Unhealthy Internals Masked By The Trillion-Dollar Club
The recent theme within the stock market has been narrow breadth and little participation in the move by the S&P 500 and Nasdaq to new all-time highs. Last week, the S&P 500 rose +1.6%, while only 188 stocks rose in price, and 315 fell in price. The following chart plots the Russell 3000 (top panel), which encompasses roughly 98% of the U.S. equity market cap, and New Highs vs. New Lows (bottom panel), where the market cap-weighted index has been rallying to new highs, yet the number of constituents making new highs versus new lows has been deteriorating since the start of the year. This divergence is a loud non-confirmation signal that spells trouble if we don’t see improvement in the weeks ahead.
The Nasdaq performance of late is even more lopsided. Over the past month it is up roughly +7.5%, but looking under the hood reveals that only ~50% of the index is positive over this stretch, and nearly 70% of gains (5% of the 7.5%) are on the back of just three stocks (Nvidia, Avago, and Apple). As for the +14% year-to-date gain in the S&P500, roughly 34% of that is the result of Nvidia’s 166% advance. The performance gap between the S&P 500 market-cap weighted index and the equal-weight index over the last two years is the widest in nearly 24 years, according to data from Morgan Stanley. In Q2, which is two weeks from coming to a close, the trillion-dollar club of (Apple, Microsoft, Nvidia, Alphabet, Amazon, and Meta) is up ~11.5%, and the remaining +490 stocks in the index are down an average of ~3%. This is not normal, and this degree of bifurcation has never happened before, as is illustrated in the following chart plotting the ‘market cap as a % of total S&P500 market cap’ of the ‘top 10’ (light blue line) and ‘top 5’ (royal blue line) which is well north of the concentration levels experienced during the 2000 Tech bubble.
This bifurcation can normalize itself in a number of ways, but the two I tend to hear most investors discussing is a ‘healthy rotation’ where the rest of the market that has been left behind catches up to close the gap. The mega-caps tread water or move directionally higher with everything else but at a more modest pace. Alternatively, we could have an ‘ugly rotation’ where the gap is closed as everything falls, but the mega-caps fall at a faster pace. Given the structural dynamics at play that have pushed us to this extreme, I’m rooting for the former, but I think the latter is more likely if a true risk-off event were to occur, i.e.) liquidity air pocket, recession, exogenous global shock… But let’s not kid ourselves; Newton’s 1st law of motion is what we should all be adhering to and have in the back of our minds, “every object in a state of motion will remain in that state of motion unless acted upon by an external force.” The structural forces at play will be hard to topple.
The basic understanding of this simple rule of physics explains why the S&P 500 has become the largest and most successfully structured momentum investment in the history of markets. The Dow Jones Industrial Average comprises fundamentally sound and successful companies, yet it is up just a little over 2% year-to-date. The Russell 2000 is its own enigma with too many blemishes to get into, but if the economy is as strong as some profess, why is it down nearly 2% for the year or still down nearly 15% from its all-time highs? The S&P 500 is where investment flows, and index composition dominate fundamental variables. Don’t get me wrong, the Mega-Cap tech companies have superior fundamentals relative to most other companies but don’t underestimate how valuable a rising stock price has been to these companies' success, where the largest expense of most companies (labor) is subsidized through stock options. Stock options are much easier to put in an employee's compensation package with little pushback when they are rising.
Before getting off this tirade, I want to hit on a couple more points. Even the Mag7 has seen a narrowing in participation, with Apple and Nvidia being the only ones logging meaningful gains in the last several weeks. But it really is Nvidia shining above the rest, and we’ll only know in hindsight whether today’s AI craze proves revolutionary or evolutionary. Since Nvidia’s blowout earnings in May 2023, the embedded 5-year EPS growth estimate for the S&P 500 has nearly doubled to +15% per annum. For reference, this is about three times higher than the historical average, which tells you that there are a lot of ambitious expectations priced into the stock market. I came across this interesting metric this morning in the Daily Shot, ‘S&P 500 hopes and dreams ratio’ – I’ve never seen it before, but it measures the “percentage of value in the S&P 500 not explained by book value or NPV (net present value) of the next 3 years EPS expectations. As you can see, we’re at the highest level since November 2000 – oh dear! Not to worry though, valuations and fundamentals are so outdated and irrelevant (sarcasm intended).
