Articles – The Investment Journal

The stock market did something amazing in 2024.

Something it hadn’t done in a quarter century…

No kidding.

The market, as measured by the S&P 500 put in back-to-back 20% or higher gains.

In 2023 the S&P 500 closed up 24%. Last year it added another 23%.

Want to be even more impressed?

Since the index was founded in 1957, it has only accomplished this incredible feat of strength six times. That’s around once a decade on average.

So what does that portend for the coming year?

Let’s look at a couple influencing factors.

That Last Time…

The last time investors were popping the bubbly over back-to-back gains like this was in good old 1999.

We suspect every investor over 40 remembers what happened after that…

The turn of the millennium brought with it the bursting of the internet bubble and ushered in the era of what’s fondly become known as the “tech wreck” — the kickoff of a decade-long bear market.

Now to be fair, the initial bear leg bottomed after only two years and a 47% washout. And while the ensuing rally attempt got off to a great start gaining 26%, the next four years put in more modest gains ranging from 3% to 14%.

The building optimism, however, was short-lived when the market was clubbed like a baby seal in 2007 by yet another exploding bubble — the housing/mortgage bubble and the disaster known as the Great Financial Crisis — which cost the market 37%.

All in all, the years between 2000 and 2009 were nothing to write home about. From the final high to the final low, the index lost nearly 50% of its value.

And it all came on the heels of back-to-back 20%-plus gains.

Is it time to get nervous?

Sons of the Tech Bubble

When we look back at those dismal years, it’s important to note that four of those six 20%-plus performances were all put in between 1995 and 1999. THAT… is unprecedented.

Of course the tech bubble was the era of the new investing paradigm. When insane valuations didn’t matter anymore because it was all about the internet — and that was going to change everything.

Of course it didn’t.

Hundreds of stocks trading at thousands times earnings will never be profitable. Ever. The pretenders were dispatched in short order.

And in a potentially great irony, today’s multi-year performance might actually be considered an offshoot of that bubble. Because it’s being driven by a select number of mega-tech companies that survived the bust and grew up out of the boom.

You know them today as the “Mag 7” — multi-trillion dollar market cap monsters. (With Tesla and Meta playing catch-up.)

These “big dogs” have fully been the driving forces behind both years’ successes.

They’ve been such forces they’ve been able to push the market higher even in the face of the Fed’s manic rate hike cycle.

They’re able to do this because they’ve got so much cash in their war chests, they don’t give a hooey about higher rates. Case in point, Microsoft has already indicated they plan to spend a cool $80 billion on data center expansion in 2025. That’s a 44% increase from last year.

And that’s not all. According to Morgan Stanley Amazon could spend $96.4 billion… Google could spend $62.6 billion… and Meta could spend $52.3 billion.

Fed looking to dial back rate cuts in 2025? They don’t seem to care.

And why not?

Because they’re all jockeying for position in what might well become the next great bubble…

AI.

Investments in the nascent technology have been pretty rampant, and with good reason:

The industry is still in its infancy, but Wall Street’s forecasts suggest AI could add anywhere between $7 trillion and $200 trillion to the global economy during the next decade.

Those are big numbers.

But they’re also forecasts (best guesses).

And in chasing their share of the pie, the valuations of these companies driving these supers-sized gains are starting to become a little rich.

The 2024 PE for the Mag 7 came in around 40 vs 27 for the entire index. Forward PEs see valuations coming off a bit to 32.3 and 23.2 respectively.

Now, these rising PEs aren’t exactly 1990s tech bubble rich, but rich nonetheless. And the extensive capital expenditures will have the effect of eating into future margins. As reported in Reuters…

“I think what investors are missing is that for every year Microsoft overinvests – like they have this year – they’re creating a whole percentage point of drag on margins for the next six years,” said Gil Luria, head of technology research at D.A. Davidson.

Typically investors don’t see a bubble until it’s in their rearview mirror. And what would one look like in this case anyway? A move to more reasonable valuations within the Mag 7 would likely make for a year (or more) of struggles in the broader market.

On the other hand, if the index can complete the 20% trifecta this year that means S&P 500 levels around 7050.

Stay tuned…

They were NEVER buying it!

The year 2024AD was supposed to be the year of rate cuts. Until the fly of sticky inflation early on flew into that ointment.

By September, the Fed figured it couldn’t wait any longer and got down to business. They assured everyone that…

Our patient approach over the past year has paid dividends: Inflation is now much closer to our objective, and we have gained greater confidence that inflation is moving sustainably toward 2 percent.

Then they tried playing catch up by cutting rates 50 basis points.

