Sam Burns on Mastering Asset Allocation Amidst Market Crossroads and Economic Uncertainty

Navigate the perplexing currents of today's investment landscape with us, Michael Gayed and expert analyst Sam Burns from Mill Street Research, as we dissect the S&P's dominance and the challenges of traditional diversification. Gain valuable insight into the shifting sands of asset allocation, where the once-reliable tactics now stumble in the face of large-cap earnings surprises and the creeping dread of 'zombie companies' amidst rising interest rates. Our conversation spans from the perplexing behavior of small-cap stocks to the potential economic ripples of the November elections, painting a comprehensive picture of a market at a crossroads.

As we parse through the intricate economic recovery, Sam and I scrutinize the historical echoes of inflation and how today's landscape differs, considering the impacts on housing, the auto industry, and consumer spending. We delve into the enigma of emerging markets and China's influence, probing the gap between GDP growth and corporate earnings while dissecting the sector allocation mix affecting investment returns. Join our intricate dance through economic indicators and the commodities market, as we shed light on gold's breakout and the shifting tides that may influence your next investment move.

Thank you for tuning in to an episode brimming with insights and a forward-looking perspective on fiscal policy, bank credit growth, and the economic indicators that matter most in our post-COVID world. For those keen on staying abreast of market trends and expert analysis, follow us on Mill Street Research, Twitter, and LinkedIn. A heartfelt nod to Sam Burns for his invaluable expertise and to our listeners for embarking on this journey through the financial landscape with us. Here's to more enlightening episodes and engaging discourse ahead.

The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.

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Transcript

Speaker 1: 0:08

with. That said, my name is michael guy, a publisher of the lee lag report. Joining me for the rough hour is mr sam burns, fellow cfh oral of uh mill street, uh, research. Uh, sam, first time you and I are chatting, but uh, introduce up to me, to those that are watching who are you? What's your background? Or have you done throughout your career? Uh, what are you doing currently?

Speaker 2: 0:25

Sure, no, I appreciate you having me on here. This is great. And yeah, so I've run Mill Street Research. It's an independent research firm that I started about eight years ago after spending a lot of years working at different types of research firms and banks and things doing mostly macro and quantitative stock selection research. So my whole background has been markets and the economy. A lot of data and indicators, a lot of model building. Really trying to find objective ways to analyze the market and avoid getting swayed by the headlines has been kind of a key theme underneath it all. So I've gotten to work at some big shops and some smaller shops with a lot of smart people and I've kind of put together everything that I've found and built and used over the years into what I offer here to primarily to institutional investment clients here at Mill Street Research. So it's a mix of kind of macro and micro, but all kind of based on data and indicators that I've tested over the years that I've found to be reliable.

Speaker 1: 1:27

Since you mentioned model building, let's face it, the only model for the last several years has been just S&P. It's been hard to really justify with hindsight, going into anything except that because it's been the number one performer by a mile, largely because of this large cap tech momentum. I'm curious to hear your thoughts on this cycle from an asset allocation perspective. I always go back to the point that the worst environment for asset allocators is actually the one that I think we're in now, because it's very hard to beat the S&P when you can argue it's the only game in town.

Speaker 2: 2:02

Yeah, you're right, it's been an unusual cycle. Everything post-COVID has been completely against the normal patterns and cycles that people are used to seeing, and I think that's thrown a lot of people off. And so, yeah, the key thing for me has been to try to rely on the indicators that have tended to work over time, but realize when things might be different. And so, yeah, you're right, it's been hard to beat stocks for quite a while. Even in 2022, which is a bad year for stocks, was also a bad year for bonds. So the normal assumption that, well, if stocks are doing poorly, you can own bonds and make money doing that wasn't even necessarily the case in this cycle.

Speaker 2: 2:42

So, again, breaking the usual rule that bonds are a good diversifier for stocks, they've been more correlated over the last few years Bond prices go down, stock prices go down too sometimes, but it's been a pretty steady trend of stocks outperforming bonds, and that's been because the economy and earnings have done better than most people expected really for the last three or four years, and particularly the last year or two. People expected really for the last three or four years, and particularly the last year or two. And so I remember coming into early 2023, late 2022, there was a huge amount of negativity in the market, a lot of people expecting recession, negative earnings growth, all the kind of bad things to happen. And then they didn't. And that's when we've really kind of been in this trend of stocks outperforming bonds and the large caps in the S&P really being the dominant players both within the US and globally. So it's been the US outperforming the rest of the world and US large caps outperforming other stocks in the US.

Speaker 1: 3:34

Here but, as I recall, the earning side has primarily been just on the large caps. As far as the surprises go right, it's mid-caps yes, some, but small caps. Large caps, as far as the surprises go right, it's mid caps yes, some, but small caps certainly not as much. So there's been a lot of aspersion, I think, in terms of that narrative around earnings being surprisingly good.

Speaker 2: 3:54

Right, oh yeah, and it's definitely been much more skewed toward large caps.

Speaker 2: 3:57

Not only just the big tech, but bigger companies in general have had better earnings, and better earnings kind of surprises, earnings estimate revisions have all done much better than the small caps have, and I think certainly the last two years a lot of that can be kind of put at the feet of the Fed, in the sense that higher interest rates hurt small and mid caps a lot more than they hurt large caps for various reasons.