Deteriorating market breadth, lofty valuations, and extreme market concentrations should be raising cautionary yellow flags for investors, but instead, they are embracing them as the U.S. household balance sheet is more exposed to equities than ever before – more than in the mania that collapsed at the turn of the century. Sentiment readings are also flashing amber, with the bull share in the Investors Intelligence Survey back to above 60% (a three-month high) and the bear camp down to a lowly 17.6%. The AAII sentiment poll came out with bulls at 44.6%, almost double the bears down at a four-week low of 25.7%.
Many of the old adages investors have been taught as ways to achieve long-term success; diversification, discipline, patience, rebalancing, and risk management have been kicked to the curb. Or those that haven’t abandoned such principles have been left watching their capital compound at a slower rate (not that that’s a terrible thing). I’m reading and hearing comments lately questioning why investors hold anything but the S&P 500 or tech, more specifically. An answer is easy to provide, but not as easy to hear – because history has shown that these principles work ‘overtime,’ but not ‘all of the time.’
Tirade over, moving on. The big data release this week will be tomorrow’s retail sales report. The consensus is at +0.3% MoM for the May headline. I’m curious to see how this latest soft patch of inflation figures impacts the number. Recall retail sales are a nominal figure (both volume and price), and I’ll be interested in seeing if there are indications of a loss in corporate pricing power, not to mention the message we’re seeing coming out of retailers catering to lower-income consumers where Dollar Tree’s stock is down more than -25% ytd and Dollar General is down -7.5%.
Now, let’s talk about the Fed and last week's FOMC meeting. It could be summed up as a big ‘shoulder shrug,’ and you know what? That is what ‘data dependent’ is. If they regain ‘confidence’ in the view that inflation is losing steam and/or the labor market weakens, they will move towards cuts. The degree of such cuts will depend on the degree to which those variables move. But they aren’t there yet. Two things we can have more confidence in are that this Fed does not want to hike and that they are still playing for time, i.e.) interest rates will be ‘higher for a little longer’.
I could belabor the point and get into the dissection of the dot plots where two cuts were taken out of 2024 from three cuts, and they now project four cuts in 2025 (up from three), so on net the Fed’s dot plots moved from six cuts in ’24-’25 to five cuts. Blah, blah, blah. I don’t type that to make a mockery of the information, but rather to call it what it is: a marking to market of the committee’s expectations at this point in time. Three months from now, their view will stay the same, change a little, or change a lot, and the market will be front-running that expected change each and every day along the way.
One thing that did stand out in the dot plots was that the Fed is inadvertently forecasting a recession in 2025. They forecast that unemployment will rise to 4.2%, which, if it occurs, is up +80 basis points from the cycle low of 3.4%. Never in the post-WWII era has the jobless rate risen +80 basis points from a cyclical trough without the economy slipping into a recession. Moreover, by the time it had risen that much, the recession was already underway.
However, if this post-pandemic economy has taught us anything, it is that historical analogs are not very applicable. Powell’s performance at the press conference is reminiscent of how I see things at the moment – all over the map. His message was very inconsistent and noncommittal. I get it; the Fed is not different from the rest of us, and they are trying to figure out in real-time where we are and where we might be going. Such an endeavor is bound to bring about apprehension, indecision, and doubt, especially for someone shouldered with the expectation that they should never be wrong (his expectation, not mine).
There was one statement in Powell’s press conference that was new and stood out as providing some insight into why the Fed is so reluctant to cut rates now or in the near future, and it has nothing to do with inflation or the economy:
“When we do start to loosen policy, that will show up in a significant loosening in financial market conditions. It's a consequential decision for the economy and you want to get it right.”
