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Happy President's Day,

It’s a short week, but Powell’s here to make sure you don’t miss any minutes. The Fed drops the minutes from its latest policy meeting this Wednesday, alongside more economic data drops this week that should inevitably drop any remaining chances of a soft landing for the economy.

The beginning of the year has seen the most violent junk stock rally since the spring of 2020. Beaten-up names like Coinbase and Carvana are set to report earnings this week. That’s not to be confused with junk you can buy, with earnings from retail giants Walmart and Home Depot both due out before Tuesday’s market open.

Let’s dive in.

Economy Heat Check

As of 2/17/2023 market close, unless otherwise stated.

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Bad News Briefings

Market movers like to bury bad news on Friday afternoon, so we've decided to excavate them. 

• Apple’s slate of new financial services — including “buy now, pay later” offerings, savings accounts and an iPhone subscription program — have hit delays (BBG)

• A son of Qatar’s former prime minister, one of the Gulf state’s richest men, has submitted a bid to take over Premier League club Manchester United (FT)

• The U.S. Department of Labor fined Packers Sanitation Services $1.5 million for employing 102 children as young as 13 (NBC)

• Russia has been cut off by Viagra's manufacturer (NYP)

• SEC charges NBA hall of famer Paul Pierce for unlawfully touting and making misleading statements about a crypto security (Decrypt)

• More than 90,000 people left Silicon Valley during the first two years of the Covid-19 pandemic, reverting the population to 2013 levels (MarketWatch)

• SEC proposes rules that would change which crypto firms can custody customer assets (CNBC)

• A UK-based salesman has won a payout of $86,000 from his former employer after his boss said he didn’t want a team full of middle-aged bald men (BBG)

DEEP DIVE: Dalio All in on Dimon

The world’s largest hedge fund just invested big in Wall Street’s largest recession denier. Ray Dalio’s Bridgewater Associates is betting big on Jamie Dimon’s JPMorgan.

Let’s discuss what it reveals about each finance titan’s economic outlook. 

Summary

• Recently, a 13F filing revealed that JPMorgan Chase & Co. stock was Ray Dalio's second-biggest fourth quarter buy.

• The rest of the top five was rounded out by other financials and an S&P 500 fund.

• Today's macroeconomic climate is relatively friendly to banks.

• JPMorgan is much like other banks in its reaction to monetary policy, but it has intriguing characteristics like large investments in AI.

Background on Bridgewater Associates

In case you’ve been renting Patrick Star’s rock, Bridgewater Associates is the largest hedge fund in the world, with $81B assets under management (as of 1Q 2023). That’s not to be confused with Citadel, who had been dominating the news cycle so far this year. 

Citadel’s record-breaking performance last year took total gains for the fund since its inception to nearly $66 billion. That knocked Ray Dalio’s Bridgewater — with gains of $58.4 billion — off the top spot for the first time in seven years. Citadel is now the most successful hedge fund ever after it made $16 billion last year — the biggest annual windfall on record. But back to Bridgewater.

Bridgewater’s Investments

Recently, Bridgewater Associates released its Q4 13F filing, which showed Ray Dalio's company buying a significant amount of JPMorgan Chase & Co. stock in the quarter. 

In fact, not only did Dalio buy significant amounts of JPMorgan (JPM), his top fourth-quarter buys were dominated by financials, with Bank of America (BAC), Citigroup (C), and Berkshire Hathaway (BRK.B) rounding out the rest of the top 5 individual stock positions.

When the Street saw Ray Dalio buying JPMorgan stock in the fourth quarter, some weren’t surprised. As both Bank of America and TD Bank’s earnings have conveyed over the past year, banks are among the best types of equities for today's economic conditions. They aren't cheap at today's prices (11.7 times earnings is high by banking standards), but they're among the few sectors that can actually gain from rising interest rates. 

Rate hikes are not guaranteed to increase bank profits: if they trigger a recession, or if the yield curve inverts, the rate hikes may hurt bank profitability. Nevertheless, it is at least possible for higher rates to improve bank profits, which is in contrast to most other industries. In most sectors, companies will simply increase the cost of debt and reduce the present value of earnings.

The only problem is that most banking analysts know this, so banks aren't cheap right now. However, in December, bank stocks took a major dip for reasons that aren't entirely clear. At that particular moment in time, they were great buys. Many upped their Bank of America positions, for example, that month, so it wasn’t the most surprising thing to see Dalio buying big as well.

But why does Dalio like JPMorgan in particular?

Bridgewater's 13F showed Dalio and his team buying 30% more JPM than BAC, which was their second most bought bank stock in the period. JPM is currently more expensive than Bank of America, getting close to 12 times earnings - very pricey by banking standards. You may prefer other bank stocks at today's prices, but let’s examine what JPM has going for it that caught Bridgewater’s attention.