Speaker 2: 4:18

But I think that's a lot of what you've seen in the earnings, the fundamentals, and that's come through in the relative stock returns as well. So I think there's been a pro-large cap environment macroeconomically as well. As that's where the liquidity is. So if you want to put money to work, it's much easier to do it in the big, liquid, large caps, particularly in the US. I think people particularly coming out of 2022, we're looking for that as well. So both from kind of a market risk standpoint and a macroeconomic and earning standpoint, it's been very kind of pro large cap and particularly the US tech areas which they don't need to borrow money and they're very profitable in general. So they've kind of had an advantage over most other kinds of stocks.

Speaker 1: 5:04

When does that end and when does that small cap weakness become a problem? I keep going back to it's like the longer you have higher for longer rates, the more at risk these zombie companies that are primarily small caps are at risk of even being ongoing concerns, meaning they go bankrupt, which you would think at the margin would cause some real unemployment problems for the economy. But at what point is it either a problem or is it a real opportunity where that large cap momentum shifts?

Speaker 2: 5:33

Right, yeah, and there's been a lot of talk about the difference between the large cap and small cap and what that means for the overall market Looking forward. If a lot of stocks are not participating as much, then is that a negative sign? And in some cases it can be. In this case, I think it is more of a relative strength play rather than a directional play. I mean, it doesn't mean the market itself is going to have to go down and small caps, some of those mix logs, have rallied, they have gone up. They just haven't gone up as much as the large caps, and so there's both an absolute move and a relative move. But I think you don't necessarily have to see large caps go down to kind of catch up to where small caps are. And small caps, yeah, it can be an issue economically in some cases. I think in this case it's less of a leading indicator for the overall economy because the large caps are doing well and because the small caps aren't necessarily doing badly in absolute terms. They're just doing less well than a lot of the large caps are and there are a lot more, yeah, kind of unprofitable companies in the public equity market nowadays than maybe there used to be and you're starting to see some of them hit the skids because if they were reliant on cheap capital, that's kind of gone away Now in some ways it's a healthy thing for that to happen at times, but as long as the bigger companies that provide most of the employment, most of the spending, most of the overall activity are still doing relatively well, and I think generally the economy itself still doing relatively well and I think generally the economy itself, you know, is doing relatively well and that's it's just. You know they're supporting each other to some degree, despite what the Fed has done.

Speaker 2: 7:12

I think that's the thing is that the Fed normally would be expected to have slowed the economy, slowed earnings, and that's happened to some companies, but not all of them and not the big ones, and so I think that's been. The trick is that there's been other factors that have offset the Fed this cycle that have not been the case in past cycles, and so normally when you see small caps lagging, it's because the Fed's tight and because the economy is going to slow down. In this case, the Fed is tight but it's not really slowing the economy down and that's broken the relationship, that's confused people and then that sort of traditional relationship between small caps, relative performance and the market hasn't followed the normal pattern. It may not for a while, as long as we don't get any other big policy mistakes or other shock events in this kind of post-COVID environment. We're in.

Speaker 1: 7:58

So it seems like the biggest factor there is that fiscal dominance idea. Right, it's the fiscal side which is countering the Fed, which makes me I thought I hadn't. It's something I hadn't thought about before. But I wonder if, in these periods where the fiscal side is overwhelming the monetary side, if that just naturally favors large caps, because fiscal side is going to be more tainted by lobbyists from the large cap companies in terms of the policies that they create, which would be stimulatory, but only towards certain mega cap companies.

Speaker 2: 8:30

Right? No, there certainly could be some of that. Some of the you know where the fiscal policy is directed is going to be influenced by you know the companies and things that are involved, and certainly there's been. You know more of CHIPS Act. Inflation Reduction Act has a certain amount of technology and green spending and all that kind of thing to it. Certainly, the CHIPS Act itself has been directed towards semiconductors and battery manufacturing and all these things that are going to be more helpful for some of the midsize and larger companies and the tech-oriented companies, as well as some of the kind of more industrial traditional industrial companies, and so I think there is probably a tilt towards some of those companies that have benefited from the fiscal side.

Speaker 2: 9:13

But then of course it all circulates in the economy one way or another and helps employment, helps consumer spending in general, and so I think there's a sort of a second order effect that goes beyond the direct beneficiaries of the fiscal policies to the broader economy in terms of hiring and spending. That's helped keep this economy going more shape, but are generally in better shape. For the larger companies it means that they've been resistant to the higher rates. They locked in debt maybe a couple of years ago at lower rates. They don't need to borrow as much. If things are good, they can spend out of income or retain earnings rather than having to take on a lot more debt. All those things are helping, but are better for the larger, more profitable companies in general because of the way that things have played out between monetary and fiscal.

Speaker 1: 10:10

What's going to change that fiscal side of the equation? I mean, if the Fed is constantly pushing up against all the government spending and the reality is you get voted because you spend more? People never vote in the guy that's asking for austerity. It's always the one that gives us more candy. So how can the Fed possibly counter that? Because, no matter what I think, the perception will always be it's the Fed's fault, but really it's everyone's fault.