That is code for the Fed wanting to ‘take the punch bowl away’ and damp down animal spirits in asset prices before cutting interest rates. Although, one could make a compelling argument that there is not much of a wick left on the ‘animal spirits’ candle. When the Fed pivoted from its hiking bias to a cutting bias in the FOMC meeting last December, the S&P 500 was trading at 4,700. At that meeting, the median Fed dot plot had three rate cuts penciled in for 2024. Here we are six months later, and the dot plots show one rate cut for 2024, yet the S&P 500 is +16% higher without much of a lift coming from higher earnings estimates or economic growth accelerating (it’s actually decelerating).
Craig Shapiro, a macro trader and out of the box thinker, posted the following comments on X following the Fed’s meeting that I thought were too good not to share. Not to mention that it aligns pretty closely with how I’m seeing things at the moment:
Hypothesis: Yesterday may have been the Fed's Trichet Moment (Jean-Claude Trichet was the former President of the ECB during the GFC and European debt crisis). Signaling a higher for longer outlook as the economy has begun to roll over means we are assured of a harder landing. Enter the narrative "The Fed is Behind The Curve."
Bad setup for small cap equities.
We are finally at the point where the long and variable impacts of monetary policy tightening are hurting a large enough portion of the economy to overwhelm the benefits that we have seen so far from higher rates that have been afforded to the wealthy asset holders, homeowners with locked in low rate mortgages and corporates that were able to borrow cheaply during Covid.
However, this transition to a growth slowdown has just begun and since inflation is still well above target, while the unemployment rate is still quite low by any historical understanding of maximum employment, the Fed will to be slower to react to the growth slowdown, which actually will increase the likelihood that the slowdown will become worse than expected as we move into next year.
The Fed needs to wait longer before acting in order to be sure that inflation has been slayed. However, their asymmetric policy stance, where the bar to cut is lower than the bar to hike, has created extraordinarily loose financial conditions which continues to bid up asset prices, and thru the wealth channel, makes achievement of 2% inflation that much more difficult. The market has already front run the Fed's reaction function and this complicates the Fed's ability to deliver on easing.
Since the Fed has basically neutered QT as a tool to help with asset prices by starting their tapering of QT, the only real tool they have left is the Dot plot. They need to show the market that their reaction function is slower and will be less accommodative than folks believe. The only way to do this is to remove cuts from their outlook, both for this year, and importantly for 2025 . They did this yesterday by moving in a hawkish direction despite lower than expected May inflation data. They took up their forecast for core PCE for 2024 as well. They also moved the LT neutral rate higher.
So the Fed is shifting in a hawkish direction as the data is shifting the wrong way. With nominal GDP growth momentum finally decelerating, it will be hard to generate earnings growth momentum to support stock prices. With the Fed slow to deliver accommodation until unexpected weakness in the labor market shows up, it will be hard to get further multiple expansion from on an already overvalued stock market. The strike price on the Fed's "put" to act is lower than here. My favored portfolio expression is short small cap equities and long gold on the above thesis.
Well said, Craig; I definitely share your affinity for gold as a part of an investor's portfolio. I also think a focus on quality in the equity market is paramount. Strong balance sheet companies, with positive free cash flow and reliable revenue streams, are factors investors should be screening companies for. Not to mention locking in higher short-term interest rates out to the 3-5 year part of the curve as the front-end won’t stay this elevated once the Fed starts cutting. Two other things investors should have heavy exposure to are patience and discipline. This isn’t a stock market top call but rather a nudge to heed an adage from Warren Buffett:
“be fearful when others are greedy and be greedy when others are fearful”
Signals and indicators I’ve come to rely on, and trust suggest there is a lot more greed and very little fear in risk assets at this juncture. Ride your winners, prune the junk, and fight the urge to chase momentum at this stage. It would not shock me if the S&P 500 sees 6,000 before this year comes to an end, but how we get there matters. If we get a straight shot from here with little to no pullbacks, I’ll just be along for the ride with the exposure we already carry while trimming risk as we go. If we get a pullback or extended consolidation that refreshes sentiment and positioning, I’d be inclined to put some idle capital to work in select opportunities. All I’m getting at is that the path matters as much as the destination at this point. We’ve had a big move in the last six months, where certain areas have gotten pretty stretched; a further push higher only stretches those extremes – in such a scenario I have no interest in standing in the way or piling on.
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