"Unprecedented, Unusual, Challenging" Economy More Bifurcated Than Ever | Michael Kantrowitz

The broader picture though is that yeah, I still think we're in an economic backdrop that is unprecedented, unusual from so many different circumstances beginning in COVID, and that things remain bifurcated under the surface and challenging, but in the aggregate from the high level, they remain okay.

Yeah, my pleasure, Adam. Always good to talk with you.

More of the same in a way. You know, there's been some now bifurcations within the bifurcations. So what I mean by like, you know, if you think about the economy, housing is very weak and the AI story is still very strong. So that's at the macro level. Underneath that, if we just look at housing, you can say we now have a lot of bifurcation within housing. And you've seen, for example, some states are now seeing sharply rising inventory, sharply falling home prices, yet in some states you're not seeing that. You're still seeing very low inventory and very sticky home prices. So housing is getting more regional or even more bifurcated within itself. And the broader picture though is that yeah, I still think we're in an economic backdrop that is unprecedented, unusual from so many different circumstances beginning in COVID, and that things remain bifurcated under the surface and challenging, but in the aggregate from the high level, they remain okay.

Sure. And I will, as I like to do, I like to show more than just, I don't want to be just a talking head. I want to be a talking head with images. So, you could see my screen, right, Adam?

So, I'll just zoom in. This is kind of the HOPE framework. It's a heat map. It's an illustration of how the economy and different indicators within the economy flow through in terms of a typical economic sequence. So you start off with housing, which tends to be thought of as an early cyclical indicator because it's very sensitive to changes in rates, which typically is followed by changes in orders or soft data like PMIs, which is followed by profits, and then lastly, all of that eventually flows downriver to companies' employment plans and whether they hire or are firing. So HOPE obviously stands for, well, that's what HOPE stands for. And yeah, we've been in a very unique environment here. In terms of the debate around the economy landing, hard landing and soft landing, which that debate I would imagine still continues because there's been these ongoing recession fears, we always look for housing to firmly rebound because historically that's what ends an economic slowdown and gives you a broad-based recovery, and we've yet to see that. So we haven't landed yet and we're still in this circling the runway perhaps, and it could go on for a while longer.

Yeah. Well, every cycle is of course a little bit different and you know, I think unfortunately '07 is the last recession that we've really gone through and it was a very bad one. And I think this backdrop has some similarities but more differences. And so when I talk about the HOPE framework, it's not, you know, each one of those segments can directly impact the other but is not necessarily always certainly entirely the cause. So, it's not that a weakness in housing makes manufacturing and services activity in and of itself weak. It's really that the conditions that have made for a weaker housing backdrop eventually flow and hit those other segments of the economy. So, it's kind of the transmission mechanism. Beyond that, of course, there is a direct impact from housing to manufacturing. You know, think about cars, for example. When people buy homes, they usually buy cars. But there's also many indirect ones. So, it's not that necessarily the housing backdrop getting worse means that the rest of the economy will get worse. You could argue that this cycle's been so unique and that some, you know, housing was really strong for a long period of time and not that all that strength has spilled over to other parts of the economy necessarily, and now it's been weak for a while. So I think we have to kind of be careful about some of the linear conclusions we draw because macro is never linear for sure and this cycle's got so many idiosyncrasies that we can kind of continue to discover. So yeah, you're right in housing's has aged, I guess, as have we. Housing has more gray hairs perhaps than it did two years ago. It's become more rate sensitive. You remember in '23 we were talking and who would have thought that higher interest rates would have made home prices go up, which is ultimately what happened because of the unique backdrop with inventory or lack of. And now that's, you know, it's aged, but it's slow. The question is, you know, whether what we're seeing in housing today, rising inventory, falling home prices, will that accelerate a downturn in the economy, will it propagate through the economy faster perhaps? I'm not sure that it's a simple yes answer. You know, I know you speak to many people who are very focused on housing that are fantastic, but I think, you know, in a sense, housing could be somewhat compartmentalized. And I think we just have to be careful of not drawing too many conclusions from certainly '07 and '08 in terms of how quickly housing blanketed the entire global economy essentially. So, I think the answer is somewhere in between.