With that they embarked on their quest for their next holy grail — “neutral.” According to the Fed, “neutral” a theoretical interest rate level that neither slows the economy nor lets it overheat. Like we said, it’s the holy grail.

It’s also a level they admit they don’t have a clue about.

No matter. They’re paid to do this kind of thing.

They’ve insisted they need to do this because their focus has shifted to the employment side of their mandate. According to Chair Powell…

As inflation has declined and the labor market has cooled, the upside risks to inflation have diminished, and the downside risks to employment have increased. We now see the risks to achieving our employment and inflation goals as roughly in balance, and we are attentive to the risks to both sides of our dual mandate.

Translation: “Don’t worry. We got inflation. Now we have to do employment. After all, we can’t be pushing the economy into a recession…”

The Reality Behind the Search for “Neutral”

This, of course, is all “narrative” — that is to say mostly BS. Inflation is still sticky by any number of measures. The real reason they need to lower rates is because levels above 5% are literally killing the Treasury.

In 2024, the US Treasury rolled over roughly $8 trillion of debt. And not just any debt. It was roughly 2% debt that was being refinanced into nearly 4% debt (assuming maturities stayed relatively the same). You don’t need to be a math genius to realize this is a lousy trade where debt goes.

But always the crafty one, Treasury Secretary Janet Yellen forged a workaround by rolling more than 84% of it (old debt plus new financing) into short-term bills — securities maturing in 6 months or less.

Basically she was willing to pay up for a few months until Powell and company came up with a story to get rates lowered. The plan is not faring so well.

Because this year (2025) about another $3 trillion in debt will be coming due… Along with a bunch of debt rolled into short term paper last year.

Putting this in simple terms… The Treasury has another boatload of borrowing to do this year.

In any case, the Fed had been spinning their story of conquered inflation and bringing rates down to neutral levels and feeding it to the media. Who in turn have been dutifully parroting it in all their reporting.

But… there has been one huge disbeliever in the whole bunch…

The Bond Market

Back in September, when the Fed was insisting that they had it all under control and rates (including yields on Treasury debt) could safely come down — the bond market effectively flipped them the bird.

You can’t make this up… The very day the Fed commenced cutting, bond yields in the 10-year (the benchmark lending instrument) bottomed and started their trek higher.

The other factor is the massive amount of debt that will eventually be hitting the market this coming year. Supply and demand are still a thing.

Lately the Fed has been trying to walk back rate cut expectations for 2025. It seems they’ve come to grips with the reality that maybe it’s not quite time to go out in search of “neutral.”

The bond market never bought it in the first place.

While financial gurus like to sound like they have some special insight into the market, no one has a crystal ball.

We’ll be the first to admit it.

Investing is about doing your due diligence.

Of course there are tools that can give a savvy investor some inside clues about the market.

It’s a little known technical indicator that measures an important statistic known as “market breadth” called the Advance/Decline Line.

It’s a tool that actually can give you a glimpse at the internal strength or weakness of any market. And best of all, it’s super-simple to use…

A Look “Inside” the Market

Market “breadth” shows the relative participation in a market move by measuring the number of shares that are moving higher versus the number moving lower — in other words whether a rally is broadly-based or being driven by a few big stocks.

The math on this is ridiculously simple.

You just take the number of shares going up (usually over a trading session) and subtract the number of shares that went down. Then add that number to the previous day’s number.

Voila! Instant market insight.

The A/D line (as it’s known) can be a leading indicator by showing a deterioration in market strength if it starts to lag as prices are making new highs. It can also show accumulating strength in a bear trend by holding previous lows while prices are still heading lower.

Now that you understand the principles behind this indicator, let’s take a look at the A/D lines for four major indexes…

Four Indexes — Four A/D Lines

Let’s start with the big dog…

S&P 500

Look at the A/D line in the first circle compared with the price action. Market breadth appeared to be weakening as the A/D line couldn’t reach a new high with the market. It eventually did post a new high, but then fell off sharply as the market stalled.

Right now the indicator appears to be relatively in line with the price action of the market. But continued weakness into the new year could mean more internal weakness.

Dow Industrials Average

The Dow Industrials is only a 30 stock index, but it also contains $12.5 trillion in market cap with Nvidia, Apple, Microsoft and Amazon. So it’s got some pretty mega-tech companies to drive it.

You can see the upward price bias throughout November, while the A/D line stayed basically flat. Year end profit taking pulled prices a bit back in line. But absent a confirmation by the indicator, new highs in the market should be viewed cautiously.

