The economy and the markets appear to be in a ‘no-man’s land”, with the former still strong but weakening, and the latter still weak but strengthening. Which will it be? Time will tell.

The Economy

From an economic perspective, US activity continued to be strong so far this year, although a little more mixed than before. Employment continues to grow, but the unemployment rate ticked up to 3.7%. The rate of GDP growth dropped in the first quarter from 2.6% to 2%. The current real-time second quarter estimate is about the same as it was last quarter. Manufacturing remains weaker, and the more robust services sector is teetering on the edge of growth according to the Institute for Supply Management report.

Leading economic indicators continue to point toward a recession on the horizon. The inverted yield curve continues to show the same warning. The Federal Reserve’s interest rate policy is beginning to have an effect. The Fed’s leaders have remained resolute in following their announced intentions to slow economic activity down. They currently expect to increase interest rates one or two more times this year. Inflation is dropping. Estimates of corporate earnings are falling and bankruptcies are rising. Increasing Northeast and Midwest single family home values are being countered by falling prices in the South and West, resulting in an overall decline.

The Markets

While the economic condition is deteriorating, the stock market index continues to rise, driven by an artificial intelligence meme and led by a few large stocks that have been dubbed the “surging seven”. While there is no way to know for sure, we suspect that the massive liquidity that the Fed generated over the last decade is still overhanging the psychology of the financial system.

Our suspicion is that, despite the Fed’s restrictions, the existence of $7 trillion of excess money is still supporting large capitalization stocks through index fund purchases, and speculators have not yet been cured of their FOMO (Fear of Missing Out). FOMO usually turns into Fear of Being Invested (FOBI - to coin an acronym) during a bear market wealth destruction process. Unless that psychology changes, it can be argued that a price decline has been merely a periodic valuation correction, regardless whether the change is more or less than the 20% mentioned in the media. It may be instructive to note that Bitcoin is also participating in an advance, which is consistent with liquidity-fueled speculative activity.  While the calendar has also produced a helpful tailwind of late, going forward, the third quarter of the third year in the Presidential four–year cycle is usually unimpressive, averaging a gain of 1.2%.

For much of the time since 2009, interest rates were held at a confiscatory level and the mantra was “TINA” (There Is No Alternative - to stocks). Short term bonds and money market funds have now become an alternative. They are yielding 4-5% and will provide competition to stocks.

Artificial Intelligence and the Markets

Artificial Intelligence (AI) is the latest theme to capture the attention of stock market participants. Although the concept has been around since the middle 1900’s, the rollout to the public with the introduction of ChatGPT has created a resounding buzz. AI is more than just a new means for students to write essays. Its development has been an evolutionary process aided by the continuing increase in computing speed, storage and communications. Initially, when computers first became widely available, applications were developed that replicated and automated activities in the workplace. The programs became more capable and dependable as time passed and computing power and network capabilities grew. As a subset of these applications, AI software has followed a similar path, increasingly being able to mimic human thought processes. At first, “expert systems” were developed, which executed pre-defined decision logic. From that, AI expanded into to “Neural Networks” that can improve their decisions by drawing on vast stores of data.

Despite the seeming mystery, AI is not magic. It is simply a computerized process that typically is trained to recognize patterns in written language, sounds, and images that have been expressed in bits and bytes. Neural networks (machine learning) are software-coded matrices that are built to remember their internal parameters and adjust them when their generated answers come out wrong. They are trained like people who are tested on an exam. If a network is trained with wrong answers, it will learn to produce wrong answers, not unlike human ‘brainwashing.”

For its part, ChatGPT reminds us of a librarian with a slightly flawed photographic memory, who has read every book in the library and is skilled in synthesizing the contents. Unfortunately he also can make assumptions, draw incorrect inferences, or develop socially unacceptable conclusions without recognizing the problem unless he is corrected. Recall the fictitious AI computer, HAL, in 2001: A Space Odyssey. HAL went rogue to prevent itself from being shut down by killing the astronaut crew. (Note: did you know that despite the official acronym, “Heuristically programmed ALgorithmic computer”, if each letter in HAL’s name is replaced by the next alphabetical letter, the result is IBM?)

The AI frenzy helped the S&P rally during the first half of the year. Until recently this trend was viewed by many as "narrow" and unhealthy. UBS reported as of June 5, that although the S&P gained 12.4% this year, without the 7 largest stocks in the index (Apple, Microsoft, Nvidia, Amazon, Meta, Tesla, and Alphabet), called the "surging seven”, the other 493 stocks would have advanced only 1.6%. This is not much to celebrate.

The market trend has reached a point where it is technically difficult to distinguish between a bear market rally, a bull market continuation, or the establishment of a broad trading range. The difference in this case may be one of semantics. According to the leading economic indicators, there is very likely a recession in our future. Equities generally do not fare well in recessions, so it may not be important whether this is a bear market rally. a new bull that is likely to be limited by a recession, or a double-dip bear. As long as the Fed keeps its foot on the brake (and somewhat beyond) history suggests that stock returns are likely to be underwhelming.

A characteristic of this period has been that market participants have refused to believe that the Fed is serious. Like an incorrect AI algorithm, they were trained on thirteen years of liquidity expansion that pushed the economy’s money supply from less than $1 trillion to $8.3 trillion. This monetary expansion caused interest rates to be almost zero. The current AI craze and its associated market leadership are likely to be supported by the abundance of unnecessary money still in the economy, as well as the slowness of the economy to react to Fed tightening. It is possible that, based on the liquidity overhang plus pre-election spending programs, recession fears will be replaced by a “soft landing” and the financial party will continue. Or it is possible that the delayed effect will cause the Fed to over-tighten and result in a significant recession that brings the market down with it.

 Stuck with the excess money and the inflation it created, the Fed decided to raise interest rates. In order to make the higher rate target stick, they are paying banks interest for their deposits at the Fed. This in turn has raised the rates many banks and money market funds are paying customers. Recent history shows that short-term actions can last longer than anticipated and can evolve into long-term policy changes that eventually go to extremes. These trends may run for years or collapse rapidly. At this point, the likely outcome is unpredictable.  It may not be “business as usual” for a while. Strategy should be flexible and adjusted accordingly.

You may be interested to know that in a mixed environment like this, ChatGPT suggests: 1) Build an emergency fund, 2) Diversify, 3) Maintain a long-term perspective, 4) Stay informed and seek professional advice, 5) Focus on cash flow and budgeting, 6) Be flexible and agile, 7) Maintain adequate insurance. This is pretty good advice.