I can show you four charts that do a nice little summary of showing you where things are. And we look at a lot of different data sets for each segment of this framework. But if you look at like home sales right there, and you know, just to start there, it's been sideways. You know, we had this nosedive in 2022 and it seems we've hit this minimum level of activity because there's always going to be housing activity. There's always household formation and then there's of course these, you know, death, divorce, default, you know, reasons, graduation that people move. And so there's still some level of activity and obviously there's a big difference between existing which has been a lot weaker than new home sales. But so far we've seen kind of this plateau and I think you need, I'm not so sure that necessarily housing on its own can make the rest of the economy really fall out of bed or at least I think we still got more cushion perhaps for that transmission to take place before we see it. Manufacturing, you'll notice all four of these charts look the same. They all took a nosedive in '22 and they're all going sideways. So you see the title there, from macro cycles to many cycles, because usually these go on these two to three-year cycles and that's not what's happening. Everything's kind of stuck and the PMI data, manufacturing has been really weak as most know, but if you take an average of manufacturing and services to capture the whole economy, we have this unprecedented backdrop where you've been kind of hugging the 50 line for now two and a half years. We've never seen that.

Yes. Yeah. Above 50 things are improving. Below 50 things are deteriorating. And the more you're above or below 50, the faster that's happening.

So, what it kind of shows you is that nothing's really changed. And again, I mean that with a little bit of tongue and cheek, but nothing's really changed in the last couple years. Again, I think things have aged. They've continued to evolve, but broadly speaking, you know, of course, we have a new administration and that's brought a bunch of new things about, but there hasn't been these radical shifts in the economy besides AI to the positive side. And then what you're seeing in earnings revisions on the bottom left is again this backdrop where you've been largely stuck just below 50, about 45% of companies in a given month have seen a positive revision to their earnings. So if I showed you a longer-term chart and I can show you that later, you'll see that that's rare to stay there for this long. And right now we're at the high tide of the last couple of years. I think that's largely just normalizing the tariff collapse we saw in revisions in the month of April. So remember they're revisions. So if things overly revised to the downside and tariff levels then came down, then analysts have to raise their numbers a little bit. And then unemployment, and I remember talking to you last time and I was more constructive or not as negative on unemployment. I still kind of feel the same that again it's just this glacial softening of employment. I think the real risk here for markets is if we're going to have, are we going to get a shock where these things really accelerate, and right now I don't really see that. Something of course could happen to change that.

Yeah, and I think it's absolutely another negative that's, you know, stacking on top of already existing negatives. You know, for housing, it's like home prices falling, which is a new part of the story that wasn't necessarily there a couple years ago. The question that I think people have to think of is whether or not this issue or any issue, I mean there's so many issues we could talk about or risks, whether they're going to be a contained, industry-specific, or stock-specific story, which I think these all are at a minimum, or they're going to become systemic and lead to some kind of shock, and how quickly will that happen? Because again, I think literally any risk we can talk about today has to be idiosyncratic before it becomes systemic.

So you can talk about interest rates right now. You know, the 10-year's at 4.40 or so. You know, is that a systemic risk? Obviously, it's not because the market's near all-time highs. Is it an idiosyncratic risk? Of course. You know, there's plenty of stocks that have underperformed or gone down because rates are where they are. So, I'm generally leaning still more that these risks are idiosyncratic. For it to become an issue for the market and the economy, I think first it has to come in the form of somewhat of a shock, and if it doesn't, it by definition would kind of play out over a longer period of time, and that's where there's more room for adjustment or, you know, more room for just that to lead to more bifurcation rather than an entire broad-based economic collapse.

