CWS Market Review – June 6, 2023

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The Economy Added 339,000 Jobs in May

On second thought, maybe the economy isn’t about to go into a recession. At least, not according to the jobs market.

On Friday, the government said that the U.S. economy created 339,000 net new jobs last month. That was well above Wall Street’s forecast of 190,000. This was the 29th month in a row of job creation. The numbers for March and April were revised higher as well.

As a general rule of thumb, the U.S. economy can’t slide into a recession when it’s creating more than 200,000 new jobs each month. This data seems to contradict many of the warnings that the economy is close to sliding into a recession. I’ll caution against reading too much into one jobs report. As we know, the monthly data gets revised, so the final numbers could say something very different. Still, it’s very good news.

The unemployment rate increased to 3.7% but that was due to a big decline in self-employment. Nonfarm payrolls and the unemployment rate are based on different surveys, so there are occasional discrepancies. The jobless rate is still near a multi-decade low. The labor force participation rate for prime-working-age adults is tied for a 20-year high.

Wages, however, are still a weak spot. For May, average hourly earnings increased by 0.3%. That matched Wall Street’s estimate. Over the last year, wages are up by 4.3%. This means that the entire increase in wages has been eaten up by inflation. The U-6 rate, which is a broader measure of unemployment, increased to 6.7%.

Professional and business services led job creation for the month with a net 64,000 new hires. Government helped boost the numbers with an addition of 56,000 jobs, while health care contributed 52,000.

Other notable gainers included leisure and hospitality (48,000), construction (25,000), and transportation and warehousing (24,000).

This data comes at the same time we’ve seen weak and disappointing earnings results from many retailers such Dollar General and Macy’s. This isn’t necessarily a contradiction. It may simply mean that consumers are being more cautious with their spending even though the labor market remains robust.

The impressive jobs report didn’t have much of an impact on the futures market. Traders still think the Federal Reserve will hold off on any rate hike at its next meeting. According to the latest numbers, traders place the odds of a Fed pause at 78%. That sounds about right. The Fed meets next Tuesday and Wednesday.

The Fed has so far raised interest rates 10 times at its last ten meetings. This would be its first break, but the central bank has been signaling that a change may be coming. The current target range for the Fed funds rate is 5% to 5.25%.

For the 12 months ending in April, inflation increased by 4.93%. This means that the “real” Fed funds rate, meaning after-inflation rate, is finally positive, albeit slightly. Prior to this, it had been negative since 2019.

It’s too early to say that inflation has been defeated, but we have made significant progress. The CPI report for May will be out next Tuesday. The Fed will make its interest rate decision public the next day.

It seems like the recession has been so widely expected for so long that it’s starting to frustrate people that it’s not here yet. Despite the good jobs news, I’m afraid to say that the safe assumption is that the economy will start to slow down later this year. Wall Street’s nervousness can also be seen if we take a closer view of the stock market.

The Cyclical Downturn

I want to focus on an important recent development in the stock market, but first I want to explain a good way of analyzing the overall stock market.

Pardon me while I go into professor mode for a bit. If you follow the markets long enough, you’ll notice how many stocks can be easily categorized by their behavior. For example, stocks can be either growth stocks or value stocks. Not every stock sits on that spectrum, but enough do that it’s a good way of viewing the market.

Another category is cyclical stocks versus defensive stocks. Again, not every stock easily fits in either of those buckets but enough do that it warrants our attention.

It’s the cyclical-defensive divide that I want to talk about this week, because cyclical stocks have been lagging the stock market for several weeks. This is very important for investors.

By cyclical stock, I mean companies whose businesses are closely tied to the economic cycle. This would be areas like housing, automotive, construction, mining and chemicals. Defensive stocks are areas like healthcare, utilities or consumer staples. When the economy gets weak, people will put off vacations or new cars, but they keep buying laundry detergent.

I like to look at the divide between cyclical stocks and defensive stocks because it’s a good way to gauge what the market is thinking. Also, these cycles tend to play out for a few years.

Lately, Wall Street has been exceptionally focused on the cyclical-defensive struggle. Each day, it seems that either sector seems to be strongly leading or strongly lagging the market. It’s as if each day’s market is a heated debate on the direction of the economy. While cyclical stocks have been lagging, they got a huge boost on Friday after the jobs report. The same thing happened today but to a lesser extent.

When we say cyclical stocks, we largely mean four major sectors: Energy, Materials, Finance and Industrials. One of my frustrations is that there’s no general cyclical index that I know of. (Oddly enough, the Russell 2000 Index of small-cap stocks isn’t a bad cyclical index. Smaller stocks tend to skew towards domestic manufacturing stocks.)

For this issue, we’re going to build our own cyclical index. It’s not perfect, but it’s good enough for our purposes. I’m going to use the four cyclical ETFs and we’ll weight them this way: 5 shares of XLF, 1.25 shares of XLI, 0.8 shares of XLE and 0.5 shares of XLB. That makes our index close to the price of the S&P 500 ETF.

Here’s our cyclical index (black line) versus the S&P 500 (red line).

Here’s why this is important: Cyclical stocks got badly bruised during the Covid bear market. After that, they slowly outperformed the rest of the market during much of 2021 and 2022. Cyclicals started to lag again at the early part of this year, but things didn’t start turning really bad for cyclicals until March. Since then, they’ve been getting left behind.

Notice in the chart above how the black isn’t doing much while the red line is climbing higher. That’s the shift away from cyclicals and it’s due to the market’s fear of a recession.

The relative performance of cyclicals tends to be correlated with the long-term bonds. When cyclicals lag, long-terms tend to fall, and that’s been happening since March.

Cyclical stocks also tend to outperform the stock market as the market itself is doing well. That gives cyclicals a double-whammy effect during a bull market and a negative double-whammy in a falling market. The Covid Crash three years ago was a nightmare for cyclicals.

It’s not that defensive stocks are in any way superior to cyclicals. It really about understanding where we are in the market. For now, Wall Street has been taking on a defensive posture.

As recession fears have grown, the market has adjusted. Once the cycle turns, and it surely will, then we can expect cyclicals to strongly lead the market. I think there’s a good chance that could happen before the end of this year.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

P.S. If you want more info on our ETF, you can check out the ETF’s website.

Posted by on June 6th, 2023 at 11:38 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.