The big news over the weekend was JP Morgan winning the bidding war to acquire First Republic Bank; that was set to fold-up had a buyer not taken them over.  This was the third bank to fail in the past two months and probably not the last, but markets appear to be comfortable with the controlled nature of this iteration of bank stress.  Everyone should realize by now that this isn’t 2008 in that the three U.S. banks that have failed this year held a total of $532 billion in assets compared to the $526 billion (inflation adjusted) held by the 25 banks that collapsed in the GFC.  Unlike 2008, markets have merely buckled and are far from broken.  In the meantime, the S&P 500 remains locked in this tight trading range between 4,050 and 4,175 over the past month.  A breakout in one direction or the other is inevitable, but I’d argue while momentum is on the bull’s side with the S&P 500 and Dow nearing their 2023 highs the internals within the market are weak and weakening. 

This is going to be a big week on the data and policy front with the ISM manufacturing survey and construction spending on Monday, ADP and the Fed meeting on Wednesday, jobless claims, ECB meeting, and Apple’s earnings on Thursday, and the BLS employment report on Friday.  Expectations are for the Fed to hike 25bps on Wednesday and futures are starting to inch up for another 25bps in June and then an extended pause.  The bond market has also moved towards pricing out rate cuts in the back half of the year with only two cuts (down from four) priced in at this point.  Ultimately it will be the ebb and flow of growth and inflation data over the next couple of quarters that will dictate what the Fed will do on the policy front.  Right here, right now the Fed has all the cover they need to notch another hike or two on its belt and then sit tight.  What’s important for investors to understand is that the policy tightening coming through the pipe from the hikes over the past twelve months is just starting to set in.  Just as rate cuts if/when they are necessary won’t act as an immediate panacea when executed.  The interest rate channel of monetary policy is a blunt tool that makes its impact through time.       

I don’t have a lot of new insight to talk about now as our work continues to have us firmly in the wait and watch camp.  Yes, we lean towards the bearish camp and as a result continue to be positioned in a defensive posture.  Given how the markets performed over the first four months of the year I can’t say this was an optimal stance to have, but there is still a lot of time left in the year and what we view as the mature stage of this business cycle that keeps us focused on not getting to caught up with catching every wiggle or the FOMO (Fear Of Missing Out) impulse to keep pace.  The price action in capital markets and incoming economic data brings to mind the “everyone gets a trophy” philosophy that’s crept into society over the past decade.  I’m not passing judgement on the philosophy, but rather I see it as a fitting analogy for the prevailing investment setup.  Both bulls and bears have adequate cover from a variety of data points to support their position at the current juncture:

• On economic growth: Bulls rightly point out the resilience in many metrics (housing, employment, consumer spending, strong balance sheets) while bears volley back with “just wait, its coming” (LEI falling for 12 consecutive months, jobless claims on the rise, lagged impacts of Fed tightening, M2 contracting at its fastest pace in history).  I hold the view that we are in a state of purgatory at the moment where growth continues to decelerate (+3.2% in Q3, +2.6% in Q4, +1.1% Q1) as does inflation (+9.1% in June 2022, +6.5% in Dec. 2022, 5.0% in Mar. 2023).  The trend in inflation is welcome as markets follow the historical analogue from the 1970’s where the peak in inflation represented the lows in that bear market.  However, what gets lost in the shuffle is following the sharp rally out of the 1974 low, equities spent the rest of the decade trading in a choppy sideways range from 1976 into late-1979. 

To be frank, from an investment perspective, I’m less fearful of a recessionary outcome and subsequent stock market decline than I am if we didn’t have a recession.  The alternative is both growth, inflation, and the equity market muddle along in a state of stagnation. 

• On market price action: the bull case is supported by an S&P 500 up +8% ytd, Nasdaq up +16.5%, International equities up +9%, and Emerging Markets up +4%.  On a sector basis, Communication Services +24% ytd, Technology +21%, and Consumer Discretionary +14% - all early cycle higher beta sectors that you expect to lead at the start of a new bull market cycle.  The bears see a different picture with 90% of the gain in the S&P 500 ytd driven by just seven companies (Apple, Microsoft, Alphabet, Amazon, Tesla, Meta, and Nvidia).  The equal weighted S&P 500 is only up 2.8% ytd and the Russell 2000 small cap index is up a meager +0.8%.  Moreover, defensive assets like gold (+8.85%) and long-term treasuries (+7.8%) are performing just as well as the narrowly led S&P 500.  On a sector basis Energy and Financials are down about -3% ytd and Industrials are only up +2.5% - doesn’t exactly illustrate an economy that is ripping.    