Speaker 2: 10:37

Right? No, I think that's right. I think the Fed gets a lot more attention and sort of either blame or benefit from whatever it's doing, when in fact tinkering with short-term interest rates doesn't have nearly the economic effect that a lot of people assume it does, including the Fed, probably to some degree, both on inflation and on growth. The assumption that you just raise your rates a few points and that means inflation will go down and the economy will slow six months later had never really been the case and certainly isn't now with or without kind of this fiscal kind of effect outweighing it. So I think there's been a lot more focus in financial markets on the Fed, because they do certainly affect financial markets, but they don't really affect the underlying economy as much as people give them credit for or blame for. And the fiscal policy, regulatory policy, immigration policy, all these other things have more effect but are not as salient, I guess, in terms of what investors see and what consumers see, because they don't have a press conference every six weeks. The markets are not focused on every little wiggle in what the fiscal policy is doing, and so I think there'll be some legs to this just because the policies that are in place are going to stay there for a little while.

Speaker 2: 11:49

Uh, certainly, what happens in November with the election could certainly influence this. You know, as we see, whatever happens to Congress, uh will then either keep things in place potentially or, you know, or focus more on deficit reduction and cutting back on spending potentially. So it'll be important to see what happens in November and then 2025 will kind of be where you might see some of that that impact. So I think over the next year or so, the things that are in place now, all the policies and the programs, will kind of just keep going on their own and I think there'll be a bit of momentum to that.

Speaker 2: 12:21

But it's going to be interesting to see what happens here in November. And if we do shift to more of a cut the deficit, cut back on spending kind of policy approach, that's going to be a risk to the economy, I think in 25 and 26, looking ahead, and the Fed will again be kind of limited in what it can do to offset it. We found out that zero rates don't really stimulate the economy, even though when you do them for years, they haven't in Japan either. So looking to the Fed to do those kind of things I think is still going to be limited and it's just going to cause a swing in the financial markets that don't translate to the real economy as much.

Speaker 1: 12:59

So is it fair to say that the only way to cool the fears around the re-acceleration of inflation is just, you know, it's got to be cutting government spending? It's not really on the monetary side, because I get the sense that, yeah, the other issue with why this environment has been, I would argue, weird, like probably saying it is because there's all kinds of lags that are still playing out. You have the lag of the COVID shutdown and the lag of the reopening, and the lag of the trillions of dollars of stimulus, and the lag of the fastest rate of high-cycle nice trade and the lag of the inflation reduction, which is a comedic name. So you've got all these weird delays right, because none of this stuff is ever instantaneous.

Speaker 2: 13:38

Oh right, yeah, I mean basically the kind of the bullet effect of all these things that you just mentioned, all layer on top of each other, from COVID, from the vaccines, from the stimulus and Russia, and then the new infrastructure related stimulus and everything else that's happened are all hitting on top of each other because, yeah, you're right, they don't all happen at once or don't have their effect at once, and sometimes the lags are quite long and companies and people take a while to respond to certain things, particularly with interest rates, but for a lot of things, and so trying to predict which one will be the thing that affects the data this month, which is, of course, the short-term focus on every monthly report, has been a problem, and so there's a lot of noise in the data, but I think the general trend for inflation is lower. I think it will continue to be lower, in part because a lot of what was causing inflation was essentially supply shocks from COVID and then the post-COVID stimulus. Those have now faded and are still fading, but not linearly, and so I think what you're going to see is this kind of bumpy ride back towards the 2% inflation. And of course, there's measurement issues with the way shelter is treated in inflation data. Some other things like auto insurance have been a big factor lately, which again are not things that like the Fed can really control directly and that are just kind of the way the data works or the way things have kind of happened. But if auto insurance is a lagged effect of car prices going up two years ago and car repair costs going up a year or two ago, then that's all again the lagged effects of things that happened in the past and that are not happening anymore. Auto prices have already stopped going up, so eventually auto insurance prices will stop going up.

Speaker 2: 15:21

Well, it'll take a while to see all that. I think all those things are going to take a while and the question is does the Fed kind of have the patience to wait for it, or should they be a little more proactive and then will the markets and the economy kind of figure that out and respond accordingly, and so I think that's been. The other thing is which of the historical analogs is the best one to look at? Is it the 70s or is it more like the post-World War II period, in the late 40s, early 50s, when you had kind of a big shock event and then inflation went up for a while and then it came back down, kind of stayed down for a while. I think that's probably the better analog. If you had to pick one is that COVID was more like a war event than a 70s-style event, which was really a whole series of shocks in the 60s and 70s.

Speaker 1: 16:10

I don't think are being repeated here and that actually lends itself to the discussion around sort of the sources of the inflationary pressure. Right, you mentioned shelter, you mentioned the automobile side, on the insurance end. I put out this post, I don't know a week or two ago that I think the concerns personally around re-acceleration of inflation, the source of it, is different than what we saw in the years prior where it was supply chain disruption and the pent-up demand. It seems to me it may actually be driven by the wealth effect, meaning the source actually could be just the fact that large cap market cap weighted average has done so well. Most people's 401ks are in there, they feel good about it. Housing is connected to that. So the dynamic of the driver of the inflation expectation side of it is maybe different, unlike in the 70s where it was still this series of shots around oil.

