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Happy Father's Day, Traderade family! I hope you are having a great holiday weekend. Remember that tomorrow (Juneteenth) is a stock market holiday.
Last week was a really busy week, especially in comparison to the week ahead. But before we get to that, let's look at the week that was.
The Macro
Core inflation measures remain elevated above levels that would give the Fed any level of comfort. While progress is being made in the battle against inflation, core inflation measures remain elevated above modern historic norms.
Last week Chair Powell spoke to this, and despite pausing the FOMC indicated that it plans to do not one, but two more rate hikes. Though the market remains skeptical.
What's interesting is if that if we net out rent and OER from CPI core services, we can see that there's perhaps more progress being made than meets the eye. With OER as a lagging indicator, it will be interesting to see whether it shows the same progress later in 2023.
Jobless claims are up 35% since January of 2023 when netting out the fraudulent filings we saw from Massachusetts. There are some signs of softening in the labor market, but it is limited and particularly focused within technology and finance as industries, and separately small-to-medium businesses in terms of size of company.
With all the macro data we got last week, and the FOMC statement as well as press conference with Chair Powell, we saw some movements across the Fed Funds Futures. There is no longer a rate cut priced in for 2023, with that expectation being pushed to January of next year. But we also did not see the market price in a second hike. Participants continue to doubt the resolve of the Fed, and with some reason after the press conference felt a bit like it was trying to walk the fine line between hawkishness and neutrality.
But we also did not see the market price in a second hike. Participants continue to doubt the resolve of the Fed, and with some reason after the press conference felt a bit like it was trying to walk the fine line between hawkishness and neutrality.
Financial conditions have eased meaningfully in the last few months from the heights we saw during the regional banking crisis. This has helped to support risk assets, like stocks, to march higher during that same time period.
Central banks ordinarily endeavor to meaningfully tighten financial conditions during a hiking cycle, but we have seen Chair Powell back off meaningfully from this goal starting in February, when he stated that financial conditions had meaningfully tightened since the Fed started hiking. By most measures that isn't the case.
A Glance at Fundamentals
A lot of the rally that we've seen from the October lows has been supported not by improving earnings, but instead multiple expansion. Indeed, we're in a (mild) earnings recession so the upward price revisions that we've seen within risk assets has largely been insensitive to valuations.
We can see the same phenomenon in the NASDAQ itself, where P/E expansion has been rather significant. Rising to levels that are objectively quite expensive, particularly in the current interest rate and earnings environment. Whether the "AI" hype manifests meaningful improvement in productivity and margins remains to be seen, but that is exactly what I am looking for in the quarters ahead to justify these massive multiple expansions.
Markets Overview
As we can see below, performance within the last three months has been largely concentrated within tech. The weightings within "Communication Services" and "Consumer Discretionary" also lean heavily towards tech. This concentration, where 15 stocks have accounted for over 90% of YTD upside is certainly a concern. Omitting them leads to an S&P 500 that's essentially flat this year.
Within the S&P 500 technology sector, we can see that total returns have brought us back to levels that mirror the all-time highs, at the end of 2021. However, this is not the same market environment as we had then, when there was an abundance of liquidity, ultra-low rates, and earnings hadn't shown the same vulnerability that we're seeing now.
Underneath the surface the Great Rotation theme that I've discussed previously is well underway, where cash and fixed income are seeing the largest year-to-date flows, and there are some outflows from a variety of equity markets. Part of this is driven by the era of financial repression on pause, or possibly ending. Many fixed income opportunities right now are among the best we've seen in 20 years.
On Thursday, we saw the largest S&P 500 call buying in history, which helped to propel the index above that key call wall at 4,400 just before quarterly options expiration on Friday.
We've also seen a growing 5-day rolling correlation between the VIX and S&P 500. Sometimes this happens before major turning points in the markets.
Speaking of the VIX, if there is seasonality to volatility, it would appear that we're within the trough before it heats up again according to 32 years of historic data.
Someone wiser than me once said, "Don't hedge when you need to do so, hedge when it is cheap." We're certainly within the realm of tail risk protection being attractive.
Positioning and Flows
I always feel a bit contrarian when I see retail flows ramp up as significantly as they have over the last several weeks. It seems like we're reaching an extreme of lopsided positioning, and not just here.
Hedge funds have also been significantly increasing net leverage.
CTAs also have a rather large amount of long positioning in the S&P 500 (and global equities).
And positioning, according to this Sentiment Indicator from Goldman Sachs is stretched to the long side.
