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Issue 36: Stocks Are in a Bull@#$! Market

June 12, 2023

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Stocks Are in a Bull@#$! Market

S&P 500 rebound belies technical weakness
It’s official: As of last Thursday, S&P 500 stocks satisfied the technical criteria putting them back in a bull market, after rallying over 20% above their October 13th close. By the end of trading on Friday, large cap US stocks in the index notched a fourth consecutive positive week, their longest winning run since August 2022; the tech-heavy NASDAQ marked a seventh straight weekly rise, its longest streak since late 2019. Despite hitting some favorable technical milestones, other quantitative features just below the surface highlight weakness in the current rally. In particular, as we’ve mentioned in past Perspectives, market breadth—a measure of how many stocks are participating in big market moves—has been particularly narrow as the current rebound in stocks unfolded. One glaring sign is the percentage of market value concentrated in the largest handful of stocks. At the end of May, the footprint of the biggest ten companies in the Wilshire 5000 Index stood at nearly 26%, considerably higher than the 15.8% weight the ten largest stocks had a decade ago, and surpassing even the lopsidedness of the market at the height of the Dot Com bubble in 2000 (see left panel below).

Figure 1 Weights of Top 10 Largest Stocks

The effect is event more pronounced when one considers the contribution of those top stocks to the market’s recovery since last October. In the right panel of the figure above, we see the total return on the Wilshire 5000 Index, as well as the part of that return contributed by the ten biggest stocks. Over the last decade, a little more than one-eighth of the market’s performance was contributed by the largest firms. During the late-90s tech bubble, over one-third of returns came from these megacap stocks. In the recent bull run, by contrast, almost the entire market return was accounted for by just ten companies’ performance. As JPMorgan’s head of US equity strategy recently pointed out, such a lack of breadth often precedes an economic downturn and suggests investors have been overly optimistic in bidding up such a small subset of stocks.


FOMO is bringing out the bulls
As discussed in last week’s dispatch, we see this year’s rally in AI stocks on the back of ChatGPT hype as fanning the flames of investor greed, spurring a ‘fear of missing out’ that accounts for no small part of the recent run-up. That view is backed up by data on individual investor trades, which point to a marked increase in exposure to tech shares over the last few weeks. Indeed, stats from VandaTrack show retail investors purchasing over $1.5 billion worth of US stocks in a single day in late May, concentrated in tech names, while single-stock call option volume has dramatically outpaced trading in puts over the last few weeks. Big moves like these come against a backdrop of persistent outflows from low-risk money market ETFs and a flood of assets into a narrow basket of technology names, including through Information Technology ETFs, which have seen big inflows in recent weeks. Such crowding by retail investors explains how in the face of a likely recession, the S&P 500 trades at nearly 20x forward earnings, the CBOE volatility index has fallen to its lowest level in over three years, and generally bearish global fund managers sit on a historically high pile of cash.


Fundamentals still matter…eventually
Of course, technicals are at best half of the picture. In the longer term, prices converge to fundamentals, and we see the macroeconomic backdrop for this new bull market as remarkably challenging. We alluded to recession risk above, and most of our quantitative indicators assign a very high likelihood to a US recession. The Fed’s own model puts the probability of economic contraction in the next 12 months at just over 70%. Digging deeper, we note that up to this point the strong consumption keeping companies’ profits high has been supported by the pandemic-era build-up of household savings at a time when supply was constrained. When those savings are depleted, it’s hard to see spending continuing to drive profits. While nobody can pinpoint exactly when excess savings will bottom out, data show that many families are tapping credit cards—Americans presently have a balance of almost $1 trillion, despite an average interest rate of over 20%—and consumer loan delinquencies have spiked. We already witnessed a year-over-year decline of 2.1% in S&P 500 companies’ earnings for Q1, according to FactSet, and we don’t expect the AI revolution to save the vast majority of firms from a downturn in the coming year.

Don’t Lose Sight of the Fed—or the Treasury

It’s a big week on the macro data front
On the fundamental front, this week is a particularly busy one, with several key events in the offing. At midweek, all eyes will be on the US Federal Reserve, set to announce its June rate decision on Wednesday. Although most traders expect a pause at this week’s meeting, futures are pricing in a 30% likelihood of the Fed hiking by 25 bps, based on data from the CME Group. Bloomberg commentators noted that for this tightening cycle, such uncertainty in the days before an FOMC meeting is unusual: in 10 consecutive rate increases since March 2022, only two FOMC decisions featured any meaningful disagreement about the outcome in pre-meeting trading. If the underdog rate hike prevails, the burgeoning bull market will likely be stopped in its tracks. We’ll have a much better idea how likely that really is on Tuesday, when the US Bureau of Labor Statistics reports inflation data, obviously a key input to the Fed’s decision. At the same time the Fed announces its decision, we will be looking at dot plots and US economic forecasts from the bank, which will tell us much more about Fed sentiment and its likely policy rate endgame.


Even if the Fed pauses, traders bet they’re not finished
At present, while consensus might be a pause in June, the last few months have resulted in a revaluation of where interest rates are likely to end the year. As the chart below illustrates, the predicted December Fed Funds rate has steadily increased since mid-March to just over 5%. This trend in expectations since Q1 has been driven by easing fears around US bank failures and resolution of the debt ceiling debate, both of which presumably reduce the chances of a cut-inducing crisis and give the Fed, still very anxious about inflation, much more room to hike again. In light of such expectations, Treasury prices have declined, with that sell-off accelerating last Wednesday on the Bank of Canada’s announcement that its policy rate, holding steady since January, was rising by a quarter point in the face of stubborn inflation: potentially foreshadowing what the Fed might do in July, given how high inflation is above a comfortable level.

Figure 2 Implied Fed Funds Rate

Treasury issuance another source of pressure
While investors rightly focus on the Fed when thinking about the trajectory of interest rates, it would be a mistake to ignore its fiscal counterpart, the US Treasury. That’s been especially true in recent weeks, amidst concerns over Congress raising the debt ceiling, and the Treasury will continue to play an important role in coming months, as removal of obstacles to debt issuance clear the path for big action on the fiscal front. Importantly, when the Treasury was running up against the debt ceiling and couldn’t issue new debt, it relied on spending from the Treasury General Account (TGA). The effect was to inject liquidity into the economy, since the government spent without concurrently issuing new debt or raising taxes. With the political standoff resolved—for now, at least—the US is ready to continue its borrowing, and will immediately seek to replenish the TGA, which has recently dropped below $50 billion, the lowest point since 2017 (see below). By the end of 2023, JPMorgan estimates that the US government will need to borrow $1.1 trillion through short-dated Treasury bills, including $850 billion in net bill issuance over the next four months.

Figure 3 US Treasury General Account Balance

The effect of such issuance, of course, is to reverse the de facto stimulus of the TGA’s drawdown, sucking liquidity out of the system by selling debt without a corresponding increase in spending. As liquidity is withdrawn, investors tend to be less inclined to invest in risk assets. Analysts from JP Morgan and Citi forecast that in addition to pushing up bond yields—which might cause stress on the banking sector to flare up once again—such a reduction in liquidity could represent a drag of around 5% on stocks this year. To the extent Treasury issuance cuts into the recent market rally, we expect the hit to growth stocks will be disproportionate, with value shares showing relative outperformance.