A New All-Time High With Warts
A late week surge in equities pushed the S&P 500 to a new all-time high on Friday with the world’s largest equity index having registered gains in eleven out of the last twelve weeks. Put aside the wall of worries (global elections, geopolitics, valuations, central bank policy, dysfunctional domestic politics, inflation, slowing economic growth, Chinese equity market implosion…) and tip your cap to the U.S. equity market which traversed new heights on the back of Mega Cap Tech, momentum, and technicals.
Leave it to me to pour a dollop of cold water over such a momentous occasion, but the divergences within the equity market that accompany this high need to be acknowledged. For starters the Russell 2000 still trading -20% below its all-time high is a huge non-confirmation. Not to mention other broad-based indices that are not close to making new record highs – Wilshire 5000 Composite, NYSE Composite, S&P 500 equal-weight benchmark, and the S&P 400 mid-cap index. The Value-Line Geometric Index, one of the broadest stock market indices, is still more than -15% below its prior peak.
To anyone paying attention to markets it should come as no surprise to learn that only one sector has managed to carve out a new high – Technology. Yup, the other 10 sectors are still below their prior peaks, with the average performance down more than 10%. For context, at the prior all-time highs (depending on the index) in November 2021 and January 2022, every single sector outside of energy was at a new high. That’s what confirmation looks like – not that everything has to be performing like gangbusters, but that the participation is broad and deep. At the close of trading on Friday with the S&P 500 registering new highs, only 47 companies in the S&P 500 did the same.
My intent isn’t so much to rain on anyone’s parade in acknowledging a material milestone but rather to provide some balance to the litany of bullish market calls that stem from new-all time highs. Like the table below from Ryan Detrick, “since 1957 I found 13 times when the S&P 500 went more than a year without a new all-time high and then made one. It was higher a year later 12 times and up on average 11.8%.”
He isn’t wrong in that new highs generally lead to additional gains in the future and the empirical data speaks for itself, but if we’ve learned anything in this post-GFC/post-Covid world – “it is different this time” and one’s ability to forecast the future based on the past has never been more in question.
This is unequivocally a highly unbalanced bull market propped up on the back of a small group of Mega-Cap Tech companies. Nvidia is the ringleader for this latest leg as it has ripped more than +20% in the first three weeks of 2024 and is now on the forefront of becoming the fifth company with a market capitalization larger than the entire Energy sector. The level of concentration present in today’s market is like nothing we’ve ever seen before. The largest ten companies in the S&P 500 now make up over 32% of the market cap, up from what was considered a high level of 25% at the start of 2023. It’s not that these companies don’t deserve the success they are garnering – they are monopolistic players that execute quarter over quarter, but such a level of concentration (perpetuated by the mass adoption of passive investing) creates risk to market structure.
Moving on from the bellyaching to some actual thoughts on markets, I’m going to borrow one of Carter Worth’s famous phrases in framing my view of the current setup – ‘it’s a pair of two’s”. Not a weak enough hand in poker to just throw out, but not a strong enough hand to put a lot of chips at risk. So, consider my strategy at the moment to be one of ‘checking’ until something forces me to take bolder action. I think that the next two weeks will serve up the first major catalyst to test investors nerves and force me to decide on how to play my “pair of two’s”.
This week is chalk full of central bank policy meetings (BoJ on Tuesday, Bank of Canada on Wednesday, and the ECB on Thursday) and more than 70 S&P 500 companies reporting results (including heavy hitters like Tesla, Netflix, Visa, Intel, General Electric, and Johnson and Johnson). On the economic data front, we have U.S. Q4 real-GDP on Thursday (the latest forecast from the Atlanta Fed GDP nowcast is 2.4%) where a number sub-2% or >2.75% will create some near-term volatility. Then on Friday we get the PCE deflators (this is the Fed’s preferred inflation gauge) where the consensus is penciling in prints of +0.2% for both the headline and core number. There are downside risks to these numbers based upon last week’s PPI report and that would spell some relief to the upward pressure on bond yields so far this year.
Next week will be the busiest week of this early 2024 calendar. More than 30% of S&P 500 companies report, including most of the Magnificent Seven. Additionally, we have a slew of economic data including the ISM manufacturing PMI and the January jobs report. Lastly, we have the January Fed meeting and the release of the QRA Treasury issuance schedule. Without question these next two weeks will set the tone for the rest of Q1.
Most importantly we’ll get color on the three most important variables driving asset prices – earnings (the Mag-Seven better deliver), the path of Fed policy (have interest rates properly recalibrated or is there more to do), and liquidity (will Secretary Yellen spoon feed the system with additional liquidity – it is an election year).
Markets, be it the bond market or the stock market, are very Fed-dependent and the Fed is doing its darndest to stress that it is ‘data dependent’. Barring the occasional weak data print, the bulk of incoming economic has been solid where employment and financial conditions data suggest the Fed should hike, while the trajectory of inflation, real rates, and lending/debt data suggest the Fed should cut. The ball will be in Powell’s court come next week and we’ll see if he wants to pushback even more on the Q4 Fed pivot that helped spur this latest rally. Have a look at the below chart plotting the yield on the 10-year Treasury in blue and the price of the Russell 2000 small cap index in orange. The vertical green line marks the October low in the Russell 2000 which occurred just days following the peak in 10-year Treasury yields. Similarly, the red vertical line marks the peak in the Russell 2000 rally which coincides precisely with the low in 10-year yields in late-December. Yields matter and now that inflation is tracking towards the Fed’s goal, it’s the Fed’s messaging that will play a more dominant role in where yields go than any one-month inflation print.
Markets have pared back expectations for the first rate cut to occur in March to just 50% odds, from what were near 90% odds at their peak. Now the first cut is priced in for May with only 5.5 cuts priced into 2024 versus 7 at its peak. We had three more Fed officials on Friday push back on the idea that rate cuts are imminent or that the Fed is entertaining an aggressive series of policy easings once the process begins. At the end of the day the big picture hasn’t changed all that much. We’ve moved beyond the tightening stage of the policy cycle with clarity that the next move is a cut, its just the timing of the first volley and the pace thereafter that will adjust over time. As such, the bond market seems to have fully repriced for this less dovish path as it too will be adjusting with incoming data.
In my estimation investors have done a good job in the last three months bullishly skating to where the puck is going – the Fed cutting policy rates and a general upswing in global market liquidity. Have a look at the charts below that plot global money supply (white line) against the MSCI World Equity Index (blue line), while every wiggle doesn’t line up precisely the general trend is obvious. Global money supply increases over time and as a result so do global equity prices.
Recognizing that the two lines tend to rise over time is the easy part of the analysis and can provide lazy investors with the false sense of security to just buy stock and never look back. You can definitely do that and with a little bit of luck on your side where the timing works out, you’ll be just fine. But it’s the periods of time when the liquidity needs of the system and the available supply of liquidity don’t line up that create problems for investors. What could cause these periodic shortfalls in liquidity – economic slowdown, recession, increasing unemployment, rising defaults…most things associated with financial hardship coincide with a liquidity suck on the system and its when things get most intense that the Fed (central banks) must step in to fill in the gap. It’s these periods that are most dangerous to investors’ capital.
I will not be penning a missive next week as I will be traveling with a jam-packed calendar of client meetings and events. Please don’t be shy about reaching out with any questions or comments and I’ll be sure to catch you up on everything in early-February.
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