Where’s The Power
Equity markets experienced a rare decline last week with the S&P 500 slipping -0.23%, the Dow falling -0.85%, and the Nasdaq Composite declining -1.15%. Friday’s price action was particularly interesting with the abrupt negative reversal in the semi-conductor sector and Nvidia in particular. Time will tell whether this was just a one off, aided and abetted by profit taking on a stock and sector that has gone parabolic, or a more protracted unwind of the momentum factor that has propelled this market higher for most of the year. BofA research put out the following chart in a note on Friday illustrating that the semiconductor sector relative to the S&P 500 is now higher than the extremes it achieved back at the peak of the Tech bubble in 2000.
Without question this move in chip stocks, on the back of an A.I. revolution, has viable fundamental coattails, but the levitation in the ‘bell of the ball’ of this sector has been unprecedented. Jim Bianco put out the following chart this morning capturing the degree to which only a few companies have been carrying this market so far this year. As of March 8th the S&P 500 was up +6.55% with one company, Nvidia, responsible for more than a third (2.66%) of the year-to-date gain. Amazon, Meta, and Microsoft combined for about 20% of the gain or +1.42%, and the remaining 496 companies in the index accounted for less than half (+2.47%). Said differently, without those four companies the performance of the S&P500 would be respectable, but a much more pedestrian +2.47%.
While everyone is focused on the breathtaking rally in a narrowing group of companies (the Mag7 has been thinned to the Fab4 as Apple, Alphabet, and Tesla fall behind) they haven’t noticed that the Nasdaq is flat over the past month and up a meager +1.4% since January 24th. What else has flown below the radar is the 15% rally since early February in the CSI 300 (benchmark index of China’s A-share market). As you can see from the chart below, the China A-share market is coming up to a big resistance level at its 200-day moving average, if it breaks through and holds above this level, I’m willing to bet you’ll be hearing and reading a lot more about the performance of the Chinese equity market.
I know, I know saying anything constructive on the Chinese economy or equity market is taboo, but one of the keys to successful investing over time is to leave one’s bias’s at the door. The below chart highlights the large alligator jaw that has opened up between the performance of U.S. Tech (Nasdaq) and Chinese Tech companies. There is no guarantee that this jaw has to close, but Chinese policy makers have taken bold steps to backstop both its economy and its stock market over the last month. Bottomline, it’s not an unfavorable risk/reward to play for a mean reversion catch up opportunity here.
Another constructive development that’s been coming through our research of late is the pickup in global industrial activity. Global manufacturing PMI’s (white line in below chart) have pushed into expansion territory and look to be picking up some momentum. Also, South Korean export orders have been steadily rising over the last several months and this region has long been a leading indicator for global activity.
Perhaps providing a spark to emerging markets, gold, and commodities is the subtle slide in the U.S. dollar and Treasury yields over the past month. All of these asset classes tend to trade together with the latter typically moving inversely to the former. Without question the weakness in the dollar and lower Treasury yields is being driven by the growing conviction from markets that the Fed cutting cycle is becoming more a matter of ‘when’ not ‘if’. Powell in his semi-annual testimony before Congress last week assured the markets that rate hikes are in the rear-view mirror and the next move is to cut. He did say that he is “not far” from gaining the “confidence” he is looking for to start the easing cycle (this was new). Other Fed officials have been working hard to jawbone back their rate cut views (Kashkari/ Bostic) and we’ll just have to wait and see what the dot plots show following next week’s FOMC meeting on the 20th. It won’t take much of a shift in the dots for the SEP to go from a collective view of three cuts this year to two, but the bond market is still pricing in 3-4 cuts this year with futures back to pricing in 100% odds of a cut coming in June.
We’ll see if Tuesday’s U.S. CPI report significantly alters this pricing. Consensus estimates are for a +0.4% print on the headline and a +0.3% print on the core index. Surely, a hotter than expected print will rile markets, but looking at option pricing we can see that markets are pretty well hedged going into this event. Should inflation come in on the lighter side then I would expect we’ll get a pretty decent rally with equities pushing to new all-time highs as option hedges get unwound.
The expectation that easier Fed policy awaits somewhere in the back half of the year hasn’t been lost on the gold market which continues to make record highs on a daily basis. The yellow metal sits just below $2,200/oz as I type and has appreciated nearly +5% in the last week.
