“Excesses in one direction will lead to an opposite excess in the other direction.”
-Bob Farrell
The October 11th RiskSIGNAL™ remains firmly red and we are sitting on over 55% cash and short-term bonds as well as 10% allocated to 20 Year Treasuries (TLT).
Our short-term and mid-term signals flipped green last week and then confirmed yesterday, so we rotated out of lower beta stocks (lower-risk) and into higher beta stocks (higher risk).
By increasing the beta exposure, this provides us the opportunity to take on more risk while not increasing our aggregate exposure to equities.
I expect this “risk-on” period to be short-lived. Based on current information, I expect this rally to start losing steam by next week and I would be surprised to see it go beyond the end of this month.
While the long-term RiskSIGNAL is red, we will not reduce our cash and short-term bond holdings until we get the “all-clear” sign from our signal.
I'd like to take a moment to discuss our long-term signal status. The market is now currently higher than when we sold. For those clients who have been with us for several years, this shouldn’t be a surprise to you as this is exactly what happened in January of 2022. At that time, we significantly increased our cash holdings, and then the market spiked by 5% over the following two months, only to subsequently plunge 23%. This underscores the importance of patience.
Following a week where most key asset classes experienced notable gains, the subsequent week focused on assessing which ones could sustain this upward trend, and determining the primary market drivers between stocks and bonds. However, my understanding today may not be much clearer than it was a week ago.
The S&P 500 saw a 1.4% increase, with growth and tech sectors each rising around 3%. However, the market's internal breadth still looks weak.
Last week, we witnessed a continuation of a trend that has been prevalent throughout 2023: the dominance of mega-cap growth and tech stocks. This trend tends to make the major market averages appear more robust than they might actually be. However, this is not necessarily indicative of a strong market over the long term. The FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Google) have become a sort of safe haven for investors, consistently attracting investment even when other market segments falter.
Yet, there's a risk associated with such a narrow focus in the market. When only a small segment, like tech, leads the market – as it did last week by being the only sector to outperform the S&P 500 – it can create an imbalance. This concentration in a few large companies can mask underlying weaknesses in the broader market and potentially lead to increased volatility and risk.
The equal-weight S&P 500 dropped by -0.6%, and small-cap stocks fell -3%. This pattern suggests that if traders are indeed adding more risk, it's primarily benefiting bubble-cap tech stocks, casting doubt on the likelihood of a broader market rally.
This trend seems to indicate that while equity investors are open to buying on the back of a potential Federal Reserve pivot, there remains considerable skepticism about the global economic outlook.
If you have not had a high concentration in bubble-cap tech, you are likely down or flat over the past year. The top seven stocks have basically contributed 100% of the SPX’s gains this year.
This skepticism is evident in the underperformance of what are typically recovery leaders like small-caps, emerging markets, and value stocks, despite a generally bullish sentiment over the past two weeks. While a rally towards year-end is still a possibility, it's becoming increasingly apparent that it might not be a widespread phenomenon.
Small-caps haven’t gone anywhere but south for two consecutive years.
While I anticipate a surge in small-caps following this morning's CPI report, I remain cautious about its longevity. The reality is, a significant portion of these companies are grappling with financial challenges.
In fact, nearly 30% of small-cap stocks have failed to generate a profit over the past three years, casting doubt on the sustainability of any post-CPI report rally in this sector.
In the first part of last week, long-term Treasuries appeared to be the frontrunners, but this changed following Thursday's disappointing Treasury auction. The market is currently experiencing an excess supply of government bonds, a situation compounded by the Federal Reserve reducing its balance sheet.
This surplus could pause the flight-to-safety trade, although demand for Treasuries might surge again if market conditions worsen. I still view TLT as a generational buying opportunity that has a long way to run.
Bear market rallies are a common occurrence and should be anticipated. The sharper and more pronounced the rally is, the more likely it is to be a bear trap. Bear markets have a tendency to draw in significant amounts of capital at their peaks, only to subsequently plummet to new lows. It's rare for bull markets to make an immediate, sharp recovery following a crash (unless the Fed is printing trillions).
As we navigate the final phase of this cycle, I expect to see several more of these rallies. This kind of volatility is typical in markets, and it's important to let the market follow its course. After all, no one – not you, me, Jerome Powell, President Biden, nor Warren Buffett – can control the market's movements.
To put this in perspective, recall the tech bubble. During that period, there were numerous bear market rallies, with several surging 5-10%, and at least three instances where the market rallied more than 20% before finally reaching a bottom.
Currently, the market was down 11% from July to October and then printed 9% in 12 trading days. Bottom line: this is not normal and is not yet a healthy bull market.
Back to reality
History whispers a warning from the last three recessions: When the 10s2s crosses zero, and continues to trend north, stocks are either crashing or about to crash.
Credit spreads haven’t moved over the past week but this is something you will want to monitor going forward. Once these spreads hit the 6 level, they generally continue to move north. Per the last three recessions, that is also bearish for stocks.
Again, history whispers a warning from the last three recessions: When the Fed begins cutting rates (not pause) they are usually doing so because economic growth has slowed too much (because the Fed has gone too far) and stocks are either crashing or about to crash.
Here’s another history lesson: When the Fed pivots - On average, the S&P 500 has crashed 23.5% over a period of 195 days from the first rate cut to the market low.
The key question on everyone's mind is whether we're heading towards a recession.
At this point, I don’t see how the Fed can both tame inflation and avoid a recession.
If the Federal Reserve successfully achieves a 'soft landing' without triggering a recession, then all our current speculations become irrelevant, and predicting future market returns becomes more challenging.
However, if a recession does occur in the next few quarters, whether it's a typical one or triggered by an extreme event like a credit collapse, the unique circumstances leading up to it make it difficult to draw definitive conclusions. Environments with hyperinflation and rapidly rising interest rates are notoriously unpredictable.
One fairly certain assumption is that if a recession is on the horizon, we could see a substantial decline in the S&P 500. Investors, already disheartened by the lack of new record highs for nearly two years, may need to brace for continued disappointment as a global economic slowdown takes hold.
And remember - The one fact pertaining to all conditions is that they will change.
Feel free to use me as a sounding board.
Best regards,
-Kurt
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President