Was Yesterday's Equity Sell-Off a Shot Across the Bow or Benign?
With a combination of lackluster earnings, a warning from New York Community Bank and a less dovish than expected message from Powell, equities sold off. Was it a pause or a warning?
While we don’t want to make too much out of one day’s market activity, our narrative has consistently been that the foundation of the equity market’s ascent has been a fragile one.
Earnings, in our view (here and in chart 2 below), have been mixed at best; economic growth has been questionable while the “soft” and no-landing scenarios seem to have been priced in (here); and the Fed and Treasury have consistently been providing “stealth” liquidity adding support to unprecedented fiscal spending (chart 2 here).
During the past month, as the S&P 500 moved higher, some cracks have appeared in the veneer. In charts 4 and 5 of “Earnings and the Fed, Oh My!” (here), we noted the divergence between the S&P 500 and the Transportation Index and weakness in February.
We view characteristics like these as similar to cracks in a windshield - will they spider-web out or will they remain contained? Below, we have highlighted some of the market dynamics that may be in their early stages but we’re continuing to watch.
As a reminder, we have added to cash, noting the possibility of better buying opportunities; bought protection through options (where appropriate); and emphasized our highest convictions and diversification (across sectors and styles (value / growth). (This is not investment advice).
1. New 52-Week Highs Have “Diverged”
Last October, one of the market characteristics that helped us position for the year-end rally the divergence between the S&P 500 and the new 52-week lows.
While the S&P 500 was moving down, fewer companies were making new 52-week lows. At the time, we viewed this is as an improvement “under the surface.”
As equities have continued their ascent, it is notable, in our view, that the number of 52-week highs in the S&P 500 peaked on December 14 while the S&P 500 is up 3.2% since that time.
While we would not make any investment decision based on any one indicator, divergences, like this (and like the Transportation Index chart 4 (here)) catch our attention.
These divergences are often a sign of the markets underlying strength or weakness and combined with other factors can help inform our view and positioning.
(Past performance is not indicative of future results).
Source: Bloomberg. Through year-to-date 2024.
2. Small Cap Earnings Growth
While astute readers will note that the growth levels presented in the chart below are in the past and equity markets discount the future, the consistent and pronounced weakness in Small Cap earnings has our attention.
Although the S&P 500 experienced three consecutive quarters of negative earnings growth from Q4 2022 through the first half of 2023 - and we could make an argument that this was “priced in” during the 2022 sell-off - the Russell 2000 is in the midst of its 4th consecutive quarter of negative earnings growth (chart below).
Thus far in the Q4 earnings reporting period, with approximately 20% of the Russell 2000 having released results, sales growth is estimated to be -3.8% for the quarter while earnings have been 4% below expectations.
It is possible that a turn from negative earnings growth to positive in 2024 (which is expected) will spur Small Cap upside (that many have called for).
However, when we view this chart and consider that many believe the Small Caps are more economically sensitive than their larger cap cousins, we wonder what Russell 2000 earnings growth says about the strength of the economy.
We have been consistent in our view that recession risk may be under-priced in the current environment, perhaps we are data mining or simply highlighting indicators that confirm our bias, but we do believe weakness in Small Cap earnings should be acknowledged.
Source: Bloomberg. Through year-to-date 2024.
3. The Dollar
The performance of the Dollar Index (below) if often inversely correlated with the performance of the S&P 500. As the dollar strengthens, the S&P 500 often moves lower. (Past performance is not indicative of future results).
From mid-July to October last year, the dollar moved higher while the S&P 500 dropped 11%.
Over the past month, the dollar has once been strengthening while this has been largely ignored by equity markets.
More recently, the dollar has been flirting with the north side of its 200-day moving average (dark green line).
If the dollar were to move meaningfully above its 200-day moving average, we believe equity markets may begin to pay attention.
Source: Bloomberg. Through year-to-date 2024.
4. Could We See a Growth to Value Rotation?
From the time that the Fed began considering accelerating its tightening schedule in November 2021 to January 2023 when market began to price in a Fed pause, Growth underperformed.
While the main take away for many from yesterday’s Fed statement / Chair Powell Q&A was that March is early for a cut, the other side of that message was possible confirmation that the tightening cycle was over.
There are two environments when value shares / sectors often do well: when growth is very high and when growth is very low / negative (recessionary).
Often with high growth, cyclical industries like Financials, Energy, Materials and Industrials which are disproportionately value rally. One explanation is that in period of high growth, when growth is a commodity among stocks, investors want less expensive ones.
In recessionary periods, investors want defensive shares like Consumer Staples and Utilities which happen to be value.
In Goldilocks periods - moderate to low growth and minimal Fed involvement - Growth shares often do well.
We believe it is possible that investors could begin to take gains and migrate from growth shares and move to value shares depending on economic growth and the Fed response - similar to rotations we’ve seen over the past two years.
While Growth relative to the S&P 500 (top panel of the chart below) has been turned away at an area of a lot of resistance in 2021, we will watch to see if Value (lower panel) can climb back to past relative levels.
(Past performance is not indicative of future results)
Source: Bloomberg. Through year-to-date 2024.
5. A Crowded Trade / the Way it Works (for Some)
Fragile.
That’s a word we’ve used a lot to describe the current equity market environment.
It doesn’t mean equity markets will go down, it simply means, as we’ve tried to consistently describe, that the foundation is not as strong as we’d like.
With that in mind, we’ve recently read two articles that have caught our attention.
The first cited Scott Rubner, Goldman Sachs’ positioning and tactical specialist. The message from his note is, as the chart below tries to show, that investors have crowded into the S&P 500.
Specifically, he highlighted that if the US stock market goes down a little from here, “it could go down a lot” as investors unwind positioning.
This reminded me of an article I recently read about how parts of the investment industry work.
While the whole article (here) is definitely worth reading, I’ve included some of the salient parts below:
“I’m reading a lot of year-end fund letters.
Everyone is bemoaning the MAG7 [the Magnificent 7], their disproportionate effect on the S&P 500 (which is effectively the index that everyone competes against), and the fact that their funds underperformed.
Look at the MAG7 screaming higher in January. Every day, portfolio managers are falling further behind.
They’re saying to themselves, “Not again! I gotta catch up!!” They’re rolling out of their core portfolio positions, and they’re telling their brokers to, “get me some MAG7!!”
They’re not investing, they’re surviving.
This is existential. If NVIDIA goes up another $100 and they don’t have it, they’re out of a job.
This is how blowoff tops get made.
I don’t know when this ends, as these things have a way of feeding on themselves. I just know that it eventually ends.”
(Past performance is not indicative of future results)
This is not a prediction or a warning, but a reminder, like today’s entire note, to keep an open mind and to maintain vigilance.