The Week in Review
Last week we saw much broader breadth in market participation to the upside, which is a healthy sign. Tech, and particularly semiconductors, helped to lead the way. Energy largely sat out the rally, and it's become a sector that hedge funds hate, with their lowest allocation to the space in years.
The NASDAQ was the leader again last week, rising 3.2%, clocking in a very impressive 30.8% year-to-date gain. In fact, it's on track for its best start to a year ever. The Dow, which we affectionately refer to here as the "Boomer" index, clocked in a comparatively subdued gain at 1.2% for the week, rising just 3.5% year-to-date. An illustration of just how much the rally isn't as broad-based as the S&P and NASDAQ may make it appear.
We closed out the week above 4,400 on the S&P 500 cash index, which caused positioning to change such that it is now a volatility trigger level. What that means is that if we cross below it meaningfully we could see volatility increase markedly, with increasing downside risk. It's also a key psychological level of support.
We are deep in positive gamma territory, with the flip level currently calculated at 4,318 on the S&P 500 cash index. Our naive model suggests that could lead to dealers compressing realized volatility by buying a 1% dip in the amount of nearly $40B, and selling a 1% rip in the same amount.
The Week Ahead
Coming up this week, despite the stock market being closed tomorrow, we do have economic data starting with the NAHB Housing Market Index. The most important events to watch, in my opinion, are building permits, housing starts, Chair Powell's testimony, Existing Home Sales, and the S&P PMI Flash data.
There's $173B in Treasury bill auctions next week, which a bit smaller than last week where we saw over $200B. Nevertheless, this issuance has so far been relatively well-absorbed by the market. But I do think it will take time to measure the total liquidity impact.
We also see $12B in 20-year Treasury bonds and $19B in 5-year TIPS on auction. The 20-year is one of the least popular maturities, so I don't tend to pay a lot of attention to the auctions, but it is still interesting to at least see what demand looks like and whether the auction has a tail (high yield during the auction over the yield prior to the auction).
Finally, we have earnings. Striking a rather subdued tone in the week ahead, I think it will be interesting to watch FDX as they report Q4 and full-year earnings (their fiscal year ends on May 31st). The company has struggled as the economy has slowed. Getting more clarity on how well they're doing in this environment and what they see moving ahead could be illuminating given their large international presence.
What Comes Next?
After the longest advance since 2021 for the S&P 500, is it ready to take a breather?
It may depend on a few factors, one of which is whether indeed the Fed is pausing or if we will continue to see a further increase of the terminal rate. After a pause, returns are generally positive, with a mean return of about 7% over 90 days.
In Closing
We have a market that's looking overheated, but a light week of catalysts for any significant moves. Because we're now past OpEx we no longer see as strong passive flows from delta and theta decay to support the S&P 500. That doesn't mean downside is inevitable, but it does mean that downside risks increase on any meaningful catalyst without those passive flows helping to bid the market higher.
I am still reluctant to call this a new bull market, as I feel we've had a rally predicated more on hype than substance, multiple expansion more than fundamental improvement, options buying more than accumulation of shares (where we actually see distribution), and an AI frenzy based more on imagination than reality.
If this is a new bull market, it is objectively the most expensive (in terms of valuations) in US history, and starting at a point where few new bull markets ever have: before rate cuts, before any sort of recession, before there's a large de-risking by US households who still have nearly the largest percentage of their net worth tied up in equities. It would also come before the apparent trough in earnings, as the earnings recession is likely to have deepened in Q2.
The economy is showing significant signs of weakness, with 13 months of negative leading economic indicators, which in the past 60 years after 6 months we've always seen a recession later follow.
The last respite of strength has been the services sector, which accounts for three quarters of GDP. But it, too, is showing signs of weakness in the last ISM Services PMI data, showing only an expansion on the margins, but looking within new orders and backlogs have declined and that means business is likely set to slow.
If we do see services roll over, because they are the largest creator of new jobs, and where most of the job growth has been occurring, I think that's when we finally see the labor market loosen and unemployment rise, which is likely to be the sign to watch for as recession risks would rise meaningfully following such a turn of events.
For now I remain observant, cautious, and skeptical. Of course, if I am proven to be wrong and this is a new bull market, my concern would be can these stocks grow into these lofty valuations, or have we already seen most of the returns of this bull run already? Should the rally not broaden out meaningfully, the concentration we've seen so far also puts the market at risk should any of the leadership falter in a meaningful way.
Be nimble out there, my friends.
Thoughtful and well balanced perspective. I’d love to know more about the 5-day rolling correlation b/t VIX and SPX (subtext:. I have no idea what this means :)