Updated September 5, 2023
Raymond Micaletti, Ph.D.
That might have been it for the dip.
Equities rebounded strongly last week with the broad market up 2.8% and the Nasdaq 100 up 3.7%. Even small caps joined the celebration, finishing up 3.7% as well.
Gold rose 1.4% and oil jumped 6.2% despite the dollar continuing its seven-week rally (barely). Bond yields fell slightly and the VIX had its second lowest close of 2023 at 13.09.
While the exuberance in markets may have been simply an end-of-summer, low-volume, no-one’s-really-paying-attention rally, the proximate cause was generally soft jobs market data that caused the market to forecast the Fed is done hiking rates.
Coming into the week, the market had been forecasting greater than a 50% chance of one more rate hike at November’s meeting. But that probability fell to 35% by Friday.
JOLTS job openings, ADP payrolls, the unemployment rate, and average hourly earnings were all weaker than expected.
In fact, by Friday morning the dollar was down 0.70% for the week, as one might expect given the disappointing jobs data. But then the ISM Manufacturing Prices Paid report came out and it was four percentage points higher than expected (48.2 vs. 43.9) and the dollar surged 1% into the weekend.
Last week’s moves were consistent with how investors have been positioning themselves in recent weeks and not much has changed on that front.
With respect to:
Equities: Institutions bought a non-trivial amount of equities, while retail sold a non-trivial amount (on a relative basis). Although direct relative sentiment in equities remains bearish, it made a big leap higher (in a bullish direction) last week. Meanwhile, cross-asset positioning remains highly favorable for equities.
Dollar: The Smart Money continues to sell the dollar rally (which is now seven weeks in the making). Consequently, we would look for that rally to stall out eventually and for the dollar to resume its downtrend.
Gold: After several weeks of aggressive short-covering, institutions resumed selling gold last week. Nonetheless, their positioning is less bearish than it had been and is within striking distance of turning bullish. But until that bullish shift occurs, we would expect gold to remain range-bound. (Even so, gold has strongly outperformed where one would expect it to be given the level of real interest rates.)
The market finished the week well off its Friday morning high and as a result is not particularly overbought (despite the strong bounce). Nonetheless, we wouldn’t be surprised by moderate pullback next week to retrace some of last week’s gain.
On an intermediate-term basis, however, things are shaping up as follows….
The Bull Case
The bull case for equities is gaining steam in the wake of last week’s bounce:
Momentum: We are still downwind from several momentum triggers and breadth thrusts from earlier in the year–the windows over which they tend to act would take us into Q1/Q2 2024
Relative sentiment: While retreating from a strongly bullish 87% last week, composite equity relative sentiment remains solidly bullish at 72%
Tech leading again: The chart of the ratio of the S&P 500 to the Nasdaq 100 looks to be in a bear flag that is breaking lower–this implies equities will move higher with technology stocks again leading the way
September: Though September has been unconditionally the worst month of the year for the stock market, when the market has been up strongly through July or the VIX has been below 14 in August (both of which occurred this year), September has tended to be a good month for the market
Earnings revisions: Global earnings revisions are moving higher, which gives “succor to the bulls” (according to Bank of America) and provides a “backstop for equities” (according to Barclays)
The Bear Case
The bear case for equities rests on two primary pillars:
Valuations: 10-year expected annualized (nominal) U.S. equity returns ended the week at 2.2%, while the 10-year U.S. Treasury yield closed at 4.18%. Thus, holding 10-year Treasuries over the next decade is likely to produce higher returns than holding U.S. equities over the next 10 years.
Fiscal dominance: According to the St. Louis Federal Reserve, fiscal dominance is “the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that ‘dominate’ central bank intentions to keep inflation low.”
It’s becoming more and more evident that higher interest rates are stimulating the economy rather than hindering the economy.
The reason is that higher interest rates applied to the mountain of debt the U.S. government is sitting on results in nearly a trillion dollars in interest expense being paid out to bondholders–on par with the COVID stimulus and prior rounds of quantitative easing.
Thus, the Fed might find itself (or already be) in a vicious circle of inflation leading to higher interest rates, which leads to bigger U.S. budget deficits (on account of increased interest expense), which leads to more interest paid into the economy, which leads to higher growth, which keeps upward pressure on inflation, which leads to higher interest rates and so on….
This situation could very well be bullish for risk assets until bond yields rise uncontrollably and in a nonlinear way. At which point, financial conditions would likely become so tight that equities would be unable to shrug them off.
We maintain our view from last week. We continue to believe equities have unfulfilled upside potential on account of the robust positive momentum and the steadfast bullish tilt to relative sentiment we’ve seen this year.
The backdrop for equities remains favorable–Smart Money has sold the dollar rally and bought assets that do well with falling real rates (gold, silver, oil). Corporate insiders have been buying equities, while retail investors have been buying puts. Institutions still prefer 30-year bonds to 10-year bonds in an environment where such a preference is bullish for equities.
Further, upwardly-moving earnings revisions and strong GDP growth (if one believes the Atlanta Fed GDPNowcast) round out the litany of points in favor of more equity upside.
This backdrop seems almost too good to be true, however.
Which raises the question: Would the market really just end its August selloff with last week’s big bounce and not look back? The market tends not to make things that easy.
Consequently, we would be on alert for a minor pullback this week–possibly in conjunction with rising yields–to retrace some of last week’s gain.
But so long as investor positioning doesn’t change materially from its current orientation, we believe the market will eventually move higher in the weeks ahead.
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