Updated July 4, 2023
Raymond Micaletti, Ph.D.
The broad U.S. market finished the week strong–rising 1% on Friday–which brought its weekly gain to 2.5%, its quarterly gain to 8.3%, and its first-half gain to 16.1%. (Don’t get us started on the Nasdaq, whose respective numbers were: 1.9%, 15.3%, and 39.1%.)
Looking back at the beginning of the year, when the macro narrative was uniformly bearish, it seemed sensible to park one’s money in cash earning 5%.
The only way that could have turned out to be a bad move was if stocks somehow happened to rally 20% over the course of 2023. Which they more or less have. Funny how the market rarely does the obvious thing.
From mid-February to late-April, our general outlook was that a squeeze higher in equities was needed in order to reverse the stubborn bearishness of speculators and retail. And that when the squeeze occurred, the narrative would shift from bearish to bullish and we would likely see institutions selling into it.
While the squeeze took much longer than we anticipated (it started on April 26, about 10 weeks after we first mentioned it and its delayed arrival caused us to give up and turn neutral at the beginning of June), now that the squeeze has arrived, institutions have indeed sold into it and the market narrative has noticeably changed.
So where does that leave us?
On the one hand, we have exceptionally strong price momentum that has triggered multiple technical milestones, each of which has historically led to substantial forward returns.
On the other hand, equity relative sentiment is slowly turning bearish.
Positive momentum and bearish equity relative sentiment tends to lead to sideways markets.
Barring any resumption of (relative) buying of equities or select commodities by Smart Money investors, our composite measure of relative sentiment will likely turn bearish on July 28.
A bearish turn in that indicator might be the most important thing that happens during that otherwise sleepy week, which will give us only an FOMC meeting, TSLA, GOOGL, AAPL, META, AMZN, and MSFT earnings. What a snoozefest!
Looking at other positioning metrics…
Dollar relative sentiment, which two weeks ago was on the verge of turning bullish, last week took a small step away from the precipice and moved back into bearish territory. It behaved similarly in 2020–flirting with turning bullish on several occasions, but not actually doing so until August 2021. While we don’t think we’ll see a repeat of that in 2023, it’s not out of the question. Any additional dollar downside from here would likely be met with Smart Money buying.
Gold positioning remains neutral-ish, as does bond relative sentiment. Energy and crude oil positioning remains bearish despite the strong bearish sentiment in energy stocks (which one might think would be contrarianly bullish).
In short, the smart money still appears to be positioning for a risk-off scenario of some sort (selling equities, buying the dollar, neutral on gold, selling commodities). But it might be the early stages of such positioning and in the near-term we might see more of the same from the past few weeks.
The Bull Case
The bull case is pretty solid:
In mid-June the Nasdaq 100 rose to a level 20% higher than its 200-day moving average. At the time, Morgan Stanley noted that such an event had happened 15 times since 1984 and that the Nasdaq was higher 12 months later in 14 of those instances–by an average of 35%.
We double checked those numbers and found 13 unique occurrences (each separated by at least three months) since 1985 (as far as our data goes back). The index was higher 12 months later in 12 of those 13 occurrences, by an average of 32.7% (a median of 25.6%). It should be noted, however, that each instance saw a double digit drawdown during those forward 12 months (with the average (median) drawdown being 18% (16%)).
So, this recent Nasdaq bullishness is no joke. When we checked the state of equity relative sentiment in each of those 13 cases, its average value over the ensuing 12 months was positive in each instance. Thus, we may be setting up for the first occasion in which Nasdaq momentum is ragingly bullish while equity relative sentiment is bearish (provided it turns bearish and stays that way).
The last 11 times equities were up more than 10% in the first half, they continued higher in the second half by a median of 10% (via Ryan Detrick).
In addition, when the previous year was negative (as was 2022) and the first-half performance the following year (i.e., 2023) was positive, the index has tended to have strong second-half performance, with a median return of 12% over the next 6 months (Carson Investment Research)
The first two weeks of July have been the best two-week period of the year dating back to 1928.
The Nasdaq 100 has had 15 consecutive positive Julys
M2 money supply is trending higher as of May, which tends to lead to positive equity returns (via Seth Golden)
Add to these the plethora of other studies in the last two months that have similarly suggested strong 12-month forward performance based on various other technical milestones
Top it off by recalling that both a Breakaway Momentum breadth thrust and a Whaley breadth thrust triggered on January 12 and a Zweig breadth thrust triggered on March 31. Each of those has typically led to strong 12-month forward returns.