Speaker 2: 16:57

Some of the 70 shocks and other shocks drove the initial round of inflation and now what you're getting is much less of that, as the supply chains have healed and a lot of the infrastructure-related government spending has helped build factories and kind of increase productive capacity, which helps eventually bring down the cost of things. But yeah, right now certainly the wealth effect more from housing probably than anything else. But yeah, the housing and the stock market are both sources of increased wealth. Now, of course, that's going to be skewed more towards higher income side of the economy, which has a lower marginal propensity to spend, but at the same time, it does keep spending up, and particularly on things that are more discretionary. A lot of the services side of the economy, which is not being picked up as much in some of the traditional leading indicators, is the part that's really holding up.

Speaker 2: 17:52

Well, people are going to the Taylor Swift concerts and things that they couldn't do during COVID or right after COVID and they're spending relatively proportionally less on goods and things than they did right after COVID, or something less on goods and things than they did right after COVID.

Speaker 2: 18:07

So the normal cycle of a typical recession is you stop spending on durable goods and buying appliances and things, but they still have to go get haircuts and go to school, and so services holds up but goods slows down.

Speaker 2: 18:15

And then later it reverses and services might slow down and goods picks back up again, but goods are the swing factor. This cycle it's been goods went up during COVID because people had nothing to do but stay home and buy goods and services plunged, and now you're getting in the reverse later in the cycle and services is going up and goods are slowing down. So it's reversed the typical pattern as well as the drivers of inflation. And you've had the fact that housing prices have not come down, even though mortgage rates are up and have been up for a while because of the supply, demand in housing and so and the fact that people are less prone to move now. So I think you've got a couple of different things going on, part of it being housing regulation, things that affect the stock market and through the housing market that's helping offset again higher rates. That would normally be expected to reduce borrowing, reduce demand, and that hasn't happened as much.

Speaker 1: 19:14

You had mentioned bonds and I think people have a hard time distinguishing between duration and credit risk. They just loop it all together. It's like bonds sold off. What's the cause of it? Credit defaults risk is very different than interest rate. Duration risk is going to be a point where there's a legitimate buy and hold case for buying bonds and buying duration in particular. I happen to still think credit risk is underappreciated, but we can maybe touch on that For you. Since you mentioned model portfolios, if you're putting together a model portfolio and you're looking at the fixed income bond allocation side, what would be your looking at the fixed income bond allocation side? What would be your catalyst to lengthen the duration side? To start saying you know what I actually want more exposure to interest rate movement.

Speaker 2: 20:08

Right, yeah, so I've been underweight bonds, long duration bonds in my recommended allocations recommendations that I give to clients for actually really since late 2020, I think and basically whatever fixed income I would be holding in these recommendations would have been on the short end in more of the cash, short-term end of the curve. And a lot of that has been initially because long-term interest rates were very low a few years ago and therefore you weren't getting paid much for the risk of the duration. Now certainly rates are higher, but you're still getting a lot of volatility. For that risk, the duration risk you're taking, you're having to sit through a lot of volatility on the long end and you're still not getting much return just because bonds are struggling, just because bond they're struggling. When you have an inverted yield curve in particular, it makes it hard for a long end to really rally on a sustained basis and give you that kind of return for the risk you're taking. If you're always kind of having to look and see if you could get more interest on the short end and that if you're a bond trader and you're financing your bonds at the short-term interest rate, you're running negative carry, which makes the long end of the bond market much more volatile. So to me, if the economy and earnings are pretty good, as they've been for a while, you're generally going to do better in stocks than in bonds, and if you have higher short-term interest rates, you might as well just take the short rate and not worry about the long end.

Speaker 2: 21:37

The thing that would change that would be if the economy really does start to slow down.

Speaker 2: 21:40

You start to see inflation not only slow but go below 2% and looking like the Fed would have to cut rates in order to stimulate the economy and therefore remove that inverted yield curve potentially and give long bonds an opportunity to rally beyond just how many rate cuts they're going to price in over the next six to 12 months.

Speaker 2: 22:01

So that's what we've been basically doing for the last two years really is just playing the game of how many rate cuts we're going to get from the Fed, and it's always a back and forth thing.

Speaker 2: 22:09

There's no real trend there, because once you price in more than a few rate cuts, the economy is still pretty strong, so you would price it back out again and then you're just kind of this back and forth, and that's not worth taking the risk for right now in my view. So you would have to see the economy really slow down, see earnings growth slow down to make it worth trying to get into long bonds on a sustained basis, and certainly higher real yields on TIPS or anything else make it more attractive to own longer term than it has been for many years. So certainly that is a better setup. For if you are thinking about it, I think you're going to have to sit through this choppy back and forth a lot of volatility and not getting paid much for it for a little while longer before things slow down enough to make bonds more attractive than stocks.

Speaker 1: 23:30

Do we need in order to get to that 2%? Does there need to be a shock Meaning? Do you think it's likely that we can get there just from the lagged effects of monetary policy, or do we need some kind of deflationary scale?

