August 7-11, 2023

Tactical Signal 9

Sowell’s technical strength weathered last week’s market pause, supported by the relative strength in fundamentals as positive results from labor and productivity. Improved results from productivity also point to easing inflation, with unit labor costs rising at a modest rate helping affirm Sowell’s technical signals to remain in full position (100%).

Following an impressive surge where the S&P 500 Index recorded robust gains of 3.21% in June, culminating in year-to-date growth of +20.65%, the benchmark index faced a setback during the initial week of August. This decline of -2.40% was prompted by an unexpected Fitch ratings downgrade of the U.S. to a negative watch, compounded by the bolstered job and productivity reports that will ignite inflation concerns within the Federal Reserve. 

With fading fears of a recession affirmed by the Feds narrative last week, bond yields have been gaining strength and normalizing away from the so-called yield curve inversion. Given the inverse relationship between bond yields and price, the Bloomberg US Aggregate gave back 59 bps as Long-Treasuries returned -2.87% MTD. Equity markets negative momentum was weighed down by big techs like Apple declining -7.07% on waning sales and weaker demand. For now, Amazon's better-than-expected sales results and upbeat forecast were not enough to lift the broader market.

As the second quarter earnings reports unfold, investor attention is shifting decisively toward pivotal economic indicators encompassing Consumer Credit, Trade Balance figures, and the eagerly awaited CPI and PPI reports. While the economic landscape remains paramount, the prominence of headline economic news is poised to be momentarily eclipsed by amplified political coverage from the media. This surge in political scrutiny begins with the third indictment of Donald Trump, coinciding with the forthcoming Republican presidential debate scheduled for September. The subsequent election cycle, culminating in the January 2024 primaries, will further shape the backdrop against which these economic dynamics unfold.

"You can't argue people out of that psychological and moral state with statistics and fact sheets. Biden is going to have to serve as a national guide, not just an administrator. He has to get outside the protective walls that have been built around him and make himself the center of the nation's attention, not Trump. He'll have to come up with a 21st-century national story that gives people a sense of coherence and belonging — that we are marching in a clear direction toward some concrete set of goals. Good jobs numbers alone don't heal a brutalized national psyche, and that's our main problem right now."— David Brooks, The New York Times "Why Biden Isn't Getting the Credit He Deserves," July 5, 2023.

Housing Inflation Misunderstood

Housing Inflation

A key category in the measure of inflation is housing inflation. In fact, housing is the largest expense for the average U.S. household and is more than a third of the CPI calculation by weight. Housing costs tended to be typically stable, but Covid-19 changed all that as housing costs skyrocketed. During the Covid years, rent grew as much as 15% annually. The above chart represents the result of the massive Fiscal Policy followed by the Monetary policy of raising rates.

But in recent years, measuring housing costs to predict inflation has come under scrutiny. As recently as October of 2022, the U.S. Bureau of Labor Statistics has studied and written about the important differences in measuring rent inflation, particularly when measuring new tenant rent versus all renters. Interestingly a report that got little fanfare.

Their report "Disentangling Rent Index Differences" found that accurate inflation measurement would critically depend on rent inflation measurement. To their dismay, they found that rent indices differed quite a bit. They found that in 2022 the inflation rates using the Zillow Observed Rent Index and the Marginal Rent Index were as high as 15% and 12%, while the BLS CPI calculation for rent inflation was a mere 5%.

The study goes on to disentangle the BLS data into new tenants versus all tenants and tries to confirm that the difference in rent inflation is indeed due to this distinction rather than other factors, including structure and quality. The BLS data defined a "new tenant" as only leasees that recently moved in. Different than all tenants, whether they had moved in recently or not. It would be safe to say that many factors affect rental levels and the change or lack thereof in rent. Or will higher mortgage rates and payments reinflate rental costs? What rent index or calculation should be used in the CPI calculation, given such a large difference in the result? Hard to say, but it was found that new tenant rent inflation led to the BLS rent inflation by four quarters. This finding isn't too far-fetched when one understands that leases are not re-signed for at least a year and the BLS only surveys units twice a year. The impact of Covid surely affected the rental rates of those "moving-in" during that time. Though that does beg the question of what would be the "rent" of those that "moved-out" or home lease ended or not. That said, understanding what normalized inflation would be and then fashioning a FED response is difficult. Should we now have more acceptance of Janet Yellen's response that "inflation was transitory," maybe she was right.

Additionally, we need to look at the Owners' Equivalent Rent which highlights what someone might pay in substitute rent for their currently owned house. This is even more interesting considering the duration of low mortgage rates leading to low and fixed-rate mortgages for many owners. This OER will not rise as people stay in their homes and demand a "lower" rent to become a "new tenant." It's hard to argue that high housing inflation wasn't "temporary," and going forward, housing inflation won't continue to come down.

Revisiting our first chart shows that housing is currently the largest component of inflation while everything else is stabilizing or in disinflation (energy). We could even defend that there is more decline to come as FED policy has fully yet to take effect. Despite the FED stating that Recession is now unlikely, we should still expect a continued reduction in economic growth and, thus, lower inflation. Our takeaway, which is still disconcerting, is the policy moves taken by the powers that be. And then, we find that the data could be more definitive for such critical inflation data, policy, and action.

Economic & Earnings Report Chart

Advisory services offered through Sowell Management, a Registered Investment Advisor. The views expressed represent the opinion of Sowell Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and non-proprietary sources that have not been independently verified for accuracy or completeness. While Sowell Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sowell Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.


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