•  On the Fed: the bulls are quick to point out how well the economy and stock market have done in the face of the fastest rate hiking cycle in 40 years.  The S&P 500 closed at 4,357 on March 16th, 2022 (the day before the first interest rate hike this cycle) and since that time the Fed has gone on to hike rates by 500 bps and implemented $500 billion in asset roll offs via QT.  As I type the S&P 500 is trading at 4,175 or 4% lower since the beginning of this tightening cycle, to which both the bulls and the bears say, “see” I was right.  The bears say that this is akin to driving a vehicle by looking through the rearview mirror with most of the lagged impacts from tightening set to bite over the next three quarters.  All the while the Richmond Fed joined the New York and Cleveland Fed districts in warning about the likelihood of a U.S. economic downturn in a recently published paper.  In the paper they concluded that “conditional on the current unemployment readings, one can argue that a recession might well be imminent”. 

• On the earnings front:  the bulls look at a little more than 50% of S&P 500 companies reporting Q1 results so far and see 79% of companies beating estimates with a beat rate of +6.9% (below the 5-yr average of +8.4%, but above the 10-yr average of +6.4%).  Bottomline is that results aren’t nearly as bad is the pessimists were looking for.  That’s the bears point exactly as they then point out that the Q1 earnings are still tracking a -3.7% decline, which no doubt is above the -6.3% expected, but this still represents the second consecutive quarter of earning contractions.  Furthermore, with earnings falling and the S&P 500 rising the forward 12-month P/E ratio for the S&P 500 is up to 18x – not rich relative to the past 10-20 years, but definitely elevated relative to the post-WWII average of 16x. 

• On the numerous other risks out there (debt ceiling, regional banking crisis, geopolitical reshuffling from a uni-polar world to a multi-polar world…):  The bulls casually point out, “yeah, what about it”.  It’s not like most of these issues haven’t been around for years/decades – markets climb a wall of worry.  On this file I just don’t have a great retort from the bear side, as I unequivocally side with the bulls in that betting on the end of the world is just a bad investment strategy.  Sure, we have big challenges and likely large structural changes in front of us, but mankind has so far proven that over the course of time we’ll figure it out.  It won’t be perfect, and we’ll likely make some mistakes along the way, but eventually we’ll figure out a way.       

As I stated earlier, I lean on the bearish side of most of these issues in this debate.  But one must be flexible and open minded in considering the viewpoints of both sides.  At this point the verdict is still out.  The S&P 500 peaked at 4,818 on January 4th, 2022, and as of now bottomed out at 3,491 on October 13th, 2022 (a -27.5% decline).  At the current 4,173 level on the S&P 500 its -13% off the high and +19% above the low.  Perhaps the one view I have the highest conviction in right now is that this is not the spot in any asset class, equities in particular, to back up the bus.  Is the top end of a year-long trading range in the S&P 500 with the VIX sub-16, rising bankruptcies, banks failing, earnings declining, and the Fed at the end of its rate hiking cycle the best buying opportunity you’re going to get this year?  I think not.  My advice is to focus on the big picture and continue to make preparations to act decisively when that next opportunity comes along.

One closing thought to think about for all those investors chasing tech higher at this juncture and abandoning small caps is the below chart put out by Bespoke Investment Group.  It plots the four-month performance spread between the Nasdaq 100 (+21% ytd) and the Russell 2000 (+0.4%) where the current 20% spread is only bested in two other time periods over the past four decades – late ‘90’s / early 2000 and early 2020.  Think about what happen following those moves as indicated by the red lines I imposed on the chart – mean reversion where on a relative basis the Nasdaq 100 meaningfully underperformed the Russell 2000.  There are two ways this can play out.  The ‘good way’ as I call it where both markets continue to go up in value, but small caps go up more.  The ‘nasty way’ where both markets fall in value, but tech falls much more.  Understandably it’s a tough call to make at this moment, but those with a time horizon that extends beyond their nose – I think this is an attractive risk/reward.    

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.

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