Sentiment and Positioning Reaching Extremes
We had some geopolitical developments over the weekend, namely in Syria, with the rebels taking down the Assad regime after 50 years of control. I don’t know what it means for the region, and at this moment, it doesn’t mean more than a hill of beans to markets (my opinion). However, the news released overnight that the Chinese politburo is set to ratchet up its stimulus efforts by easing both monetary and fiscal policy further in 2025 to support the economy could have significant implications for markets should these policies have some teeth behind them.
As for last week's market action, it was rather unexciting, with equities making new all-time highs as the S&P 500 gained +1.0% and the Nasdaq Composite ripping +3.3%. What was interesting about the move was seeing S&P 500 breadth (stocks increasing vs. stocks declining) negative every day last week and the S&P 500 equal weight index closing lower every day except one (it was flat that day). The top ten largest market cap companies were lifting the entire market; without them, the S&P 500 and Nasdaq would have declined on the week. There is not much to make of it at the moment other than to acknowledge yet again the structural change underway with the steady growth of passive investing herding the masses into a narrower and narrower group of companies. Mike Green published an outstanding piece on his Substack over the weekend that I would classify as a must-read for all investors to get an understanding of where this is going should it continue unchecked (What to Expect When No One's Allocating).
Commodities were weak last week, with base metals getting hammered by more than -4%, while gold sold off a little over -1.0% on the week. Bitcoin continued its breathtaking surge as it pushed above the $100,000 mark for the very first time – before the election, it was lifelessly chopping around below the $70,000 level, but seems to have found some gusto from a new administration that appears willing to give it some form of validation. Since November 5th, the crypto market has tacked on an amazing $1.2 trillion market value. Look, I’ve long been a skeptic of the ‘bits in the sky’ concept, thinking that it could never gain enough prominence to threaten sovereign currencies (if it ever did, governments would act swiftly to short-circuit it), but I must admit that such a bias has tarnished my objectivity in not looking at it as a tool to use in a portfolio. Well, it's time to overcome that bias and spend some time doing some analysis on this market to see if and how it can be prudently incorporated into a diversified portfolio.
Don’t get me wrong; I think the crypto market is nearing a crescendo of euphoria – my mom reached out to me last week wanting to put some money in Ripple (XRP) without having any idea what it was. Still, she heard it was going up and should double or triple in the next six months. I told her she was on her own and wished her good luck. There is little doubt in my mind that we’ve reached the FOMO (Fear Of Missing Out) stage, and this classic JP Morgan adage epitomizes the times in the crypto space today:
“Nothing so undermines your financial judgement as the sight of your neighbor getting rich.”
The equity market doesn’t appear to be too far behind the crypto space as it relates to sentiment and positioning. However, we do have a much longer history of data and fundamental metrics to analyze the equity market. It’s difficult to make the counter argument that valuations are not stretched for the broad equity market, with the S&P 500 trading at a 22.5x forward P/E multiple. Sure, it could be argued that there is no constraint (other than imagination) as to how high a multiple investors might be willing to pay, and that is precisely what we are seeing on some metrics like the Buffett Indicator, which measures the total market capitalization of equities to Gross Domestic Product.
This isn’t to say anything is wrong with the fundamental backdrop; economic growth is firm (Atlanta Fed GDP Now is forecasting 3.3% growth in Q4), the Fed is cutting, the labor market is solid, inflation while sticky is trending towards the Fed’s mandate, and corporate earnings continue to grow. But much of this is reflected in equity prices trading at elevated multiples where consensus estimates of +13% earnings growth in 2025 and +12% EPS growth in 2026 better come to fruition. These elevated expectations are confirmed by a slew of Wall St. strategists releasing their year-end targets for 2025: Goldman Sachs, JPMorgan, and Morgan Stanley projecting the S&P 500 will reach 6,500, Barclays is at 6,600, Deutsche Bank and BofA are at 7,000 and 6,666 respectively.
2024 has been a remarkable year for the U.S. equity market, where the S&P 500 looks like it will finish up more than 20% for the second consecutive year. Momentum has taken center stage, and the “American Exceptionalism” narrative has turned to gospel, with the U.S. stock market capitalization expanding to an incredible 67% share of the world — a record by any stretch. It was below 60% in the other two made-in-America bubbles: the Nifty Fifty in the early 1970s and the Tech mania of the late 1990s. The front cover of The Economist sums up how mainstream the primacy and cult of U.S. equities has become.
