Divergences May Persist

The S&P 500 continues its ongoing rally and is approaching 4300, which is its highest level since 8/17/22.  The bulls off of the October low have clearly had the better of the bears.  Admittedly, I have been in this latter group having an unfavorable view of the overall equity market.  Despite this ongoing strength in the cap-weighted index, several key indicators that I monitor, and that have been historically reliable, continue to not support the full extent of the rally.  Does this mean that these signals are just wrong this time around?  Based on my work, the answer is a NO. 

With that being said, those same unfavorable flags are doing a good job of forecasting what the broader equity market has been doing and where it is likely headed.  We can use the equal-weighted S&P 500, S&P 500 ex-tech/AI-related, or Russell 2000 as examples of indexes that are less dominated by the top 10ish Large-Cap Tech/AI-related plays that have dominated the cap-weighted indexes in which they are constituents. 

So, what is the base case for equities?  New Bull or Ongoing Bear?  Although this may sound nonsensical to some, maybe for now, it’s BOTH.  My research shows that an odd occurrence has a decent probability of happening —measures of the Tech sector and AI areas could keep surging up making higher highs while the equal-weighted S&P 500/Russell 2000 fall below their respective October price lows.  Thus, I am going to try and not use the word “market,” but rather comment specifically on the two main buckets, as my work suggests the divergences that have occurred may persist for quite some time. 

From one who has not been pounding the table for a broad-based new bull market to begin, I have to acknowledge that there have certainly been some positive developments.

• The VIX has fallen dramatically from both its October high of 34 and its 2023 max of around 26, and now stands below 15, which is the lowest level since November of 2021. 

• Although I still remain in the higher-for-longer camp for the Fed and the final level for the terminal rate, we are certainly closer to the end game than we were during 2022. 

• Even though core inflation ex-housing has been quite stable over the last several months, it is off its peak. 

• Forward earnings expectations have stopped falling, and a handful of areas have some increases. 

• The economy remains resilient and is still growing. 

All of these things, both separately and in aggregation, could be used to make a bullish case.  However, there are also many things that are not so positive. 

• Core inflation isn’t coming down persistently or fast enough. 

• A resilient labor market is beginning to show some cracks. 

• The weakest quarters for U.S. economic growth look to still be in front of us. 

• The Fed remains in the picture, and the odds are that their next move will be a hike instead of a cut. I still expect higher for longer. 

• Despite the recent “less bad” in earnings revisions behavior, my work does not confirm that broad-based increases are occurring, and it still looks like forward numbers remain too high. 
• Because of my view on forward profits, my work does not show the equity market to be attractively valued.  

• Hence, a couple of things are clear to me — the data is not fully bullish in the slightest.  However, my indicators have remained better than fully bearish. 

Do these two different buckets in the equity market — 1) Tech/AI related and 2) Everything else — have to always be completely aligned?  NO, they do not.  Historically, there can be divergences, but usually, they are smallish.  During 2023, the magnitude of the spread is not unprecedented, and relative to past periods when there have been large variances, my work shows the current situation could last longer before it becomes mega-extreme. 

So, what’s an investor to do?  Well, my work continues to support a barbell approach of some traditional defensive areas and some Large-Cap, Higher-Quality, Secular growth areas and continues deemphasizing Smid cap, Lower Quality, and Cyclicality.  The Energy sector continues to slowly move towards a potential upgrade, and for longer-term investors looking at the Financials (Banks), it seems too early to aggressively raise weightings.  Importantly, as I have been discussing all year, beneath the surface, stock picking/idiosyncratic selection is gaining in importance and relative investors have a nice opportunity to add alpha by looking at the trees and not the entire forest.  

Below are my updated macro/market thoughts:

• The broad labor market is clearly not weakening, which keeps the Fed’s inflation fight challenging.
• Core inflation readings are not falling at the same pace as before and have caused some uncertainty about their path in the coming quarters, which lowers the probability of the market’s dovish Fed expectations.
• I remain in the “Fed is higher for longer” camp, and my forecast for the terminal rate is still 5.25-6.25%.
• NO EASING — Despite the recent problems in the banking industry, my view remains that once the Fed does pause, it will likely keep policy unchanged for an extended period.
• The weakest quarters for the U.S. economy are still in front of us. It looks headed towards a shallow recession, and then an extended period of sluggish growth.
• Corporate profit expectations remain too high and need to be lowered as there are strong headwinds.
• Importantly, the immediate upside potential for the S&P 500 equally weighted still appears limited, at best, while considerable downside risk remains for equity investors. Despite being tactically overbought, my work suggests that any pullback in the AI/Tech leadership will likely be a dip in an ongoing uptrend that should likely last till their ASM indicators rollover.
• From a positioning standpoint, economically sensitive areas/names are looking the riskiest based on my key indicators, while secular growth ideas look relatively favorable.
• Single stock opportunities are sparse, but they are slowly increasing. The general theme is higher vs lower quality and larger vs smaller cap.

GENERAL CLIENT QUESTIONS/CONCERNS/TOPICS

• Most of the main client questions and issues have remained quite stable over the last 4-6 weeks.
• Despite the S&P 500 cap-weighted index still moving higher and now near 4300, there remains a reasonable amount of distrust about the ongoing equity rally.
• Investors remain skeptical that the tone is still uber bearish, as highlighted by competitor trading desk commentaries, and nearly everyone wants to know what I am hearing about sentiment from others.
• I still am not hearing any excessive amounts of bullishness or bearishness. More about confusion, frustration, and lack of conviction.
• Where to be looking for new ideas and how to position continue to be the dominant discussion points during my client calls.
• There were some large (i.e. managers with mega AUM) value investors that have started nibbling on banks and energy as they don’t have conviction that their respective bottoms are in, but they are beaten up and look interesting from a longer-term perspective.
• There is still a lot of interest about what is happening with forward earnings expectations.

SPECIFIC CLIENT QUESTIONS

Is there any evidence from your work that supports the AI/Tech performance that has been seen during 2023?

What is your broad market ASM indicator showing?

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• Is there any evidence from your work that supports the AI/Tech performance that has been seen during 2023? 

YES.  Although I have been generally unfavorable on the broad equity market, especially Smid, Low Quality, and more Cyclically related areas, there has been a clear shift in the ASM indicators for Tech and the large AI-related single names.  As long as they can remain positively sloped, they will likely have higher highs to be reached regardless of the speed limit that they have been rising, notwithstanding tactical pullbacks along the way.  Also note that all the names below (NVDA-9.55% , GOOGL-1.47% , META-4.14% , MSFT-1.48% , and AAPL-1.22% ) had negative inflections in late 2021 or early 2022, which were negative signals. 

• What is your broad market ASM indicator showing?

There has been a positive inflection, but I remain skeptical that it is the beginning of a new, improving ASM trend that is going to be the fuel for an ongoing and sustainable broad bull market.  As shown in the charts below, it is not uncommon for the ASM indicator to have a countertrend rise before heading to its ultimate trough.  Once the economy starts to show more signs of slowing, it is my expectation that this key metric will once again be headed lower, which will create a significant headwind for the broad equity market.