No Market for Old Men
With respect to a challenging market environment, we are deviating from our song title theme today and pivoting to a book / movie title. Some fun things below. Let's dig in...
Over the past two months, we have had 3 themes at Charting Alpha:
US Fiscal Dominance - the idea that the US debt outstanding and interest payments are so great that: a) they are impacting policy decisions in that the government needs rates lower despite economic data that, in our view, may warrant higher; b) 10-year yields may face the wrath of the “bond vigilantes” that will send long-term yields higher and force difficult decisions on policy makers (austerity / higher taxes?). (See chart 2 here and chart 2 here),
Something in equity markets changed in late January / early February. We have seen reversals in several sectors, commodities and relationships. This has led to a rotation towards cyclical sectors (Energy, Materials, Industrials) over AI / Technology). (Chart 1 here, chart 1 here, chart 1 here and charts 4 and 5 here). We promised thoughts on the catalyst, please see chart 2, below.
Stealth liquidity - with “official” monetary policy relatively tight, the use of non-conventional means of stimulus from the Treasury (the General Account and Reverse Repos) - were partially responsible for the 20%+ move in the S&P 500 from October through February. (See chart 3 here, chart 2 here and chart 4 here).
Within these themes, to help guide our market narrative, we have highlighted several sub-themes such as: a) earnings expectations look unrealistic; b) valuations are elevated particularly given 10-Year yields and our 10-Year yield outlook; c) this is not the 2023 equity market; d) the outsized gains from of AI 1.0 themes (Semiconductors etc.) are largely in the past.
Where does that leave us - we see the 4800 area (the 2022 high) on the S&P 500 as the key battle zone that will likely be tested. (See chart 1, below)
1. How it Started, How it’s Going…the S&P 500
Source: TradingView. Through year-to-date 2024.
After rallying 28% from the end of October to the beginning of April, the S&P 500 has dropped 5% in the last 3 weeks.
While the velocity of the sell-off (stairs up, elevator down) feels extreme, a) a 5% sell-off is very normal and; b) after any significant rally, a pullback to the 0.236 Fibonacci retracement level (of the rally) is typical.
In the current, environment a confluence of factors that the market had been ignoring (and we had been citing) finally began to resonate.
We have highlighted questionable fundamentals (1% earnings growth in 2023 combined with aggressive forecasts for the second semester of 2024) paired with elevated valuations, but have reiterated these conditions, in isolation, were not enough to change market direction. (We often state - valuation is not a catalyst, but a measure of risk).
As Stan Druckenmiller has said:
“We look at valuations. We use them to determine, really, the market’s risk level, as opposed to its direction… Valuation is something you have to keep in mind in terms of the market’s risk level… when catalyst’s come in and change the market’s direction… the decline could be very major if you’re coming from the kinds of overvaluation levels.”
The catalyst and the most significant factor, in our view, has been the change acknowledgement by the Fed that the higher-than-expected inflation in each month of Q1 would delay their previously announced plan (December) to cut rates as price increases drifted towards their stated goal of 2%.
A chorus of Fed speakers has been out this week with a similar message - there is no rush to cut rates:
On Monday, San Francisco Fed President Mary Daly said, "the worst thing to do is act urgently when urgency is not required."
Yesterday, Atlanta Fed President Raphael Bostic offered "the end of the year" as his view of the likely timing for a first rate cut, and said, "I'm comfortable being patient."
New York Fed President John Williams said yesterday, “"I definitely don't feel urgency to cut interest rates."
On Tuesday, Fed Chair Powell said “Given the strength of the labor market and progress on inflation so far, it's appropriate to allow restrictive policy further time to work and let the data and the evolving outlook guide us.”
As recently as January, the market had priced in 6 cuts for 2024 beginning at the last meeting in March. It is now pricing in between 1 and 2.
More from Stan Druckenmiller:
“Earnings don't move the overall market; it's the Federal Reserve Board... focus on the central banks, and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets.”
While a 0.236 retracement / 5% drop are typical after a significant rally, we continue to be focused on the area around 4800 on the S&P 500.
Not only is 4800 the scene of the January 2022 (at the time) all-time high, it coincides with the 0.386 retracement level and, depending on timing, the 200-day / 40-week moving average.
Although the S&P 500 could drop below 4800, as we highlighted yesterday, the Fed and Treasury would likely once again begin to use their less conventional and less visible stimulus tools to calm volatility.
“It's liquidity that moves markets.” Stan Druckenmiller, one of the greatest investors.
(This is not a recommendation to buy or sell any security and is not investment advice).
2. What Happened in Late January / Early February?
Source: TradingView. Through year-to-date 2024.
One of the themes in our work has been that the market character changed in late January / early February.
In general, there has been a rotation from AI / Tech related sectors towards cyclical sectors such Energy, Industrials and Materials (see chart 3, below).
Since early February, Copper, a critical cyclical commodity, has rallied 22% - nearly in a straight line.
Copper is often seen as a barometer of global growth. Industrial infrastructure and homebuilding are two key sources of copper demand.
Given higher for longer Fed funds rates and increasing 10-Year Yields, a cyclical rotation seems somewhat counter-intuitive.