NASDAQ Composite

If you want a look at a troubling chart, look no further than the Nasdaq Composite. The Nasdaq is a capitalization-weighted index of 2,500 companies that lean heavily toward the tech sector.

The index was up over 30% in 2024 while its A/D line had been heading significantly lower for most of the year.

The price action is closer to what we’ve seen in the S&P 500 (another market-cap weighted index) but given the index contains 5-times as many stocks, this divergence between price and AD line drives home the fact that the rally is still in the hands of a handful of mega-tech companies.

Russell 2000

The Russell 2000 is an index of small cap companies.

Small caps have been struggling. While the S&P 500 gained over 24% last year, the Russell Index managed less than half that rallying 10.8%. Here you can clearly see the divergence between the A/D line and the price action of the index. New price highs were made, but market breadth didn’t support it.

The pullback has brought prices back into line somewhat, but the fact that the A/D line has moved so far below previous lows may be indicating the market is still under some stress.

As Always: One Caveat…

To be sure, this indicator is not the “holy grail” of investing. There are no sure things.

When it comes to the markets, “only price pays” — no matter what your indicators may be telling you, price is the only indicator that really matters!

Everything in your technical arsenal could be screaming “sell, sell, sell,” but if the market keeps going higher… It’s going higher. (Have another look at the Nasdaq Composite chart!)

It’s no secret that for the past two-plus years, it’s been basically a handful of stocks — the AI/mega-tech sector — that has been pulling the market higher. And they’ll continue to be an influence.

But all that said, technical indicators like the advance/decline line can offer important insights into what may be building internally in the market.

And that’s always important for a smart investor to know.

Every year as we get around to pinning a new calendar to the wall, financial writers start focusing on two topics… the big events from the year gone by and the big opportunities for the coming one.

Many sites will make calls on certain stocks based on things like developing trends, companies’ past performance, and just enough analysis to justify their logic.

(In all cases, we recommend that you always do your due diligence before investing in any opportunity, to make sure it fits in your investment goals and risk profile.)

We don’t do that. But…

If you are interested in a small group of stocks that has the potential to outperform one of the major market indexes, there’s a strategy we’d like to introduce you to…

The “Dogs” of the Dow

What’s that?

The “Dogs” concept was popularized in 1991. It’s an investing strategy that looks to outperform the Dow Industrials by buying the 10 stocks in the index with the highest dividend yields.

Why would this be a good idea?

A company’s dividend yield is its annual dividend divided by the share price of the stock. Let’s say Company X pays a $2.50 annual dividend and is currently trading for $27. That means it has a 9.2% dividend yield.

However, if Company X is trading for $19, its dividend yield would be over 13%.

So a higher dividend yield generally indicates a lower stock price.

Remember, the Dow Industrials is an average of 30 of the bluest of the blue chip companies in the market. All solid, well-capitalized companies. Not a high-risk name in the bunch.

So when one of these stocks’ dividend yield rises, it usually means its price has come under some cyclical or temporary pressure. Which should make them poised to outperform the market as their share prices recover.

How does it work?

The Dogs of the Dow is basically a “set it and forget it” strategy. You buy the Dogs in January, hold them through the year, and then adjust your holdings for the following year.

Simple.

But how does it perform?

You might be surprised.

A Pretty Impressive Record

In an era of Nvidia-like return expectations, a lot of investors think of dividend paying stocks as “stodgy” companies that can’t keep up the growth pace with the rest of the market. But these “Dogs” have done pretty well relative to the DJIA index.

Between 2007 and 2009, the Dogs portfolio was beaten by the Dow, but…

In 2010 it was Dogs up 16% – Dow plus 9%…

In 2011 the Dogs beat the Dow by 11 percentage points…

In 2012 it was a dead heat with both rising roughly 10%…

In 2013 it was the Dogs again closing up 35% vs the Dow’s 30%…

In 2014 it was a closer contest with the Dogs up 11% and the Dow up 10%…

In 2015 the Dogs gained 3% while the Dow was flat…

In 2016 it was Dogs up 20% and the Dow up 17%…

In 2017 the Dogs took it on the chin gaining 19% vs. the Dow’s 25% rise…

In 2018 the Dogs fell 1.5% while the Dow dropped 6%…

In 2019 the Dogs managed a 15.4% gain while the Dow posted a 22.3% rise…

In 2020 the Dogs got clobbered losing 12.6% while the Dow gained 7.2%…

In 2021 the Dogs got some revenge rallying 25.3% compared to 21% for the Dow…

In 2022 it was Dogs plus 2.2% – Dow minus 8.8%…

And in 2023 the Dogs got edged gaining 10.1% vs the Dow’s 14.4% move.