Investments in AI

One big thing JPMorgan has going for it right now is heavy investment in AI. These investments could provide efficiency gains in the future. In 2017, JPMorgan used AI to complete 360,000 hours of finance work (mainly filings) in a few hours. It has an entire AI research division. It ranks #1 among banks in the Evident AI Maturity Index. 

In 2023, AI is the talk of the town. Some companies are gaining from it (e.g., OpenAI and its ChatGPT product), others are perceived to be losing from it.

Companies that rush out AI products to consumers may be at risk of issues if the AI creates liability. For example, Tesla's "full self-driving" has been blamed for many crashes and Microsoft’s Bing AI rollout has been marred by inaccurate information and even users being insulted by "Sidney" (the company's chatbot). 

It's not clear that blasting AI products out to the consumer is a wise strategy, but so far, JPM appears to be using AI to automate internal work rather than to sell as a product. So, there is a plausible case to be made that JPMorgan will take the lead in efficiency as long as it continues using AI responsibly.

Profitability

Another thing JPMorgan has going for it is profitability. Among the three biggest U.S. banks, JPM is the most profitable, easily trouncing Citigroup and slightly edging out Bank of America. As the table below shows, JPM has the best margins of the group.

When it comes to the three metrics that analysts look at the most closely, there's no question: JPMorgan is built different.

Understandably, this is reflected in the stock's valuation. JPM currently trades at 11.7 times earnings, 3.4 times sales, 1.57 times book value, and 4.57 times operating cash flow. By contrast, Bank of America trades at 11.06 times earnings, 3.1 times sales, 1.15 times book value, and 38.51 times operating cash flow. Apart from the cash flow multiple (which can be misleading for banks), Bank of America is far cheaper. So, with JPMorgan stock, Dalio’s Bridgewater is paying up for the profit and quality they’re getting.

(Let your intern summarize this part) Discounted Cash Flow Valuation 

At this point in most analyses, analysts will point to a terminal value or discounted cash flow model ("DCF") for a stock. In JPMorgan's case, using free cash flow as the "earnings"/cash flow metric could cause problems. When a bank loans money, it creates a cash outflow. But it's an outflow you want to see occurring, as that is directly used to bring in future income. 

So, to get as close to the metrics Bridgewater was looking at as possible, let’s value the present value of JPM's future earnings. That means using earnings per share in place of free cash flow per share:

• According to Seeking Alpha Quant, JPM's trailing 12-month earnings per share is $12.09.

• If you assume no growth and discount that at the 10-year treasury (US10Y) yield (3.8%), you get a terminal value estimate of $316, an upside of more than 100% to today's price. 

• If you add a 4.2% risk premium, you get a $150 price target, which is still a slight amount of upside. 8.5% is the discount rate at which JPM ceases to have an upside under the zero-growth assumption. 

• If you add a 5% CAGR growth assumption (well below the historical 10-year CAGR growth), then you get a $147 price target even with a 10% discount rate. 

Overall, this range of possibilities looks about as optimistic as JPMorgan is for the state of the US economy.  It has an upside in more scenarios than not.

Bridgewater Cosigning JPM’s Market Optimism?

While central bank warnings of steep interest rate increases have spooked some investors, JPMorgan has its head in the clouds is optimistic. 

For the past year, JPMorgan has been Wall Street’s wide-eyed arts major sibling who thinks IRR is the federal agency who arrested that weird crypto kid. That is to say that JPM strategists, led by Marko Kolanovic, aren’t so pessimistic. 

According to JPMorgan’s trading model, seven of nine asset classes from high-grade bonds to European stocks now show less than a 50% chance of a recession. That’s a big reversal from October when a contraction was effectively seen as a done deal across markets.

Risks and Challenges

On the whole, JPMorgan looks like a good opportunity right now. Its earnings and book value increased last quarter, it's not overly expensive, and it currently sits as the undisputed profitability champion among big banks. Nevertheless, there are risks and challenges to watch out for, including:

• Increasing charge-offs and delinquencies. Most big banks are reporting increases in charge-offs and delinquencies this year. JPM itself reported $877 million in charge-offs last quarter. Because of these increasing charge-offs, banks are having to raise their provisions for credit losses ("PCLs"), which is eating into their profit growth. Bank of America's net interest income grew 29% last quarter, yet its earnings only grew 3.8%, largely because of the PCL build (weakness in investment banking also played a role). JPM is affected by these factors, too.

• Valuation issues. 11.74 times earnings is fairly pricey for a bank. Investors don't generally expect banks to deliver vast profit growth, so many aren’t interested in them when their multiples climb into the double digits. Last quarter, Warren Buffett significantly trimmed all the banks in his portfolio, apart from Bank of America. Charlie Munger later said that, while banks are doing well, they are starting to get pricey. It appears that big investors are sensing rich valuations in the big banks. Notably, Dalio's big buys were in December, when these stocks were much cheaper than they are now.

