Services PMI: The Rotation is Confirmed

We are three for three now when it comes to where the economic data is leading us into.

All suggest the U.S. economy is changing seats after one of the fastest and most aggressive runs in a while.

And,

It’s choosing to let something else take over the steering wheel, sending AI and all the other “speculative” growth areas of the market to the back seat instead.

Who’s driving now?

Defensive sectors, essential spending, and some of the more “boring” areas of the market.

It’s no coincidence these picks from last month’s PMI run led us to more than 50% in cumulative profits, leaving both the S&P 500 and the AI trade in the dust.

As we continue to get more confirmation in today’s Services PMI print…

I’m here to give you the other side of the mechanics behind my new watchlist.

A watchlist that is aimed at beating the market again this month.

Click here to read the Manufacturing PMI analysis and my industry selection.

Today,

We’ll continue into a services sector analysis, and a subsequent industry selection for long and short biases.

You will need this research for context into this weekend’s idea pipeline.

Let’s get into it,

Services PMI: The rotation is confirmed.

There’s one thing both PMIs agreed upon this month.

And it is that we’re entering into what seems to be a late-stage economic cycle.

Manufacturing demonstrated, through pricing and restocking dynamics, that the next six months are likely to see a contraction in the cyclical corner of the economy.

Services is trending in the same direction now.

A wave of restocking due to rising input costs has masked an underlying weakness in true demand.

After all, buying now because you don’t want to pay higher prices tomorrow, isn’t really organic demand.

Most commodities, services, and products in the U.S. went from being in short supply and up in price…

To just being up in price.

Except for:

Which of course has everything to do with whatever is left of data centers being built, but not so much on new projects still in the pipeline.

Now look at the other areas like:

All going from short supply to just being up in price.

Which directly benefits our various trade ideas riding on a topping cycle for those products and services.

Just look at Valvoline vs Valero this month!

Click here to read the analysis behind this diesel long/short trade.

When this sort of dynamic takes place…

You have to think about what markets interpret this as, and how the economy reacts to that shifting trend.

With adequate supply, and steady or cooling demand activity, businesses will carry less corporate profits and spending power.

All thrown into a consumer sentiment that sits at an all-time low right now.

You can begin to see how and why GDP drivers are leaning on defensive sectors and industries, and also why the market rotation is beginning to accelerate further.

Because services makes up ~80% of the economy, it is important to track prices and labor within the sector.

And right now, prices paid for services suggest that PCE will come in at roughly 3.7% next month, with the manufacturing side of things adding to the pressure mix.

Just like manufacturing, businesses are reacting through the only lever they are able to pull when the government refuses to:

When these pricing pressures decline, margins and retained earnings improve.

That allows for easier operating conditions, and increased certainty around future prospects.

Now imagine what happens when 80% of the U.S. economy feels that way.

Hiring begins to take place, and it is happening right now.

That should have a positive effect on this Friday’s NFP print as well, but where these jobs go matters more than how many jobs were created in the first place.

If defensive industries are doing most of the hiring, then that tells you something as far as our trending thesis.

Now I want to introduce an interesting dynamic specific to jobs in the software and information technology industry.

You can see that backlogs of business activity keeps rising while payrolls decline.

AI bulls will blindly say this is the result of productivity gains in the technology sector.

I’m here to tell you that this is simply a pick-up of demand and activity in the software companies that serve the real economy.

Like Workday, Intuit, and Upwork.

The firing is happening across those who bet too much on AI and now need to reduce headcount to keep funding their investment losses.

Like Amazon, Google, and Microsoft.

We can take a mix of business activity, employment, and lead times to come up with the services version of our composite momentum scores.

Which suggest breakouts in:

And breakdowns in:

However,

The level of this month’s score only tells us what is happening now.

Because services industries are less cyclical than manufacturing ones, we have to pay more attention to the quarterly change in these scores rather than the one-month score.

Manufacturing, being more cyclical, gets a better signal from monthly changes.

On these quarterly momentum changes, we get very clear breakouts in the industries that demonstrated the highest scores this month as well.

That gives me the confirmation on some of the areas of the economy to look into for long ideas.

And also confirms some of our current holdings in defensive companies, expanding on our watchlist a bit further.

For those who lost momentum on the scores, and fell into contraction:

Two of which are a direct feedback loop to the AI trade and implications to how the elections threaten to take the foot off the gas in the data center complex.

Retail trade is just another side effect of the broader economic and market rotation away from cyclical spending and activity, and into defensive areas in nature.

Let’s talk longs briefly, giving them a bit more context as to what may boost some companies in this breakout.

Transportation & Warehousing

With diesel prices coming down on easing supply constraints, we may see a breakout in transportation related areas like airlines, trucking, and shipping.

This also carries a side benefit to other adjacent areas that derive their margins from transportation costs going up or down.

A defensive pick up in the economy would boost activity for this industry, so we’ll pass it on our selection.

Wholesale Trade

As transportation costs ease, and defensive activity picks up, businesses will be more prone to land attractive supplier contracts and lock in months of sales ahead of time.

Which stabilizes cash flows and pricing certainty for other adjacent industries as well.

Finance & Insurance

This one is a bit more interesting, as the breakout is due to a sudden shift in employment and some commentary data from executives.

One of the first (and only) industries to cite AI costs as a concern, and begun an active effort to cut these down.

Yes, this is another threat to the AI trade and its underlying economics.

Real Estate Renting & Leasing

This breakout can also be tied to the renewed activity in the residential and consumer property market, taking market share from the slowdowns in commercial property seen in the data center space.

This isn’t set in stone however, as I will still need to see the confirmation in indicators like housing starts, building permits, and mortgage rates.

There isn’t one trade in specific to take into account with all of these changes.

What’s more important is to understand the reason why these changes are happening in the first place.

Just like every such episode before this one…

When the markets get this concentrated and uncorrelated to what the underlying economic data suggests,

Combined with valuation extremes,

A scenario that made Buffett stay out of the market in 1999 comes into play.

A “lost decade” as they call it.

From 2000-2010, those who relied on the S&P 500 to get them through wealth creation and/or retirement failed to see any gains other than their monthly deposit rates.

I believe we are about to see another decade like that coming up.

In fact, my belief is beginning to turn into a reality.

And after studying 36 countries over 50 years, I’ve found the two-way formula that leads most investment capital into two specific areas.

So rather than give you one trade here for free…

I want to give you a new way of doing things moving forward.

Click here to see where alpha still lives.

Meanwhile, here is the latest from Goldman Sachs talking about the state of bullish bets and options flow.

It will guide you through some of what market participants are thinking of doing right now, and explain some of this week’s unwinds:

Until next time,

OFFSIDE RESEARCH

Against the Tape, Ahead of the Curve.