Updated April 4, 2023
Raymond Micaletti, Ph.D.
The broad U.S. equity market finished the quarter strongly last week, rallying 3.6%, to finish up 2.7% on the month and 7.2% on the quarter. The market is now up 2.9% since the Breakaway Momentum breadth thrust was triggered on January 12, 2023 and up 12% since the October low.
Year-to-date, the market has been led by the tech-heavy Nasdaq 100, which finished the quarter up 20.7%, after putting in a 3.2% rally last week. It’s now up 15.2% since the Breakaway Momentum signal flashed.
The rise in equities over the past five and half months—despite all the doom and gloom from the financial media, the large sell-side banks, and the Fed—was foreshadowed by the near-constant relative bullishness of institutions with respect to retail traders since last June. A relative bullishness that reached its then-peak at the October low only to surpass that peak (i.e., institutions got even more relatively bullish) in early January.
One would have thought that as the market moved higher off the October low that retail investors and speculators would have gone from selling the market to buying the market for fear of missing out. Such behavior would have allowed institutional investors to unload their positions to those late-to-the-game entrants.
But that isn’t what happened. Despite the rally we’ve witnessed, retail and speculators are still selling the market!
Who can blame them though with the constant stream of negative news we’ve been subjected to. Whether it’s the always-impending recession or the recent bank crisis, the news just hasn’t been cheery enough for those investors.
With respect to the bank crisis, the S&P 500 is up 6% since March 10, the day Silicon Valley Bank collapsed. This goes to show two things: 1) be greedy when others are fearful, as Warren Buffett has said, and 2) the financial news can be severely hazardous to your portfolio’s health.
Now, with a strong Q1 in the books, what can we expect as we move into April?
To us it appears there is a tug-of-war going on between the macro reality, which is bearish, and investor positioning, which continues to be bullish. So far, positioning has won out. Will it continue?
Well, the positives at the moment are numerous:
Fund flows and corporate buybacks turn positive again in April.
Seasonality is bullish.
Institutions are still positioned for higher equity prices relative to retail and speculators.
Breadth (i.e., the number of advancing stocks minus the number of declining stocks) has been strong recently–so much so that it’s numerically possible we may see another Breakaway Momentum signal triggered this week if breadth remains elevated.
The debt ceiling issue means the Treasury General Account will release nearly $400 billion into the economy over the next several months, which will be functionally equivalent to a bout of quantitative easing.
The negatives, however, are equally numerous:
The market finished the week at extremely overbought levels, so a near-term pullback is likely.
The recent (and perhaps still ongoing) bank crisis led the market to believe the Fed would not be able to continue its hiking cycle. This led to a fall in the dollar, interest rates, and, most importantly, real interest rates. The fall in real interest rates led to a rise in equities (particularly tech stocks) and gold. But with perhaps the worst of the bank crisis behind us and equities soaring, the market may recalibrate its expectations for Fed rate hikes, which might send the dollar and real rates higher, undoing some of the recent rally.
One event that might accelerate the market’s shift in thinking about interest rates is OPEC+’s announcement on Sunday that it will cut oil production by over 1 million barrels per day starting in May. As we write this, oil is up 5% (after earlier being up 7%). If this rise in oil holds, it would likely feed into future inflation numbers and tie the Fed’s hands.
With the market’s recent rally, valuations, which were already unattractive from a buy-and-hold standpoint, have gotten even worse. The equity risk premium is now -0.30% versus the 10-year Treasury bond. That is, broad U.S. equities are likely to return 0.30% less on an annualized basis relative to the 10-year Treasury bond over the next decade.
The valuation (i.e., price-to-earnings ratio) of the tech sector relative to the S&P 500 is at a worse level now than at the end of 2021, the peak of the post-COVID bubble.
How will this tug-of-war resolve?
The Bull Case
The bull case for equities is that the market holds fast to its belief that the Fed is done or close to done with its rate hikes. As a result, interest rates don’t move much and interest rate volatility calms down. But with oil rising on account of OPEC+’s production cuts, real interest rates and the dollar continue to fall, supporting equities (particularly tech and energy stocks) and gold. Moreover, this fall in the dollar and real interest rates will be exacerbated by the injection of liquidity from the Treasury General Account–turbocharging the equity tailwind.
The Bear Case
The bear case for equities is that the rise in equities and/or the rise in oil change the market’s views about the end date of Fed rate hikes–extending that date further into the future and raising the terminal rate higher than is currently expected. This recalibration causes the dollar and (real) interest rates to rise, which causes equities to unwind some or all of its recent rally. The rise in interest rates may reignite the bank crisis, accelerate the coming credit contraction, and just generally slam the brakes on the economy.
So far this Monday, oil is up big, the dollar is down moderately, and risk assets are down small. Interest rates don’t seem to be moving much. This is consistent with the market pulling back because it is overbought, not because of a wholesale change in market expectations about interest rates (although Fed funds futures are now pricing in a 55% chance of one more rate hike, whereas last week it was below 50%).
Thus, near-term pullbacks aside, and though we may sound like a broken record, we have to come down on the side of the market generally trending higher (i.e., the bull case) until institutions become sellers, especially given the coming Treasury liquidity, corporate buybacks, and the likely need for speculators and retail to eventually cover their short positions.
Energy stocks, commodities, and precious metals—all core holdings in Allio’s portfolio—should all get jump started by the OPEC+ news provided the dollar does not rise markedly.
Likewise, the Nasdaq 100 appears to be in the midst of completing several technical patterns, all of which suggest as much as 5% more upside for the Nasdaq over the coming weeks. (One should also note that investment managers are extremely underweight tech stocks and the higher the Nasdaq rises, the more uncomfortable it gets for them to remain underweight.)
Let’s see how it plays out.
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