Mixed Messages
Equity markets are wasting no time trying to make back the 10% selloff that took place from the end of July to the end of October. Last week the Dow rallied +0.7%, the S&P 500 gained +1.3%, and the Nasdaq ripped by +2.4%. The technical crowd is gaining confidence as the three major averages are all now above their October highs. As if this year hasn’t been challenging enough with the bulk of year-to-date performance being tied to a handful of Megacap Tech companies, but there also is this series of concentrated upside bursts that have defined the year. If you are one of the unfortunate souls that happened to be positioned too bearishly just before the S&P 500 went on a ripper of a rally, then you’ve been left in the dust (see chart below).
The most recent rally is nearing 8% in a little less than three weeks and with it we have seen the VIX melting away for eight days in a row to a mere 15. One possible driver of the recent rally that is not getting the same attention as the Fed, interest rates, or short covering is the return of stock buybacks post-earnings. The bulk of these buybacks stems from the Magnificent 7 where Apple is up 7% since it reported on November 1st (an increase of $200 billion in market cap). Since Microsoft reported on October 24 its stock has increased by almost 8%. Amazon is the best performer of the group with a gain of 20% since earnings and Meta is up 10%. None of them delivered blowout earnings reports, but all went into their respective release with share prices in a downtrend. The Megacap Tech companies continue to distort the market in ways we have rarely seen. The majority of stocks that make up the S&P 500 have struggled in 2023, yet the Nasdaq and S&P 500 are within spitting distance of all-time highs.
The following chart from Tier1Alpaha is perhaps the best visualization of this distortion, as of last Wednesday only 25% of the constituents within the S&P 500 have outperformed the index over the past twelve months. This is one of the lowest numbers we’ve seen in the last decade, and not by a small margin. Just goes to show you how impactful the Megacap Tech contingent is at moving the market and how unforgiving this year has been for stock pickers that picked the wrong stocks.
As for the current rally in equities, breadth measures have continued to lag – calling into question the sustainability of this move. The average S&P 500 stock, as measured by the equal weight index, is actually down -0.5% for the year and down just over -14% from the cycle highs of nearly two years ago. Waning breadth is a yellow flag that warrants caution and let’s keep in mind the ongoing lagging performance amongst Financials and small-cap stocks – with the Russell 2000 tumbling -3.2% over the course of the week.
It's the opinion of this humble analyst that the Russell 2000 is more reflective of the underlying economy than the S&P 500 or Nasdaq which are dominated by the monopolistic Tech behemoths. Don’t get me wrong as we own the majority of the Magnificent 7 in client portfolios, and they are great companies – perfectly suited for the current environment – but they are the exception, not the norm. With the year-end performance chase upon us and a lot of money managers lagging the index I can see this dispersion get more exaggerated into year-end. When it comes to managing capital for other people, it’s more important to make money than it is to be right – not a philosophy one should live their life by though, just saying.
Nevertheless, in the words of Helene Meisler, “nothing like price to change sentiment” and that’s what we’re seeing in the latest sentiment readings. Investors Intelligence showed the bull camp in its latest poll ratcheting back up to 49.3% and the bear share sliding to 23.9%. We now have two bulls for every bear which is a far cry from only two weeks ago (November 2nd) when the bears outweighed the bulls by a 2:1 ratio.
Looking across other markets we have oil prices that have cratered by -8% over the past month even with demand firm and global supplies remaining tight. It’s likely that forward looking investors see demand destruction on the horizon which is being corroborated by the U.S. consumer spending data as real expenditures on gasoline and motor fuels have declined -2.1% in the past twelve months to September. Historically, at this time of year gasoline usage is up +3% YoY in this nation of drivers, but not the case at the present with plenty of other expenses pinching the consumers wallet. Elsewhere in the commodity markets I see the price of copper having plunged more than -15% over the past ten months – not exactly a signal of economic strength for the base metal that has a PhD in economics.
As for the week ahead, we have two key data points in the October CPI report and retail sales. In addition to the data, we are once again on shutdown watch with the 45-day government funding measures expiring on November 17th. The odds of another shutdown are on the rise and who knows if the downgrade of U.S. debt by Moody’s last Friday will smack some sense into policymakers? I suspect we will start to see some fiscal restraint going forward, but if the last couple of years are the baseline, then we are talking about reigning things in from stratospheric levels. Which is unlikely to make much of a dent, but you have to start somewhere.
