Updated June 5, 2023
Raymond Micaletti, Ph.D.
The broad U.S. equity market finally had a meaningful gain last week (+2%) after spending weeks going sideways.
The Nasdaq 100, which has had many meaningful gains in recent weeks, added yet another, finishing the week up 1.8% (bringing its 3-week total to +9%).
Year-to-date the Nasdaq 100 is up 33%, while the S&P 500 is up 12.3%. They’re up 27% and 8%, respectively, since January 12, 2023, the day multiple “breadth thrusts” triggered. These breadth thrusts (namely, Breakaway Momentum and Whaley Breadth Thrust) have historically been staunchly bullish for equities, with equities tending to return, on average, ~22% over the ensuing 12 months.
The recent move in mega-cap tech stocks has market commentators talking about a bubble.
Indeed, prior to Friday, when the S&P 500 outperformed the Nasdaq 100 by 0.70%, it had underperformed 18 of the prior 26 days, and in the eight days it did outperform, its maximum daily outperformance was 0.22%–a level that represents the 0.25th percentile (i.e, in 99.75% of all historical 26-day periods, the S&P 500 had at least one day of outperformance greater than 0.22%).
In other words, the relentless Nasdaq’s outperformance has been one for the record books.
In previous commentaries this year, our view was that equities would likely continue higher as institutions were relatively bullish, while retail investors and speculators were relatively bearish, and institutions tend to be the “smart money” when it comes to equities.
Our thought was that until that relative positioning changed–which would likely be accompanied by a narrative shift from “the world is ending” to something more bullish (such as the current AI narrative)–equities would likely continue to cause FOMO in retail investors and underweight asset managers.
Now, we are at an interesting crossroads for U.S. equities.
For starters, the Nasdaq 100 (which has dragged the S&P higher, kicking and screaming, this year) has gone parabolic, which suggests it is due to cool down for a spell (and if not now, soon).
Secondly, after its 1.5% gain on Friday, the S&P 500, on a total-return basis, is now higher than its August high. One would expect that level to provide at least a little resistance in the short-term.
Further, investor positioning, i.e., relative sentiment, is no longer as favorable as it was from the fall of 2022 through the first third of this year.
Whereas earlier in the year, institutions were relatively bullish the Nasdaq 100 and speculators relatively bearish, now the tables have turned, with speculators being relatively bullish and institutions relatively bearish.
Last week, our composite measure of relative sentiment fell to its lowest level (50%, suggesting a 50% equity allocation in a tactical portfolio) since last June. For reference, it had reached as high as 95% earlier this year and was at 83% the week the market bottomed in October.
A reading of 50% is still marginally bullish historically, with equities tending to annualize about 11% over the ensuing four to eight weeks (but a 11% annualized return in four weeks is only a 0.8% gain).
Looking under the hood, the drop in the composite reading was driven by our flagship measure, the Smart Money Indicator (SMI), which turned completely bearish, moving from a 100% equity allocation to 0%. In turn, this move was driven by how investors have been positioning in long-duration bonds and along the yield curve.
Assuming we are still in a secular (inflation-driven) regime in which equities and bonds have positive correlations, if institutions are positioning for bonds to fall (and they are), that tends to have negative repercussions for equities as well. Hence, the shift in the SMI.
From a cross-asset perspective, relative sentiment in certain commodities and currencies is also at levels that have tended to be headwinds for equities. The same is true of retail sentiment in commodities, which is plumbing levels that tend to coincide with slowing growth, recession, or deflation.
On the positive side, our survey- and machine learning-based relative sentiment indicator is still bullish, clocking in at 80% (though down from 100% last month). And our newest measure, which looks at relative sentiment in a host of growth- and inflation-related assets, is also still bullish, but only marginally so (in terms of the distance between its reading and the threshold at which it flips bearish). [Note: Without our newest indicator, our composite reading would be at 38% equities, a decidedly bearish reading.]
All this is to say that the positioning landscape for equities looks notably different now from how it looked several months ago.
One thing remains the same, however. In October, it was extremely uncomfortable being overweight equities given the prevailing doom and gloom. Now, it’s also unpleasant being underweight equities given the AI mania and the inability of the market to sustain any downside.
