After the December slump, the markets started the new year with a strong advance. For January, the S&P 500 gained 6.3%, the NASDAQ jumped 10%, and the DOW lagged with a gain of 2.8%. Bonds advanced 3.2%, RSP equal weight gained 7.5% and RPV/Value surged 11%.
WHAT MOVED THE MARKET – Bulls vs Bears
Risk appetite returned to the market to start the year, with last year’s laggards becoming this year’s leaders. High beta/high valuation stocks outperformed defensive stocks, as the battle between the bulls and bears gave the bulls the upper hand. Once again, the market appears to advance on the belief that the Fed is going to pivot, or start to reduce rates towards the end of the year. Those bullish investors looking to the bond market to better understand the path of the economy would suggest that due to declining interest rates on the 2- and 10-year bonds, inflation expectations are coming down, and the Fed will soon follow with rate cuts.
On the other side of this observation, is the bears view with the bond market signaling a recession, as long duration bonds yields are lower than short duration yields (also known as an inverted yield curve). This inversion has pre-dated just about every prior recession with great accuracy. So, who is right? The jury is still out, but the Fed continues to declare higher rates for longer, and we have a hard time justifying fighting the Fed and going all in on risky assets.
As has been the case for over a year now, inflation and Fed policy continue to be the biggest drivers of market movement. Fed speakers have been adamant in their goal of reducing inflation and frequently state that rates will need to remain elevated for an extended period to cool off the U.S. economy without causing major harm – the “soft landing” scenario.
For the bull’s case, inflation continues to subside, and a lukewarm economy is keeping consumers spending, albeit with less strength than in 2021 and 2022. The bull’s case requires ongoing declining trends in inflation while also keeping the economy healthy – a tough mandate given the uncertainties. However, the past few months have demonstrated not only inflation continues to decline, but economic activity remains stable (GDP for Q4 was better than expected, and the labor force, while starting to show some cracks, remains strong). To us, these conditions are likely causing the exuberance in the market YTD.
For the bear’s case, inflation is often lumpy, and just because we have seen a string of declines, we are not yet close to the Fed’s 2% inflation target. Further, with the Fed continuing to tighten monetary policy, the full effects of the rate hikes have still not been fully integrated into economic activity. Layoffs are starting to increase as well, and the longer rates stay high, the more impact it will have due to dwindling savings rates and maturing corporate borrowing that will need to be rolled into higher rate loans.
Herein lies the real battle – if inflation stays elevated, the underlying economy is probably still in good shape to support higher prices. On the other hand, a severe recession will likely lead to low inflation as consumers are forced to cut back. So, you must be careful what you wish for. A strong economy would suggest higher rates, and a severe recession would suggest a rate cut. Do we really want a rate cut, which, in our opinion, is most likely due to a severe recession? Hitting the soft-landing scenario is a huge challenge, and only time will tell the outcome. Thus, we continue to tread cautiously. If we enter a recession this year, then inflation will probably accelerate to the downside, and the Fed could more comfortably take rates down. However, if rates continue to stay elevated due to inflation not coming down fast enough, then the result may be a severe recession farther in the future, which would probably be the more damaging long-term scenario. Is the economy ready to rip off the band aid, so to speak?
PORTFOLIO ADJSTMENTS
Given the market backdrop in December, we are not surprised our process reduced equity exposure as 2022 ended. With the surge out of the gate to start the year, we were back to adding risk assets back into your portfolios. The new daily signal methodology assisted in our adding stocks earlier than we had observed in prior years, and, by mid-month, we were tracking our benchmark closely.
We first added back in RPV on January 11th, only six trading days since the last reduction in RPV on 12/28. Throughout the month we continued to add RPV bringing it back up to 95% of target.
We also changed the core position, SPTM/US total stock market index, to an international stock fund, given the outperformance of foreign stocks relative to the US over the past several months. All our indicators point to a long-term trend change where the US Market has been stronger than foreign markets. It has been more than 10 years since this relative strength metric has favored international stocks relative to the US, and we have made this adjustment, accordingly, replacing SPTM with IEV, the ishares Europe ETF. IEV’s top holdings include Nestle, Roche Holding, Shell, Novartis, AstraZeneca and Unilever, and is up 10% YTD and up over 22% in the past 3 months (vs. 6% and 5% respectively for the S&P 500).
Trends like this have been long term in nature over the past 20 years, and our indicators are pointing to markets other than the US market to start to outperform.
Also in January, we reached our maximum target exposure to RSP/equal weight and SPLG, our S&P 500 index fund.
LOOKING AHEAD
So far, 4Q earnings have held up reasonably well, even as forward guidance has become more cautious. Layoffs, while previously limited to technology companies, are starting to show up in other sectors, such as industrials and financials. An important metric of money supply, dubbed as M2 supply, has cratered from the highly elevated levels coming out of the pandemic. This M2 surge in the money supply was the likely cause of the inflation spike. While a reduction in M2 is probably necessary to reduce inflation, the fact that there is less supply would suggest that financial conditions remain restrictive.
On 2/1, the day of this writing, the Fed raised interest rates by .25%. This is after the prior meeting rate increase of .50%, signaling that they are moderating the pace of rate increases, which is encouraging. However, the Fed has been very vocal (and continues the same rhetoric today, 2/1) that rates will remain elevated until inflation can be maintained down to their 2% mandate.
The S&P 500 has been in a trading range between 3,700 and 4,100 since June 2022 after the initial shock from the shift to a higher rate regime. Given the move higher in January, the index is within striking distance of the high end of said range. Thus, we would not be surprised to see a near term pullback to the middle end of this range. Future data on inflation trends will likely dictate whether the market can advance beyond the 4,100 level or fall below the 3,700 level. Barring a string of negative economic data, we don’t think that a significant breach below 3,700 is likely. However, if the downward trend of inflation does not continue, we can’t really see the market moving much beyond the 4,100 overhead level. The future direction of the market will likely also be dictated by earnings, and if earnings decline materially, then the market multiple is probably too high to justify the current level. If earnings continue to grow, even at a slower pace than average, one could argue that 3,900-4,000 levels could be supported.
We will continue to monitor the pricing behavior and adjust your risk exposure accordingly to mitigate substantial drawdowns while also participating in the eventual end to the bear market cycle. We look forward to months ahead when the Fed will not be the cornerstone of our monthly notes to you, and when we can again look forward to a better economic environment that will lend itself to less volatility and greater productivity as we have enjoyed in the past.
We wish you well.