• Continued weakness in investment banking. Investment banking didn't thrive in 2022. In its most recent quarter, JPM's investment banking fees declined 52%. The reason why investment banks are doing poorly is because not many people want to take companies public in this environment. SPACs are as old news as the term “transitory.” Tech stocks are still way down from their highs, there's a sense that if you go public today, you won't raise as much money as you would if you waited. So, the weakness in IB could continue into 2023.

It’s not groundbreaking news that the head of the world’s largest hedge fund found himself on the right side of a trade. In this case, that choice was buying bank stocks in December. Dalio is sitting on the upside on those buys, and if earnings turn out well, further upside may be coming.

Keep in mind that bank stocks are today more pricey than they were when Dalio bought JPMorgan. Nevertheless, you've got tech stocks today trading at 20 times earnings while earnings and free cash flow decline by high double-digits year-over-year. In that case, JPMorgan could be a better buy. But at that point, so would be just continuing to rent Patrick Star’s rock under the sea.

WEEK AHEAD: Signal to Noise

Next week’s market outlook and whether you should actually care. 

• Monday: Happy President's Day

• Tuesday: S&P Global U.S. Manufacturing PMI, S&P Global U.S. Services PMI, S&P Global U.S. Composite PMI (🐻); Existing Home Sales (🐻)

• Wednesday: FOMC Meeting Minutes (from Feb. 1) (🐂) 

• Thursday: GDP 4Q revisions (🐂); Initial Jobless Claims (🐻)

• Friday: PCE (🐂); Personal Income, Consumer Spending (🐂); New Home Sales (🐻); University of Michigan Consumer Sentiment (🐂)

Signals 🐂

FOMC Meeting Minutes (from Feb. 1) 

Wednesday afternoon, the Federal Open Market Committee releases minutes from its early-February monetary-policy meeting. Minutes from the meeting will offer insight into the thinking behind officials' 25 bps increase earlier in the month. You can also expect conspiracies for next month’s rate hike. 

Economic data released since the meeting, including a blowout jobs report and hotter-than-expected consumer price index and producer price index, have challenged the disinflation narrative Powell has been pedaling since his post-meeting press conference. The bumpier-than-anticipated road to restoring price stability and strong economic data to start the year — nonfarm payrolls rose by 517,000 in January while retail sales surged 3% — have prompted Wall Street banks to revise their expectations for upcoming rate hikes by the Fed.

If Jerome Powell finally accomplishes one thing in his tenure as Fed Chair, it’s getting Wall Street to agree on something. Teams at Goldman Sachs and Bank of America said last week they estimate three more rate increases this year. Ahead of February's interest rate increase, some market participants had seen that move potentially marking the end of the Fed's rate hiking cycle. Cute.

Economists at Goldman Sachs and BofA each added additional 25 bps rate hikes in June to their forecasts, bringing both banks' projected estimates for the peak of the federal funds rate in this cycle to a new range of 5.25%-5.5%. Consensus currently anticipates a 0.50% increase at the Fed's next meeting in March.

GDP 4Q Revisions

The Bureau of Economic Analysis reports its second estimate of fourth-quarter gross-domestic-product growth this Thursday. Economists forecast that GDP increased at a seasonally adjusted annual rate of 2.5%, four-tenths of a percentage point less than the BEA’s preliminary estimate, which was released in late January.

The advance estimate of the 4Q 2022 GDP surprised on the upside with a 2.9% quarter-over-quarter expansion (versus Bloomberg’s estimate of +2.6%). For the full year, that meant US GDP grew by 2.1% in 2022, from 5.9% in 2021.

4Q’s 2.9% surprise expansion was due to volatile private inventories, which contributed to half of the gain. The other half came from government spending, which rose to its fastest pace since 1Q 2021. 

For 2023, consensus expects the US economy to fall into a shallow recession due to the combination of elevated inflation, aggressive Fed rate hikes and global growth slowdown with a European recession. As a result, projections have US GDP contracting by 0.5% in 2023. 

PCE

All eyes will be on the Personal Consumption Expenditures (PCE) price index — the Fed's most closely watched assessment of how quickly prices are rising across the economy — which is set for release Friday morning.

Prices in January likely jumped 0.5% over the prior month as measured by the PCE index, according to data from Bloomberg. In December, PCE inflation rose just 0.1% month-on-month. On an annual basis, PCE inflation is projected to come in at 5% in January. That would mark no improvement from the year-over-year figure reported at the end of 2022.

Core PCE, which removes the volatile food and energy components out, is set to show a 0.4% climb over the prior month. That would be a slight uptick from 0.3% in December — and a marginally slower rise of 4.3% over the year, down from 4.4% in the last month of 2022.

