A Narrow Market's Illusion of Stability
Exploring the Potential Air Pockets in a Tech-Dominated Market Landscape
Right now, the market is a bit overheated, so we might see a pause in growth for a little while. Despite this, the Ivory Hill RiskSIGNAL™ is still green, meaning we're fully invested in this market.
The current market aligns with my 2024 outlook, which predicts most of the gains will occur in the second half of the year. How we get from here to there is likely going to be very bumpy. This is due to several uncertainties in the first half of 2024 that pose challenges for the market. Number one is the Hard vs. Soft Landing narrative.
The debate over a "hard landing" versus a "soft landing" for the economy has taken on even greater significance following the Federal Reserve's recent dovish shift. Here's why: if economic indicators start signaling a hard landing, the Fed's ability to support the market is limited. This is because it has already made a dovish pivot, and the market has factored in expectations of aggressive rate cuts. The Fed gets one shot and one shot only at pivoting and that shot has already been fired. Consequently, the market is now particularly susceptible to a downturn if economic data begins to point towards a hard landing.
This vulnerability is amplified by two factors: firstly, there's a near-universal market belief that a hard landing won't occur, and secondly, stock market valuations are quite stretched, with the S&P 500 trading at nearly 20X next year's earnings. To say this market is overvalued is an understatement.
In practical terms, this means two things: firstly, a "growth scare" – a scenario where economic data weakens and the likelihood of a hard landing is acknowledged – is likely to lead to a 5% pullback. Secondly, if a hard landing becomes the predominant expectation, we could see a much larger correction, potentially in the range of 10%-20%.
In short, while many investors may have already made up their minds on this issue, there's considerable risk to this rally if they are caught off guard and a hard landing becomes more probable. Therefore, it's crucial that we continue to closely monitor economic data to guide our strategies and decisions.
Federal Reserve's Rate Cut Timing: There's growing anticipation about when the Federal Reserve will cut rates. The equity markets are particularly sensitive to this timing, and any delay or uncertainty could cause anxiety among investors.
As I have been saying since the beginning of the year, with inflation still coming in hotter than expected, the Fed is not going to be cutting rates anytime soon. If we don’t get any rate cuts by May, I think we are looking at at least a 10% market correction.
The bond market is showing signs of turning over once again (eye roll). While we haven't reduced our exposure to bonds yet, we are strategically holding new cash on the sidelines, awaiting the right opportunity to deploy. In the past three weeks, interest rates have experienced a slight increase, influenced by some mixed signals regarding inflation. Looking ahead, I anticipate a highly active bond market throughout the year, presenting more opportunities that I am aiming to capitalize on.
Fundamentals & Technicals
Here is an updated market multiples chart. The S&P 500 pushed further beyond the upper bound of the current fundamental valuation target range of 4,655 and is now quickly approaching the “better” valuation target of 4,875. The weekly RSI indicator is hovering just below overbought levels at 69 suggesting the rally has some room to run.
On Friday, the S&P 500 surged to new nominal all-time highs, reinforcing the bullish trend in the stock market across all time frames.
Please be aware that when adjusted for inflation, the S&P 500 has not reached new all-time highs. This detail is often overlooked, but the impact of inflation is significant.
Until we surpass the inflation-adjusted highs, we are not in a "new bull market." The influence of inflation is a critical factor in accurately assessing market performance and future trends because it does matter.
From a technical perspective, while there's still a possibility of a "Double Top" formation, which is typically a bearish signal, last week's surge to new highs has significantly diminished this risk. Instead, our focus shifts back to the "Cup and Handle" pattern (on the chart below), which I initially identified in the fall. This was when the S&P 500 exceeded its 52-week highs set in July 2023.
Our price target for the S&P 500, calculated by adding the point value of the second half of 2023's pullback to the summer highs, is around 5,100. This represents an approximate 5% increase from Friday's closing level.
Bubble-Cap Tech Stocks Lead The Way
Last week, the group of tech stocks known as the Magnificent Seven (M7) saw an impressive 3.5% increase, propelling the markets upward as they reached new all-time highs. This surge was evident both in their outright price (as shown in chart below) and in their relative strength compared to the S&P 500.
An important technical detail is that the Relative Strength Index (RSI) for these stocks has re-entered the overbought territory on the weekly timeframe chart. While this is a point of interest, it's not necessarily a prompt for selling. In 2023, the M7 proved to be a challenging target for short-sellers, as it remained in the overbought zone (above an RSI of 70) for an astonishing 11 consecutive weeks from late spring to mid-summer.
Looking forward, a key indicator to monitor will be a declining RSI in the context of still-rising outright prices. This divergence could serve as a warning sign for those anticipating a pullback in bubble-cap tech stocks in the upcoming weeks, months, or quarters.
