Ides of March Are Just Around The  Corner

Ides of March Are Just Around The Corner

February 28, 2024

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For the last number of weeks, I have been talking about how it could be expected that the markets are prepared for a digestion or a minor correction. I have expressed caution and the possibility of this as a result of the length of time of the current advance, the cyclical / historical precedents at this point in the year and the fact that the Fed remains quite stingy with their desire to lower interest rates. In today's note, I wanted to take a moment and discuss where the markets are currently and then I would like to take some time and talk about interest rates and inflation and quite possibly that the Fed might not provide the punchbowl of lower rates as all seem to be focused on and waiting for. 

Obviously the S&P 500 chose not to take the scenic route with a digestion and a rest before breaking back out to yet another new high. Thanks in large part to the largest and most profitable AI semiconductor company's 16% up day on Thursday and strong performances out of many of the other mega cap stocks, the S&P and NASDAQ 100 shot back higher, increasing the odds further that the brief dip in the market could be over. That does sort of leave us in an awkward position, though, since the recent corrective phase, at least in the large cap averages, was neither deep enough nor long enough to really be ideal when the index broke out to new highs, so that does sort of leaves me with less confidence in terms of where the broader rally stands, and its possible pullback.

We were expecting to have seen either a deeper drop down toward 4800 in the S&P 500 or at least a more prolonged sideways period that would have done more to recharge the market before another push higher. Presently overlooked by many, there has been more of a correction under the surface this year, with the percentage of NYSE stocks above the 50-day moving average falling to around 50% at the recent low after being above 80% to begin the year. Without a more obvious corrective phase on the surface of the S&P, though, it's more uncertain whether a "new wave" up in the rally has now begun or if this is still just an extension of the previous upside leg. Either way, I think we have to now follow the path of least resistance higher until given a good reason not to do so. While Thursday's advance was not as strong as the mega caps made it appear (only 62% of NYSE operating companies advanced), it was still enough that I don't exactly want to fight it.

To show exactly what the S&P 500 has done can be clearly examined by looking at the attached chart, courtesy of FundStrat:

The biggest takeaway from the broad market's surge Thursday on the heels of the strong semiconductor company's earnings signifies to me that there could still be substantial "dry powder" on the sidelines. I've often made reference to the unbelievable amount of cash that has been dumped on the economy during the Great Financial Crisis and the Pandemic. Here is where it stands currently:

With this much cash still floating around and earning a risk-free rate of return of around 5% while sitting idle, there still appears to be plenty of money available for investment to support the current level of the markets. Undeniably this rally is mature as it has risen for 17 weeks straight and up almost 24%, this compares to the previous two rallies since October of 2022 which were +20% and +21% in periods of 16-19 weeks. On top of this, in conversations with investors, we found many recently cautious. Citing both the higher inflation readings, and their generalized belief that the equity gains are overly concentrated, and as a result the advance is construed as unhealthy. Again, I question this logic as the advance seen on Thursday had many leading companies in many different sectors (other than AI related technology) show prices that were new all-time highs. In many cases the magnitude of the advance in these "other names" were not as large as the mega-cap tech leaders, but they did exhibit that money was flowing other places besides AI tech. 

Now I want to bring up a phenomenon that is in place that I am still trying to wrap my brain around. This is the “expectation” of the Fed needing to lower interest rates to stave off the dreaded recession and continue to provide the "necessary" fuel for continued economic growth. In Barron's over this past weekend, there were two articles that caught my attention. The first one to mention was the "Other Voices" section of Barron's. The title of this was, "What if the Economy Is Actually Getting Stronger." If it is strong and getting stronger, could it be that this expectation of lower rates is not an appropriate expectation? In the article, Chris Grisanti brings up the points that inflation is not increasing, labor remains stubbornly strong, and corporate earnings- as evidenced by the most recent earnings report are strong and getting stronger. This Goldilocks scenario hardly begs the Fed to lower rates, particularly with the fear of the economy not recessing but instead overheating again and putting the US debt burden even further behind the inflation eight ball. 

Randall Forsyth in his opening comments in Barron's made a very interesting comment. He said very specifically, "Why does the Federal Reserve need to lower interest rates when the capital markets are providing free money? That is, for tech winners such as Super Micro Computer, which was able to raise funds via a private convertible note deal this past week for $1.5 billion. Not only did the notes carry 0% interest rate, but the securities were exchangeable into the company’s stock at a 37.5% premium over what the shares fetched at the time of the pricing." This seems quite absurd to me,  but it also speaks to the fact that there is still a ton of money out there looking for a home. Again, reference the picture above showing over $6 trillion still sitting in cash.

This brings me to the last absurdity that I recognized these past few days. Our Fed policy rates at 5.3% are the highest among any developed nation in the world today. How could this be? if we are the strongest economy on the planet currently, shouldn't our debt be the safest and therefore pay a lower rate than less safe economies? See the chart below:

I believe that there is a message here. Either the global interest rates are set to rise or ours is set to drop. Quite possibly this month’s inflation statistics will help address this anomaly. I say anomaly as I find it really quite strange that if we are considered the safest and most consistently growing economy that our cost of capital would be the highest.

So as it stands, the US equity markets have not sustained the feared pullback as of yet, and this leaves us with what will sure to be front and center on the news channels this week. I am referring to the US Government shutdown. Over the last weekend appropriations staff and Congressional leadership continued talks.

The House returns for votes today, leaving only 48 hours to try and find a fix to avoid the partial government shutdown. At this point there appear to be two options that could avoid a shutdown. Likely the easiest is to punt one more time one more time and kick the can down the road. The second is that the work by Members and staff over the last few weeks magically come together and a deal is approved by both the House and Senate and signed by President Biden. If this all seems unlikely, it is! And as of this morning a shutdown Saturday looks possible. So would this be enough to catalyze the pullback that is being feared? To answer that, look at what has happened in the past:

It is clear that although this seems incredibly discomforting to many as a US Government shutdown seems perilous, in reality the equity markets have historically not paid much attention to it at all. 

My last point is that of one of the most inflationary measures of the markets; overall commodity prices and what affect these prices could have on the US equity markets. Commodity prices, strangely enough, have continued to decline. This seems strange as prices at supermarkets, restaurants and other retail establishments have not shown any decrease in their continued price increases.

We’ve found commodity prices have historically shown an inverse relationship with forward equity returns and stronger commodity rallies over the prior 12 months having been followed by poorer S&P returns over the next 12 months, and vice versa, since 1961. We’ve found the best S&P returns have occurred when this commodity reading is less than -10%; current reading is -11%. Again, it appears that the commodity market seems to know something that the correction crowd seems to be missing. This is just another factoid, but it seems to be supported by recent market action all the same.

This week will finish with a new set of economic data. The earnings season is essentially over and the reports were quite positive. We will stay on the lookout for changes in the markets and will be sure to let you know if anything noteworthy occurs.

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