Yet To Be Determined
The best way to describe the equity market of late is directionless with a splash of sector rotation, and a pinch of short-lived rallies/selloffs. It’s not lifeless, as the business cycle, central bank policy, corporate earnings, and even a minor deposit crisis in small banks progress through time, but by golly, price action has become outright boring. The S&P 500 is coming off another flat week and continues to be contained on the upside by the 4,150 – 4,200 level – a level ironically that it traded at in May of each of the past two years (2021, 2022, and by the looks of it again in 2023). However, under the surface the overall strength of the S&P 500 is decaying and signaling that we are nearing the point of exhausting the upside of this bear market rally that started in mid-October. Per the below chart from Liz Ann Sonders (Chief Investment Strategist at Charles Schwab) only 4% of S&P 500 members have made new 52-week highs (orange) which pales in comparison six months into the start of the last two bull markets in 2002 and 2009.
This week has the potential to break us out of the ongoing slumber with 40% (160 companies) of the S&P 500 constituents reporting earnings – including the likes of Microsoft, Amazon, Meta, and Alphabet. Anyone of these companies (Apple reports on May 4th) is big enough on their own to move the entire market and given the runup many of them have experienced so far in 2023, the bar is high for them to deliver. So far with one-fifth of the S&P 500 reporting we have 76% beating estimates (in-line with the historical average), but better than expected is a low bar given that EPS is on track for a -6.2% year-over-year contraction.
I want to share some comments on investor sentiment and the widespread pessimism permeating out of some high-profile fund manager surveys. Before getting to the negative side of things it’s worth pointing out that not all sentiment readings are displaying doom and gloom. The investor’s Intelligence bull-bear ratio has risen to its highest level since the start of 2022 (the start of this bear market), and the CNN FearGreed Index is smack-dab in the middle of “greed” territory.
But that’s where the excitement ends. The BofA global fund manager survey for April was released last week and it showed that investor allocations to equities relative to bonds has declined to the lowest level since the GFC in March 2009 (which coincided with the low of that bear market). Other observations from the report were that a net 63% of institutional investors see GDP falling in the ensuing several quarters (highest level of the year), nearly 84% see inflation continuing to decline, and 58% see a decline in policy rates (highest level since November 2008). Cash allocations are north of 5% as has been the case for seventeen consecutive months (only behind the 32-month stretch during the bursting of the dot-com bubble). The Barron’s Big Money poll echoed the BofA fund manager survey with only 36% of the professional investors in its poll considering themselves bullish on the outlook for stocks over the next twelve months (28% find themselves in the bearish camp). What’s more is that those in the bullish camp only see a modest 1% upside to the S&P 500 for the rest of the year, while the bears see downside of 13% from current levels.
Keep in mind that from an investment standpoint sentiment is typically viewed as a contrarian signal, akin to the Warren Buffett adage; “be fearful when others are greedy and greedy when others are fearful”. Negative sentiment among institutional sentiment is one thing, but what about how they are positioned? Well, hedge funds have been loading up on their bearish bets with the net speculative short position on the CME regarding the S&P 500 at its most short exposure since October 2011 (68,087 contracts).
On the surface, one would easily conclude that investors have learned from past cycles and are already cautiously positioned into the most anticipated recession in modern history. Ahh, if it were only that simple. The fund flow data for 2023 shows that individuals have purchased a net of nearly $78 billion in U.S. equities and ETF’s in Q1 2023. This sum trails only Q1 2021 (the peak of the Covid speculative mania in meme stocks) and Q1 2022 (peak in the S&P 500) when they bought roughly $80 billion. Well Corey, what about all the talk I’m hearing about cash on the sidelines and money market fund balances near all-time highs as investors pursue mid-single digit returns on cash and cash-like instruments? Isn’t that a lot of potential buying power that could come in to offset market declines? Isn’t that constructive from a contrarian standpoint? The short answer is yes. But is the “so much cash on the sidelines” talking point backed up by the data. Below are three charts from three separate sources using three different methods to vet out this monumental level of cash used in bullish talking points.
The first chart from BCA research measures the total value of U.S. money market funds as a % of total market value of stocks and bonds. As you can see it’s near its lowest level in the past twenty-five years and nowhere near the panic levels reached in the popping of the Tech bubble, the GFC, or even the Covid pandemic.
BofA’s Quant and Equity Strategy team conducted a similar analysis where they measured consumer cash balances relative to the market cap of the S&P 500 (dark blue line) and corporate cash balances relative to the market cap of the S&P 500 (light blue line). Both are at or near their lows for the post-GFC cycle. And if you look closely at this chart, you’ll see that both these lines typically reach their lows at the end of a business cycle and spike during the ensuing recession/bear market.
Lastly, is a chart from Fidelity’s Director of Global Macro Jurrien Timmer where the black line in the top panel of the chart measures money market fund assets as a percent of market capitalization which at 11.2% is about average for this ratio over the past decade. The pink bars in the bottom panel measure the absolute level of money market fund assets which stand at their highest level in the past decade at $4.8 trillion. Keep in mind global GDP, money supply, world population… is all larger today (or close to) than it’s ever been so it should be of little surprise that money market levels are in a similar place. That’s why measuring cash levels relative to another metric like market capitalization is more insightful in that it provides a scale for comparison to for a unit of measure that is often mentioned on an absolute basis.