The Market is Increasingly Narrow
Last week, the Technology Sector, represented by the XLK ETF (black), experienced a significant surge of 4.13%, reclaiming the dominant position it held for the majority of 2023.
The tech sector stands out as basically the sole contributor to the S&P 500's recent surge to new all-time highs.
Remember, Bob Farrell’s rule #7? “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”
This is not a strong market because it is still being driven almost exclusively by bubble-cap blue-chip tech stocks.
Additionally, the sector's relative strength compared to the S&P 500 has escalated to its highest point since the peak of the dot-com bubble.
This remarkable increase in relative strength justifies an upgrade in the sector's status. The recent performance of XLK underscores the sector's resilience and its renewed momentum in the market. We remain bullish on tech until we aren’t.
As expected, last week the small-cap Russell 2000 Index did not join the rally that led the S&P 500 to new record highs. The Russell did recover from its lowest points but still reached new lows for the year, ultimately closing the week with a loss.
On the daily chart, the 2024 low closing of 1,914, recorded on January 17th, stands as a critical level for small caps. A fall below this level could lead to a further drop towards 1,860. Conversely, for those bullish on small-caps, overcoming the January 8th, 2024 closing high of 1,989 is essential to kickstart a renewed upward movement.
I realize I sound like a broken record, and some of you might be skeptical, especially with the S&P 500 hitting new nominal all-time highs last week. However, I remain convinced that we are not in a true bull market yet. Over the past two years, the macroeconomic situation has only deteriorated, and the market's focus has increasingly narrowed to almost exclusively bubble-cap tech stocks.
The fact that we haven't yet experienced a recession or a major market crash should not be interpreted as a decrease in the likelihood of such events occurring. In my view, the probability of facing a recession or a significant market downturn has increased.
Consider this: if we label the October 2022 lows as the "bottom," then why aren't other sectors in the S&P 500 performing anywhere close to the tech sector? As the tide rises, so should all the ships, right?
If October 2022 was indeed the bottom of the market, we would expect to see a more widespread market rally at this point, encompassing not just the major indices but also small-cap stocks.
This expectation is particularly relevant considering the significant role of small businesses in the U.S. economy. There are approximately 32.5 million small businesses across the United States, accounting for 99.9% of all businesses in America. Moreover, these small businesses contribute about 44% of the U.S. economic activity, as measured by the Gross Domestic Product (GDP). This substantial impact underscores why their performance is a crucial indicator in assessing the health and direction of the broader market. Indeed, while it's true that not every small business is publicly traded, this fact remains relevant. The dynamics and health of small businesses, even those privately held, can significantly influence the broader economic landscape and market trends.
Yet, small-caps are still in a full cycle crash, down 20% since their November 2021 high. This is not characteristic of a bull market. What we're seeing is a market of individual stocks, not a stock market.
Recessions and major market crashes have a history of blindsiding investors, striking precisely when the crowd assumes the coast is clear. I am increasingly convinced that we are approaching this critical juncture.
While we haven't arrived there yet, it's clear we're still in the midst of the 'Fear of Missing Out' (FOMO) phase, with the 'Euphoria' stage of the market cycle looming on the horizon so this market still has room to run. This stage, marked by extreme optimism and often overconfidence, is typically a precursor to a significant market correction or downturn. It's a crucial time for vigilance and strategic foresight in your investment decisions.
History is relevant here as it suggests that when yields peak in a market cycle, they initially provide a relief rally in stocks, paving the way for new market highs, as we're seeing now.
However, it's when yields reach their peak and then experience a sharp decline, this is often a precursor to a recession and a subsequent downturn in the market.
This pattern of peaking yields followed by a significant drop is a key indicator that investors should be watching closely, as history shows, that when this happens, stocks tend to crash.
What we've observed in the markets so far seems to follow this historical pattern.
The critical question remains the length of this runway, which can vary significantly.
Do We Chase the Market Here?
The S&P 500 may continue its ascent higher, but let's be clear: the market's current strength and momentum, while impressive, should not be mistaken for an all-clear signal.
I am not advocating a bearish position or a drastic cutback in equity exposure. However, I am cautious about buying into this market at its current levels.
My reasoning is straightforward: there are barely sufficient factors, other than existing momentum, that I can point to that will drive stocks substantially higher in the medium term.
Conversely, there are numerous potential triggers for a rapid, roughly 5%ish market correction. It's in the aftermath of such a correction that I see a better opportunity to deploy capital.
For those looking to invest now, I strongly recommend a focus on lower-volatility stocks and sectors, with an emphasis on sector diversification. Especially as we brace for what I foresee as an impending economic slowdown, a defensive equity stance is likely to outperform.
And remember - The one fact pertaining to all conditions is that they will change.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President