Well, it's hard to tell how much of that was just kind of precautionary savings due to tariff uncertainty or other factors. To me, where the buck stops is in earnings more so than it is in the macro data. I mean, I use macro data to try to infer where earnings are headed. And so, we're still definitely seeing, you know, to speak stock market, we're still seeing the mega-cap earnings estimates and earnings continue to rise. You know, it's been the same story. It's the Mag 7, it's mega-cap tech, it's communication services, some discretionary names. So I don't see, you know, we haven't seen that really change meaningfully. And I guess my basic view on the consumer is that yeah, it's not hard to find really bearish consumer data right now, but again the question is, is that representative of the aggregate? And the simple answer, you know, people always talking about, you are surprised, the consumer's been resilient, it's been resilient, well as long as unemployment's not rising sharply, the consumer will be resilient, period.

And so unemployment right now, if you look at the unemployment rate in the last year, it's gone sideways. It kind of looks like, you know, the bottom chart there is claims, but we're at 4.1 now and we were as high as 4.3 and change, you know, and there's of course all these nuances of what's been driving the numerator and denominator, but it really again hasn't changed meaningfully. Yeah, you know, continuing claims have gone up, initial claims have been up a little bit recently, but again, if the unemployment rate went up between now and year-end, you know, 0.2 or 0.1, I don't really know, that's not that big of a deal. I think, you know, it's just more softness perhaps, but it also then opens the door for the Fed to cut rates, which gets investors excited. So I just keep coming back to this backdrop that everything is moving at such a glacial pace and part of it's because we have big deficits. Part of it's because 20% of personal income is derived from social security. Thus 20% of the consumer spending is just basically people that are getting paid from the government to then therefore spend. So that's not going to go away. They're not going to lose that job. Let's hope so. So, there's not a lot of negative macro impulses right now. And I hear you on the student loan repayments, and I think again that's an incremental negative, but I'm not so sure that that's going to by itself lead to a quick and broad-based deterioration with all of the other potential offsets we have going on in the economy right now. You know, oil prices are absurdly low right now on a real basis. Oil prices have to be at like multi-decade lows. And everyone's watching gas prices go up 50, 40 cents here and there, but again, gas has been the same for the last 15, 20 years. So interest rates, yeah, they're elevated, but they've been at the same level for two and a half years. And it's really rates of change that create these big cycles. And it's when rates go from really low to really much higher like we saw in '22 where you really get an economic hit, which we did see, but it wasn't big enough to cause a recession because obviously it happened during a time of great stimulus as well from the fiscal side of things. So, sorry, long-winded answer, but I think there's a lot of things to worry about, but I think they're largely stock-specific and maybe industry-specific.

Yeah. Well, it's not a sideways market, that's for sure. You know, we can go, so housing is, you know, I agree it's deteriorating in terms of lagging data, but the question is, you know, will that lead to a deterioration in leading data. So, you know, we look at builder sentiment that's fallen to 32 as the most recent reading. So that's on the weaker end of the range. You even look at total home sales that's at the lower end of the range. So my view is that housing is going to keep getting worse. The question is whether it becomes kind of a negative shock and how quickly it gets worse. So, on the profits and employment side, same thing. I would say it's going to continue softening. I certainly would not characterize this as any kind of a broad improvement or a positive tilt. If there is one, maybe it's the manufacturing parts of the tax package are going to allow for, you know, full expensing of investment.

Yeah. So that could help. So again, it's mixed but, you know, there's certain, I'd say housing and employment will continue to soften, but that doesn't get me quite bearish quite yet.

Um, I don't know, but if you have the opportunity to receive income and there's jobs that allow for that, then why would that be a negative? I guess I would see that as more of a positive, maybe not fully employed. You know, there's underemployment data. There's people that are falling out of the labor force potentially. I mean, there's been problems with the employment data at large for a long time. But again, that's why I go back to earnings data and revenue data which is kind of really where the buck stops.