Gold has now gained close to 20% since its low in October and almost 10% since mid-February. This move in gold has occurred despite the dollar holding up, the Fed delaying the pace and timing of rate cuts, and yields staying 'higher for longer’ (for now). Gold hanging in despite these headwinds speaks to something fundamental or structural going on (expansion of global FX reserves into gold by central banks around the world). Interestingly, investors have been net sellers of gold exchange traded funds in favor of high-quality government bonds. But other savvy investors with deep pockets are recognizing the role of gold as a diversifier and a non-correlated asset class relative to richly priced U.S. stocks and run-away government deficits. It would not be a surprise if we experienced a short-term pullback in gold, but it does seem as though we are in a bona fide bull market where gold can move higher over the next year as the Fed starts to cut rates. The rise in geopolitical risks should be supportive as well.
As for the general equity market, I continue to hold the view that the S&P 500 is trading a bit too rich for my liking at a forward P/E multiple of 21x. I know no one cares to respect valuations when equities keep going up and to the right, but this is what blinds investors from giving it the respect it deserves. Keep in mind that we have seen the S&P 500 soar nearly +30% over the past twelve months while EPS growth has increased by a measly +4%. The forward P/E multiple has expanded by a full 3 points and all the while 2024 consensus EPS growth estimates have remained stagnant. Come at me all you want with the makeup of the market being different today relative to history, with revolutionary Tech companies and dominant monopolies comprising a larger percentage of the index – I don’t contest those points – but I will rebut that claim with the fact that 9 of the 11 sectors making up the S&P 500 are trading above historical average valuations. Energy and REIT’s are the only two outliers trading at below average valuation metrics. So no, it’s not just Tech pushing up valuations, its practically the entire market.
It may sound as though I’m getting hostile in my tone, but we all need a reminder now and again (me included) that it’s important to recognize that investing involves risk and paying too lofty a price for even the best company can turn out to be a very poor investment. Don’t get me wrong, we all need to recognize that there are other forces at play causing significant deviations from historic norms. Structural changes that have taken place like passive investing and the U.S. equity market becoming the world’s savings account. Look at the inflection in the U.S. equity market cap relative to GDP compared to equity markets ex-U.S. since the GFC in 2009.
The world equity market ex.-U.S. is flat at 60% compared to the U.S. that has more than doubled. Can and will this continue? Probably, but if/when some of the global funds that are parked in U.S. markets are called home for whatever reason, it’s going to apply a whole lot of pressure on U.S. asset prices.
This is one area where I sympathize with the Fed (some blame them for perpetuating it) when they ponder to themselves about what more they have to do to reign in the wealth effect. They just implemented the most aggressive tightening cycle since 1981 where they hiked interest rates by more than 500 basis points, yet the punchbowl continues to flow. Equities are at all-time highs and credit spreads are near record tights. It was only December 13th with the S&P 500 at 4,700 (not 5,100) and high yield spreads closer to 400 than 300 that the Fed felt comfortable sounding more dovish. Today is just the opposite with everyone’s investment portfolios flush and real estate values (outside of commercial office space) sky high, both acting to fuel confidence and consumption. We got the Fed’s Flow of Funds data last week that showed U.S. household net worth expanded $4.8 trillion in Q4 to a record $156.2 trillion. This is up +8.0% from a year ago and almost all of it came courtesy of the stock market. The ratio of net worth to disposable income surged from 745% in Q3 to 761% in Q4.
If I’m the Fed, this is one area that would have me worried no matter what. If I’m dovish and I shouldn’t be, then that likely pushes asset prices even higher. If I’m hawkish, and I shouldn’t be then I risk toppling the life blood of what has become the U.S. economy and that is U.S. asset prices. Damned if you do, damned if you don’t.
Let me end this week’s missive with a focus on an area of the equity market that I continue to confidently own irrespective of some of the inexplicable short-term volatility and that is the energy sector. I’m constructive on most forms of energy at the moment, but oil, natural gas, and nuclear is where we have the bulk of our exposure. But, instead of me loquaciously rambling on, I think a better end would be to allow the following tweets do the talking. We have all been inundated with the unimaginable capabilities of A.I. and big Tech, but what gets less attention is the energy demands of operating said Technology:
Well Freda, we’re seeing big Tech take matters into their own hands. Last year we saw Microsoft take a step towards using next generation nuclear reactors to fuel it’s A.I. power needs and now we see Amazon doing the same.
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