Speaker 2: 23:48

My general view is that we'll probably will get there kind of on our own without a big shock, just because there's a lot of the longer term factors in the economy I think are kind of still disinflationary in general and the fact that as long as we don't get any new big sources of inflation meaning fiscal stimulus, really big fiscal stimulus, or supply shocks from oil or something else then I think the natural tendency will be to kind of revert back towards that 2%-ish inflation rate as time goes on, again without any shocks.

Speaker 2: 24:29

They would force it to get there Just because I think the demographics in in the US in particular and then generally the developed world are slowing, I mean they're kind of disinflationary, birth rates below the replacement rate, all those kind of things that are longer term effects. Again, technology and productivity all kind of tend to push down on the rate of inflation in general, of tend to push down on the rate of inflation in general, and so unless you get a supply shock or some big demand shock, you're generally going to kind of revert back to that eventually. And that's just a matter of the path that we take to get there and how policymakers view it and whether they make kind of policy mistakes along the way or there's again some war or some other event that comes along, but absent a big shock event, I think we do get back towards that 2%. Potentially towards the end of this year or early next year we could be there just on a steady state environment that we're in.

Speaker 1: 25:25

Since you mentioned demographics, one of the often cited reasons to invest in emerging markets is demographics. You have a younger population. On average. They get from poor to middle class. They want to spend more, they want to buy higher quality things, they want more protein. All this stuff and you and I both know emerging markets have been like a widowmaker trade. I call it volatile cash. With the exception of India for the most part you look at the broad-based EM indices it's been a horrible death by a thousand cuts on the momentum side. I don't know what changes that, but I'm curious to hear your thoughts on when is it ever going to be another? Is there going to be a reason to buy emerging markets or international in general? Because the reality is, yeah, it's been a US only game.

Speaker 2: 26:13

Yeah, no, that's right. And yeah, I certainly agree with your view on EM that there's been a lot of people certainly some of my colleagues in strategy and other investors that I talked to who have continually tried to make the case for EM. They say it's cheap, they say it's oversold, they say it's been too long that this kind of can't go on, and then it does. And I think part of it is the fact that China, of course, is the big driver of EM in general, both in the kind of the indexes that are heavily weighted toward China and then all the economies that are tied to China in Asia and elsewhere are tied to China in Asia and elsewhere, and I think that 30 years of China's unusually high growth rate has come to an end over the last decade or so really, and certainly now and without that big tailwind from China, the rest of it is kind of a mixed bag and struggles with the usual risks of political risk or kind of policy risk, where it makes being an equity investor, an external equity investor in a lot of these emerging markets an unattractive proposition. Say, okay, well, chinese GDP, or even EM GDP, has grown at a faster rate than developed market or US GDP has. Maybe it's 5% or 6% versus 2% or 3% over the years. That has not translated into the corporate earnings for emerging markets. If you look at the earnings for the MSCI Emerging Market Index or any of them, they're lower than they were two years ago. They haven't grown at all, despite all the supposed GDP growth. So that whatever is happening at the GDP level, which is often kind of hard to pin down and not entirely reliable, has not trickled down into what corporate earnings for shareholders in those companies would receive. And particularly if you think that in some cases the government will step in and tinker with things or be involved in corporations more directly. In China, as well as other markets, that risk is that it's not really as big in the developed world. It's still there. I think those are the things that have really meant that the fundamentals have not supported emerging markets, that it makes sense that they've underperformed because their earnings just haven't grown nearly as much as they have in the developed world and certainly as in the US. So something will have to change.

Speaker 2: 28:39

I don't think that China is going to suddenly go back to the growth rate it had between 1990 and 2010 anytime soon. It's just the demographics. There are certainly much more slow growth or negative growth than they used to be, and so India maybe can take over some of that. It's doing better, but it still has a lot of issues.

Speaker 2: 29:01

The rest of the markets are a very mixed bag. Some of them are far enough along, like Korea or Taiwan, that it's hard to have really high growth rates at that point. And then some of them have political issues Brazil or Turkey or things like that where it's just harder to get the infrastructure there, the institutions, to drive growth that would help the stock markets and so forth and avoid the inflation and all those other factors that tend to derail emerging markets historically. So something eventually you could get all the bad news will be priced in. They'll just be so cheap that you know that any kind of good news will help them. I don't think we've gotten quite to that point yet, um, and I would want to see some of the fundamentals and the earnings the actual earnings that an investor would get start to improve, and most of my work says that they haven't really. So I'm staying on the sidelines and staying underway for now, as I've been for quite some time, until I see some of that fundamental underlying things change.

Speaker 1: 30:05

How much of that is attributable to the countryside versus the sector allocation mix? Right, so technology has been where the earnings primarily are focused on in the US. Is that on the earnings side? Do you see a similar dynamic for technology companies in emerging markets? Yeah, I'm thinking about the China tech names. Yeah, they clearly have very strong earnings. Thoughts have been mixed, but I wonder how much of the attribution is because of the international side versus just the sector allocation.

