The stock market remains in an uptrend and stock participation continues to improve and new highs continue to expand. At the closing of Friday 28, 76.8% of the S&P 500 companies are trading above their 200 DMA (Day Moving Average), 73.25% of Mid-Cap stocks, 63.17% of Small Cap stocks, and 83% of Nasdaq 100 stocks are doing the same. Historically, this is enough strength for a sustainable bull market. Only a few weeks ago the S&P 500 did not enjoy such luxury.
In other words, the current bull market is switching from a handful of large-cap leaders to broader participation. During the last month, all 11 sectors of the economy are in positive territory led by energy and financials, both had experienced strong headwinds earlier. Technology-related ETFs are consolidating, and Housing and Retail are moving higher. Regional Banks and Insurance are surging too. Utilities are lagging, which is expected in bull markets. Last but not least, volatility (VIX) continues to be under pressure, and its “Main Trend @GCCM” remains bearish, which is positive for stocks.
The spread in credit markets is showing no signs of stress. This refers to the spread between corporate bonds and U.S. Treasuries. Wider spreads are a sign of stress, therefore negative for stocks, and tight spreads show stability in credit markets and are positive for stocks. Although spreads are far wider from where they were before the 2022 bear market, they are tighter than the peak experienced back in October 2022 and heading lower. At least for now. Federal Reserve’s (FED) balance sheet continues to contract after a big expansion in March due to the regional bank crisis.
- The FED raised rates by 25 bp to 5.25% – 5.50%. They seem undecided regarding future rates, which is a positive change for stocks from their previous hawkishness.
- Inflation continues to decelerate.
- Unemployment remains strong.
- Consumer confidence climbs to a 2-year high.
- 2nd Quarter GDP accelerated to 2.4%.
- For some economists and forecasters, the U.S. economy is no longer at risk of recession. Worst case, a soft landing of the U.S. economy is almost certain.
What can go wrong?
We’ve been increasing the allocation to risk in clients’ portfolios during the first half of 2023, and it is paying nicely. But as Risk Managers that we are, it is our fiduciary responsibility to figure out what may trigger the next leg down to protect our client’s capital. It is correct that earnings momentum if sustainable, may push the stock market to new highs. But we’ve noticed a surge in some of the lagging sectors and industries such as Agribusiness, Copper, and Wood (MOO, COPX, WOOD). Gold Miners (GDX) is breaking out ahead of Gold (GLD). Base Metals (DBB) seem to be turning up too. The Main Trend @GCCM of the U.S. Dollar (USD) is bearish. This is important because a weak USD makes U.S. exports more competitive abroad, which helps sales and economic growth in the U.S. Most of the time, the USD and commodities move in opposite directions. Therefore, a weaker USD may create a spike in economic activity and commodity prices including energy and oil. All this is important because it might cause a resurgence of inflation pressure.
Our quantitative analysis still shows the Main Trend @GCCM of the 10-year U.S. Treasury Yield, bullish. The explanation above might be the reason for the stubborn uptrend of the Treasury yields, all maturities across the curve. The price of bonds and stocks have similar reactions to inflation, for different reasons but similar reactions:
Low Inflation = Lower interest rates and better profit margins (higher bond and stock prices)
High Inflation = Higher interest rates and lower profits (lower bond and stock prices)
If in fact, the U.S. economy is transitioning into a low-inflation environment, then the stock market will continue to rally. But why are Treasury Yields heading up? Bond investors are either wrong or if there is a resurgence in inflation investors should expect another selloff in stocks. The question is when?
There are two reasons for yields to move up: (i) accelerating economic growth usually at the beginning of the economic cycle, which is good for stocks, and (ii) fighting inflation at the end of the economic cycle, which is bad news for stocks. Perhaps this is the reason for an inverted yield curve that is now 12 months old. Give or take the inversion remains at -100 bp, which is double the inversion seen before the burst of the internet bubble.
The bond market anticipates events in the real economy by about 12 months or more. Following this rule, we are only seeing now the effects of the 2022 summer rate hikes and we are far from experiencing the real impact of the 2023 hikes. The stubborn inversion of the yield curve may be announcing a hard landing for the U.S. economy within the next 12 months or perhaps even more. In the meantime, the bull market in equities may continue, and being invested is the only way to participate. But there is a big difference between being invested in equities at the whim of volatility and being invested with a proven Risk Management strategy in place to protect capital.
Strong momentum and a sustained overbought stock market are a sign of strength and positive for stocks. But focus on the evidence. Beware if the rotation of capital that started a couple of weeks ago, which is helping to broaden stock participation, ends up being a rotation out of growth and into value and more defensive sectors of the economy. Keep in mind that usually August and September are averse to stocks.
What needs to happen to solve the inversion of the yield curve? The stock market reacts to the yield curve with a lag. Unemployment going up has always signaled that the end of the inverted yield curve is upon us and a sustainable bull market ensues. For the time being, unemployment remains quite low and the inverted yield curve persists. Some say this time is different. It remains to be seen.
(*) The Greenwich Creek Capital “Index Trend Table” is not meant to be used in isolation, it is part of a more complex set of variables and it is not designed to provide trade entry and exit points.
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