Discount Rate. When this number is below zero, it means the Discount Rate is above the CPI and this policy may be deemed restrictive. When it is above zero, it means inflation is higher than the Discount Rate and the policy may be deemed easy. I compare this pink line to the yearly change in the SPX Index and the yearly change in GDP. If we look at this pink line, when it has been below zero in the early 00s, around 2014-2015 and then in 2019, this restrictive policy has led to shrinking GDP and negative SPX returns. Right now, the policy by this measure would be deemed restrictive, yet we have seen neither negative SPX returns nor a shrinking GDP. We can draw a parallel to the mid 1990s when this policy was also restrictive for quite some time, but we saw neither negative growth nor negative equity returns. This is the soft landing period that we mentioned yesterday. This was a period of very strong global growth, particularly in emerging markets, that led to what Alan Greenspan referred to as a ‘savings conundrum’ with money flowing into the US from savers abroad. Perhaps this is what created easier financial conditions even though the policy was seen as restrictive. Thus, investors today need to ask themselves if there are any exogenous factors that are making conditions easier today in the face of restrictive policy. This is what we may need to support economic and equity performance right now. Could it be an expansive fiscal policy? Could it be retiring Baby Boomers spending in the services economy? Could it be the development of AI? |
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Financial market research from professionals at the forefront of technical analysis innovation. |
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Source: StayVigilant.Substack.com, Bloomberg |
One part of the US economy that is always a tried and true indicator of strength or weakness is the housing market. Given the large ‘multiplier’, housing stimulates economies by the large number of jobs created, the wide variety of products that need to go into a house, and the incremental of spending that results from orders for lumber, to copper for plumbing & electricity to the money spent at local diners by the workers. As a result, many people track housing as an important indicator of what may happen in the economy. One critical data point that many investors follow is the National Association of Home Builders (NAHB) Index in white on the second chart. It is a composite index of strength or weakness in the economy and here I have inverted it so it lines up with the other data. It was strong in 2021, weak in 2022, started 2023 with a sharp bounce but has recently been struggling. What is leading to this? The first suggestion would be mortgage rates. On this chart I use the average 30-year mortgage rate in the US in blue. We can see that it was historically low throughout the 2015-2021 period but moved sharply higher in 2022 and 2023. Federal Reserve rate hiking was a key driver to this but perhaps not the entire driver. I want to explore that because if the FOMC is set to cut rates, this could be a tailwind for housing. The purple line is a custom index I created called mortgage spread (MORTSPD). It is the difference between the 30-year mortgage rate and 10-year US Treasury. I look at this spread because banks that provide mortgages will hedge their interest rate risk with the most liquid US Treasury which is the 10-year. Historically this spread averages between 1.5-2.0%. You can see that in 2023, this spread surge to 3.5%, the highest in 20 years. What happened? While we don’t know for sure, there are two things that I can think of that we may want to consider: 1. The Federal Reserve is shrinking its balance sheet which includes mortgage-backed securities 2. A banking crisis in March of 2023 has many banks unable or unwilling to make new loans. This is important as it may suggest some stickiness in how quickly mortgage rates will come lower even if the FOMC lowers rates. The last line is another custom index that I created that I think does the best job of indicating the health of the housing market. Mortgage rates tell one piece of the story but as we all know, if mortgage rates are 0% and we do not have a job, we will not buy a house and take out a loan. Similarly, if mortgage rates are high, but we have a good job, we can afford those higher payments. My first mortgage was 8%. Thus, my custom index simply combines the 30-year mortgage rate and the US unemployment rate. You can see that this indicator did a better job of calling for strength in housing early last year when rates alone did not. It is still giving us a better signal, primarily because of the strength of the jobs market. This is another case where the soft landing (remember a slowdown with no job losses) is helpful to the economy and markets. |
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Source: StayVigilant.Substack.com, Bloomberg |
A simple way that strategists have tried to capture this housing dynamic is in the acronym H.O.P.E. This stands for housing -> orders -> profits -> employment. The acronym covers how money/stimulus flows into and out of the economy. As lower rates make housing more appealing, the housing market picks up. This leads to a range of new orders for lumber, roofing, windows, copper and even furniture and landscaping. As companies start to process these new orders, they will start to generate profits. It is only after a company has been profitable for some time, that it starts to add workers and employment improves. This works in reverse too as a housing slowdown leads to a reduction in orders, declining profitability and then layoffs. The third chart shows you visually this H.O.P.E. dynamic using the NAHB Index for housing, the ISM New Orders measure, S&P adjusted earnings per share and finally the yearly change in US labor force. As we look back through time, we can see that housing in white leads new orders in green. The next line to move is the profits in red and finally the employment in blue. The employment data is the most lagging of all of these, which is why I get less excited about it the first week of every month than everyone you may see in the media or politics. Is the recent slowdown in housing a foreshadowing of tougher times ahead or was this just a blip in the data that will be reversed as mortgage rates come lower? This is a critical question that investors need to ask themselves. |
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Source: StayVigilant.Substack.com, Bloomberg |
Finally, we can pull this together by looking at the performance of the housing ETF (XHB) and the S&P 500 (SPY). You can see that this ETF ever-so-slightly leads the SPY into and out of not only recessions but also bigger moves higher and lower in the market. It was the rally in XHB from the late fall 2022 into the early part of 2023 that presaged the move higher in SPY for the year. It was also the fall in XHB from August through October of 2023 that led to the move lower in stocks across the board. Since then, the XHB has rallied sharply coincident with the strong rally in all assets into the end of 2023. Can this rally continue? This is the question that should be top of mind for investors as we start 2024. As goes housing, so goes the US economy and the broader US stock market. |
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Rich Excell, CFA, CMT is a 30-year hedge fund and proprietary trading veteran who has lived and worked in Asia and Europe in addition to the United States. He has run investment businesses spanning equities, fixed income, commodities and foreign exchange. Rich is now a Clinical Assistant Professor of Finance at the Gies College of Business, University of Illinois, Urbana-Champaign. He also is the host of the Investment Exchange Forum and Macro Matters podcasts for the CFA Society Chicago and writes a bi-weekly options trading blog ‘Excell with Options’ for the CME Group. Finally, he writes a weekly Substack blog called ‘Stay Vigilant’ which aims to demystifinance for the average investor. |
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