Speaker 2: 30:29

No, you're right. Yeah, I know Anytime. I always tell people when you're making a regional bet, you're also making a sector bet and can be vice versa in some cases. So if you look at even like US versus Europe, Europe has a lot less technology than the US does. In terms of the weighting of the index. If you buy a European index, you're just not going to get as much tech, and the tech companies over there have generally not done as well as the tech companies in the US.

Speaker 2: 30:51

The same is true for China To some degree. The weighting is not as large for tech, and you've got the fact that the government in some cases will intervene and throw a wrench into certain tech companies or the industries that they act in, which then whatever they might have been doing gets derailed by the fact that, you know, the government is now involved, which, again, the governments are involved everywhere and everything but less so in the US. The US tech companies have had a freer hand to do what they do, and do it profitably, than even in Europe, which has a lot more regulation on tech, or in China, where they sort of, you know, interventions from on high tend to show up when you least want them and I think that political risk, as well as some of the trade risks between the US and China on chips and technology and things like that, have kind of hurt the outlook or the risk for investors. Again, looking to the Chinese companies, yeah, they may be doing fine now, but if the politics are going the wrong way maybe I don't want to put long-term money there because the risk of that either the US cuts off chip supplies or China gets angry and does something else.

Speaker 2: 31:59

All those kind of macro political risks start to affect the valuations. People are willing to pay for what otherwise might be good results, but I think otherwise. Yeah, the earnings that they have in tech there are not enough to outweigh the weakness elsewhere, Whereas in the US the strength in the big tech is enough to outweigh weaker parts of the economy and keep corporate earnings generally rising for the S&P by 100 and other indexes. So, yeah, it's both a weighting effect, but also the fundamentals and the relative performance of whether it's tech or other sectors outside of the US has been weaker even after you account for the sector weights.

Speaker 1: 32:39

I wonder if commodity strength ends up being sort of the tell or the sign for emerging markets, because it's not tech driven, it's pretty much every other sector driven. Let's talk about commodities for a bit. Well, you can touch on gold and some of the momentum there, but broadly speaking, when you look at the commodity space, going back to model allocations and putting ideas together, is there an opportunity in commodities now or not?

Speaker 2: 33:07

I mean my general kind of longer term view has been kind of neutral to negative on commodities as a whole and particularly on oil, because it's the biggest component of most of the commodity indexes. Because I don't see again. Going back to China, china has been the big source of commodity demand for decades and again it's just a much weaker source of demand now. Now it's not going to produce that kind of incremental growth in demand for whether it's oil or cement and steel or copper or all the other things that we're going into building all the infrastructure in China we've had for decades but then now they just can't do as much of that was kind of where a lot of that demand came from and it's not really there anymore. It's slowing down a lot. The developed world, you know some demand, but again it's gradually slowing. The shift away from fossil fuels and things and more efficient use of them has limited the growth in demand for oil and particularly for things like natural gas, which we've got plenty of in this country. All those things kind of push downward and then you've got these kind of periodic supply shocks like OPEC or the Middle East or Russia that come along and either disrupt or potentially disrupt supplies, but that's usually a temporary thing. It turned out that supply disruptions from Russia and Ukraine. We got around it. They're still producing oil and natural gas is still going to Europe. It's just going through LNG and stuff in other ways. So we found ways to get around what otherwise potentially been big disruptions in supply shocks in commodities. So you are seeing a bounce in some of them now. You're seeing oil bounce, although it's coming off again. Copper's bounced, some of the other metals have bounced some lately.

Speaker 2: 34:51

But I think the longer term trend is going to be a struggle if you don't have growth in demand.

Speaker 2: 34:58

And I don't see where that's going to come from China or elsewhere, barring either big fiscal support from some of the other economies or a real change in the supply-demand balance. So there are going to be individual commodities that might provide opportunities and certainly tactical trading opportunities you'll always get. But I wouldn't think of commodities as a place to go, kind of as a super-cycle long-term play, because I think the general trend in technology is to use less commodities per unit of output in general over time and so unless something breaks that, then the trend is going to be kind of downward in demand relative to other things, to services or to technology or things that are less commodity driven. And so if you don't have China, maybe India does take over or other parts of Africa or other places that are still needing to grow a lot, but I haven't seen that yet. So I would probably kind of be neutral to negative on commodities, aside from short-term trading opportunities or things like gold, where there's clearly been a breakout and again China demand seems to be a driver there.

Speaker 1: 36:09

Let's expand on that gold point for a bit. It's volatile in the last couple of days here, but I've kept on saying gold is sending a warning, ominously because I have a flair for the dramatic when it comes to X. But yeah, gold does truly seem to be diverging from pretty much every other major commodity and you can argue that that's actually largely what gold does. It's not as industrial, obviously, as other commodities, so it kind of marches to its own beat. Do you view the gold move as just FOMO momentum investing? You mentioned China demand. I don't know if that's the full story, maybe it is, but what do you make of the gold move relative to everything else?

