Updated May 23, 2023
Raymond Micaletti, Ph.D.
All it took for the S&P 500 to finally break higher out of its two-month trading range last week was for us to go from relentlessly bullish to neutral on equities. If we had only known… We’ll turn neutral sooner in the future, we promise!
The Nasdaq 100 (futures) sustained decisively above its prior resistance levels at 13200 and then barreled through its August high at 13740. It finished the week at 13858 (+3.5%), but reached as high as 13960 before easing off.
We would note that this year-to-date move in the Nasdaq was foreshadowed in January when institutions continued to buy the Nasdaq hand-over-fist into February despite the index being up 12% to start the year. That’s not the type of behavior one would expect from institutions if they thought the Nasdaq were going to roll over and resume its downtrend. And so far, it hasn’t.
The S&P 500 (futures) briefly broke above its February high at 4208, reaching as high as 4227, and is hovering around 4200 as we write this Sunday evening.
Notably, equities rallied despite the dollar moving higher (+0.50%) and rates moving sharply higher (10-year yield +21 bps!). As one would expect, gold suffered on those dollar and rates moves.
(As an aside, last week was options expiration and those weeks tend to deliver wonky cross-asset moves–thus, we should take last week with a grain of salt and see if there is follow-through this week.)
Economic data was mixed, with retail sales and Empire State manufacturing coming in below estimates, while industrial production, business inventories, and initial jobless claims came in above expectations.
Fed speakers also gave mixed messages. Dallas Fed President, Lorie Logan, said the data supports another rate hike, while others such as Neil Kashkari, Minneapolis Fed President, said a case could be made for a pause to assess the effects of prior Fed moves.
The market ended the week forecasting a 17% chance of a hike at the June Fed meeting, down from 35% on Thursday.
In the background, we have the ongoing debt-ceiling negotiations, but the market doesn’t seem to care. Of course, that stance may change as we approach the X-date.
Where do we go from here?
The Bull Case
The bull case for equities is beginning to see a handoff from investor positioning to the technical conditions of the market.
Several technical conditions (courtesy of Ryan Detrick and Sentimentrader) now prevail that in the past were overwhelmingly bullish for equities:
The Nasdaq has had a narrow rally (few stocks participating) and when breadth has been this bad historically, the next 12 months have tended to be bullish (on account of the mean-reverting nature of equities where good follows bad and bad, good)
And lest we forget, we still are in the wake of two recent breadth thrust signals–a Breakaway Momentum signal that triggered in mid-January and a Zweig Breadth Thrust that triggered at the end of March. These signals have long-acting windows of up to a year, and we are only four months into the first and seven weeks into the second.
As for investor positioning, relative sentiment in broad-market equities is still substantially bullish. But as mentioned in last week's note, under the hood it is not trending in the right direction and we could see a deterioration in its readings in the next few weeks.
Notably, however, it's trending bearish NOT because institutions are selling equities relative to retail traders–on the contrary, institutions continue to buy, speculators and retail continue to sell.
Rather, it’s what institutions are doing in intermediate and long-duration bonds that may cause the indicator to flip bearish.
Institutions are positioning for bonds to fall. Given the (typically) positive correlation between equities and bonds in inflationary secular regimes, if institutions are positioning for bonds to fall that tends to have negative repercussions for equities.
Last week, higher rates (lower bonds) did not hurt equities, but it's hard to envision that divergence continuing indefinitely.
On a positive note, the smart money sold the dollar hard last week, which likely will forestall dollar relative sentiment from turning bullish (on the dollar) in the near-term. Bearish dollar relative sentiment tends to be supportive of risk assets and thus the window for a continued equity rally may have just been extended.
An extended rally window would give the AI narrative more time to take hold in retail traders’ imaginations and potentially coax them back into the market (or at least get them to cover their shorts).
Getting the retail trader back on the long side is likely a prerequisite for this equity rally to end.
The Bear Case
Despite a moderate bounce in regional bank stocks (8%), the bank crisis does not appear to be over.
The wide gap between T-bill yields and banks’ savings rates continues to provide strong incentive for depositors to move money out of banks. If banks were to raise their savings rates to be more competitive with T-bill yields (in an attempt to stem deposit outflows), they would lose money (as their assets wouldn’t provide enough yield to cover the higher savings rates).
This lose-lose scenario for banks suggests they will lend less, which will likely cause economy-wide credit to contract, which in turn will likely lead to a falloff in economic activity. One would think such a chain of events would put a dent in corporate earnings and eventually the stock market.
And we haven’t even mentioned the looming commercial real estate crisis the banks are hurtling towards—a crisis which will likely only intensify the outflow and lending dynamics we have seen thus far.
On the fundamental front, as megacap tech stocks soar, we are again seeing valuation levels reach nosebleed territory.
During the dotcom bubble, Scott McNealy, then CEO of Sun Microsystems, said investors were insane for pricing Sun at 10 times sales:
"At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold… That assumes zero expenses... That assumes I pay no taxes… And that assumes you pay no taxes on your dividends… And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? …. What were you thinking?”
Investors never seem to learn. Today we see NVDA trading at 26x sales, ASML trading at 9x, AVGO trading at 7.6x, and TSLA trading at 6.6x. Buying those stocks at those valuations does not appear to be a wise long-term investment, with or without an AI revolution.
We are sympathetic to the idea that stocks over the next several months can continue higher based on the fact speculators and retail continue to fight the rally and based on the renewed bearishness in dollar relative sentiment.
In the short-term, however, we again have a neutral outlook:
U.S. equities are overbought and given the mean-reverting nature of equities, equities may decide to go sideways or pull back a little.
Several megacap tech stocks (GOOG, TSLA, AMZN) are up against resistance, which might be the needed catalyst to turn the Nasdaq 100 lower to test its recent breakout levels (13200, 13750) from above.
Also, given the extreme outperformance of megacap tech year-to-date, it wouldn't be a surprise for small caps and non-tech large caps to outperform for a spell. Thus, we may end up seeing the S&P and Russell 2000 go sideways or slightly higher, while the Nasdaq 100 retrenches.
The market looked like it squeezed people last week and investors did nothing to ameliorate the positioning that led to that squeeze. Thus, it’s not outlandish to think the squeeze could continue.
Our playbook is as follows:
If the market were to continue higher in the short-term and become more overbought, we would then expect a moderate pullback to cool things off.
If instead the market were to pull back in the near term, we would expect that dip to get bought—so long as nothing extreme happens with investor positioning.
Let's see how things unfold.
Allio Portfolio Updates
We took partial profits on our long QQQ position last week, which we established about 5% lower. Our core strategic portfolio remained unchanged.
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