Bear/Bull Market

In Section I, we examine some concerning signs of US economic weakness that emerged in June. We also discuss portfolio positioning in the face of falling interest rates and cross-check our recommended US equity overweight in the face of extremely optimistic expectations about AI’s impact on growth. We conclude that defensive positioning continues to be warranted. In Section II, we dig into those optimistic expectations for AI. We find that the US equity market is significantly overvalued unless the deployment of AI technology causes a 10-to-20 year productivity surge in line with what occurred during the IT revolution of the 1990s, with persistently high margins on the revenue generated from the improvement in growth. We doubt that AI will end up truly boosting economic activity by this magnitude.

The consensus soft-landing narrative is wrong. The US will fall into a recession in late 2024 or early 2025. We were tactically bullish on stocks most of last year, turned neutral earlier this year, and are going underweight today. We conservatively expect the S&P 500 to drop to 3750 during the coming recession.

The signs of an approaching recession are starting to emerge. We will turn tactically defensive once they all fall into place.

MacroQuant downgraded equities from neutral to underweight on a 1-to-3 month horizon. The model suggests increasing exposure to cash.

Q1 earnings results of the largest US banks have demonstrated that the engine of recent growth in profitability, NII, has faltered as funding costs are rising fast. However, the resurgence in non-NII thanks to a revival in corporate activity has been a saving grace. Earnings growth appears to have bottomed, while valuations are attractive. To play up portfolio exposure to an upcoming surge in capital markets activity, and minimize exposure to declining profitability in traditional banking services, overweight Diversified Banks and Capital Markets, and underweight Regional Banks.

We look beneath headline data to assess the state of the labor market in cyclical goods-producing industries that have previously led overall nonfarm payrolls and in the services segments that have recently been leading the charge. The bottom-up view looks a lot like the top-down view: the labor market is softening, but very slowly, and offers no indications that a recession is at hand.

Contrary to conventional wisdom, most leading indicators suggest that the US labor market is weakening, including our very own “Mel rule.” After being overweight stocks last year, we moved to neutral at the start of 2024, and are now putting equities on downgrade watch with the expectation of shifting them to underweight later this year.