The Risk/Reward Is Much Less Favorable Than Six Weeks Ago
Only five weeks ago on October 27th the S&P 500 nearly touched 4,100 in intraday trading, bond yields were at their highs, so was the U.S. dollar, the Fed was at max-hawkishness, and investor sentiment was in the gutter. Back then investors were presented with an opportunity to take on as much risk as they were willing to bear as forward return potential improved with asset prices reflecting a pessimistic outlook. Fast forward five weeks and that math has changed meaningfully.
The major equity averages enjoyed their best month of the year with the S&P 500 finishing November up +8.9%. The index has risen 12% from its October low and is now up +19% on the year. You name the asset class and its highly likely that it has rallied over the past month:
The small-cap Russell 2000 has ripped +11.76% over the past month – last week decisively clearing its 200-day moving average after hitting resistance multiple times.
The S&P 500 Equal Weighted index jumped +10.43% - ripping +2.45% last week to a three-month high.
U.S. Investment Grade Bond Index is up +5.60 and now positive for the year. High Yield Bond Index +4.60% with spreads in both nearing ytd lows.
Long-term Treasury Bonds (30-year maturities) have surged by +9.20% while municipal bonds have gained 7.84% over the past four weeks.
Not to mention Gold gaining +4.53% and quietly up +13.33% year-to-date with Bitcoin outshining everything, booming +23% since October 27th.
For me the shift up in valuations (S&P 500 is trading at just under a 19x P/E), lofty 2024 earnings estimates (+11% growth), and dramatic rise in investor positioning and sentiment are all signals indicating now is not the time to be chasing this rally any further. Nothing moves in a straight line, and no this is not a call to sell everything and go to cash. We had a choppy August that kicked off the equity market correction, a horrible September followed by a volatile October that ended up marking the correction low. In November we had a massive melt-up that takes us into December, which is seasonally very positive, but raising some cash and taking some chips off the table for the next opportunity is the prudent thing to do at this juncture.
Bullish sentiment in the AAII investor poll has risen to 48.8% and is just a couple ticks below its 1-year high. All the while the bear camp has slumbered into winter hibernation.
Not to mention the overall market is reaching overbought levels with over 30% of stocks notching an RSI of 70 (see chart below from Tier1Alpha). This percentage of the index reaching an RSI over 70 is a top 1% reading in the past decade – so not unprecedented, but pretty rare.
Another zinger of a chart from Tier1Alpha tabulates that such high RSI levels are often difficult to maintain. These overbought conditions typically normalize via a pullback or consolidation – further gains from here without either would just push things further into an unsustainable extreme.
One last comment on technical voodoo, dealers are currently in a long gamma position (option jargon) where to hedge their books they will be selling equity futures if the market moves higher and buying equity futures if the market moves lower – this ultimately stabilizes the market and volatility levels. Until the dealer gamma position changes, it is going to be difficult for the equity market to move much higher given current conditions as dealers will be forced to sell on the way up.
While the equity market gets all the attention it’s the price action in the bond market that investors should really be taking note of. Since the October 25th yield peak, the 30-year Treasury bond has generated a +12% total return which is right in line with what the S&P 500 has done. The 10-year T-note has delivered a +6% total return and the 5-year Treasury has returned just shy of 4%. The drastic outperformance at the long-end is a great illustration of how convexity works in generating total returns – although those that were early to this trade know all too well that this works in both directions. What do you know, all those calls for diversification becoming obsolete or that the 60/40 portfolio is dead need to reassess their thesis as a 60/40 asset mix generated a total return of +7.3% in November. This was the ninth-best performance in the past seventy years.
U.S. Treasury yields are the most important asset in the world and that has been the case since the Fed started hiking rates back in March 2022. Yields go up and the rest of the dominos start to fall: the dollar rallies, stocks sell-off, credit spreads widen out, and financial conditions tighten. Yields go down and all those variables reverse. Sure, economic growth and inflation play a role in the equation, but when back testing the historical data there is no variable more important in explaining the movement in treasury yields than the Fed. And the Fed has definitely changed their tune over the past month. St. Louis Fed President Waller (one of the most respected economists on the FOMC and noted hawk) did not mince words in a speech last week titled “Something’s Got to Give”:
“If you see this (lower) inflation continuing for several more months, I don’t know how long that might be – 3 months? 4 months? 5 months? – you could then start lowering the policy rate because inflation’s lower.”
Then later in the speech he dropped this bombshell:
“I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2%.