Well, it's a sign of, I mean, it's a sign of bifurcation. I totally get, I mean, it's a bifurcated, I mean, it's just a reality of the conditions. That's a discussion on values and morals and political views which, you know, we're not here to discuss that. We're here to discuss what those policies are creating and, you know, again, how to make money from that. So is it a healthy economy in the context of broadness and breadth? No. But again, that's exactly what we've been talking about for three years now that there's strong winners and unfortunately losers. And one of the charts I can show you here. Okay. So this chart here is a chart on the top of what percentage of income comes from government transfer payments. So social security is the biggest part of that. So when you think about income of consumers, compensation is the biggest, transfer payments probably the second largest, and then you have interest income and dividend income. Basically that's all the money that consumers are getting from the government, I'm sorry, for income available to spend. So let's just assume for simplicity that there's zero savings rate. So if 19% of personal income or in this case now personal spending is coming from the government, that all else equal, and again not to debate if is it good or bad, just is a very stable source of spending. This has gone up over the years largely due to demographics. You know, the baby boomer population is quite large and we're seeing social security.

Another way to think about it is looking at the bottom part of that panel which is how much of income or spending is derived from people working, employed compensation. So again in '07 that was about 66, 67%. So two-thirds of consumer spending was business cycle dependent, unemployment. Today that's down to 60%. That's a 6% decrease. That is huge.

So that's another, again, just a source of moderating, that's arguably making things more moderate from an income and spending perspective. Maybe a little less cyclical than what certain conditions today would have created in the past. So that's another form of stabilization and, you know, there's many others obviously we can talk about, but I think that's an important one. But yeah, there's a big gap between the winners and losers. A lot of that gap is explained by expense, you know, margins for companies and disposable income for consumers. And a big part of what's keeping disposable income or margins weak is interest and high prices and high costs. And the irony here, unfortunate irony at least in the near term is, well, we already have low oil prices. So I'm not sure how much lower those are going to go until people start thinking of the lack of investment and we kind of put a floor in. You can get interest rates down but it's going to be hard to get rates down meaningfully without higher unemployment. Well, as long as Powell's chair, chairman of the Fed. So we'll see. You know, that story could evolve.

Yeah. Yeah. So yeah, we're plenty, again, a lot of headlines. But we'll see. I think he's going to serve out his term. And the market will adapt.

Yeah. But you see the same thing in earnings, you know, in terms of bifurcation idea. You know, here's again a chart of ISM manufacturing and the percentage of positive earnings. And so we've been in this yellow band really since 2022. So we've, you know, how you get better market breadth and people have continued to say when is the market going to broaden out? Well, it's done so at times not sustainably due to macro events where, you know, you get some relief from some macro issue, the, you know, people think the Fed's going to cut, we get a good CPI report, but it doesn't sustain itself because there's not broad earnings to sustain that. You need to get earnings revisions up to 60, 70% which you typically see in, you know, when the economy lands and recovers. So we're not there and that's the reality of that there's just not enough firms with positive earnings momentum to get that number up. But at the flip side, there's also not enough firms with negative earnings momentum to cause a big decline in the market from earnings or a big decline in the economy from employment.

Well, yeah. To kind of what you're speaking to, usually what you'll see like in a recovery, the PE will go up a lot because the market moves ahead of the earnings being realized and then the market will go up at a slower pace as the earnings grow.

Yeah. Well, basically the market goes up less than earnings. So, your PEs come down.

And I think that's kind of where, well, we're not in that kind of recovery, but certainly the market has recovered, not because the economy has recovered broadly coming out of a big slowdown, but more because, you know, the tariff levels have come down from April 2nd or from April 9th. So this is a chart of valuation, the PE of the S&P 500 with credit spreads on the other axis inverted just to highlight the point that PEs move with credit spreads as kind of a mirror image. They're both measures of risk premia and we've pretty much priced out most macro risk in the last three months, meaning the market's not very worried about much. People are worried about plenty of stuff and again that's where my point about that's more idiosyncratic, like you're still seeing the effect of, you know, certain names are underperforming or outperforming because they have more or less exposure to tariffs, let's say, same thing you could say about interest rates. But is the market, both the credit markets and the stock markets, small caps included, worried about much right now? No. Is that a bearish thing? Not necessarily. But does it portend lower returns going forward? I think so.

Not negative necessarily. That'll be a question of something, you know, whether risk pops up that the market reacts to.

