One of the inherent frustrations of navigating business and market cycles is the disparity in frequency between the two. Business cycles are like sloths on Quaaludes, while markets can be like squirrels on methamphetamine. This week’s consumer price index (CPI) report offered a decent example of the disparity between the two.
ECRI’s leading inflation indicator rolled over earlier in the year and they went public over the summer with a forecast that a cyclical peak in CPI inflation was at hand. The fact that Thursday’s report came in cooler than expected was not surprising within that context. Of course, it appears and it has been my experience, that not that many influential people use leading indicators all that much, so the market response was an explosive one - SURPRISE!
As I return to the analytical process used for The Worked Shoot, leading indicators are now forecasting the first synchronized global recession in over 40 years, with a cyclical peak in inflation. The downturn in ECRI’s future inflation gauge has been more of a glide path so far, so it is unlikely that CPI will drop precipitously at least for the next quarter and possibly longer. This suggests that the trend in reported CPI is likely to be lower, but not at a rapid pace. Given what the Fed has been declaring publicly, that scenario seems aligned with continued rate hikes, even if at a slower rate (50 or 25 bps), until/unless there are acute problems in credit markets and/or the banking system.
That graphic shows business cycles from 1929 through the GFC. In the cycles over the past fifty years times, here were the cyclical peaks in employment growth relative to the start of recessions:
November 1973 Recession vs July 1974 Employment
January 1980 Recession vs March 1980 Employment
July 1981 Recession vs July 1981 Employment
July 1990 Recession vs June 1990 Employment
March 2001 Recession vs February 2001 Employment
December 2007 Recession vs December 2007 Employment
I have excluded the 2020 recession due to the very specific circumstances surrounding it - i.e. pandemic-fueled lockdowns were not a ‘normal’ business cycle progression.
Of course, all of this data was post-revisions - contemporaneous government employment reports at business cycle turning points are often very inaccurate. In addition, this cycle has included massive shifts in consumer patterns and supply chain issues, which have introduced all sorts of labor market issues relative to shifts in aggregate supply and demand curves - i.e. labor is relatively slow to respond in a lagged way and not very efficient.
What will central banks’ reaction function be to inflation data on a glide path lower while contemporaneous employment data may not suggest recessionary conditions until well into the recession? My analysis suggests that this mix, along with the global nature of the recession, is opening up the left tail and skewing the cycle distribution- something like this:
Of course, that is the sloth on Quaaludes backdrop. The methamphetamine perspective is far more volatile and adventurous!
Investors and traders have become addicted to easy monetary conditions and moral hazard bailouts amidst prolonged lower volatility business cycles. The ‘Great Moderation’ appears to have created significant muscle memory. With an explosion in options trading, market liquidity falling, and the top half of consumers still flush from the pandemic-era stimulus and asset inflation, the process of the DT’s setting in has been an extended one.
The casino-fication of the stock market during the pandemic era has metastasized into pretty incredible degrees of gambling in short-dated stock options. This has become known as 0 and 1 day to expiration, or 0DTE/1DTE, trading, with S&P 500 instruments now listed to expire every week on Monday, Wednesday, and Friday.
The 0DTE and 1DTE options are now routinely 40%-50% of all options volume and overall options volume has increased dramatically over the past two years! As just one example, on October 27th, 49% of SPX Index options volume was on contracts that expired that day. At the start of that day, total contract open interest was about 181,000, while total volume for the day was 1.2 million contracts traded!!!
With nominal economic growth having remained high this year, the Fog of Cycles has offered plenty of ammo for people to continue to buy each dip and gamble. The real bite of recession likely remains to come, with things like a dramatic decline in corporate earnings, and eventually job losses, still in the pipeline.
For example, corporate earnings are just starting to roll over with 2023 consensus estimates now trending down. As covered in An Optimistic Catastrophe back in May, even an 8% operating margin (recessionary levels have been typically been 5%-6%) on $1,900 ‘per share’ of 2023 S&P 500 sales would result in $152 in EPS. Wall Street sell-side analysts still have 2023 earnings estimates well over $200 per share!
From purely a price perspective, here is an updated daily chart for the German DAX over the last year:
Even more so than the US stock market, it has rampaged higher over the past six weeks. The cycle timeframe outlook remains bleak, in my opinion, but bear markets have a way of chopping up traders and investors with heightened volatility in both directions. Here was the initial price iteration I shared on the DAX using an hourly chart from December 22nd last year:
Look pretty ‘self-similar’? The waves in the ‘earthquake’ continue to act like a quake is indeed still unfolding, but when will the current wave higher exhaust? Great question! For the vast majority of investors, I think the timing is not all that relevant.
Despite the huge temptation to join the gamblers, using bear market rallies to right-size cycle timeframe risk exposure, whatever that looks like for each individual, remains a good idea, in my opinion. And if you insist on gambling, just do not do it with the rent money.
Are You a Meth Head?
Love the probabilistic analysis when so many are saying this it it, period.