That’s all the markets needed to here as they ripped following these remarks last Tuesday. Then markets went into hibernation mode until Friday when Chairman Powell spoke and offered very little pushback (some, but not much) on the subtle shift in the Fed’s monetary policy path. Keep in mind that the Fed now has the cover of softening economic data to support the evolution of its policy from tightening to the current pause, and then eventually cutting. What really got asset prices rallying at the end of October was the QRA announcement by Janet Yellen that the Treasury was going to issue a lot less long-dated Treasuries to fund the federal deficit over the next six months. Then we got a weak payroll report in early November, once again bringing relief to investors that the Fed didn’t have to keep its foot on the tightening accelerator. And this was all capped off with a milder than expected inflation report in mid-November.
This set the stage for yields to roll-over (the 10-year Treasury yield has declined nearly 80 basis points), the dollar to top out, credit spreads to tighten, and equities to rally. All of which move in unison to dramatically loosen financial conditions. However, its important to keep in mind that all that good stuff is now in the review mirror. We got the typical kneejerk reaction of equities rallying on the notion the Fed has shifted to the pause phase of its tightening cycle. If yields continue to fall from here, I suspect it will be for reasons that won’t be favorable for equities. A further decline in yields would likely occur because economic growth is slowing more dramatically than expected and this would call into question the $245 earnings number analysts are penciling for 2024.
For me the key economic data point to be focused on going forward is the labor market (inflation has been yesterday’s story for over six months) and we are definitely seeing some cracks emerge. Last week’s jobless claims came in at 218k for the week of November 25th (hardly a worrying number for sure), up modestly from the prior week of 211k. The four-week moving average grinded higher as well to 220k from 210k – once again not a scary level (take note if/when we get north of 275k). But what really stood out in this report was the +86k rise in the backlog of continuing claims to 1.927 million. The takeaway from this data point is that while it suggests that firing rates remain tame, businesses are also reluctant to hire. This is why we are seeing a significant rise in continuing claims, but not in initial claims. On Friday we’ll get the November jobs report and see if it adds anymore drama to the situation.
Last week we got yet another dismal print on the manufacturing front with the ISM manufacturing index for November coming in at 46.7, unchanged from the 46.7 print in October. This survey has now printed below 50 for twelve consecutive months and clearly indicates that the manufacturing side of the economy is in recession. The Fed is aware of this and combined with the feedback they are receiving from business contacts in various industries it undoubtedly influences their policy shift. As recently as the September 20th FOMC the Fed was still penciling in one more 25 basis point hike this year. Well, they have one Fed meeting left on December 12- 13, but it’s become quite clear that they are done hiking. Moreover, the Fed Funds Futures market was pricing in only two 25bps cuts in 2024 following the September FOMC, but now the futures market has shifted rather emphatically with a minimum of four cuts in 2024 and possibly as many as six. Odds have increased to a 60% probability that the Fed’s first-rate cut will come as early as the March 20th meeting and at least two 25 basis point reductions by June of next year.
Could the market be wrong, yes. But keep in mind, market pricing is a collection of probabilities from the entire brain trust around the world. If it is wrong, then a dramatic repricing of everything needs to occur. Bottomline, we’re back to a situation in the capital markets where I don’t see much of an opportunity in anything. As a result, we have client capital fully invested in a balanced allocation. The general stock market interested me when the S&P 500 was around 4,200 in October and bonds across the spectrum were very intriguing when yields were pushing towards their high throughout October. But here and now with everything back to a level of some equilibrium I find myself decisively back in the ‘indifferent’ camp.
Stocks could go higher or lower over the next several months, but I lean in the direction that the risk/reward is now skewed to the downside. The S&P 500 pushing back up to its all-time highs around 4,800 wouldn’t shock me, but I can see a downside path back to 3,900. Hence the risk/reward for me, at this moment, is unfavorable to add much more risk.
Fixed income is somewhat similar although I see the risk/reward as still slightly skewed towards more reward than risk. I do think the Fed will be cutting next year, and typically when the Fed is cutting, they are doing so in an aggressive fashion. Such an outcome could take the yield on the 10-year Treasury down into the low 3’s. Even if they don’t cut dramatically because the elusive ‘soft landing’ occurs then I still think the Fed cuts to keep real rates from getting too high as inflation continues to slide lower. In a nutshell, I think we’ve seen the high in yields for the next twelve months and the upside in yields from current levels is moderate. Anyone holding bonds at the moment gets the opportunity to sit back and clip coupons of 4 – 6% on high quality paper with moderate volatility.
Then there is gold which I still think warrants having a place in everyone’s portfolio for the foreseeable future. In fairness, gold has had quite a run this year and over the past six weeks, so it is no different than most other asset classes at the moment – a bit of consolidation is in order. But I suspect it will continue to serve as a solid diversifying asset to a heavy stock bond allocation in the years to come.
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