Stocks Catching Up To Yields And The Dollar In Repricing The Fed
Equities are reminding investors that compounding returns over time is a two-way street. The S&P 500 is undergoing a meaningful correction after a monster run of +28% from the October 27th low at 4,104 up to the April 1st high of 5,263. A run that saw five straight months of positive results and two consecutive quarters of double-digit gains for stocks. From the October lows to the March highs; sentiment, positioning, fundamentals, and technicals have done a 180 with recent sentiment and positioning data rivalling historic extremes. All of which set the table for the correction that started several weeks ago.
Last week the S&P 500 put in its worst weekly decline since March 2023 as it slid -3.1% and sits just shy of a -6% slide from its April 1st high. Without question some technical damage has been done to the S&P 500 as it trades -3.0% below its 50-day trendline and is up just over +4% on the year after being up +10% at the end of Q1. The 100-dma is the next big level to watch and sits at 4,930 with the 200-dma quite a bit lower (~6%) at 4,674. The Tech heavy and momentum driven Nasdaq has been the epicenter of the pain as it plunged -5.4% on the week and has declined for six straight sessions. The index is -5.0% below its 50-day moving average, -2% below its 100dma, and the key 200dma sits just 5% lower at 16,257. The once high-flying Nasdaq is up just 1.4% for the year after being up 8.5% at the end of Q1.
Broadly speaking the stock market is in an ominous state right here. Yes, we’re through the bulk of what is considered to be a run-of-the-mill 5-10% correction, but further declines from here always feel more uncomfortable than the initial 5% drop. Moreover, semiconductors plummeted over 9% last week (fourth consecutive weekly decline) and are off 17% from their March all-time high. This is a highly cyclical segment of the stock market and considered to be the ‘picks and shovels’ beneficiary of the A.I. revolution. Nvidia and other tech bellwethers are no longer immune from outside forces with the likes of ASML disappointing on orders and Taiwan Semiconductor providing lackluster guidance for upcoming quarters. Don’t get me wrong, this is still a place you want to have capital in over the long-term, but these are the bumps and bruises you get along the way. Netflix was another stock riding high on the momo wave going into its earnings report last week where it provided a disappointing outlook and presented justifiable concerns when the company announced that it was going to stop reporting subscriber growth in its quarterly reports next year.
Bottomline, the setup for the equity market has been ripe for a correction for some time now and as long as the fundamental backdrop (economic growth, earnings, and policy) continue to trend in a constructive direction then I don’t think there is reason to extrapolate this market decline as anything more than a necessary correction. Afterall, it’s called a correction when the market falls in the midst of a sustainable uptrend because this is the way Mr. Market cleanses excess optimism, herd behavior, and extended valuations.
I’m starting to see some signals on my dashboard that suggest we’re approaching the worst of this downturn. No, I’m not arrogant enough to call a bottom or say the correction is over right here right now, but between here (S&P 500 4,960) and 4,750 I’m inclined to be more of a buyer than a seller. Consider that just 6% of the S&P Technology sector stocks are above their 50-day moving average – that’s a pretty washed-out reading. Furthermore, the percentage of S&P 500 stocks registering oversold readings is at the highest level since September 2022 (see below chart from @Soberlook at The Daily Shot).
Yes, the S&P 500 trading at what I consider a rich valuation of 20x forward earnings isn’t ideal for my liking, but that’s only one variable in the mosaic that drives my investment decision making. I think its important for investors to keep in mind what has been repriced from where we started the year. We came into the year with expectations for nearly seven Fed rate cuts, which have since been almost entirely priced out. As of Friday, Fed fund futures are pricing in less than 40 basis points in rate cuts in 2024 – that is a monumental shift inside of four months. Perhaps the last of the doves on the FOMC, Austan Goolsbee, put in the peak in terms of Fed hawkishness for the year when he threw in the towel last Friday indicating that he is now just fine with leaving policy where it is. I take a glass half full view on the Fed in that they have a lot of room to maneuver if they want/need to provide support to economic growth, employment, and/or financial stability. Not only is the Fed funds rate at 5.375%, but they have walked the market back to virtually no cuts priced into the futures curve. That’s a lot of accommodation that can be applied if/when they need it.
As of now the bond market is doing the dirty work for the Fed with the 2-year T-note yield back up to 5% for the first time since last November. The 10-year Treasury yield has ripped over 80 basis points to 4.65% last week from 3.80 % at the end of last year. The yield on the 1-year / 1-year forward T-bill is brushing up against the top of a trading range that has constrained it going back to the yield peaks in 2022 and 2023. My guess is that it will remain constrained once again, but a sustained break higher is an incremental negative that will have dominos across all markets.
Without question there is a rational explanation for this move higher in yields: Fed policy expectations shifting hawkishly, inflation coming in hotter than expectations, and economic growth firmer than expectations. The question this raises in my mind is what effect (if any) does the lagged impact of higher rates have on growth, inflation, and employment dynamics two to three quarters out? Based on the performance of these metrics over the past year with yields trending higher it is a reasonable guess to conclude not much. Perhaps the financial system and households are adjusting to a ‘higher for longer’ interest rate regime, but it would be naïve to conclude higher rates are having no impact.
