The first of the three bodies - Fundamentals

 FUNDAMENTALS

The first component of the three body problem is the Fundamentals. Rarely will an investment work for anything measured more than in days if there are not good fundamentals. Yes, there are some that have persisted (I am looking at you GameStop), but the first metric that an investor and not just a trader must concern themselves with is the fundamentals.

In macro investing, the fundamentals are not just for a single investment but for the market overall, for the risky market overall. I have found that the major drivers of the market can be categorized into four areas: relative valuation (of equities relative to other market beta), the economic trend (primarily in the US but I consider the globe too), the liquidity in the market (has always been important but has become increasingly so after the Great Financial Crisis) and the velocity (there can be tons of money but if no one uses it who cares). 

I am a visual person. I like pictures. They tell a big story. As the front page reads, history doesn't repeat but it rhymes. This is why I like to look at a time series.  I like to look at overlays. I don't expect the precision of a quantitative investor, inquiring of the robustness of the R^2 and correlation, investing only on this metric. Instead, I like to look at a lot of things, and from there determine the preponderance of the evidence. It is a diffusion index of sorts. Is there more good information than bad? Is it a lot more? Is it more than last month? This is my goal.  I actually look at far more pictures than I include in this small space, but I want to give you a representation of what I am seeing and thinking. 

(My source for most charts is Bloomberg but I also use the St. Louis Fed FRED database)

Relative Valuation

I always start with the relative valuation. You will notice I am not thinking about absolute valuation. I look at that in the Behavioral section. After all, the absolute multiple someone is willing to pay for an investment, a market etc. is driven by the overall panic or euphoria in the market. It matters, but not here. In this section, I am saying, if someone wants to add beta risk, would they add it in stocks or credit or commodities etc. 

My version of the equity risk premia (ERP) that I use here compares the US credit market yield to the SPX forward earnings yield. It is an apples to apples yield comparison, with indexes (Moody's Baa & SPX) that have a relatively similar credit profile. Ypu can see from this chart over the last 30 years, that there are clear periods when one should prefer credit to equities and vice versa. Late 90s? Equities were clearly overvalued. The period between the tech bubble and post GFC? There was really no strong signal. Right now we are at or near the most attractive relative valuations this century. Want to hate on risk? You should go to the credit market first and not stocks.

 

Economic Trend

 We can't begin a discussion about whether we should take on market risk or not without considering the strength of the economy. This week globally we got PMI measures from every region and country that reports them. In aggregate, it was a pretty robust picture even if it wasn't that much better than what was expected. For the record, I am only looking at trends in this section. For the discussion of how the data is relative to expectations, that will be in the catalyst section in a couple of weeks. 

The most critical market for me is the US market. We received an inline US ISM number this week at 58.7. It may seem like a yawner until you look at the longer term time you see that this level in absolute terms is the highest this century. In spite of all of the negative news on jobs, on supply chains and on Omicron, the US economy is humming along at a pretty brisk pace.

 Of course we also care not just about where this number is but where it is going. For this, I look to the internals of the ISM itself and compare the ratio of the new orders to inventories. If orders are coming in faster than inventories are being built, this is a good thing, right? Thus this ratio does have some mildly leading properties with the headline index. While it did perk up this month, it is still pointing to a slowdown that should occur in the next quarter or so. Thus, it isn't all good news.

 

 Next, I want to put in a few more charts but I won't put as much commentary. 

Leading indicators - good:

 

Chinese economy - bad but getting better:

 

 Eurozone economy - good but weakening

 

 Finally, the US yield curve: not horrible but could clearly be better. However, given the Fed's distortion still of the 10 year part of the curve, I am still hesitant to put as much weight on this as it typically deserves, since the yield curve historically is the best predictor of recession. For now, I will say it is a yellow flag;

Liquidity 

I do not want to spend a great deal of time on this section as we are all well aware of the abundant liquidity in the system. However, I want to overlay it with the ISM to show you that for a lot of the yellow flags I see above, the abundant cash can very well serve to keep the economy afloat much longer than many of us might be expect. Monetary policy acts with a lag of about 12 months. The Fed has only started oh-so-slowly pulling some money out. There is still a good deal of cushion supporting the US economy. One negative is that emerging markets central banks have been tightening for about a year. Thus global liquidity is not as robust as it has been. However, the ECB and BOJ are still out there pulling their weight. For the time being, and this will change this year, financial conditions are still quite loose.

Velocity

Of course, as we saw post the GFC, abundant money means nothing if it is not making it's way into the economy. Using the Quantity Theory of Money (M*V=P*Y), if velocity is near zero, prices and output will also be near zero regardless of the money growth. Post Covid, it has been a different picture than post GFC. Velocity has been much better, some of which is because the Fed is going directly into the markets and not leaving this up to the banks, but partly because we are  seeing demand from companies and consumers to borrow money. This is a combination of opportunity but also the desire to lock in historically low rates. When I look at some of my measures that either proxy or lead the official velocity, they paint a picture of money going to work in the economy, which will support the market.

 

Pulling this all together, in the first part of the three body problem, the fundamentals, we see that while it is not a picture that is 100% supportive, the preponderance of the evidence is still quite strong (even historically strong in some places) and should be supportive of risk in the medium term. There are clearly places we should be looking at as potential risk areas:  inventory builds, China and emerging markets, even the yield curve. However, for the time being, it is supportive of risk and therefore this pillar is POSITIVE for the model. 

STAY VIGILANT