The Stock Market Continues to Party On
The stock market continued to move higher in January (about 3.5%), generally ignoring increased geopolitical risk in the Middle East and traditional signs of recession. Excitement about large amounts of cash on the sidelines, supposed easing financial conditions, expectations of imminent FED rate cuts, a “soft landing”, and all things AI pushed several key indices such as the Dow Industrials, NASDAQ, and the S&P slightly back above the highs reached two years ago.
What has bulls drooling is that the amount of money on the “sidelines” in money market funds is well over $6 Trillion. Just five years ago, it was about half the current levels. It has gone up about 50% just since the middle of 2022! Excesses in monetary and fiscal policy can do that for you. We would agree with the bulls that this enormous pile of loot if directed toward stocks, will certainly help drive stock prices higher. However, note in late 2019 the number was soaring, just before a recession. In the investing business, there are few guarantees things will work out just as you hope. Some of this may simply be money pulled out of bank deposits and hence, not “new” money.
Price momentum continues to be pretty decent with no major violations of any linear or moving average trend. As mentioned, we have seen news highs, which usually are quite positive. Thus, from a pure price action point of view, the market still looks healthy and likely to advance. However, excessive sentiment and divergences argue for caution, despite the new highs.
Market participants are positioned for multiple rate cuts in the year ahead. There also seems to be a pervasive attitude that the FED is politically savvy, not protective of their “independence”, and will be easing monetary conditions further in front of the important Presidential elections. It has been reported that the specter of Arthur Burns has been seen at the corner of Broad and Wall Streets. This is in part, one of the reasons enthusiasm has run so hot of late. James Stack at Investech.com points out that articles about “soft landing” have soared, so much so they are roughly twice the level seen before the last two recessions. Ironically, when everyone quits worrying about recession, the markets become vulnerable to breaking bad news.
In our last visit with you, we opined that given the overvaluation of the market, the very lopsided bullish sentiment, and the persistent signals that are typical before recessions; market strength would not carry too far into January. We caught the low in October and we have maintained positions through the market through a period of usual “seasonal strength”. It gets a bit trickier going forward. Since we eat our own cooking, we recently lightened up as the market neared old highs. Whether that will create indigestion remains to be seen.
While the market has pushed modestly higher during January, our concerns are still worth reviewing.
The market strength remains narrow and has even gotten worse. It is estimated that 75% of the S&P gains in recent weeks came from just two stocks. That pretty well subverts the idea of “indexing” with a supposed diversified portfolio, does it not? The small-cap sector has lagged very badly, still down about 20%. This has been largely a selective big-cap tech rally. So much so, that as the markets reached previous peaks, the ratio of advancing to declining issues has rolled over for the moment and has not “confirmed” new highs in the stock averages.
Of the 12 industry groups in the S&P, only one (technology) made it to a new high, but that group is so heavily weighted, that it was enough to push the whole index higher.
We have seen new highs in the S&P and the Dow Jones Industrial Average. Interestingly for devotees of Dow Theory, the Transports have not confirmed the new high in the Dow. This failure to “confirm”, is another sign of divergence. And, as mentioned before, small-cap indices continue to lag badly.
These divergences (strong price strength while participation is waning), are concomitant with very high sentiment readings (the CNN Fear and Greed gauge reached a dangerous 80% reading), which has usually spelled trouble. That index incidentally, has started to come down a tiny bit (as we write it is at 77, still in the extreme greed range) and usually both the market and the index will descend together until the market gets a pessimistic reading (usually around 20).
But like so many venerable indicators, market participants have ignored these readings and feel it is different this time, largely because of good stock momentum, Federal stimulus is still in the system, the FED has seemingly relented on further rate increases, and it increasingly appears that the “soft landing” has been achieved by the FED. We will soon get lower rates, with good corporate profits, and consumers will keep spending. Inflation has been tamed to acceptable levels. Or so, that is how the argument goes.
However, we have difficulty ignoring some of these time-tested indicators, even if they were developed before AI and steroid-driven fiscal stimulus.