When you dig into the numbers, it really is breathtaking to see how irresponsible policymakers have been on the fiscal side over the past three years. When Covid hit back in 2020 none of us knew how that situation was going to unfold in real time and while with hindsight it looks foolish to have shut down the economy the way we did it is the call that was made with the facts as they were in that moment. The $4.2 surge in debt in 2020 can easily be explained by a once in a generation event that required an equivalent level of government support (that is what most civilians would expect of their government). Then, in November 2020 we had breakthroughs on the vaccine front and while variants (Delta or Omicron) popped up, the pandemic was no longer in complete control. The quickest recession in U.S. history was over before we knew it and in 2021 the economy was re-opening (yes, fits and starts, but reopening it was). Moreover, by the end of 2021 unemployment was back below 4% and real GDP was hitting a new all-time high.
But policy makers continued to use the pandemic as a reason to stimulate (I know there is an element of Monday morning quarterback here but give me a little bit of latitude). President Biden tacked on an additional $4.2 trillion of national debt at a time when the pandemic and most of the ill-effects were behind us. And no this isn’t a partisan issue as more than $7 trillion in Federal debt was racked up under former President Trump, including non-sensical tax cuts at the peak of an economic cycle in 2018. Where I’m going with this is that we are now reaching a point where the rubber is meeting the road in that interest expense on this $33 trillion and counting debt pile is starting to create friction within the financial system. Last week’s 30-year Treasury bond auction is a perfect illustration where not enough buyers showed up and the banks had to take down one of the largest shares of an issuance on record. We have another long-bond auction scheduled for November 20th, and you can bet that markets will be paying particular attention given the volatility they have been creating of late. There is nothing more unsettling to financial markets than the world’s reserve asset (U.S. Treasuries) trading like a startup biotech stock.
Speaking of inflation, more and more data are lining up on the side that it’s set to start to slide again after a couple months of drifting higher. China, the second largest economy in the world, is experiencing outright deflation. The UN Food and Ag price index has contracted for 12 consecutive months, rivaling the streak from 2018 into 2019.
The average gasoline price (blue) has fallen to the lowest level since this past March, with the 60-day rolling change (orange) most negative since this past January.
Used car prices as measured by Manheim are down -18% from their peak (largest decline in the history of the index). Recall this was one of the largest “trouble areas” for inflation during the runup to the 9% peak in CPI in June 2022.
Then there is housing where activity levels are the lowest since just after the housing crisis during the GFC. In addition to sky high housing prices, the rise in mortgage rates (see chart below) has made the spread between the effective rate of interest on outstanding mortgage debt and current 30-year mortgage rates the widest we’ve seen in the past two decades – and by a country mile.
As for the Fed, they are just in a tight spot – it’s one of those damned if you do, damned if you don’t pickles. They try to back off their restrictive stance even a little and financial markets take off – easing financial conditions which unwinds the tightening they wanted to occur in order to cool economic growth and stymie inflation. This is what Jay Powell did (eased off the break) at the press conference following the Fed meeting on November 2nd. What did markets do – stocks have ripped over 7%, long-end bond yields fell roughly 50 basis points, credit spreads came in, and fed fund futures pulled forward rate cuts.
Following this reaction, Chair Powell had to come out swinging last week at the IMF panel discussion saying the Fed is “not confident” that it has achieved a policy stance “that is sufficiently restrictive to bring inflation down to 2%”. Well, that is inconsistent with the comments two weeks ago where Powell made the statement that the Fed was convinced that “the stance of policy is restrictive” and “tight policy is putting downward pressure on inflation”. Like I said, it’s a tough spot.
In case you haven’t figured it out yet, the Fed does not want asset prices to be higher, interest rates lower, and animal spirits to get going. This is why we’ve been in a range bound market for more than two years now as investors try to front run a Fed pivot (in both directions) which forces the Fed to then push back on the markets – rinse, wash and repeat until something breaks the circular loop. We’ve landed at the phase of the tightening cycle where central banks have finished hiking but don’t want to unleash the easing in financial markets that would occur by openly admitting they are done. So, a tightening bias (higher for longer) must be maintained while not acting, a psychologically difficult position for sure. However, the cognitive dissonance being displayed by the Fed while trying to hold this awkward posture is something to behold.
I truly do sympathize with the Fed because the fundamental backdrop is itself perplexingly inconsistent: hot GDP versus stagnant GDI, the establishment payroll survey showing job gains compared to the Household survey showing job losses, market-cap weighted S&P 500 up 15% ytd versus the equal weighted index – 0.5%, expanding ISM services index versus relentlessly contracting ISM manufacturing index… the list goes on.
In time the Fed and investors will get a resolution on these inconsistencies, but they are the reality that we all have to navigate through in the here and now. I think the words of Ralph Waldo Emerson are applicable here, “its not the destination, it’s the journey” – enjoy both as best you can. As it pertains to markets, the path matters and that means you have to be flexible in your view as the cycle progresses. For instance, one can have a bearish view about the long-term destination yet have the mental flexibility to position bullishly at times depending on existing conditions. If it sounds complicated, it is, but it’s an important nuance to appreciate.
The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.
Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.