Overall, according to Nasdaq, “From 2000 to 2022, the Dogs of the Dow had an average annual return of 8.7% compared to 5.8% for the Dow Jones Industrial Average (DJIA).”

What about last year?

In 2024 the Dogs were, well… dogs. The portfolio lost 2.97% while the Dow as a whole was up 12.8%.

Their performance lagged in large part on the backs of healthcare/pharmaceutical stocks. Amgen was down 9.5% and Johnson & Johnson fell 7.7%. But the biggest loser in the bunch was Walgreens which took a huge 64.3% hit thanks to a combination of bad business decisions and industry pricing pressures.

Chemical conglomerate Dow Inc. also took a dive dropping 26.8%.

The only two tech stocks, IBM and Cisco gained 34.4% and 17.2% respectively.

One of the chief criticisms of the strategy is that it may overweight an investor in one particular sector. That appears to have been a factor.

But it’s also worth noting that the Dogs have a tendency to bounce back. If you look at the returns above, the Dogs portfolio got its butt kicked in 2020 only to rebound to outperform in 2021. (And Walgreens got dropped from the index.)

So are the Dogs of the Dow right for you?

Only you can determine that by doing your due diligence.

But if you are interested in looking into this unique portfolio, here are the Dogs for 2025…

Verizon (VZ) — 6.78%

Chevron (CVX) — 4.50%

Amgen (AMGN) — 3.65%

Johnson & Johnson (JNJ) — 3.43%

Merck (MRK) — 3.26%

Coca-Cola (KO) — 3.12%

IBM (IBM) — 3.04%

Cisco Systems (CSCO) — 2.70%

McDonalds (MCD) — 2.44%

Procter & Gamble (PG) — 2.40%

The FOMC is closed out 2024 this week.

While humbly bragging that inflation is well under control, they’ve set off in search of more “neutral” interest rate levels to ward off any slowdown in the economy.

Most media will tell you that they have spectacularly engineered the elusive “soft landing.” And that you don’t realize how good you’ve got it!

Others would beg to disagree..

They’ll point out Donald Trump won the White House in pretty amazing fashion based on the fact that Bidenomics and the economy it created both sucked.

Each camp comes to their conclusion based on the measuring stick they use.

And there’s more than one way to measure an inflation monster…

Welcome to “Sticky-ville”

As if there weren’t enough ways to demonstrate how badly the economy is treating you, the Atlanta Fed itself has devised another. It’s called the Sticky-Price CPI.

What is that?

The Atlanta Fed started tinkering with this measure nearly ten years ago. The idea behind it is that some items in the CPI basket change very rapidly in response to economic factors (they’re known as “flexible”) while other items change much more slowly (they’re “sticky”).

The big question on everybody’s mind was whether either of these groups was a better predictor of different drivers of inflation. In other words, was either one a better forecast tool.

After examining the data for a bit, they discovered that half of the categories change their prices every 4.3 months. So they used that as their cut off.

Items with prices that changed more frequently (like, say, tomatoes) were dubbed “flexible” while those that moved less frequently (like coin-operated laundries) fell into the “sticky” basket.

When you plot the two categories, they look pretty much like you’d expect:

But the trillion dollar question was still was either basket a better predictor?

To determine that, they dove into some high-level math. They used something called the root mean squared error (RSME) which is a statistical way to measure how accurate a prediction is.

They compared the RMSE of each basket to the RMSE of the forecast produced from the headline CPI at intervals of one month, three months, 12 months and 24 months out. (We’ll skip the boring math discussion.) What you need to know is that according to the Fed…

A relative RMSE less than 1.0 indicates that the alternative proxy for inflation expectations is more accurate than the headline CPI.

The results were undeniable.

The one month forecasts were all about equal. But, starting with three months out, the sticky and core sticky baskets proved to be better forecasters. And they became even better predictors the further out they went.

Forecasting Trouble

So what are they showing as the FOMC’s year came to a close?

The Atlanta Fed’s sticky-price consumer price index (CPI)—a weighted basket of items that change price relatively slowly—rose 2.4 percent (on an annualized basis) in November, following a 3.6 percent increase in October. On a year-over-year basis, the series is up 3.8 percent.

On a core basis (excluding food and energy), the sticky-price index rose 2.4 percent (annualized) in November, and its 12-month percent change was 3.9 percent.

The year-over-year numbers are double the Fed’s “mandate.”

While their “preferred” inflation gauge, the PCE index, is showing headline inflation around 2.3%, other measures like core CPI which hasn’t been below 3% since April 2021, suggest that things are still not under control.

