Weak labor report hammers stocks

Key Points

  • The S&P 500 and Dow fell sharply on the poor July jobs report
  • Financial markets warn of easy credit conditions, which could lead to markets mispricing risk
  • Real GDP growth is misleading due to the buildup of inventories in Q1, ahead of tariffs, and their subsequent rundown in Q2
  • Long-term Treasury yields fell, and the dollar weakened, anticipating lower interest rates, with the fall boosting gold demand

July payrolls increased by 73K, below the estimate of 104K, but big downward revisions to the previous two months spooked investors. A combined revision of -258K to May and June employment lowered job gains to 19K and 14K, respectively.

Employment Growth

Stocks were hammered, with the S&P 500 displaying a bearish engulfing on the weekly chart. Breach of support at 6200 would signal a correction to test 6000.

S&P 500

The Dow Jones Industrial Average failed to confirm the S&P 500 bull market signal and has now broken support at 44K, warning of a correction to 42 K.

Dow Jones Industrial Average

Financial Markets

The Chicago Fed National Financial Conditions Index warns of further easing with a fall to -0.57, signaling loose monetary conditions similar to 2021 during the COVID pandemic.

Chicago Fed National Financial Conditions Index

During the week, we highlighted the risk of a credit bubble if super-easy financial conditions persist:

Looser monetary policy would accelerate credit growth (light blue) above the nominal GDP rate (dark blue), leading to malinvestment as in the credit bubble preceding the 2008 global financial crisis. Mispricing risk feeds instability, leading to an inevitable collapse when assets reprice.

Bank Credit & Nominal GDP Growth

Bond market guru Jim Grant today confirmed the worrying speculative bonanza:

It’s a speculative-credit bonanza. Freewheeling conditions in the primary market pushed leveraged loan activity to new heights in July, with domestic new issuance reaching $223.2 billion. That’s the largest one-month total on record, comfortably topping the prior $206 billion peak established in January.

One instructive development: Feverish demand helped software firm Datasite International price two loans in less than a month to fund a pair of acquisitions, with pricing on the second deal on July 23 matching the first even after Moody’s Analytics downgraded the firm to B3 from B2 (equivalent to single-B-minus from single-B) during the interim, dubbing its roll-up strategy “more aggressive than anticipated.”

Within the high-yield bond category, supply clocked in at $35 billion, the busiest July since at least 2006. Last month, the triple-C-rated portion of Bloomberg’s junk bond gauge posted a meaty 1.47% return, compared to sub 0.5% advances for the single- and double-B-rated categories.

“I haven’t seen a market quite like this post the Great Financial Crisis,” Jon Poglitsch, managing director at Sycamore Tree Capital Partners, marveled to Bloomberg Wednesday. There’s a “grab for spread where anyone can find it,” he noted.

Treasury Markets

The weak jobs report swept aside concerns over the uptick in June core PCE inflation to 2.8%.

PCE & Core PCE

10-year Treasury yields plunged, anticipating Fed rate cuts, testing long-term support at 4.2%.

10-Year Treasury Yield

Economy

Real GDP growth recovered to an annualized rate of 2.9% in Q2, but the numbers are misleading. The biggest contributor was a sharp reduction in inventories after massive Q1 pre-orders, front-running the tariffs announced by President Trump in April. The contraction in Q2 aggregate hours worked reveals a far gloomier picture.

Real GDP & Total Hours Worked

A 50K July decline in employment in cyclical sectors — manufacturing, construction, transportation, and warehousing — warns that the economy is slowing.

Cyclical Employment

Labor Market

Job openings and unemployment remain in balance, as highlighted by Chair Powell at this week’s FOMC announcement.

Job Openings

Annual growth in average hourly earnings at 3.9% reflects reasonable labor demand.

Average Hourly Earnings

Dollar & Gold

The US Dollar Index fell sharply on the July jobs report, anticipating lower interest rates ahead.

Dollar Index

The fall boosted demand for gold, which is testing resistance at $3,360 per ounce. Breakout would signal a test of $3,440.

Spot Gold

Conclusion

A weak jobs report, with falling employment in cyclical sectors, warns that the economy is slowing. Stocks are expected to undergo a correction, with the S&P 500 testing support at 6000 and the Dow testing 42K.

Interest rates are expected to fall, with the Fed cutting rates to create a soft landing. Lower interest rate expectations have also weakened the dollar and boosted demand for gold.

