Our short-term and mid-term signals remain red while the Ivory Hill long-term RiskSIGNAL remains green. As a refresher, our short and mid-term signals are predictive signals while our long-term signal is reactive. When either of our short and mid-term signals are red that means we should expect higher volatility in the near future. I care about increased volatility because volatility is most associated with down markets. Volatility is predictable, market direction is not.
We are currently sitting in roughly 40% Treasuries and 13% money market and will be looking to increase exposure to fixed income.
The Fed raised rates as expected by 0.25%. While headline indexes appear favorable, smaller indexes have dropped significantly, indicating deteriorating conditions. Mega-caps are hiding the true situation, and our signals are saying increased volatility is very likely.
Investors expect rate cuts from the Fed, but it's more likely the Fed will pause hikes and maintain the current rate until inflation drops. This would enable additional quantitative tightening without tightening monetary policy. However, this could increase the government's borrowing costs, with projected interest costs doubling over the next decade to $1.4 trillion by 2033. To cover these costs, the government will likely pursue revenue-generating measures such as higher taxes and audits. Businesses and individuals who received PPP loans or unemployment benefits may be targeted for revenue collection. You didn't think all that money was free, did you? Anyways there is an argument for the Fed to start cutting rates before year end to avoid the debt rolling over into higher rates.
BUT, I would not be surprised to see the Fed do another rate hike or two this year if inflation remains sticky and especially if more "things" are not breaking.
Remember, if conditions get so bad the Fed starts cutting rates earlier than they communicate to us, that is not good for risk assets. Almost every time the Fed goes into a rate hiking cycle, risk assets sell off after they start cutting rates (not pausing).
Although investors feel encouraged by the earnings of super-cap tech companies last week, there are other signs that conditions are deteriorating. Small-cap stocks are lagging and lower volatility stocks have been outperforming higher volatility stocks since February. Additionally, long-term Treasuries have done well over the last two weeks. Despite the generally positive data, risk asset prices do not appear to be rising.
The S&P 500 (SPX) is being driven higher almost purely from the mega-cap tech names. So far this year we've had just 7 mega-cap stocks account for 90% of the gains in the S&P 500 year-to-date. Apple and Microsoft make up over 13% of the indexes' total market capitalization. The index is the most concentrated it has ever been in roughly 60 years. Not very diversified, is it?
This is not a good sign to see because all it takes is for one of these companies to stub its toe and it will bring the entire market down very quickly. Risk starts off slowly and then it all comes at once. Apple's earnings on Thursday could keep this party going or break the market.
Below is a chart of the market cap weighted SPX index (white) and the equally weighted SPX 500 index (yellow). The cap weighted index is outperforming the equally weighted index by a little over 6% YTD because the cap weighted index can contribute 90% of its gains to 7 stocks while the equally weighted index is essentially being dragged down by the other 493 companies.
Let's look under the surface. The behavior of small caps is VERY important because their strength or weakness tends to lead the larger capitalized indexes (like the Dow Jones and the S&P 500) around major trend reversals. The S&P 500 and the Dow at times camouflages subtle weakness in the market trend.
The SPX is driven by a few large companies and can reach new highs without the majority of stocks contributing much. This phenomenon often happens around major market tops. Small-caps, which have less financial strength, tend to show early signs of market deterioration and decline before large-caps. This weakness is reflected in broader indexes like the Russell 2000 and the even smaller Russell Microcap Index, which is currently in the red. This suggests a trend reversal might be taking place, as small-caps are failing to confirm strength in the SPX. If a market bottom had been reached, the Russell Microcap Index would likely be on the way back up by now.
The US banking sector is the wild card in the current economic climate. Three of the largest banks have already collapsed, and while this will not go unnoticed, it seems that the Fed and major banks have a plan in place to minimize further downside risk. However, I want to be clear that I believe a major credit event is still looming, and whether that involves another bank or not remains to be seen.
Bank deposits are plummeting at an alarming rate, reaching levels not seen since the Great Depression, a period marked by the collapse of the banking system. This sharp decline in deposits has historically signaled a market crash and recession are coming.
The debt ceiling drama is another important market influence to keep an eye on. This week, Janet Yellen stated that the time for extraordinary measures to expire could be as soon as June 1st, expediting the need for Congress and the White House to reach an agreement.
I notice many similarities between the present and 2011 if we consider that year as a template for how this entire circus may unfold. In both scenarios, a divided Congress was present, with conservatives pushing for spending reductions in exchange for raising the debt ceiling. I anticipate that our elected officials will procrastinate until the final moments and potentially hinder future economic growth due to the restrictions on spending. I find spending restrictions are basically worthless as they are often disregarded as politicians are skilled at creating emergency spending situations. Both parties do this.
Up until roughly a week before the deadline, the markets were mostly sideways up until moments before the deadline. Despite the possibility that the U.S. government could default on its debt, stocks started to fall, and Treasuries started to soar. Shortly after the debt agreement was made, the S&P 500 plunged by almost 18%, while long-term Treasuries rallied by more than 30% from their pre-crisis values. No two circumstances are exactly the same, of course, but if this drags on much longer, things might get pretty bad.
Lumber prices have me a little concerned here. Lumber prices have declined to their lowest level since May 2020, likely due to the massive tightening of credit in the commercial real estate market via regional banks.
This will likely have a negative impact on housing and the overall economy as the lumber market tells us to expect higher volatility going forward.
The yield curve remains inverted at -51 basis points. Remember, the sell signal is not the inversion, its the reversion back up and we are not there yet.
US Consumer Credit Card debt is approaching $1 Trillion and the average interest rate on that debt is 24.24%. Is the consumer still strong Janet?
The VIX has been sleeping since April. The fear index, has been inching its way up this week as it sits at the 18 level. If all of our signals were green right now we would be buying everything in sight but that is not the case.
In the short-term, our next hurdles are AAPL earnings today, followed by the debt ceiling drama at the end of the month, and then the Fed's upcoming decision.
To see a bottom, several factors need to happen, such as the yield curve reverting back up and staying there, the Fed cutting rates (not just pausing), the VIX blowing out above 45, and our signals turning green.
Until we see consistent patterns of higher lows and higher highs over multiple quarters, we remain skeptical of the rally and will be cautious of a possible retest of the lows. Long-term outperformance is achieved by avoiding major market crashes. Now is not the time to buy penny stocks or hold onto profitless tech stocks.
In the short-term, we are focusing on sectors that align with the current market cycle, such as precious metals, defensive stocks, and treasuries. If the long-term Ivory Hill RiskSIGNAL turns red, we will not hesitate to increase our cash levels and stick to the process.
It's important to be patient and avoid listening to the clowns on CNBC. Instead, prioritize spending quality time with your loved ones or engaging in leisure activities like playing golf.
And remember – the one fact pertaining to all conditions is that they will change.
Feel free to reach out to me and use me as a sounding board.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President