Updated April 25, 2023
Raymond Micaletti, Ph.D.
The broad U.S. equity market was largely unchanged last week, trading within an exceptionally narrow 1.5% range the entire week. The containment was likely brought about by hedging flows related to last week’s monthly options expiration. But with options expiration out of the way, the market should trade more freely this week.
Equities continue to lull both bulls and bears into complacency, having stationed themselves just below resistance for the past 16 trading days (and counting).
A bullish interpretation of the recent behavior is that in 2022 when the market reached its sequential interim highs (March 31, August 18, December 13), it changed direction quickly (often hitting resistance and reversing course within one to three days). The fact the market has kept attempting to break the current resistance for more than three weeks is encouraging.
A bearish interpretation is that the S&P 500 Implied Volatility Index (VIX) hit lows last week not seen since the market peak in early January 2022 (when the S&P was at 4800). Yet the market has not even reclaimed its February 2023 high (4200) let alone its August 2022 high (4300). How much lower can we expect volatility to go? And if the VIX were to rise alongside equities, would that be a harbinger of a larger correction about to unfold?
Interest rates were modestly higher last week and the market is now forecasting an 86% probability that the Fed raises interest rates at its May 3rd meeting, up from 78% on April 14. A month ago, that probability was only 27%.
The increase last week was likely brought about by renewed hawkish jawboning by most Fed speakers (“inflation is still too high and more work needs to be done” yada yada yada) as they got their last licks in before the Fed’s blackout period commenced on Friday.
Notably, the hawkish tone of most Fed speakers last week continued the pattern of hawkish talk after equities have rallied and dovish talk after equities have sold off.
Tax receipts came in below expectations last week. According to macro analyst Luke Gromen, this actuality shows how dependent the U.S. government is on rising asset prices (if it were not dependent on rising asset prices, inflation plus full employment should have kept tax receipts high).
The underperformance of tax receipts has likely brought forward the “X-date,” the date on which the U.S. Treasury hits the debt ceiling. The original estimate was for September, but after last week June looks more likely and some (e.g., Morgan Stanley) are even saying it may be hit in May.
One would expect the market to react negatively if it looks like the debt-ceiling situation won’t be resolved in a timely and seamless way. In other words, if politicians don’t resolve the situation with time to spare, the market will likely force them to do so (by selling off violently).
So where does this leave us?
The bull case for equities continues to be driven largely by positioning, with a smattering of breadth thrusts and looming political pressure on the Fed thrown in for good measure.
On the positioning front, institutions continue to buy equities. Speculators continue to sell and retail continues to hold a bearish stance (although they bought modestly last week).
Such behavior suggests equities still have higher to go before reversing course for a sustained period. (Please note, however, that we may continue to see scary pullbacks along the way just as we have on three occasions since the October low.)
The smart money also continues to be bearish on the dollar relative to retail traders–not to the degree they were in the early part of 2023, but still bearish nonetheless. Bearish dollar relative sentiment tends to foreshadow falling real rates and easing financial conditions, both of which would likely be supportive of equities.
We are also in the wake of two recent breadth thrusts, each of which (historically) has been a reliable signal of higher equity prices over 6- and 12-month horizons. We’re three months into the first signal (January 12) and three weeks into the second (March 31).
Lastly, we think there will be immense political pressure on the Fed not to crash markets as we move toward the 2024 election season.
One of the recent appointees to the FOMC, Austin Goolsbee, a former chair of the Council of Economic Advisers during the Obama administration, has (predictably) been one of the lone doves on the Fed speaking circuit in recent weeks. His contention is that the Fed needs to be cautious about raising rates in the aftermath of the bank crisis.
We suspect the Fed will be feeling similar pressure from the White House and Treasury in the coming weeks.
The bear case for equities is formidable and to us it appears quite likely equities will at some point retest and even violate the October lows.
The slate of negatives include:
The bank crisis is likely not over. Deposits continue to leave small banks given the large differential between bank savings rates and short-term Treasury bills. Moreover, those banks have commercial real estate problems coming down the pike.
Inflation may be taking a turn higher. Consumer inflation expectations jumped in recent weeks and wage growth has begun ticking higher again after falling for a few months.
The U.S. budget deficit continues to grow, which could cause Treasury market dysfunction (a negative for equities) given the relative lack of demand from foreign investors for U.S. government debt.
The market has been dragged higher by mega-cap tech stocks this year and the valuations of those stocks are again bordering on the ridiculous.
While so far Q1 S&P 500 earnings have been better than expected, those earnings were largely generated before the bank crisis and the resultant slowdown in lending and thus are not necessarily reflective of next quarter’s earnings.
Small business optimism, which tends to be a strong leading indicator of GDP, is hitting decade lows, which suggests a recession is on tap for the second half of 2023.
While the third year of a president’s first term tends to have positive seasonality, within that third year May seasonality tends to be weak.
While investor positioning across various asset classes is currently supportive of equities, that positioning is inching closer and closer to a door, on the other side of which positioning becomes unfavorable for equities. Thus, unless the Smart Money continues to trade in the direction of its current positioning, we may soon (within a few weeks) see investor positioning turn bearish for equities.
Taking a step back, the overarching situation we find ourselves in is one where equities are in a secular bear market driven by high inflation. The U.S. government’s fiscal position, which requires both rising asset prices and inflation to remain solvent, will tie the Fed’s hands and prevent the Fed from sustainably squashing inflation. Indeed, the Fed will eventually have to resume quantitative easing (likely with inflation still elevated).
Zooming in, in prior weeks we have mentioned our belief that a continued short squeeze is likely given that retail traders and speculators (so far) continue to be on the wrong side of the market.
For example, on February 12 we wrote:
“But today, the market establishment is expressing skepticism [of the rally] and retail traders will react to that skepticism by staying out of the market or selling. Thus, in our opinion, it’s likely markets have to move higher–climb a ‘wall of worry’ as the saying goes–to remove that retail skepticism. Only then do we think markets will top.”
Last week, we wrote:
“...what we would then look for is a major squeeze higher in equity indices–perhaps brought about by better than expected earnings in a seasonally strong period–such that the market narrative shifts from one of doom (‘recession,’ ‘hard landing,’ etc.) to one of hope and optimism.”
We continue to maintain that view especially after coming across an interview this week of volatility guru, Cem Karsan, by TDAmeritrade. In the interview, when asked the likelihood of new highs in the S&P 500, Karsan responded:
“New highs, I would be very skeptical of. A blowoff top of some kind, I think is likely. And the reason is, as I mentioned before, this is HOW markets work. You need to squeeze shorts. You need people to lose conviction–not people, just institutions, entities betting against the market–to lose conviction in that short. The narrative has to change in order to lose that conviction! And generally that means some type of move up.”
Thus, while the window of opportunity for the market to rise may be closing–as the negatives accumulate–and while we can’t rule out a near-term pullback, we do believe investor positioning is likely to flip (i.e., institutions turn bearish and retail turns bullish) before the market tops.
And we’re not quite at that point yet.
Allio Portfolio Updates
No major changes to the Allio portfolios this week. We remain primarily positioned for the secular macro regime—tilted toward commodities, energy stocks, and gold—with some tactical exposure to the technology sector given our belief the current squeeze in equities will continue until the market narrative changes.
This week we will get lots of earnings from mega-cap tech stocks, which should provide the market with some movement, one way or the other.
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