Easy credit conditions increase the risk of a credit bubble, which could lead to investors mispricing risk.

We are underweight stocks except for defensive sectors, and overweight cash, gold, and short-term financial assets.

Acknowledgments

US Market Leading Indicators

Bull/Bear Market Indicator
Stock Market Pricing Indicator

The gauge on the left indicates bull or bear market status, and the one on the right reflects stock market drawdown risk.

Bull/Bear Market

The Bull/Bear indicator remains at 60%, with two of five leading indicators signaling risk-off:

Bull-Bear Market Indicator

Financial market liquidity is climbing, with the Chicago Fed National Financial Conditions Index declining to -0.57, indicating easy monetary conditions.

Chicago Fed National Financial Conditions Index

However, declining manufacturing jobs have caused a 50K decline in cyclical sector employment since June. The decline is less than the 300K needed for the cyclical jobs indicator to signal risk-off, but unsettled stock investors, with both the Dow and S&P 500 indicating a correction.

Cyclical Employment

Stock Pricing

Stock pricing climbed to 97.57 percent, compared to a low of 95.04 percent in April and a high of 97.79 percent in February. The extreme reading warns that stocks are at risk of a significant drawdown.

Stock Market Value Indicator

We use z-scores to measure each indicator’s current position relative to its history, with the result expressed in standard deviations from the mean. We then calculate an average for the five readings and convert that to a percentile. The higher that stock market pricing is relative to its historical mean, the greater the risk of a sharp drawdown.

Estimated stock market capitalization at the end of June soared to a new high compared to GDP for the past year. At 2.85, Warren Buffett’s favorite long-term indicator of market value is more than double its 1.17 long-term average and more than 50% higher than the 2000 high of 1.89 during the Dotcom bubble.

Stock Market Capitalization/GDP

Conclusion

Stocks are bordering on a bear market, while extreme stock pricing raises the risk of a significant drawdown.

Acknowledgments

Notes

Bull/Bear Market Indicator

We aim to consolidate our economic and financial market analysis into a single quantifiable bull/bear market indicator.

Bull/Bear Market Indicator

We modified one of our five component market risk indicators to reduce whipsaws. Instead of the Fed Funds Rate confirmed by ISM Services Business Activity, we have created a composite indicator comprising:

  • the Fed Funds Rate;
  • the Coincident Economic Activity Index from the Philadelphia Fed;
  • the Chicago Fed National Financial Conditions Index; and
  • the S&P 500 with 30-week Twiggs Smoothed Momentum.

Three out of four components are required to confirm a bear market.

Our first signal was the Coincident Economic Activity Index which crossed below 2.5% annual growth for the 12 months to July, warning that the economy is slowing.

Coincident Economic Activity Index from the Philadelphia Fed

Last week, the Fed announced a 50 basis point rate cut, adding a second bear signal.

Fed Funds Target Rate (Average of High & Low)

However, the Chicago Fed National Financial Conditions Index below zero signals easy monetary conditions at a low -0.56.

Chicago Fed National Financial Conditions Index

30-Week Twiggs Smoothed Momentum also signals a healthy up-trend on the S&P 500 at 12.8%.

S&P 500 with 30-week Twiggs Smoothed Momentum

The signal, therefore, remains Risk-On.

Of our four remaining risk indicators, only one signals Risk-Off.

The spread between the 10-year Treasury yield and the 3-month T-bill discount rate has been negative for 22 months. While that is a record time, it does not negate its reliability in predicting a recession within 12 months after the inversion ends.

10-Year Treasury Yield - 3-Month T-bill Discount Rate

Our second risk signal would only be triggered when the yield curve inversion ends.

Employment in cyclical industries—manufacturing, construction, transport, and warehousing—accounts for most of the jobs lost during a typical recession. Cyclical employment grew by 17,900 in August, with no sign of a recession on the horizon.

Cyclical Employment

Heavy truck sales are another reliable leading indicator of recessions. Seasonally adjusted sales of more than 42,000 units in August continue to signal a robust economy.

Heavy Truck Sales

Conclusion

Four out of five risk indicators continue to signal a bull market.

Our strategy is to divide our investment portfolio into five equal-sized buckets of 20% each. For each indicator warning of a bear market, one bucket will be switched to alternative investments—such as A-grade bonds or gold.

At present, only the 10-year/3-month Treasury yield curve warns of a bear market, so we maintain 80% exposure to stocks.