The below chart from Arbor Research delineates the difference in mortgage payments as a percent of income between 1st time home buyers and all home buyers. It’s the 1st time buyers that are being impacted by mortgage rates moving up from 3% in early 2021 to above 7% today and this is having a dramatic impact on household budgets with nearly 40% of income needed to cover the mortgage today.
Another variable I look at through a glass half full lens rather than half empty is the chart of the U.S. dollar index which is trading at its highs for the year (above 106) and pushing against levels where it rolled over last October.
Like yields, a sustained breakout to the upside on the dollar will spell trouble for all risk assets and set off a set of dominos, but also like yields I think the bulk of this move is in the rearview mirror. The year-to-date high in yields and the dollar is being digested and repriced across asset markets. Combine this with the resetting of Fed policy expectations and we’re talking about some major variables that are at the center of what is driving this correction. Have a look at the below chart from Bloomberg highlighting the degree to which bullish bets on the dollar have shifted from the start of the year - non-commercial players were short the dollar at the start of 2024 and are now carrying their largest long exposure going back to 2019).
Let me state plainly, should these trends in interest rates and the U.S. dollar persist and not flame out as I suspect they will, then the ‘glass half full’ lens from which I’m viewing capital markets from this point forward will be wrong. I think this correction has been a good cleansing in complacency and I’d prefer to see stocks slide 1-3% more and the correction to extend for another week or so to reset sentiment and positioning even further. Either way, I think we’re at a point where idle capital can be deployed for investors with a time horizon that extends beyond one’s nose.
A concerning variable that still lingers out there is positioning in the CTA, Vol-targeting, and risk parity space where only a modest amount of selling has taken place to this point. Here’s a comment from JP Morgan’s trading desk that I think aptly sums it up:
“Flow risks are two-way as CTAs could re-lever if markets recover the short-term signals that were crossed over the past couple of weeks, but they have considerably more room to sell on a further decline. Nearby downside signals on major US indices that could cause CTAs to de-lever further sit between ~4700-4950 on the S&P 500, ~16400-17500 on the Nasdaq".
If realized vol starts to pick up as well, then I'd expect the selling from CTAs to intensify, with Vol control strategies and risk parity funds finally joining in the fun. On the other hand, if realized volatility remains relatively muted, it is unlikely that CTAs alone will have enough of an impact to trigger a market crash. That said, this remains a highly dangerous setup from a positioning standpoint, as we're only one volatility shock away from a much larger deleveraging event.
This is a big week for markets not only from a technical and sentiment standpoint as it pertains to the ongoing correction, but it’s loaded on the data front. Investors will be focused on Thursday’s Q1 GDP data (consensus is at +2.5% at an annualized rate) and Friday’s PCE price data (market bracing for +0.3% on both the headline and core). We also have a busy earnings week ahead, especially for the Tech mega caps (Tesla on Tuesday, Meta on Wednesday, with Alphabet and Microsoft reporting after the market close on Thursday). All in all, some 300 S&P 500 companies are due to report in the next two weeks, so expect volatility to remain the name of the game. Just this week, roughly 35% of the S&P 500 will release their quarterly numbers.
In a nutshell, we’re not out of the woods, but this correction is much more constructive for the magnitude and duration of this bull market than had we just continued to levitate in an unconstrained fashion. This week also brings with it a heavy dose of Treasury issuance with a combined total of $183 billion of 2, 5, and 7-year T-note sales (the first two are record sizes). Next week we’ll get the much-anticipated auction schedule from the Treasury which marked a turning point for risk assets in October of last year with Yellen choosing to lean heavy on the front-end of the yield curve for funding the deficit. Given its an election year, I suspect more of the same, but these quarterly refunding announcements (QRA) have become a must watch macro variable.
I’m going to make my final comment this week about gold. The yellow metal has been on a tear since the end of February as its price has risen from $2,030/oz to $2,430/oz on Friday (~+20%). The rise has defied a lot of historical correlations with yields and the dollar pressing higher which typically act as strong headwinds to the price of gold, but not this time. Have things changed? Yes, in particular the U.S. debt and deficit situation are spiraling higher at unprecedented levels while at the same time U.S. treasuries are losing their allure as the world’s reserve asset. Not to mention geopolitics, in particular, the events following Russia’s invasion of Ukraine back in February 2022 when the U.S. and its allies confiscated nearly $300 billion of Russia’s reserve holdings. This action caused the rest of the world to take steps to safeguard its stockpile of foreign reserves in case they ever found themselves in a similar situation on the opposite side of the U.S. of a geopolitical issue in the future. This is one of the driving forces behind the relentless bid for gold over the last several months.
I point this out because it looks as though gold is ripe for its own correction episode. For those underexposed or having no exposure, I suggest you look to take advantage of this weakness that could take gold down to $2,200/oz. It’s one of those assets that you never have enough of when you need it and too much of when you don’t, but have a look at the chart below and you can see why it is a great diversifying asset to a portfolio – irrespective of the currency you measure it in.
The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.
Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.