Chapter 3  Markets

Stocks and bonds were higher last week while commodities once again fell with crude oil. The drop in crude, by the way, isn’t what the economic bears want it to be. As I pointed out last week the drop in WTI crude is more likely about pipeline maintenance than a drop in demand. While WTI is in a slight contango – which we normally associate with reduced near-term demand – Brent crude remains in solid backwardation. We’ve seen this type of contango develop before due to pipeline capacity issues (2015) so it isn’t anything new. The reduced pipeline capacity can also be seen in the Brent/WTI spread which has more than doubled from $3.54 to $8.70 since October 26th. Again, pretty typical for this type of issue and also seen in 2015 when the spread widened to $11.

Real estate had another good week with the fall in rates and I expect that to continue even if rates start to creep back up. Earnings in the real estate sector are up nearly 20% year-over-year, second only to energy which you might note has performed a tad better. REIT distributions are also rising so the yield effect will be muted if rates rise again.

Value resumed its outperformance last week and I think the trend has more to go. We are going to need to see better earnings growth if the trend is to continue but based on some of the industrials earnings that may not be much of a worry. Financials are the largest allocation in S&P 500 value and have not performed well earnings-wise but that has been more than offset by double-digit gains (triple in the case of energy) in real estate, energy, and healthcare.

S&P 500 value (IVE, Alhambra owns) is now down just 4.5% YTD and 2.7% year-over-year. The Select Dividend Index ETF (DVY, Alhambra owns), another version of value, is up 4.7% YTD and 9.6% year-over-year. (Alhambra and its clients own IVE, DVY and SDY.) International value also continues to outperform with the EAFE Value ETF (EFV) down just 5.8% YTD and 1.4% year-over-year. And yes, Alhambra owns that one too. We do own some underperformers too, most prominently Japan where the drop in the Yen has hurt a lot more than the Euro has hurt European performance. The Nikkei is down just 1.8% this year but the yen is down 17%. Fortunately, our Japan position is much smaller than our value bets at just 2.7% of the typical moderate risk portfolio. It still hurts but we’ve owned Japan for most of the last decade and have no intention of ending that now; Japan is still a lot cheaper than most of the rest of the world.

International stocks performed well last week too with Europe and Japan both beating the S&P 500. Both are also beating the US YTD and Europe is outperforming year-over-year. That doesn’t fit the narrative of the US being the best place to invest but markets are speaking a different language than the pundits.

Stocks are quite overbought in the short term and I expect some kind of pullback but if inflation and rates have peaked as I think they have, another big down leg seems unlikely. Of course, a bad recession might change that, but for now, the market isn’t predicting that outcome. Rates are expected to peak at 5.25% in the middle of next year and come back down some based on the Eurodollar curve but only to around 4% by June 2024. That would be a very mild recession or none at all if it comes true.

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