And considering the Atlanta Fed’s sticky forecasting tool, it may not be for a while.

We suppose that on occasion it may seem like we’re obsessed with predicting Armageddon.

We cite sky-high stock valuations.

We talk about the fact that the strength in the market has largely been driven by a handful of mega-tech/AI stocks.

We point out economic realities (and the Fed interventions they prompt) that don’t support the case for a stampeding bull market.

Our only goal in offering these observations is to make you, our readers, aware of the realities attached to the stock market (and to a larger degree, the economy). It’s important to know these things because we believe that you don’t always get the unvarnished truth (occasionally not even the “varnished” truth) from the mainstream.

For example… A few months ago in August, the Bureau of Labor Statistics released its 2024 preliminary benchmark revision.

Each year, the Current Employment Statistics (CES) survey employment estimates are benchmarked to comprehensive counts of employment for the month of March. These counts are derived from state unemployment insurance (UI) tax records that nearly all employers are required to file. For National CES employment series, the annual benchmark revisions over the last 10 years have averaged plus or minus one-tenth of one percent of total nonfarm employment. The preliminary estimate of the benchmark revision indicates an adjustment to March 2024 total nonfarm employment of -818,000 (-0.5 percent).

In plain English, once a year the BLS adjusts its jobs totals against state unemployment tax records (a more accurate number than their monthly guess). This past March the 12-month jobs number had to be revised down 818,000 jobs. That’s five times the average of the last 10 years.

Things aren’t as rosy as they’ve been letting on.

In the reality of our financialized economy, this is business as usual. But that doesn’t mean you shouldn’t be aware of it.

So we point out the bad stuff. To make sure you have all the facts at your disposal.

But that doesn’t mean we’re looking forward to the doom and gloom. The bigger reality is…

Stocks are a Bullish Phenomenon

The primary direction of the stock market is up!

In fact 80% of the time the market is in a bull trend.

It’s always the corrections (“calamities”) that get the news coverage. But stocks, as a whole, have always come back. Let’s go back 40 years for an example…

In October 1987 the market experienced one of the most spectacular crashes in modern times. After putting in a rebound high on October 2, the market gave up roughly 35% of its value in just 12 days. (Actually, the majority of the crash came in only five days!)

S&P 500 – The October ‘87 Crash

It shook investors’ confidence for months. It led President Reagan to establish a group called the President’s Working Group on Financial Markets (known colloquially as the “Plunge Protection Team”).

But once the shock had worn off, the market started to rebound. And within two years, it had eclipsed its previous all-time high in 1987. (Meaning that those who were buyers during the bottoming period made somewhere around 50% on their money.)

Some declines (and subsequent rebounds) take longer than others.

The tech wreck of 2000 — sparked by the “new paradigm” of paying multiples for companies with zero earnings — took the better part of two years to find its bottom.

But it eventually did.

Today the S&P 500 is 1,700% higher than its high in 1987…

It’s 290% higher than its high in 2000…

It’s even 79% higher than its high in 2020…

Patience is the Thing

There’s a saying about the market that goes, “It’s better to be out when you want to be in, than to be in when you want to be out…”

Bear markets, especially those that happen in a hurry (i.e. crashes), can take their toll on investors’ nerves.

And there’s always the question of how long before it resumes its upward path. (And relative to an investor’s cost basis (the price where you’re in the market) that can try an investor’s patience as well.)

But given time, the market always rises.

Legendary NYSE commentator Art Cashin once said…

“Never bet on the end of the world because that only happens once and something that happens once in infinity is a long shot.”

Our goal is to give you all the unvarnished info out there.

But we’re not betting on the end of the world.

Here’s to a great 2025!

“All the Whos down in Whoville liked Christmas a lot.

But the Grinch, who lived just north of Whoville, did not!”

– Dr. Seuss

The annual holiday classic, that we’ve all seen a million times, tells the story of a nasty green cave dweller who tries to stop Christmas.

Despite the fact he eventually learns the true meaning of Christmas and saves the day, his name has become synonymous with being cynical or mean-spirited.

Well, since the holiday season is at hand, we want to say up front that we really don’t mean to be a Grinch about the markets.

But given we feel it’s our duty to show our readers the unvarnished investing truth, here’s a development you need to know…

Recalling the “Value Master”

A couple weeks back, we took note of the fact that none other than Warren Buffett — mister buy and die — had become a net seller in the stock market.

Buffett, who still actively manages Berkshires’ portfolio, has been a net seller of stocks for the past eight quarters, significantly rearranging his portfolio. …

Add it all up and Buffett has raised Berkshire’s cash position to $320 billion versus just $272 billion in stocks.