If realized, those numbers would support recent indications inflation is not falling at the pace and extent investors have been hoping for, even as prices have stabilized from the peaks of the current cycle.

Personal Income and Consumer Spending

The BEA reports personal income and expenditures for January the same time it reports PCE (above). The consensus call is that both income and spending rose 1%, month over month. This compares with a gain of 0.2% and decrease of 0.2%, respectively, in December. 

The takeaway from last month’s personal income and spending data showed that consumers, the bedrock of the U.S. economy, are becoming increasingly wary. In September, the personal saving rate fell to a rock-bottom 2.4% — the lowest recorded in over a decade. Since then, it's risen steadily, hitting 3.4% last month.

The drop-off in consumer demand, however, did bode well for curbing inflation. This month’s report will tell whether it could be the beginning of a bigger, more worrisome slowdown that could put the economy in a rut.

University of Michigan Consumer Sentiment

The preliminary sentiment report for the month climbed to a more than one-year high in early February. This Friday, the final report will tell whether US consumer sentiment remains upbeat.

The sentiment report showed an index of current conditions strengthened to 72.6 from a January reading of 68.4. At the time of the preliminary release, a rebound in stocks helped fuel optimism about personal finances among those with large equity holdings. Time will tell whether views of current conditions will outweigh lingering concerns about the outlook.

Noise 🐻

S&P Global U.S. Manufacturing PMI and S&P Global U.S. Services PMI

S&P Global releases both its Manufacturing and Services Purchasing Managers’ indexes for February tomorrow. Despite rising in January, the PMI remains at one of the lowest levels recorded since the global financial crisis, indicating a worryingly steep rate of decline in the health of the goods producing sector. 

Production has now fallen for three successive months, signaling a sharp fall in output. This slump is now becoming increasingly evident in the official statistics and suggesting that the manufacturing sector has become a major drag on GDP.

Consensus estimates are for a 47.2 reading for the Manufacturing PMI and 46.7 for the Services, each roughly in line with the January data. Both indexes have been below 50, indicating contraction in their respective sectors, since November.

Meanwhile, improved supply chains and weaker demand should help keep a lid on manufacturing price pressures in the months ahead. A slight uptick in the PMI survey’s input cost and selling price gauges in January, though, suggests that the road to lower inflation could be bumpier than previously anticipated. This difficulty is reflected in the still-elevated prices for many raw materials relative to pre-pandemic levels and sustained upward wage pressures.

Existing Home Sales and New Home Sales

Is the bottom in? 

Tuesday’s existing and Friday’s new home sales data won’t be the relief some hope it will be. After only a few months in the tank, analysts are already asking whether the U.S. housing market is close enough to a bottom. Much to their second wives’ chagrins, spring shopping season isn’t near enough. 

Signs are accumulating that the big price bust — and mortgage-rate relief — that buyers wanted isn’t materializing, at least not soon. But don’t expect the return of 2008, or the 3% mortgage rate. 

The biggest reason why housing prices aren’t plunging like they did after 2008? Because the market isn’t being flooded with homes that drive down prices, as happened then.

Capital-rich banks aren’t under pressure as they were in 2008, with foreclosure rates less than a tenth of those from the housing bust. Neither are households, with debt payment burdens near historic lows and few homeowners owing more on their mortgage than the house is worth. Serious delinquency rates, which skyrocketed after 2006 and led to 6 million foreclosures, have fallen by nearly half in the last year to less than 0.7% of mortgages, according to Fannie Mae. 

Unemployment is the lowest in 54 years, letting homeowners either trade up or hang on to their current homes easily. And, if they are among the 85 percent of owners whose mortgages carry interest rates below 5 percent, many will stay put rather than buy a more expensive house with a costlier loan. 

All that means the supply of homes for sale is likely to stay tight, which limits price declines.

Initial Jobless Claims

Last week’s initial jobless claims dipped unexpectedly to 194,000 people, according to Labor Department data on Thursday. That’s an inch lower from a downwardly revised figure of 195,000 in the prior week. Economists had predicted that the reading would climb to 200,000.

This week’s jobless data is your weekly reminder that the US labor market remains secularly tight. Continuing and initial claims have been moving sideways at low levels. Employment is probably not booming as much as payrolls suggest, but the labor market is still strong.

The four-week moving average, which aims to account for volatility in the weekly count, moved up by 500 to 189,500 last week. Meanwhile, continuing claims also edged a touch higher to 1.696 million, up from 1.680 million in the prior week and topping estimates.

It seems like layoffs are the new stock buybacks, but data hasn’t priced them in yet. There are still plenty of vacancies on offer for those newly out of work. Job openings rose above 11 million in December, while the latest labor market report was far stronger than economists had first anticipated.

Meme Bank

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