As we like to say, when price does something you wouldn’t expect, it often pays to listen.
While I am not sure if it will pay to listen in this case, we do think it is important to find the catalyst.
With that in mind, looking at the chart above, it is easy to see that in mid-2022, copper dropped 30% over the course of a month.
Although the US was tightening interest rates / slowing the economy at the time, the proximate cause for the drop in copper prices, in our view, was a surge of covid in China that led to a wave of lockdowns.
As a result, the first place I looked for a cyclical rotation / copper rally catalyst was China.
Sure enough, in late January, China began providing stimulus to its economy.
On January 24th, China announced a lower reserve requirement at its banks (a tool the PBOC - China’s central bank to provide or withdraw stimulus.
At the time, the PBOC cut the reserve requirement ratio (RRR) at banks by 0.50% which released 1 trillion yuan ($139.8 billion) to be lent out. Nomura had been expecting a 0.25% RRR cut (in other words, larger than expected stimulus).
In mid-February, China followed up the RRR cut (and other smaller stimulus measures) by announcing its biggest ever reduction in the benchmark mortgage rate (the five-year loan prime rate (LPR)).
“It's liquidity that moves markets.”
Although, we have highlighted Chinese Internet shares (more of a trade than an investment - we most recently showed this here, but also here and here), we see the cyclical rotation as a way to play China without the political risk.
We will continue to watch copper as a barometer of global economic growth, the validity (or continuation) of the cyclical rotation and a reflection of Chinese stimulus.
(This is not a recommendation to buy or sell any security and is not investment advice).
3. Technology relative to Energy
Source: TradingView. Through year-to-date 2024.
Perhaps no chart captures our AI to Cyclicals rotation theme quite as well as the one above that shows the relationship of Technology to Energy.
Interestingly, in late January / early February the Technology relative to Energy experienced a double bottom as Technology’s outperformance began to give way to upside in the Energy sector.
Since that time, the Energy sector (oil and gas companies) has consistently outperformed.
The relationship is now at a level that has been an important one in the past (horizontal light blue line).
We will watch closely to see the direction of the relationship from here (best guess - pause?).
Following on something we wrote yesterday with respect to oil.
We questioned why the price of oil had dropped over the past week despite missiles fired between Iran and Israel. As we wrote, often when there is heightened tension in the Middle East, oil prices move higher not lower.
We asked:
Was the move lower because economic growth prospects have been reduced given a tighter than expected Fed?
Given the chart of Copper, this doesn’t seem to be the case.
Was it because the bombs from Iran were largely intercepted and, therefore there is a lower likelihood of escalation?
Despite the Israeli retaliation over night, this is a possible answer as the exchange of missiles seemed to cause little damage (as far as we know) and was seen as a mutual face-saving exercise by many.
Was it because the Biden administration knows the sensitivity of the US electorate to oil prices and has been aligning itself more with Saudi Arabia (notice the coordination in between the US and Saudi Arabia in defending Israel) to keep oil in check?
Although this might not be exactly the right reason, I wouldn’t be surprised to see a OPEC quota increase or another source of supply that is weighting on oil price.
We’ll watch, but all else equal, lower oil = lower inflation / inflation expectations = lower treasury yields and lower Fed Funds expectations.
(This is not investment advice or a recommendation to buy or sell any security).
4. AI Implementation
Source: Bespoke Investment Group. Through year-to-date 2024.
Despite our near term caution on AI and Technology, if our view is correct that the Fed and Treasury will provide non-conventional liquidity at some point in the near future, we want to begin to build a list of possible investment targets in the AI 1.1 and 2.0 space.
As a reminder, our view is that the outsized gains in AI 1.0 (Semiconductors and infrastructure) may be primarily in the past. (See here).
AI 1.1 and 2.0 will revolve around implementation, data and analytics. In our view, this will likely benefit a number of well positioned software companies among others.
While the list above from Bespoke Investment Group, is not exhaustive, it is representative.
Furthermore, in our view, if the fundamentals are correct, many of these companies will benefit from stealth liquidity.
It may make sense to consider a barbelled portfolio of selective cyclicals and high growth AI-oriented software companies as an equity portfolio strategy for the second half of 2024.
(This is not a recommendation to buy or sell any security)
5. Fading the Consensus
Source: Bank of America. Through year-to-date 2024.
The chart above shows the results of the Bank of America Fund Manager Survey (FMS) to the question “What do you think is currently the most crowded trade?”
Despite the fact that the Magnificent 7 has been soft for 2 months (somewhat in line with Technology) and that Chinese equities bottomed 2 months ago, the perception of positioning among fund managers has not significantly changed.
It’s also interesting to me to see no responses that involve the cyclical sectors.
In our view, this may mean that the cyclical (Energy, Industrials, Materials) outperformance has a longer runway than if the trade were consensus.
Furthermore, it may mean that a continued rotation away from the Magnificent 7 and into AI 1.1 and 2.0 software and data names could provide outperformance.
Have a great weekend!
(This is not a investment advice and is not recommendation to buy or sell any security).