In a nutshell, on an absolute basis there is a lot of cash tucked away in money market holdings. Is it a strong contrarian bullish signal, I don’t think so. What I interpret from the BofA and Barron’s surveys and the above chart is that we are seeing a lot of fully invested bears. Additionally, short-end interest rates have risen to 4 – 5% (a level investors haven’t seen in the past fifteen years) and some investors are making what I consider to be a prudent choice of taking the low-risk mid-single digit secure return versus the unknown, but much riskier possible higher return offered in other markets.
As for markets, the sideways grind in equities has the VIX hoovering around the 17 level which is the lowest reading since January 2022. Given what I’m seeing in the economic data (more on this in a bit) I think this is embedding excess complacency especially with a forward P/E multiple on the S&P 500 pressing back up to 19x. As for bonds, the market has shifted yet again following continued hawkish rhetoric from Fed President’s Bullard, Mester, and Waller as the four rate cuts that were priced into the yield curve a month ago are down to two cuts at this point. Let me be clear, I am not a long-term bull on Treasury bonds or fixed income in general, but given the decay I’m seeing in the economic data, the continued decline in inflation, and potential land-mine from the debt ceiling showdown I’m a bond bull with the expectation that the 10-year yield gets to 2.5% before it sees 4.0% again, the 30-year yield sees 3.25% before 4.25%, and the 2-year see’s 2.0% before it sees 5.0%.
A major contributor that gets overlooked to the rise in asset prices following the SVB bankruptcy is liquidity. In a perverse way the bank failures in early March turned out to be an upside catalyst for stocks because it forced the Fed to step in and increase its balance sheet. Even if this liquidity is temporary (which it is) the Fed’s balance sheet is up more than $200 billion since the end of March. Beyond the Fed we have the Bank of Japan’s balance sheet expanding at a 20% annual rate so far this year as it continues its yield curve control (YCC) strategy. Even the PBOC (People’s Bank of China) has expanded its balance sheet. According to the FT the net addition of central bank liquidity this year has come to $1 trillion. Given what we learned about the post-GFC relationship between central bank balance sheets and global equity prices, it’s no wonder the MSCI World Index is up about 8% year-to-date on fundamentals that are “better than feared” not an actual improvement.
In an ironic twist of fate, the Fed isn’t the only government entity refilling the stimulus tub. The fiscal largesse in the U.S. with its fiscal first half deficit running much larger than expected is stimulus, just under the vail of deficit spending. Just as giving those with excess savings a 4 – 5% risk free return on short-term Treasuries is stimulative via a government funded pay raise on idled savings. I’m not complaining about it, from an investment perspective, but we are talking about interest expenses on government debt clipping along at an $800 billion annualized pace. That’s a lot of interest income being paid out by Uncle Sam and in another twist of irony this interest income is offsetting the roll-off of handouts provided to U.S. citizens in the aftermath of Covid. The biggest difference between the stimulus provided in 2021 is that it went to everyone and particularly to those in need, today’s stimulus via higher interest rates goes to U.S. Treasury holders.
Unfortunately, none of this has changed the outlook for the U.S. economy when viewed through the lens of the Conference Board’s Leading Economic Index which fell -1.2% month-over-month in March. This was the 12th consecutive month of a negative print with the depth and duration of declines lining up with previous recessionary periods.
The year-over-year slide in the LEI is now at -7.8% - never in the past six decades has the LEI reached this deep a slide and the U.S. economy not been in or slipped into a recession.
Keep in mind that the lead time for the peak in the LEI until a recession starts is 14 months which puts Q2 right on schedule for the possible start date given the LEI peaked in December 2021. This is what makes it so hard for me to take smart people like St. Louis Fed President Bullard seriously when he says that he sees no recession and wants another +75 basis points of rate hikes. At the same time his own Fed staff is forecasting a mild recession in the most recently released FOMC minutes. I mean really, come on. We get that you have a part to play and yelling fire in a crowded theater doesn’t bring about calm, but denying it’s possible with smoke in the air is just plain tone deaf. I could go on and on, but I’ll save you the time and effort.
Bottomline, nothing I’m seeing in the data is causing me to back off the view we’ve held for the past six months: an economic recession is our base case expectation for the economy. Such a backdrop creates considerable risk for equities and risk assets. Does it assure a 50% decline in the stock market like we saw in 2000 – 2002 or 2008 – 2009? No! There is no way of knowing how exactly this plays out. In my estimation if an economic recession were to get underway in the next 3 – 4 months, there isn’t an asset class in the markets that is priced for it. Equities aren’t with a P/E multiple at 19x. Credit markets aren’t with spreads near their tightest levels of the cycle and Treasury yields are high relative to the typically 400 basis points of Fed cuts during recessions.
What I think makes sense for investors is to acknowledge and assess the risks – then act accordingly. For me it’s positioning portfolios in a cautious and defensive manner. That means a mix of higher cash and short-term cash instruments, lower overall equity exposure, some fixed income, some foreign equity exposure, and some gold. Add to this a healthy combination of patience, humility, and flexibility.
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