Speaker 2: 36:50

Yeah, it has been pretty extraordinary to see gold move even more than, say, silver or a lot of other metals, and to me, I think it's partly people expecting lower rates, and that tends to help gold. Higher rates are worse for assets that don't produce income like gold, and so I think anticipation of lower rates either in the US or globally and we're starting to see a little bit of that already I think it's also China's demand. I think that the fact that there's all that kind of financial repression, essentially in China you can't do what you want with your money, the stock market is doing badly, rates are very low, you can't move your money outside the country. So gold has gotten a lot more attention in China and probably other areas where there's a lack of opportunity to do what you want with your money and you might have worries about the traditional financial assets, traditional financial markets. So I think it is being seen somewhat as a hedge, not so much for the US but for other parts of the world where there are constraints on what people can do with their money and that they're looking to gold.

Speaker 2: 37:57

And then you have people yeah, piling on the momentum trade of like, well, we've got a commodity that's really moving here. Let's go with that. You can certainly make arguments about inflation and other factors driving it. I don't think that's a big story in terms of driving gold, but I do think it is people looking for a hedge against either traditional financial assets or the US dollar and in other parts of the world where they don't have as many options, and gold is one of them. So India and China both have a lot of gold demand. Historically, I think that's probably picked up some and then driven a bit of momentum trade as well.

Speaker 1: 39:06

So I had named the show, as we're streaming, why Indicators have Failed, because you sent me this note saying why is it that so many people seemingly got things either wrong or early? Because there's a fine line in this business between being wrong and early. It's like people were wrong saying that housing would cause a great financial crisis in 06. They were wrong for two years until something hits. So was it wrong or just early? I don't believe that being early and wrong is the same thing, because you can manage risk while being early. But why is it that so many people got things wrong? As far as the calls for recession the last year and a half, I mean, there's always false signals in any indicator, any kind of data set, but this seems to have been almost overwhelmingly. The vast majority of so-called professionals really were off.

Speaker 2: 39:53

Oh, yeah, yeah. And I remember seeing all the articles a year, a year and a half ago about 100% chance of recession according to the models and all those things. People were very, very confident that we would have a recession and that things would really kind of come unglued. And I think part of it is the fact that COVID and the post-COVID environment has been so different than past cycles most of the last 50 years that anyone using kind of rules of thumb or traditional kind of cyclical analysis, looking at the traditional economic data, those just didn't work. They didn't apply because COVID broke the rules and, in fact, even just a scale of everything. If you look at the year-over-year changes on all these kind of indicators that people look at, they literally went off the scale that things were normally bound between zero and 5% or something went up to 15%, and so when you get those kinds of things that break the scales and all the amplitude of everything is, you know, many times the size of it normally is, including fiscal policy. The fiscal policy response was much bigger this time than in previous times, even post great financial crisis, when it arguably should have been bigger. You know it wasn't and so you got. You know kind of people got used to kind of looking for that sort of thing, and so I think that things like the leading economic indicators or the yield curve have been thrown off because of the differences in policy responses and the fact that we had this reverse cycle of, you know, people bought goods early in the cycle when things were negative, and then they're buying services later, which is the reverse of everything else, and the fact that people have been overly focused on monetary policy relative to fiscal policy and other regulatory policies.

Speaker 2: 41:35

This cycle, okay, as again it's more salient Everyone likes to look at the Fed. It's easy to look at and they get a lot of attention and are given a lot of responsibility for that, even when the Fed is not in fact in control of the economy a lot, and particularly in times when there's either COVID, big shock events or big fiscal events, and I think that's completely overwhelmed the usual kind of playbook that people have been used to using, and so when the playbook doesn't work anymore but you feel like you kind of have to use it or something or you're kind of stuck on it, then you get wrong sided by things. And so I think you had the fact that the second wave of the fiscal policy and the resilience, the resumes that the supply chain's coming back online faster than people thought they would threw off people's views on where the economy was going to go after the initial COVID stimulus went away in 2021. And I think that's been the last two years really has been people trying to catch up to that. And then you've got things like lately, immigration has been higher than expected, so there's been a lot more jobs being created, without pushing the unemployment rate down than everyone thought there was going to be, and so you don't have wage pressure but you still have a lot of jobs. And they're still literally trying to figure out how many people there are in the country and how this can be. And it turns out there's more people than we thought there were, there's been more immigration and that's kind of allowed the monthly job reports to be stronger than everyone thought, without causing inflation, without causing kind of wage pressure.

Speaker 2: 43:05

So I think there's been specific things that have been unusual factors and the fact that the post-World War II cycles just don't apply when you have these shock events that are more like a war or more like one-off events like this, and that's kind of thrown people's perception of what's supposed to happen off relative to what has actually happened. So the LEIs have been off, the yield curve has been off, all these things that people have traditionally relied on that had a 100% track record before. That just hasn't worked now. And so unless you dug into it and saw what might be causing that, which of the specific drivers and why that might be, and just kind of looked at it on the surface, has it worked? Same thing with Fed policy. You look at Fed policy by itself, it doesn't tell you as much as looking at Fed policy in the context of fiscal, regulatory and underlying COVID-driven kind of other things and global growth. What's happening in China and everything else means that. And the fact that US can produce a lot more energy now the 70s, doesn't apply because we're producing more oil than Saudi Arabia does. So even though OPEC's trying to make the oil price of oil go up, they're not really being very effective at it because the US is now the big counterweight to that. That wasn't true 50 years ago or even 20 years ago. So all those things are kind of having their effect, but again with lags and with kind of noise in the data.

