Quality Over Quantity
The Nasdaq and the S&P 500 made new all-time highs last Wednesday, and investors are witnessing an equity market returning to an environment where the 'few' are propping up the 'many'. The S&P 500 is up roughly +12% year-to-date, but if you exclude Nvidia, it's up approximately +8%; if you exclude the 'Mag7' it's up approximately +5%, and if you exclude the "AI Big Ten" (NVDA, GOOG, MSFT, META, AMZN, AVGO, QCOM, AMD, AMAT, and MU) it's up roughly +3.5%. Without question, investors are showing their willingness to pay up for quality over quantity by pushing the AI Big Ten market cap from $5 trillion to $13 trillion since Q1 2023, while the collective revenue of these companies has increased from $15tn to $26tn. As an aside, the Russell 2000 small cap index is down --0.3 % on the year, the S&P 400 Midcap index is up +4.8%, and the S&P 500 equal-weighted index is up a modest but respectable +4.3%.
When it comes to markets, the 'what' is more important than the 'why,' so you cannot afford not to have exposure to this narrow group of Mega-Cap monopolies that are pulling the broad indices higher. Nvidia surpassed the $3 trillion market cap level for the first-time last week, and Apple reclaimed this level for the first time this year. Both joined Microsoft in the $3tn club, with each alone being bigger than the Canadian economy and collectively, they are larger than the entire German and Japanese economy combined - wow. You're not alone in thinking that such narrow participation or having more than 30% of the S&P 500 comprised of just ten companies is unhealthy. Still, the forces of strong underlying fundamentals and structurally positive passive flows will continue to perpetuate this trend until they don't. We're constantly monitoring variables in search of a change that could alter this course (the labor market and retirement trends are two biggies for us), but in the meantime, I advise embracing it and not fighting it.
Outside of U.S. equities, Asian stocks logged their best weekly gain since mid-May, even with Fed cut expectations getting priced out. This is a very interesting development that I think investors should be paying more attention to. India is leading the charge, but China, Hong Kong, and South Korean equities have all shown considerable resilience and rate of change improvements since the end of January.
As for Treasury yields, they came close to breaking below the lower end of their trading range, but Friday's stronger-than-expected payroll data stopped them in their tracks - though the yield on the 10-year T-note ended the week 7 basis points lower at 4.43%. Now, about that May jobs report that was reported on Friday. It was a tale of two employment reports - the establishment survey showed job gains of +272k (well ahead of consensus estimates for around 185k), and the Household Survey showed a decline of -408k. The unemployment rate ticked up to 4.0%, and average hourly earnings were solid at 4.1% year-over-year (+4.0% the prior month). The bottom line is that the stronger-than-expected job growth dashed any chance that the Fed would cut rates at the July meeting. Moreover, the swaps market is now pricing in just better than 50/50 odds of a cut by the September 18th Fed meeting, down from over 80% ahead of Friday's report.
Look, there were definitely signs of a cooling labor market in this report, and if someone wanted to take the bearish view, they could rightfully cite the ongoing trend in negative revisions while rolling out the QCEW data, which is a far more complete data series. This data series revealed that payrolls in 2023 were overstated by +800k. A bear could also refer to declining response rates in the data collection process (the Current Establishment Statistics Survey response rate in late 2019 was 60% versus 43.5% currently), and this is why the revisions three months after the initial report have been so large compared to the pre-COVID era. But at the end of the day, markets react to the headline figures as reported, and while these figures indicate that the labor market is cooling, they are also showing that it's not 'cool.'
I have one last point on this subject: the +0.5% rise in the unemployment rate from the cycle low needs to be watched closely. Such a rise should serve as a trigger signal that recession probabilities are on the rise. Additional increases from here are likely to start having more adverse effects on risk assets, given that they will force markets to start pricing in rising recession risks. However, if the last couple of years have taught me anything, it is that macro and market models that worked in the past are not as reliable in a post-COVID world where a multitude of structural variables are distinctively different from past eras. In other words, what we all learned in our finance and economics studies during business school is not nearly as useful today. A basic case in point is the foundational principle in finance that a discount rate be applied to value future cash flow streams to determine the value of an asset. Yet, that seems less and less relevant in the equity markets today, which are dominated more by policy, narratives, and memes (Gamestop, ARKK, SPACS...). Liquidity, sentiment, and positioning have become the overriding forces driving markets. Couple this with technology democratizing investing and information asymmetries no longer present, and it starts to make sense to rational/thoughtful investors how some parts of the market have taken on the attributes of a casino filled with degenerate gamblers.