So, where does the market go from here?
The Bull Case
The bull case for equities has two primary pillars:
The market’s generally favorable technical underpinnings–i.e., it has positive momentum, it’s downstream from several recent breadth thrusts, and it’s triggered other events that have tended to coincide with strong 12-month forward returns (for example, going seven months without a new 52-week low, etc.)
Retail sentiment, which had been severely depressed for an abnormally long time, is only now starting to become more bullish and is nowhere near extreme levels yet. As retail sentiment normalizes from depressed levels after a long period of time, equities tend to do well.
Another potential pillar is that bubbles tend to feed on themselves and if mega-cap tech keeps moving higher on the AI narrative, who knows how high equities could ultimately go?
Lastly, dollar relative sentiment remains bearish after flirting with turning bullish several weeks ago. Bearish dollar relative sentiment suggests a continued easing of financial conditions, which would likely be well-received by equities.
The Bear Case
The bear case for equities is somewhat scattershot, but formidable.
To begin, valuations are unattractive. The expected 10-year equity risk premium relative to the 10-year U.S. Treasury Note is -90 basis points. I.e., owning 10-year Treasuries is likely a better bet over the next decade than owning U.S. equities at current levels (and who thinks a 3.7% 10-year U.S. Treasury yield will provide positive real returns over that span? Anyone?).
Second, bearish technical divergences have developed on the Nasdaq 100 and S&P 500, with the indices making new price highs, but their relative strength indices not following suit.
Third, while the market has seemingly settled on a Fed pause at the next meeting (having been talked into it by Fed speakers this past week after earlier having priced in a 70% chance of another rate hike in June), there is chatter about a resumption of hikes at subsequent meetings.
Indeed, Larry Summers tweeted over the weekend that if the Fed pauses in June, it should consider a 50 basis point rate hike in July!
When we consider the amount of Treasury issuance in the second half of 2023 (approximately, $1.55 trillion, which covers the deficit ($1.1 trillion) and the refilling of the Treasury General Account ($450 billion)) along with the selling of Treasuries by the Fed (~$540 billion) as it reduces its balance sheet, this total–$2.1 trillion–amounts to 70% of the total growth in world GDP this year, according to independent macro analyst Luke Gromen. This suggests there will not be enough balance-sheet capacity worldwide to buy those Treasuries without first selling other assets.
This dynamic might be why the smart money is bearish on bonds, and falling bonds might lead to falling equities.
We learned a long time ago that fundamentals don’t really matter until they matter. The bear case is solid and we do eventually expect equities to move lower. But it’s not uncommon for institutions to turn bearish on equities a bit early (and they’re not truly bearish yet in the aggregate, “neutral” would be a better description–and when looking only at equities and not considering any cross-asset relationships, they are still bullish in their equity positioning).
Moreover, the strong technical underpinnings of the market should be respected. Just as the breadth thrusts, given their long and strong track record, should be respected.
Market tops are usually processes that play out over months and the initial dips will likely be bought.
Hence, though we wouldn’t be surprised to see a multi-week cooling off of the indices (especially the Nasdaq 100), at present, we suspect that the indices will make higher highs than last week’s in the coming weeks.
Some things to keep an eye on:
AAPL has seemingly broken out (to the upside) of a 16-month bull flag. The measured move of that bull flag would be a price of approximately 250, 40% higher than current levels. If AAPL rises 40%, equity indices will almost certainly rise as well.
META has a gap on its chart from its earnings release back in February 2022. To fill that gap would require META to gain 17%. It’s up 170% year-to-date. Thus, we wouldn’t be surprised if it tacks on another 17% from here and closes that gap.
The year-to-date performance differential between the Nasdaq 100 and the S&P 500 is quite large, thus we expect some reversion in the Nasdaq’s outperformance in the near-term (i.e., we would expect the S&P 500 to outperform for a bit and if it doesn’t, the eventual unwind will likely be legendary).
Allio Portfolio Updates
No changes to Allio’s strategic or tactical portfolios last week. Over the longer-term, we expect inflation-sensitive assets to outperform U.S. equities. Over the near- and intermediate-term, we believe the tactical landscape still favors the Nasdaq 100, although its recent strong runup induced us to cut our position in half recently.
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