Speaker 2: 44:46

No-transcript. What's going on at the corporation level to tell you is this really going on? And so we saw that in the earnings for industrial companies when all the fiscal support came in in 2022, 2023. And we saw it in the pricing trends that we saw from companies slowing down. So the inflation pressure is kind of easing. Commodity prices were a tell. They peaked in mid-2022 and have basically been going down since. So all those things kind of would tell you that the inflation story was probably not going to be the big factor. Fiscal is stronger than monetary, and those are things that most people, including some of the strategists that I talked to, aren't used to looking at. Sorry to go on there. No, no, that's actually real. So let's talk about some of the strategists that I talked to aren't used to looking at. Sorry to go on there.

Speaker 1: 45:31

No, no, that's actually real. So let's talk about some of the sort of major indicators that you tend to gravitate towards from a macro perspective, things that you consider to be your favorite things to pay attention to, because I always think it's interesting, right? Everybody's got their sort of set of leading signals, so what are some of yours?

Speaker 2: 45:52

Yeah. So I think right now you kind of have to look at fiscal policy in the form of something like the deficit to GDP ratio as a very simple kind of measure, Because I think that the main reason the US economy has done better than people expected and how it would have done in the past and had done better than other countries right now, is because of that fiscal support. That's been the real differentiating swing factor, I think from a macro standpoint. That wasn't the case in past cycles. So that's one thing I've been looking at. It's been kind of running in that six-ish percent of GDP range for a little while now. As long as that's in that range, you probably got some support for the economy. If it starts to go down and get to a lower level, then you would kind of be more concerned that there would be a headwind on growth.

Speaker 2: 46:43

I think in terms of actual activity and things, certainly the employment and consumer spending are important. But I think you have to look at kind of the hard data, not the surveys. Consumer sentiment, for instance, has been a misleading indicator for quite a while. I think that you know when you look at what consumers are actually doing, the spending they're doing, and what the consumer sentiment surveys say. They've really diverged in a big way for a long time and I think there's some explanations for that. But it's been misleading to look at the consumer confidence data, which actually feeds into the leading economic indicators along with the yield curve and other things. Now that manufacturing means that a lot of the traditional indicators that are manufacturing focused are going to be less likely to be the leading drivers that they have been in the past. That you have to look at spending on things like going and hotel spending and consumer spending on things like that.

Speaker 2: 47:43

Discretionary spending and the fact that people are still going to Taylor Swift concerts and all those kind of things tell you that consumers are actually pretty positive. They've got income to spend. They're not taking on a lot of debt. So debt growth bank credit is something I've been watching. The Fed has slowed it down as they wanted to.

Speaker 2: 48:02

Bank credit is very 2% or 3% right now, so it's not contributing to inflation. It's not people running up their credit cards or mortgage debts or things that are really driving consumer spending. It's income growth primarily, and so that could change as the lagged effects of higher interest rates start to hit, maybe next year, but for now, looking at those factors tell me that income growth is still rising and that's driving consumer spending more than just taking on debt or direct stimulus from the federal government, that it's more the indirect supply-driven stimulus that's still there, plus the fact that the economy is more resilient to higher rates. Balance sheets are in better shape consumer and company balance sheets and that tells you that rates are not going to have the same effect now that they did in 2006, when everyone was much more levered and the economy was more sensitive to rates and didn't have the fiscal support behind it then.

Speaker 1: 49:04

Sam, as we wrap up, I want you to talk about some of the services that you offer. What does somebody expect to get from some of your research, and where do you point them to?

Speaker 2: 49:13

Sure.

Speaker 2: 49:13

So yeah, so most of the work tends to be for institutional investors, but that can be of any size, so a small investment advisor all the way up to big mutual fund companies and things that get the research and that would get all the kind of in-depth economic and market analysis so what we've talked about here on a regular basis, all the models and indicators that I developed.

Speaker 2: 49:39

But there is also a report that's more for individuals or smaller investment advisors called the Weekly Roundup, which you can find on the millstreetresearchcom website. It's a weekly report that will update the current market indicators that I track, give us macro commentary and we'll also give some stock selection ideas. Some of the quantitative stock ranking model output so the 20 highest ranked, 20 lowest ranked stocks based on earnings estimate, revisions, price momentum evaluation, kind of the fundamental drivers that I look at are in there every week. So if you're looking for some kind of a taste of what Mill Street Research looks like it's $50 a month, so it's much less expensive than the standard research. You can try that out or follow me on Mill Street Research here on Twitter or on LinkedIn where I'll post commentary and interviews and things and get a feel for things, but otherwise reach out via the website or here on Twitter Always a good way to reach out.

Speaker 1: 50:31

Everybody. Make sure you check out that and make sure you follow Sam here. Great conversation. I'm hoping to do these two or three times a week, so stay tuned. Make sure you like, comment, subscribe all that good stuff, sam, I appreciate your knowledge here.

Speaker 2: 50:43

My pleasure. Thanks for having me on, michael Cheers everybody.