The two big events of the week fall on Wednesday, with the CPI report released at 8:30 am (EST) and the conclusion of the two-day FOMC meeting at 2:00 pm (EST), followed by Fed Chairman Jerome Powell at 2:30 pm. No action is expected, but the Fed’s update to the SEP (Summary of Economic Projections) for growth, inflation, and rates will be key, along with Powell’s comments at the presser. The expectation is for the ‘dot plot’ to move to 2 cuts from 3 – a move to 1 would surprise markets and likely cause a negative reaction for stocks and bonds. As for the inflation report, expectations are for it to be on the cooler side and step down from the hot prints we got in the first four months of the year. Looking at the volatility curve, investors are hedging downside risk fairly aggressively for Wednesday. With that being the case, if we don’t get any surprises on Wednesday, I would expect a sizeable relief rally to ensue as hedges get unwound. Such a rally could carry through the rest of the week – call it a case of the ‘hedged pot never boils’.
One last topic I’d like to hit on before signing off on this week’s missive, and that is the recent sell-off in commodity markets. Commodities are inherently cyclical and can often see price swings incongruent with underlying fundamentals. Not to mention the marginal commodity investor is typically fickle and short-term in nature – consider them momentum traders chasing the next big thing until price moves against them. That is what I think we experienced across the board last week in commodities where it didn’t matter what the fundamental story is – if it was on the periodic table, it more than likely got sold. Gold fell by almost -2%, energy stocks via the XLE sold-off -3.4%, silver was slammed -5%, copper miners were whacked by -5.5%, the SPDR S&P Metals and Mining ETF cratered -6.2%, and uranium miners plunged more than -8%. The long-term fundamental thesis underpinning these commodities (underinvestment, supply deficits, energy transition, growing demand, scarcity over abundance investing theme…) didn’t meaningfully change in the last week, but what did was a recalibration to future Fed policy adjustments (higher for a little longer), and as a result weak hands exited their positions. In my opinion, that’s all that happened, and those investors with a time horizon that extends beyond their noses had to endure the downside volatility.
However, as the chart below shows, commodities are prone to ebb and flow between positioning extremes over time. Net-long contract exposure to Brent crude prices has declined to their lowest level in 10 years, and make a note of the speed at which this latest decline occurred.
Widening the scope to include WTI, the combined net long has slumped below 200k contracts, something that has only happened twice in the last 12 years: in 2020 during the pandemic and last December just before Houthi rebels and Israel/Gaza war helped trigger a strong rebound. Peeling back the onion a little further, we see that hedge fund positioning in the oil markets is at its lowest level in over fifteen years.
In a world with rising geopolitical risks, where energy commodities are becoming highly strategic macro assets for nations, such low positioning in oil represents an opportunity for those willing and able to act upon it. Not to mention, the global growth outlook looks healthy, while US production growth has stalled. Wasn’t it only two or three weeks ago that every major media outlet was trotting out headlines about the amount of energy demand that is going to be needed to fuel the A.I. revolution? Yet, in the blink of an eye, that fundamental reality can be forgotten.
Overwhelming skepticism almost always morphs into opportunity. According to my work, copper and uranium continue to be two of the most compelling commodities for the road ahead. Both commodities look to be facing a multi-year period of supply deficits while demand continues to grow, and both stand to play a major role in strategic themes that promise to span years, if not decades: replacing aging infrastructure, the AI revolution, rising electricity demand, and a global energy transition. Short-term cyclical forces may weigh on prices as demand fears increase. However, long-term investors looking to capitalize on the supply story can treat such episodes as potential buying opportunities.
Final thoughts on various markets:
Equities – directionally, I think they drift higher rather than lower. Earnings have been good enough, interest rates at this higher level seem to have been digested, and economic growth, while slowing, is still robust enough to support earnings estimates and lofty valuations. Risk can poke its head out at any time, so be prepared to change your view, but for now, don’t fight a tape that seems to have more tailwinds than headwinds. Themes we like in equities include Big-Cap Tech monopolies, defense, infrastructure plays, and select healthcare exposure.
Bonds—borrowing a term from Carter Worth, they’re a ‘pair of twos’. You can hold them or fold them; neither is a silly play, and both offer some upsides and downsides. The short end of the Treasury curve, where 12-month paper is paying 5.18% and 24-month paper is at 4.88%, is a no-brainer for idle cash, safe money, or capital awaiting a better opportunity.
Precious metals – I think all investors should hold some exposure to gold in this environment dominated by fiscal irresponsibility, heightened geopolitical anxiety, and at the peak of a Fed’s interest rate hiking cycle where the probability of the next move being a cut far outweighs a hike.
Commodities – we like copper, uranium, and energy (both oil and natural gas) for the reasons described above.
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