We speculated on the reasons for this notable shift in sentiment:

Is the Oracle calling a top? It’s certainly not impossible. Buffett is the king of buying value — great companies fairly priced. If valuations are exceeding what he deems reasonable, he may be building a cash store to take advantage of a major correction.

We also noted that Buffett is not a market timer. So the fact that he’s unloading now doesn’t suggest that anything is imminent. Better to be out when you want to be in instead of in when you want to be out.

But given our speculation, we found a recent analysis of the market’s overall valuation to be worth noting. But first…

A Little Primer On Valuation

When you buy a stock, you’re basically buying a piece of the company’s expected future earnings. And the price you pay today should reflect a discounted value of that. So in basic terms, price should be a fair reflection of value. But that’s not always the case.

Comparing the price of a company’s stock to its earnings (price-earnings or P/E ratio) is the most common way of establishing valuation. Below is an historical chart of the P/E ratio of the S&P 500:

You can see that for over 100 years, valuations basically oscillated around the long-term mean with a dip 50% below indicating undervalued and rise to 50% above indicating overvalued. Then, however, came the tech bubble and valuations became both extreme and extremely volatile.

Another, more smoothed measure, is known as the cyclically-adjusted price-earnings (CAPE) ratio. (It’s also known as the Shiller PE Ratio for the economist Robert Shiller who invented it.) This ratio measures price to earnings except instead of using a single year of earnings, it uses average real earnings over a 10-year period. This smooths out volatility as a result of business cycles.

You can see this measure smoothed things out considerably leaving only two overvaluation spikes: before the crash of 1929 and the bust that followed the tech bubble… until today.

Today valuations according to the Shiller ratio are at their second highest levels in history.

But there’s yet one more level of smoothing that can be done…

It comes from Damien Cleusix of QuantasticWorld and it’s called the margin-adjusted, cyclically-adjusted price-earning ratio (MAPE).

MAPE factors in and adjusts for the level of profit margins embedded in the valuation calculation.
And by this measure the market isn’t just overvalued… It’s insanely overvalued. According to Cleusix “the US stock market is the most overvalued it has ever been.”

Looking at this chart, the sky-high valuations (the level traced in green) are obvious. Further, if you construct a band with boundaries between the 0 and 50 percentiles of historical MAPE, this is what you get:

According to Cleusix:

The S&P 500 is currently almost 400% above the level corresponding to a bottom MAPE and 130% above the 50% percentile MAPE history.

Valuations at the high end of any measure suggest that an investment is “priced for perfection” — that earnings and growth will continue ad infinitum. And that leaves the door open for any kind of disappointment to send prices plummeting back to more “reasonable” valuations.

Like we said, we don’t want to be Grinchy this close to the holidays. But being aware of the potential threats to the market (and the bad news that could result) is the key to actually having a merrier Christmas!

The Fed has officially embarked on its quest for the holy grail of monetary policy…

Having slain the inflation monster with restrictive rates of 5.5% (or so they say) they must now start easing off the brakes so the rest of the economy doesn’t sputter and die.

The problem is, as Chairman Powell has admitted over and over, they have no idea what “neutral” actually is. (But they assure us, they’ll know it when they see it.)

And despite not knowing where they’re headed, they launched their effort by slashing their target rate by 50 basis points. Pretty much as large as they could go without sparking some panic in the market.

The market, which had been in a solid uptrend since the low in October 2022, driven largely by mega-cap AI stocks, celebrated by continuing its rally.

This policy reversal by the Fed is something the market has been anticipating for some time. And now that the easing cycle is underway, it should continue to please those big players driving the market.

But it should also benefit another segment of the market that has been lagging. And that creates an opportunity for investors…

Rise of the Small Caps

Since the low in October 2022, small cap companies have lagged the bigger players in the market. Take a look at the chart below…

S&P 500 vs Russell 2000

You can see tightly related performance of both the S&P 500 (an index dominated by mega-cap companies) and the Russell 2000 (an index of small-cap companies) into the 2022 low.

Once mega-AI stocks began to drive the rally, the bigger better capitalized stocks took off. Smaller cap stocks, on the other hand, struggled to keep up lagging by over 20%.

That’s one sector that had been significantly impacted by the Fed’s tightening cycle. Now that’s very likely to change.

Why Small-Caps Love Lower Rates

Small cap companies are typically more sensitive to interest rates. One reason is that they tend to be more reliant on external financing to fund their operations and growth.

Huge companies like Alphabet, Amazon, Microsoft all have massive cash reserves they can fall back on to fund their strategic plans. Tens of billions have been spent by big tech from their war chests on AI development.

