Some Random Thoughts
Equity markets are coming off a lackluster week in which the Nasdaq Composite gained +1.42% and the S&P 500 was flat. Those gains were almost entirely due to Nvidia's delivering another blockbuster quarter of semiconductor domination. Those broad-based indices that don’t hold Nvidia, like the Dow and Russell 2000, fell by -2.30% and -1.21%, respectively. Outside of equities, bonds were little changed as interest rates trade at the upper end of this ‘higher for longer’ range. Commodities experienced some modest selling pressure after a torrid pace of gains since the end of February, with gold sliding -3.32 % and silver falling -3.64 % on the week. This was a rare opportunity to add to the yellow metal where the structural tailwinds only seem to be getting stronger.
As for the equity market, there are a few things worth commenting on. Last week's lesson was that the risk/reward profile for equities is now skewed toward less reward and more risk, given the current setup. Thursday's painful downside reversal should be a reminder for investors who got very aggressive right into that market top. Market breadth is starting to narrow at the margin, valuations are stretched, and growth (both economic and earnings) is slowing. Not to mention that sentiment and positioning are skewed heavily toward the bull camp. Remember that psychology is very important in this craft we call investing, and the combination of excessive sentiment and valuations (in either direction) creates a toxic cocktail for investors.
We currently have three bulls for every bear in the AAII survey, a VIX holding around the 12 level (40% below its historical average), and a forward P/E at 21x. Nothing about this combination is enticing from a return standpoint. Sure, the forces of momentum and flows could continue pushing prices higher, but we are looking at an S&P 500 trading at a forward earnings yield of 4.85%, just a tick above the 4.5% yield on a 10-year T-note. Not that the 10-year is a screaming buy, but compared to a 1-year T-bill at 5.20%, it should make an investor think twice before deploying any more capital into the equity market.
Even in the credit markets, things are getting stretched. We have investment-grade credit spreads inside 90 basis points, and high-yield spreads are inside 300 basis points. Both are about half the historical norm and have only been here in 2000 and 2007. I’m not implying we have another Tech bubble implosion or housing market meltdown, but I am purposely pointing out that the return potential for various asset classes is poor. Like in 2000 and 2007, conditions can stay this way for an extended period of time, but eventually, something does go ‘bump in the night,’ and when that occurs from lofty levels it makes the downside impact of that ‘bump’ worse. At current spread levels, the corporate bond market is signaling a no-default future. Yet, we see with our own eyes that corporate bankruptcies have risen +35% over the past year, and the default rate has ticked up to 5.8% for junk-bond issuers over the twelve months through March, its highest level in three years (Moody’s data). The thing is, high yield spreads were sitting some +40 basis points wider back then than they are today.
Speaking of extremes, when does the chart below, which shows the five largest companies now make up more than 27% of the S&P 500, start to worry investors? It is already for the most thoughtful investors (myself included). I get it. These companies dominate their respective industries, continue to find ways to grow, and are ridiculously profitable (full disclosure: we hold AAPL, MSFT, NVDA, META, GOOGL, and AMZN in client portfolios). Still, at some point, the law of large numbers, competitive dynamics, or regulation will come for these companies. And if it doesn’t, then perhaps we have a different set of problems because the rest of the companies in existence get relegated to afterthoughts, and all our hopes and dreams are tied to the ambitions of a half dozen entities. Okay, so I’m being a little dramatic with that last bit, but I’m guessing you’re getting my drift.
When you think about it, there is a lot of symbolism in these dynamics when overlaying them with the dynamics of the U.S. economy/financial markets relative to the rest of the world. According to data from BofA ML Strategist Michael Hartnett, Wall St. is now 6x the size of Main St. (chart below), U.S. Treasury bonds now represent 48% of the global government bond market, and the combination of U.S. credit and stocks markets is nearly 65% of respective global market caps. All of this implies that policymakers (and investors) understand that the U.S. economy and financial system are ‘too big to fail’, which means that policy must be implemented knowing that a recession is more consequential than inflation.
This bifurcation between the ‘haves’ and ‘have mores’ be it wealth inequality, large company versus small company, and sovereign debt and deficit levels around the globe, is what has many investors confused and arguing that monetary policy is not tight enough to curtail inflation even though the Fed just implemented the most aggressive interest rate hiking cycle in four decades that took Fed Funds from 0% to 5.25%. The real issue is that fiscal policy is too loose to curtail inflation, and this is aided and abetted by a public debt/GDP ratio of more than 120%. At this level of debt, interest rate hikes cause federal interest expenses to balloon (on pace to exceed $1.1 trillion over the next twelve months), which acts as a stimulus/subsidy to savers holding that debt. The corresponding credit contraction in the private markets via reduced borrowing due to higher interest rates is not large enough to offset the credit expansion occurring at the federal level.
I’ve said it before, and it’s worth saying again, the job of investors isn’t to complain about ‘what should be,’ but rather understand and adapt to ‘what is.’ With that in mind, I do think the current setup has created an opportunity in the Energy sector relative to the Technology sector. As depicted in the chart below, the relative price performance of energy stocks compared to technology stocks looks to be troughing, which suggests there is limited downside risk for energy versus technology going forward. Moreover, from a fundamental perspective, the trend in relative EPS revisions also indicates that Energy company EPS downgrades look to be bottoming versus Technology companies. Keep in mind there is a fundamental and sentiment element to this – earnings are improving, and analysts' expectations are low for the energy sector (leaving room for positive surprises) compared to the complete opposite playing out in the Tech sector (earnings growth is plateauing and the sentiment is high).
I’ll let the following tweet from Blackrock’s Rick Rieder close up this week’s missive, which I think is on point. Since the popping of the Tech bubble in 2000 and the GFC in 2007 – 2008, everyone has always focused on equities or other risk assets when talking about bubbles. Rarely do you hear about government debt being the bubble, but that is precisely the bubble many have overlooked popping over the last two years where the rolling 10-yr annualized return on long-term government (+15-yr) debt is the lowest it has been since 1961. Not to mention the 30-year U.S. T-note registering a negative return in three of the past four years while incurring its worst ever calendar year return in 2022. Could this be causing investors to shun fixed income irrespective of higher yields and continue to favor equities irrespective of the inherent risks?
** I will not be publishing a missive next week as I will be traveling to visit clients and trying to convince them that while the world seems as complicated and confusing as ever, we have it all figured out.
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