Random Ruminations

Tech & Smalls, Commodity Prices, Inflation Stocks, Animal Spirit Stocks, S&P vs. Capital per job ratio, and Energy Stocks vs. the Dollar

Analyst hacks like me look at a lot of charts. It’s a good habit because it keeps one engaged with the many layers of the financial markets and the economy on a real time basis. What follows are a few relationships illustrated with color pictures – a few economic thoughts and a few investment themes – which I hope you will find interesting. Please enjoy the latest Random Ruminations Pictorial.

1. Are Small Cap Stocks Tethered to Technology?

Small cap stocks have been persistently frustrating during the last 15 years. Yes, they have had a few good periods of outperformance here and there, but mostly it proved best to just ride along in the large cap S&P 500 stocks. During these years of chronic underperformance, there were often “good reasons” to buy smalls including economic growth was set to improve, optimism should rise, liquidity was expanding, and their relative valuations were become compelling. But alas, none of these ever really awakened small cap stocks.

Chart 1 shows the fate of small cap stocks may simply be tethered to large cap technology stocks. This chart overlays the S&P 500 Technology sector relative total return index (blue line, left scale) with the relative total return of the Russell 2000 small cap index (red line, INVERTED right side scale). The correlation of their respective total returns since 1990 suggest a strong inverse relationship at -0.71. The popularity of large cap tech stocks has seemingly ensured underperformance by small caps. When will smalls outperform again? Perhaps, it isn’t so much about when small cap fundamentals finally improve but rather about when the tech darlings finally fall from favor? If the mighty technology stock market run still has legs, it’s probably too early for a big commitment to smalls. But, if tech stocks ever fall from grace, small caps may prove the best antidote.

2. Commodity Prices PRESSURED by a Strong Dollar!

Both the Federal Reserve and the bond market seem worried lately about overheated economic growth and inflation pressures, but since the U.S. dollar has been so strong, it seems more likely commodity prices will decline rather than rise.

Chart 2 overlays the S&P GSCI U.S. Commodity Price Index (blue line) with the real value of the U.S. Dollar Index (red line, INVERTED right side scale). The real U.S. Dollar Index was allowed to freely float in the early-1970s and reached a monthly record high in February 1985 at 126.4 when annual nominal GDP growth was a scorching hot 12%. Currently, with nominal GDP growth of only 5%, the real value of the dollar has nonetheless risen to about 124, nearly reaching its record in 1985. One could argue that contemporary U.S. dollar policy is the most contractionary it has ever been relative to economic growth than at any time since it was allowed to float.

As shown in chart 2, dollar strength tends to price domestic producers out of the world marketplace causing commodity prices to decline in order for domestic manufacturers to remain competitive. The recent spike in the U.S. dollar since mid-September has not yet led to any significant drop in commodity prices, but it probably will. If commodity prices do finally succumb to the most recent surge in the U.S. Dollar, economic growth would likely slow and probably force both bond yields and the Fed funds rate lower.

3. Inflation Stocks Show No Sign of Inflation Pressure?

Although bond investors and the Federal Reserve both seem concerned by the recent uptick in some inflation reports, as demonstrated in chart 3, stocks which are the most sensitive to inflation show no signs of inflationary strength.

This chart overlays the relative total return of Bloomberg’s Inflation Sensitive Stock Price Index (red line) with the annual consumer price inflation rate (blue line). Bloomberg’s inflation sensitive stock price index includes the performance of stocks with a sector classification of energy, industrials, materials, or real estate that demonstrate a strong positive correlation with inflation. The index tracks a subset of stocks in the Bloomberg US 3000 Index. At least since 2007, the relative total return performance of this index has closely tracked the directional thrust of the annual consumer price inflation rate. Currently, inflation stocks have been dramatically underperforming suggesting that inflationary pressures within the economy are poised to show considerable weakness perhaps dropping the inflation rate towards or below the Fed’s 2% target.

4. Animal Spirit Stocks Remain Wimpy!

Typically, before any meaningful drop in the overall S&P 500 index, animal spirits make themselves known within the stock market. Currently, though, animal spirit stocks remain wimpy!