But many smaller companies, companies with market caps in the lower billion dollar range, don’t have that kind of financial ammo. They have to keep their eyes on operations. That means strategic borrowing is much more critical when it comes to things like financing growth and innovation.

Another reason is bottom line profitability.

Smaller-cap companies generally have smaller profit margins than their bigger capitalized cousins. And a higher cost of capital (what they pay to borrow) tends to take a significant bite out of their already-thin bottom line.

With the Fed moving to ease, lower financing costs will ultimately boost many small-cap companies’ bottom lines making them more profitable companies.

And of course, that leads to a third factor in bolstering the fortunes of the small-cap crowd — more profitable companies are more attractive to investors.

Lower interest rates, from an investor perspective, tends to generate what’s known as a “risk on” investment environment. One where funds and other institutional investors will leverage their portfolios by borrowing money to invest in companies they feel have potential for significant returns.

And companies that have the potential for significant returns? Well they’re generally the ones that are undervalued or have been lagging the broader market.

Right now, that’s the small cap sector.

Looking at the chart above, the small-cap sector as a whole has significant room to actually outperform larger-cap competitors.

Some small caps will do better than others. But right now may be the time for savvy investors to start scanning the small-cap universe for significant opportunities.

They’ll never say it out loud, but the position of Treasury Secretary is basically your mom.

The high-profile, cabinet-level position is basically in charge of paying the bills, collecting the income and managing the finances — pretty much like your mom did way back when.

Unlike your mom, the Treasury Secretary is also in charge of overseeing national banks, printing currency (not like the Fed, but actually printing and minting bills and coins), enforcing financial laws and prosecuting financial criminals and tax evaders.

These are all important jobs. But one of the most important that your mom also doesn’t get to do is weigh in on fiscal policies. Fiscal policy refers to how the government spends its money.

As the government doesn’t actually “create” value, it doesn’t really “earn” money. So for the record, fiscal policy is how the government spends other peoples’ money.

To obtain this money, the Treasury Department levies taxes on its citizens. And what that money can’t cover, they borrow.

Since the turn of the millennium, there have been eight people from both sides of the aisle to hold the office. During that same time, the national debt has increased by 523%.

Thanks to this irresponsibility two major credit rating companies downgraded the US’ credit rating under the terms of Timothy Geithner in 2011 and Janet Yellen in 2023.

(That is terrible fiscal planning that threatens our economy overall.)

So when a new Treasury Secretary is nominated, markets generally have a say…

The New Guy on the Hill

Recently, President-Elect Trump nominated Scott Bessett to take over the job in his administration.

FILE – Investor Scott Bessent speaks on the economy in Asheville, N.C., Aug. 14, 2024.(Matt Kelley | (AP Photo/Matt Kelley, File))

The following Monday, the Dow Industrials erupted, soaring as much as 519 points on the news.

It would seem the market approved. Bessent does represent a change from the current Treasury administration.

Janet Yellen has been a lifelong academic and a career bureaucrat.

Bessent on the other hand, has a background in the market. The letters behind his Yale degree only reach to BA (but he was a member of the Wolf’s Head Society — one of Yale’s three “secret” societies — so that’s gotta count for something).

He basically made his bones in the market working for Soros Fund Management (yes, that Soros) where he was on board during the Black Wednesday crisis where his boss crushed the British Pound.

He left Soros in 2000 to start his own hedge fund which shut down in 2005. He returned to Soros where he stayed until 2015 when he went off to start another fund, the Key Square Group.

While some may wonder about his Soros-related pedigree, he is a guy with in-the-trenches experience in financial markets.

A Deeper Look

Bessent is a “macro” investor — a strategist who considers macroeconomic and geopolitical factors — which gives him a real-world perspective on what works and what doesn’t where the economy goes.

Among his stances around the incoming president, he’s promised to take action on Trump’s tax cut plans. Including “making his first-term cuts permanent, and eliminating taxes on tips, social-security benefits and overtime pay.”

He’s been a vocal critic of the US’ debt load which the bond market should find interesting. In a plan to help get the debt under control he’s promoted the ideas of reducing government spending. And freezing non-defense discretionary spending.

This will be an important focus as Congress will have to re-implement the debt ceiling it suspended in 2023.

He’s also proposed an economic policy he calls “3-3-3.” According to the Wall Street Journal:

Bessent’s “three arrows” include cutting the budget deficit to 3% of gross domestic product by 2028, spurring GDP growth of 3% through deregulation and producing an additional 3 million barrels of oil or its equivalent a day.

