Updated May 8, 2023
Raymond Micaletti, Ph.D.
Despite a strong move higher after the jobs report on Friday, the broad U.S. equity market finished the week down about 1%, as it digested an FOMC meeting, Apple earnings, and continued volatility in the regional banking space.
The market’s weekly loss was the largest since the week Silicon Valley Bank collapsed in early March. Notably, however, the Nasdaq 100 finished the week (slightly) higher, as it continued its year-to-date dominance.
Zooming out, we are witnessing a whole lot of sideways action in the S&P 500. It has gone sideways the last six weeks and is at a level it traded at in February ‘23, December ‘22, August ‘22, May ‘22, and May ‘21—in essence, two years of going nowhere.
Not only are equities in a holding pattern, the dollar and (commensurately) gold have also traded indecisively in recent weeks. That the dollar can’t seem to break its February low, gold can’t seem to break out to all-time highs, and the S&P can’t seem to break 4150-4200 are probably all related.
When it comes to equities, it appears as though the market is being buffeted by two opposing forces–the negative force of economic fundamentals and the positive force of investor positioning.
At some point, one will overpower the other. Which one will win out?
The Bull Case
The bull case, which in recent weeks was largely underpinned only by investor positioning, seems to be gaining some narrative talking points.
A few weeks ago, we came across a comment by Goldman Sachs that suggested the bond market was pricing in recession (inverted yield curve), while the equity market (particularly the Nasdaq) was pricing in AI.
That comment seemed a bit premature at the time with respect to AI, but in recent days we have come across several articles suggesting AI is moving at a much faster pace than even experts thought possible. As one example, IBM announced it is pausing hiring as it plans to replace 7,800 jobs with AI.
We’re skeptical that an AI revolution will help us escape the myriad fiscal and monetary problems we face (and may even exacerbate them), but in the near term AI as a talking point may help shift the market narrative from bearish to bullish to lure retail traders back into buying equities. Such a shift would give institutions the opportunity to offload the shares they purchased when things looked dark in mid-to-late 2022.
In the same vein, individual investors have been more bearish than bullish in 72 of the last 76 weeks and 98% of the time in the past year. Stocks tend to do well when individual investors’ bearishness retreats from such high levels–and there’s seemingly nowhere for their sentiment to go other than to less bearish levels.
It’s interesting that the AI theme seems to be coming to the fore just as relative sentiment in equities–i.e., institutional positioning compared to retail positioning–which had been the driving force behind the bull case in recent weeks and months, appears to be trending in a more bearish direction.
To be clear, relative sentiment in equities is still bullish, but its underlying components are getting closer and closer to thresholds that would flip the metric bearish. Such a shift could happen in the next few weeks if recent trends continue. But until it turns bearish, it’s bullish.
Relative sentiment in the dollar is also still supportive for equities for the time being. But it too is inching closer to levels that would likely bring headwinds.
Another potential arrow in the bulls’ quiver is the recent move in Apple. To us it looks like Apple is breaking upward out of a multi-year “bull flag” pattern–the measured move of which would target a price of $250 (Apple closed Friday at 173.57). That’s a 44% increase over Friday’s close. Needless to say, if Apple were to rise anywhere near 44% over the next several months, it would drag the entire market higher.
While such a move might seem far-fetched, The Market Ear reports that tech profit margins are widening with respect to the S&P 500 while tech valuations relative to the S&P 500 are at the median level of the past 20 years. Taken together, those seem like a recipe for continued tech outperformance.
Lastly, the market appears to be saying that the Fed is done raising rates. A pause in rate hikes tends to be good for equities so long as the economy doesn’t fall into a recession.
The Bear Case
The bear case for equities continues to rest on narrow breadth, poor valuations, and the difficulty of the Fed sticking the landing.
Despite the meteoric rise in the Nasdaq 100 since late December, its cumulative advance-decline line is trending downward and is hitting new lows. That doesn’t seem healthy and speaks to how concentrated the rally has been (15 stocks have delivered 97% of the S&P 500’s return year-to-date).
On the valuation front, 10-year expected nominal U.S. equity returns are in the ballpark of 3% annualized (based on a confluence of time-tested indicators). The 10-year U.S. Treasury Note is yielding 3.5%, while secular forces will likely keep inflation well above 3% for the coming decade. Thus, from a strategic perspective, U.S. equities are not even remotely attractive at current levels.
Lastly, in every prior hiking cycle, the Fed ended up breaking something. This time it appears to be the regional banks. The bank crisis flared up again last week and is likely to persist, so long as depositors can easily move money to higher-yielding money market options from their phones.
Moreover, the regional banks bearing the brunt of the current deposit flight are also in the crosshairs of the looming commercial real estate debacle expected to hit later this year.
On top of that, we have the debt-ceiling situation that was brought forward by several months due to disappointing tax receipts. But U.S. government spending is not slowing down. Thus, the supply of Treasuries will increase and likely continue to inflame bond market volatility.
In short, it’s hard to see how the Fed and Treasury can ultimately engineer a soft landing.
If they refrain from injecting liquidity to ease financial conditions, the U.S. government will enter a debt doom loop, which would have catastrophic consequences.
If they do inject liquidity, inflation will reaccelerate.
Given those lose-lose options, we should probably be thankful for the relative calm that currently prevails.
In recent weeks, the market has gone sideways and volatility has plummeted. That suggests we are setting up for a big move one way or the other.
Our bias is that the move is likely to be higher given that institutions are still more bullish than retail investors. But time appears to be running out on that relative sentiment condition and thus if the market is to move higher, it would likely need to happen soon, lest the window of opportunity close.
A move higher would likely also be accompanied by a bullish shift in the narrative. If you notice more optimism from the financial media in the coming weeks, it’s a good bet institutions will be selling into it.
Allio Portfolio Updates
No change to Allio’s portfolio. We continue to tilt to inflation-sensitive assets—gold, commodities, energy stocks, TIPS—to align with the secular forces that will dominate over the coming decade.
From a tactical perspective, we continue to like the prospects for the Nasdaq 100 to squeeze higher given investor positioning and its current technical backdrop.
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