Chart 4 illustrates a proxy index for “animal spirit” stocks. These are the stocks that perform best when private sectors players on Main Street and investors on Wall Street get enthusiastic and excited about future prospects for both the economy and the stock market. The proxy utilized combines the relative performance of the lowest quality stocks within the overall S&P 500 Index, the S&P 500 High Beta Index, and the Russell 2000 Small Cap Index. When investors get optimistic about the future, they tend to go with the most aggressive stocks – low quality, high beta, and small caps.

As shown in the chart, at least since the late-1990s, every major decline in the S&P 500 Index was preceded by a noticeable outperformance of animal spirit stocks. The “animals” outpaced before the dotcom bust in the early-2000s, before the Great Financial Crisis of 2008-09, before the almost 20% correction in the S&P 500 during 2011, before the 20% 2018 correction, and before the 2022 bear market. They didn’t significantly lead the stock market before the 2020 pandemic bear market, but this was caused by an abnormal health crisis rather than by a traditional economic or market catalyst.

I suspect a stock market correction lies ahead yet this year. But the fact that within the stock market animal spirits still remain AWOL suggest perhaps the S&P 500 may avoid a correction, or maybe it will only prove to be a mild selloff. Part of the reason stock market selloffs occur is because investors get too aggressive and become vulnerable. Maybe in the contemporary period, exuberant excess is not showing up in the traditional “animal stocks” but rather among the Mag Tech darlings?

5. S&P 500 Index has not yet responded to a drop in the capital/employment ratio?

Since at least the 1990s, there has been a fairly close relationship between the capital goods per job ratio and the S&P 500 stock price index. Chart 5 compares the S&P 500 Index (blue line, left natural log scale) with the ratio of nondefense capital goods orders excluding aircraft to the total level of U.S. employment (red line, right scale). Major movements in the stock market since 1992 have closely mirrored movements in the capital/employment ratio. When the capital/employment ratio rises, it suggests companies are confident enough in profitability to raise investments in their staffs leading to stronger worker productivities. Naturally, the stock market would respond favorably to this trend. However, once companies begin slowing capital investments, the stock market has typically struggled. This happened before and during the dotcom bust, the 2008-09 financial crises, and leading up to the 2018 correction and pandemic stock market collapses.

Most recently, the capital/employment ratio peaked in the Spring of 2023 and has been primarily declining ever since. So far, the stock market has not shown any reaction to a declining capital/employment ratio. At a minimum, this is a warning sign for investors. Will the S&P 500 soon suffer a correction -- reflecting the recent reduction in investment spending per job -- or will this time prove to be different?

6. Drill Baby Drill meets a Strong US Dollar?

Many investors have become interested in the energy sector since President Trump was elected with his “Drill Baby Drill” mantra. I think commodity prices overall and energy stocks in particular are likely to stay under pressure in the months ahead because of a brutally strong U.S. dollar and because of a rising factory unemployment rate.

Chart 6 overlays the S&P 500 energy sector relative total return index (blue line) with the capacity utilization rate/U.S. Dollar Index ratio. A decline in the capacity utilization rate – essentially a rise in the U.S. factory unemployment rate -- connotes excess supply and tends to put downward pressure on all commodity prices including energy prices. Likewise, a strong U.S. dollar makes U.S. energy production increasingly unaffordable to foreign buyers shrinking domestic energy company markets. The simultaneous combination of a falling capacity utilization rate and a rising U.S. dollar is particularly challenging for both energy and materials companies.

Since early-2023, the capacity utilization/dollar ratio has been declining and so has the relative performance of the S&P 500 energy sector. As shown in chart 6, there has been a very close directional relationship between energy stock performance and this economic ratio since at least 2000. While a U.S. policy promised by President Trump of Drill baby Drill may help, until the utilization/dollar ratio starts rising again, it may remain challenging for energy stocks. An interesting year for energy stocks as “Drill Baby Drill” meets a “Strong U.S. Dollar”.

Thanks for Taking a Peek! Jimp

Disclosures________________________________________________________________

Please note that stocks are inherently risky. Any stock can lose most of its value at any moment, including any stock I mention here. You should never rely on a single source for investment decisions, including me. I am a retired investment strategist offering opinions and observations on the markets, the economy and companies. You should do your own research and also consult a qualified financial planner and investment advisor before making investment decisions.

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