Well, you can't really create those bands across long periods of time because, yeah, there are, I guess there's two things that determine the level of the PE. One is, you know, generally the fundamentals of the index. So, we happen to have a S&P 500 today that has got much better fundamentals than any time in the past. That's a fact. And index concentration that's less cyclical in terms of a sector representation. So, it does warrant a higher PE. Short-term, think of 2025. The PE is higher today because, well, we just had the big tariff scare and Trump backed off and we're maybe closer to rate cuts. Maybe inflation's not going to be as horrible as people thought three months ago. Maybe the economy is not going to go into recession immediately like people thought three months ago. So, all that macro risk has been priced out. So, we're kind of

of back to where we were. And yeah, there's certainly today a lot more optimism than where things were 3 months ago. And I would even say 3 months ago things were at an extreme even though they weren't at doom and gloom. So again those are kind of I guess a little bit subjective bands but you could say I mean we were there in 2020. You could see that there but I think it's an important point I want to make about valuations is valuations go down because a macro risk pops up.

So in 2021, people, you know, could say, well, the stock market fell, you know, 30% because, you know, the PE was high. Maybe I, you know, you can't disprove that necessarily, but the stock market fell because inflation, you know, had the first inflation shock in 40 years. It wasn't because the market was high. And in fact, actually, a lot of the cheaper stocks went down more than the more expensive stocks. Not totally the case, but I'm just saying like small caps went down a heck of a lot more in parts of that like the Russell. A lot of growth stocks got hit that were trading at ridiculous valuations during COVID. So that took the NASDAQ down a lot but point is is that valuation is not always a great determinant of future returns even in a down market and where we are today is a reflection of again the fundamentals of the index and the current perception of macro risk which is very low right now and the question again is well why do PEs go down? It's really three different buckets: interest rates and inflation spike, that's bucket number one, that was 2022. Unemployment spikes, that's a recession typically.

And the third one is kind of a kitchen sink of anything from tariffs to long-term capital management to, you know, whatever else is not one of those.

Exogenous shock. Exogenous shocks.

I don't think the first I don't think we're going to see a spike in interest rates or inflation that's going to take down the market in a meaningful way. I don't think in the near term I don't think this year we're going to see a spike in unemployment. And not to say that it may not go up or could go up, but I just don't think it's going to go up fast enough, sharp enough to cause a big downturn in markets.

The third bucket, you know, geez, who knows? We got a lot of tariff headlines these days. So, but no, I don't think we're going back to April 2nd levels or, so my base case here is that multiples more or less stay at these levels.

Until one of those three things happens.

But to my point is to fight the market because multiples are high. Again, markets don't go down because in my opinion, and everyone can have their own views, they don't go down because they're expensive. They go down because something bad happens. And you can go back and throw out every major peak downturn in the market, which is all the corrections and bear markets, something bad happens. In the absence of those one of those three things happening, the markets will grind higher because earnings will continue to grind higher. And that's the other component of the story. So, I'm not delusional. I'm not saying the market's going to go up another 20% from here. And I do believe there's not a lot of risk priced in. And if something pops up, the market, you know, maybe goes nowhere, pulls back a little bit. But in the absence of a rate shock, employment shock, and some kind of exogenous shock, what you're going to see in markets going forward is they're going to trend with earnings, which move a lot slower. And so if we look at just ignore the title there for a second, this is just the S&P 100, 500, 400, and 600. So mega caps down to small caps.

And that's what we're looking at. So this is the poster child of bifurcation. So if you think of small caps, well, they've gone up a lot in the last 3 months. Why did they go up? It wasn't because of earnings. It was because the same reason large caps went up. It was because we have less risk around tariffs, inflation, and recession. Now from here for that to continue unless you're going to get mass exuberance, more risk appetite in investors and the PE is going to go up even more then it becomes a function of earnings kind of which is what you were talking about earlier and small cap earnings as an index are not going up. So that's definitely an area you want to be a stock picker not owning the aggregate.

The 100's the largest 100 stocks. The 500 is inclusive or the 100's in the 500. The 400's the next 400 midcap stocks.

Okay, that's kind of what I was asking, which is that the 500 is the 100 plus the 400, right? The S&P 500 includes the those 400 plus the 100.