The inverted yield curve remains a concern to us, largely because of its excellent predictive value based on history.
When the yield curve is inverted (see below the 0 line), it has preceded recession (the shaded area). You can see this is the steepest inversion since 1980 and notice that a trip to zero or below has preceded every recession in the past 60 years. Do we just blow off that sterling record?
Another concern has been the sharply declining money supply. This is a long-term chart, but note this is the worst since the 1930s. Critics like to say that these numbers no longer accommodate a world of non-bank lending, cryptocurrencies, and newly minted FED credit facilities. The plumbing of the financial system has changed a lot in the past few years, they would argue. But since 1831, the banking system has always been evolving and innovating, and the sharp drop in the money supply caught the trend that would lead to economic downstrokes.
Famed analyst David Rosenberg also points out that his calculations of global money supply, are also contracting. That is important to note because capital today easily flows around the world.
The declining money supply seems hard to square with all the talk about “liquidity” and huge piles of cash on the sidelines. Data concerning money is quite confusing. Bank deposits are contracting very sharply, as is bank lending, yet money fund balances are rising and so is credit card debt.
The interest rate on Federal Funds is 5.25% to 5.5% still above the rate of inflation, which usually connotes “tight money.” In short, the bullish story lives with considerable contradiction.
We have mentioned before that the leading economic indicators are falling and data from manufacturing is soft. Services have held up pretty well and it seems the consumer has kept spending longer than most observers thought. But that has pushed credit card debt over $1 trillion for the first time. Employment remains strong but there have been signs of weakening. Consumer sentiment in the Michigan survey has been rising, but consumer sentiment often tracks the stock market.
Finally, there is valuation. Stocks never really corrected much of their pricing excesses. We have an expensive market that simply wants to get more expensive. We are speaking now about the S&P, the indicator for most “indexed” buying and selling. Small cap is distressed and relatively cheap, and some foreign markets are very cheap.
The Chinese market has been in crash mode and now has elicited government rescue efforts. No one seems to care that the stock market in the second largest GDP in the world is doing that, even after the Covid lockdown ended.
Speaking of China, we have indicated before our view that years of wild indulgence in debt when we had zero interest rates, would likely lead to a major credit event. We may have the first of a string of them, and the first big one comes out of China. Just as we write, a court in Hong Kong has ordered the liquidation of Evergrande, a giant property company in China. With liabilities worth $300 billion, that defaulting paper is owned by somebody, Chinese and even some American interests. It is also believed a lot of this paper is owned by Chinese citizens. The scale of this default is on the scale of a country failing. The hazard is counterparty risk happens to be much like a spider web. You tug on one strand and another moves quite remote from the initial disturbance.
Market sentiment, strong capital flows into stock indices, and price momentum are the best things this market has going for it right now. Despite our concerns, we must give the devil his due, despite the contradictions in the data. The market wants to go up.
If the divergences are a precursor to a decline in price momentum, it will be important to pick that signal up as early as we can. Let’s see if the divergences persist.
On Wednesday, January 31, the FED will have its first meeting of 2024. The market is banking heavily on a sequence of five or six rate cuts this year. But unemployment is very low, the economy is stronger than expected, and inflation is not below 2%. Does the FED cut rates anyway to support the market expectations, or does it give primacy to the inflation fight? If it favors the market, will the FED lose credibility on inflation? How many of the rate cuts are already discounted in the wildly bullish sentiment? What will the market do if the FED disappoints? What will be the spillover from the Evergrande bankruptcy liquidation?
This is all coming on the heels of a 19% upside move in the last three months, which puts this move in the 99th percentile. It should make for an interesting period just ahead.
To make ourselves clear, we have not exited the market. We just look at the indicators and try to get a sense of which ones are more important and which ones have a decent record of prediction and try to avoid the hype of the crowd. We are comfortable having less in the market right now, and if the market moves higher, we might reduce exposure even more.
For the reader, we just want you to be aware of the arguments for both enthusiasm and caution and you will weigh that in terms of your circumstances.