But most notable is his stance on Trump’s tariff policies.

Tariffs have been the most controversial aspects of Trump’s economic plan. Opponents have called it mercantilist and protectionist promising higher costs for consumers.

Bessent backs Trump’s ideas on tariffs, just not all at once. Taking a more gradual approach, “Bessent said he favors that they be “layered in” so as not to cause anything more than short-term adjustments.”

Bessent called for tariffs to resemble the Treasury Department’s sanctions program as a tool to promote U.S. interests abroad. He was open to removing tariffs from countries that undertake structural overhauls and voiced support for a fair-trade block for allies with common security interests and reciprocal approaches to tariffs.

Seeing Bessent as a backer and a balance for the incoming POTUS, the market has approved of the choice thus far.

Nevermind that so many retailers have their Christmas decorations out and for sale sometime around Halloween (or even earlier!)

Things don’t start heating up until the day after Thanksgiving.

The day that has infamously become known as “Black Friday.”

The shopping version of the day started back in the 80s. In theory it’s the day retailers went from “in the red” to profitably “in the black.” And to kick off the holiday shopping season, they offered some of the most irresistible deals ever.

Sometimes opening in the middle of the night, retailers would open their doors to “hordes” (and we do not use that word hyperbolically) of bargain hunters stampeding in to get their hands on one of the limited number of big screen TVs, or computers, or gaming consoles…

It made for some riveting images over the years…

With the ascendency of Amazon, online shopping began to steal some of Black Friday’s thunder and Cyber Monday was born.

The span between the two days has become a critical barometer for how the larger shopping season will go. And ultimately how retailers will perform during what’s become a really critical season for profits.

This year may be even more telling.

Predictions of a Booming Season

Management consultancy Bain & Company has prepared some predictions for this year’s holiday shopping extravaganza. First the good news…

Retailers can expect another doorbuster Black Friday–to–Cyber Monday shopping period. Bain forecasts US retail sales will reach $75 billion for the first time ever, growing by about 5% year over year and outpacing our total holiday season forecast of 3%. What’s more, around 8% of Bain-defined holiday sales will come between Black Friday and Cyber Monday this year—the highest share since 2019. This underscores the enduring importance of this key shopping weekend.

Further, they anticipate that 8% of all holiday sales will be made during that weekend.

A big kickoff to the shopping season is a key signal for retailers. Over the past three years, Black Friday has ranked either first or second in terms of sales made over the period. (Over the past two years, Cyber Monday has dropped out of the top-7 sales rankings.)

A softer start to the season would not bode well for retailers and increase pressure to boost sales during the 2-3 days before Christmas — another popular shopping window.

Still the initial outlook is bright.

Something Else to Watch…

We hate to be a total Grinch during this festive season, but the actual consumer is something else we need to watch. Simply because they’re spending in record amounts, shouldn’t be interpreted as a booming consumer sector.

Financial website NerdWallet recently published its holiday spending report. Right in line with the Bain report, their feedback has been positive.

The holiday season is nearly here and with it, ample opportunity to spend big. According to a new NerdWallet analysis, Americans plan to spend about $17 billion more on gifts and about $46 billion more on flights and hotels this holiday season than they did last year.

Unfortunately, what this survey doesn’t tell us is whether shoppers plan to buy more things or just anticipate paying higher prices. Or some combination of both. Still, more money spent is generally good for the retail sector.

One thing the study does indicate is how consumers are paying for all their holiday joy.

Most shoppers plan to use credit cards again for this year’s holiday shopping: Nearly three-quarters of 2024 holiday shoppers (74%) say they’ll put at least some of their holiday gift purchases on a credit card.

More and more shoppers are relying on credit to make purchases.

And while some shoppers use their plastic to earn some type of reward, suggested by the number of shoppers who quickly pay off their balances…

Of Americans who put 2023 holiday gift purchases on a credit card, less than a third (31%) paid it off with the first statement.

…Others use them out of necessity evidenced by lingering balances:

The survey found that nearly 3 in 10 Americans who used credit cards to pay for holiday gifts last year (28%) still haven’t paid off their balances. Likewise, the same proportion (28%) of 2023 holiday travelers who put flights and hotel stays on a credit card still haven’t paid off the balances.

We’ve been writing about the struggles of the average consumer and how it’s been showing up in the retail sector. Certain retailers (Walmart, Costco…) are booming while others (Target, Kohls, and most dollar stores…) have been getting the cold shoulder from consumers.

Retailer’s earnings fate in the coming quarter will depend largely on how holiday sales go.

The economy, on the other hand, is far more dependent on the fate of the consumer…