The Pieces Are In Place For A Correction
Equities have been on quite a run since the end of October but clearly look like they are running out of steam. The Nasdaq, which has been the leader on this rally, endured its first weekly decline (-1.3%) since the first week of the year. The S&P 500 slipped -0.4%, ending its own five-week winning streak with the Dow finishing slightly in the red. Breadth metrics continue to deteriorate with decliners outnumbering advancers by around 2-1 on the NYSE as the week came to a close.
All good things come to an end and after what has been a remarkable run with the S&P 500 positive in 14 of the prior 15 weeks it should come as no surprise if we take a breather.
The number of indicators piling up on the ledger for a correction continue to grow:
Sentiment, no matter what gauge you’re using to measure it, is above average if not flirting with extreme readings. Additionally, speculative activity is thriving with bullish call-option trading back to levels last seen during the meme craze in 2021. Bloomberg reported that searches for “option trading” on Google have hit the highest level in two years. These are solid contrarian indicators that we are due for a generous serving of humble pie.
Positioning is also decisively in the bullish camp whether you’re looking at hedge funds, CTA funds, or Vol-control strategies – each near multi-year highs. This is tinder for a significant level of selling pressure should volatility move higher, and we tip into a sustained period of negative gamma. Keep in mind when dealers flip into negative gamma they have to sell more as markets move lower.
Equities are moving into a period of seasonal weakness in the back-half of February and post February options expiration.
You can also lump on a host of fundamental indicators flashing amber: valuations are stretched with the S&P 500 trading at a 20.5 P/E on forward twelve-month earnings, Treasury yields are relentlessly pushing higher as rate cuts get priced out, and economic growth is set to slow from last year’s torrid pace.
Another risk that is difficult to quantify and falls under the category of how you define pornography. “I don’t know, but I know when I see it” – is the waterfall risk posed by an increasing amount of capital being managed quantitatively. This has propelled momentum chasing strategies to the top of the performance leaderboard and has clouded the feedback loop as to whether an asset is a good investment for fundamental reasons or is it a good investment because other investors are chasing momentum and that’s why it’s going up. This gets to the heart of George Soro’s meaning of reflexivity in markets where higher prices beget higher prices. This is what I think is playing into the A.I. craze that is propelling the share prices of Nvidia, Super Micro Computer, and the Mag7, it’s not an indictment on the life changing potential of the technology, but rather the extent to which share prices have over-priced all that future unknown potential in the present. When the reflexive nature of these mini-bubbles flameout the late-comers to the momentum chase get burned to the downside.
As for the bond market, it has recalibrated for the latest set of higher-than-expected inflation prints and the corresponding shift in the Fed’s rate cut guidance. Last week’s trio of above expected inflation data eviscerated expectations for a March rate cut (down to 11% odds) and the odds of a cut coming on May 1st shriveled to 29%. Even the expectations for the Fed meeting on June 12th have been pared back to 60% from 80% a week ago. The total amount of cuts for 2024 are down to just over three cuts and now right in line with the current set of dot plots. While our work has us in the camp that inflation trends lower over the course of the calendar rather than remaining stubbornly high or rising, last week should serve as a warning that if inflation were to re-accelerate from here, we can kiss goodbye to any rate cuts in 2024. Even more so if the economic data remains firm as has been the case over the last couple of quarters. As long as the labor market holds up, the Fed can focus solely on the inflation data and throw caution to the wind on everything else.
This is what has the bond market on edge, where the impressive trend in disinflation from June 2022’s peak north of 9% seems to have stalled out as of June of 2023. Sure, it’s still trending lower, but the rate of change has clearly moderated.
Even when weak economic data is reported, as was the case with last week’s retail sales report, industrial production data, and housing starts the Treasury market can’t even muster a tepid rally. This tells you all you need to know as it pertains to the bond market and yields – it’s inflation and the Fed that matter, everything else is a distant second.
I must say that the front-end of the Treasury yield curve looks very enticing at the moment, both on an absolute and relative basis. Consider that long-term return expectations for the equity market are around 8% and history would suggest they are lower when equity valuations are elevated like they are today. So, 1–3-year Treasury bills with yields ranging from 5.0% - 4.40% with virtually no capital risk and minimal price risk provide you with 60% of the unknown potential 8% long-term return offered by equities. Take this another level deeper and consider that we are on the backside of a very dramatic Fed tightening cycle, the labor market is already at full-employment, and any further move up in interest rates will pressure economic growth, corporate earnings, and increase recession risks – all of which makes it prudent to see cash and short-term Treasuries as highly desirable investment options.
Another place I’ve been highlighting as exhibiting a constructive set-up for capital deployment is emerging Asia. This is one area of the world where investor expectations are at ground zero, valuations are historically cheap, and policymakers have some stimulative levers to pull. All of which heightens the risk/reward allure of dipping one’s toe in the waters. I know, mentioning anything constructive about China in today’s Cold War part deux is taboo, but when I see articles like this one in last weeks FT, “US investors in emerging markets switch to ETFs that exclude China” it sets off contrarian alarm signals. The following post on X by SentimentTrader is yet another signpost of just how bombed out investor’s views are on China:
I’m not saying investors should back up the bus as geopolitical risk from any direction could justify why investors have been staying away, but investing involves risk and long-term success favors those who take chances where the risk/reward setup is favorable.
As for the week ahead, its lite on the U.S. data front. Nvidia’s earnings after the market close on Wednesday will be the big event for the week. Expectations are high and they need to deliver with the stock up 40% for the year and 70% since the end of October. If they do disappoint it will be interesting to observe the fallout and see if this serves as a change of sentiment for the overall market. We will also get the Fed minutes from the January Fed meeting which should not bring much in the way of any surprises given all the jawboning by numerous Fed Presidents since that meeting.
All that said I think we’re at another one of those junctures where holding some dry powder aside, staying disciplined, and being patient is the prudent thing to do with tactical capital. Strategic capital, otherwise considered capital with a longer-term scope should still be skewed towards the equity market, short-term debt with yields where they are, some gold, and commodities benefiting from the tailwind of the global energy transition.
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