Speaking of sentiment, it is off the charts and fully loaded on the bullish side of the boat. Market Vane is at a 73% bullish reading – near the very high end of the historical range (a top 1% ranking of bullish sentiment going back to 2001). The Investors Intelligence poll has bulls at 62.9%, and we know from history that readings north of 60% indicate excessive optimism. A VIX index trading below 13 wreaks of equity market complacency. As per the Conference Board survey, household ebullience over equities has never been higher in the history of its data series. The Citi Panic/Euphoria index has moved up to 0.59, which is a historically high reading given that this model defines a reading above 0.41 as euphoria. The last metric I’ll hit on is the National Association of Active Investment Managers (NAAIM) “exposure index,” which reached 98.93 on November 27th, which is just below the March 27th peak at 103.88% (within 2 days, the S&P 500 peaked and dropped 6%) and the July 3rd peak at 103.66% - by mid-July the S&P 500 peak and fell 500 points.
The past is not prologue, but I think you’re getting the point. Everyone is all in. The reason why investors are positioning the way they are – deregulation, tax cuts, MAGA… - is only part of the equation when evaluating the investment landscape. The other part is how much juice is left to squeeze out of the orange should all the good outcomes come to fruition. Right here, right now it doesn’t look like there is much left to squeeze. On the other hand, what if things don’t go off without a hitch? A growing risk for the stock market is that households are exposed to equities like never before. So, if everyone starts selling at the same time, that could be a problem because there aren’t a lot of investors out there who have the liquidity to step in and buy to support the market.
Moving on to interest rates and the Treasury market, bonds have been performing better of late, and that in large part is because the futures market is back to pricing in three rate cuts next year from just two a week ago – odds of a 25-basis point cut on December 18th moved up to 85% (from 70%) following Friday’s jobs report. Markets are priced for the fed funds rate to end 2025 at 3.70%, another four cuts total over the next twelve months. Without question, the Fed is going to be data-dependent, so we’ll all have to continue to measure and map the data to see how things evolve in the months and quarters to come. Nevertheless, it seems to be that a new consensus is forming among the Fed in that they are looking to be more patient with the pace of rate cuts moving forward.
As for the incoming administration and its policy agenda, I found the following article from the WSJ rather enlightening (Musk Wants $2 Trillion of Spending Cuts. Here’s Why That’s Hard) in that more and more people are doing the math and coming to a similar conclusion as us in that it’s going to almost impossible to come up with this level of cuts. As you can see from the clever graphic put together by the WSJ, there is no way to get to $2 trillion without going after Medicare, Social Security, Net Interest, Other Mandatory Spending, and/or Defense.
Look, I applaud the notion, but it is soon going to dawn on everyone who is unaware that the U.S. fiscal math is too far gone without a substantial cut to Entitlement spending, a substantial tax hike, and/or a productivity miracle. I’m guessing the probability of this administration even thinking about touching Entitlements is below 1%, so it's likely they keep going through the motions and putting on a good show. However, I don’t expect we’ll see much of an impact on the government purse. According to the St. Louis Fed database, the total number of government employees in May 2000 was just over 21 million, and this compares to 23.5 million as of November 2024. Federal employees totaled 2.9 million in March 2000 vs. roughly 2.95 million at the end of September 2023. So, total government employees increased by about 10% or 2.4 over the last 25 years. All the while, U.S. GDP has tripled from roughly $10 trillion to just shy of $30 trillion today, and government expenditures have increased nearly 4x from 1.866 trillion to above $7.05 trillion. Don’t get me wrong, they will make some headway on regulatory reform and cutting red tape, but otherwise, I’m not holding my breath.
The graphic below shows the biggest challenge facing both the Fed and the group of leaders we have in Washington, D.C.: the amount of Federal debt that needs to be refinanced in 2025. Keep in mind that this is just maturing debt.
If we run a deficit of $1.5 - $1.8 trillion, that only adds to the number, and keep in mind the funds needed to fund this rollover wall needs to be sourced from somewhere – private investors, foreign governments, banks, pensions, insurance companies… this pulls on the liquidity available to push asset prices higher. This is something to keep in mind as we move through 2025, as our estimates indicate liquidity is set to get tighter as we progress through the year, which is not a good thing for risk assets.
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.
Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.