The Bear Case
What could possibly bring this market down? Some thoughts:
Institutions selling equities and commodities, and buying the dollar? Perhaps, but the positioning isn’t extreme enough yet to suggest an imminent reversal in markets.
Nosebleed valuations (e.g., NVDA > 40x sales)? Eventually they will come down, but that’s a longer-term consideration (and currently they aren’t quite as bad as they were at the top in 2021–so there’s room to run!)
Lag effects of past rate hikes? One would think this might do the trick, but with U.S. government debt so high and interest rates at 5%, that amounts to $1.5 trillion in interest expense paid out into the economy–on top of the several hundred billion dollars that the Fed is paying the banks in interest on their excess reserves. These payouts appear to be counteracting any slowing effects that previous rate increases might have had.
Fed actions or rhetoric? Unlike in 2022, it doesn’t appear the Fed is targeting the equity market this year. Indeed, Chicago Fed president Austin Goolsbee noted this week that the equity market isn’t in the Fed’s mandate.
A commercial real estate crash? A few weeks ago this seemed like a prime candidate to torpedo the market, but an interesting thing happened last week (pointed out to us by the inimitable macro analyst Luke Gromen).
The government asked banks to work with commercial real estate firms to defer loan payments and ease terms; similar to how the government implemented mark-to-model in March 2009 to end the Great Financial Crisis, and how the Dallas Fed did the same in January 2016 with troubled energy loans for shale oil assets. Both of those other instances kick-started major risk-asset rallies.
Also of note is that SL Green Realty sold a Manhattan building last week at a $2 billion valuation–only a slight discount to the $2.2 billion valuation the same building sold at during 2017–the peak of the NYC commercial real estate market. The shares of SL Green Realty leapt 20% on the news.
Instead, what might actually bring the market down is mega-cap tech earnings, regardless of whether they are good or bad.
If they disappoint, the market is likely to call into question the validity of the AI rally—most likely arriving at the conclusion that it has gone too far, too fast.
If earnings surprise to the upside, there will likely be a surge of buying volume by the so-called “dumb money” thinking the AI rally will continue indefinitely. Institutions (the Smart Money), who have lots of capital to manage and need large volume in which to transact, would almost certainly take advantage of that buying frenzy by selling into it. (Similar to how they took (buying) advantage of the hot September inflation report (released in mid-October) that caused the S&P 500 futures to plunge to 3491. Futures ended up finishing that day at 3682, 5.5% off their lows).
In other words, if earnings disappoint, the rally has been unjustified; if earnings excite, it’s a sell the news event.
The rally is starting to look a bit tired. While prices have made higher highs, technical indicators have not confirmed. Thus, we are starting to see so-called bearish divergences.
Consequently, sideways action or small-to-moderate selling this week would not be a surprise. (We would also note that scanning Twitter this weekend, we see the bulls are really feeling their oats these days. Such euphoria tends to get punished at some point.)
Any near-term pullbacks aside, however, the market appears to have time and room to run higher. July seasonality is strong and equity relative sentiment won’t turn bearish until late July (at the earliest).
Thus, it really looks like the week of July 24 (FOMC plus mega-cap tech earnings) might be the first potential catalyst for any material pullback.
The target of any such pullback would likely be (at least) to the uptrend line from the October lows, which is currently about 6%-7% away depending on the index (but will be much closer to the current price come the end of July).
Even if we do get a pullback, it might not mean the end of the rally.
As we have mentioned a few times since early May, several mega-cap tech names have technical patterns that look as though they are playing out.
For example, META has a gap from February 2022 at 320. That’s only 11% away from the current price (the stock is up 138% this year).
On May 7, we noted that AAPL looked to have broken out of a bull flag (at 173), whose measured move would take the stock to ~240. AAPL closed Friday at 194, just 24% away from the measured move target (AAPL is up 50% so far this year).
In light of the historical statistics, it’s reasonable to expect both continued equity appreciation and non-trivial pullbacks along the way to shake out weak hands.
If and when equity relative sentiment turns bearish, however, things could get really interesting.
Allio Portfolio Updates
No changes to Allio’s portfolio last week.
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