Positive signs in a changing environment | OPINION

The stock market in the US remains in an upward trend, the stock market participation continues to improve and the new highs continue to expand. At the close of Friday the 28th, 76.8% of the S&P 500 companies were trading above their 200 DMA (Day Moving Average), 73.25% of the shares of mid-cap companies, 63.17% of small-cap stocks as well as 83% of the Nasdaq 100 Index stocks followed suit. Historically, this type of participation is enough for a sustainable bull market. Just a few weeks ago, the S&P 500 did not have these characteristics.

In other words, the current bull market not only includes a handful of leading large-cap companies, but now enjoys broader participation. Over the past month, all 11 sectors of the US economy traded in positive territory led by energy and financials, both of which had previously experienced strong headwinds. Tech ETFs are consolidating in price, while the housing and retail sectors are rising. Regional banks and insurance companies are also increasing. Meanwhile, the utility sector is lagging behind, which is normal in bull markets. Last but not least, volatility (VIX) continues to be under pressure, with its main trend still down, which is positive for stocks.

The cup spread in the credit markets shows no signs of stress. This refers to the spread between corporate bonds and US Treasuries. The higher the rate spread, the greater the stress in the credit market, which is negative for stocks. The tighter the spread, the more stable the credit markets and the more positive it is for stocks. Although spreads are currently substantially higher than before the 2022 bear market, they are lower than the peak experienced in October 2022 and continue to decline; for now. The Federal Reserve (FED) balance sheet continues to contract after a large expansion last March due to the regional banking crisis. All this is positive.

What changed?

• The Fed raised rates by 25 bps to 5.25-5.50% and the rhetoric shows some indecision regarding further increases. This change is positive for stocks.
• Inflation continues to slow.
• The unemployment rate continues to be very low.
• Consumer confidence rises to the maximum experienced in 2 years.
• GDP for the 2nd quarter accelerated to 2.4%.
• For some economists and forecasters, the US economy is no longer at risk of recession and they forecast that, in the worst case, a soft landing for the economy is almost certain.

What can go wrong with this scenario?

We have increased the risk allocation in our portfolios during the first half of 2023, which is paying us off very well. But as risk managers, it is our fiduciary responsibility to figure out what might trigger the next leg down to protect our clients’ capital. It is true that the earnings momentum, if sustained, can drive the stock market to new highs. We have noticed an increase in prices in some of the lagging sectors and industries, such as agribusiness, copper and wood (MOO, COPX, WOOD). Gold Miners (GDX) is outperforming Gold (GLD). Base metals (DBB) seem to be making a comeback as well. Additionally, the main trend of the US dollar (USD) is bearish. This is important because a weak USD makes US exports more competitive abroad, which is conducive to US sales and economic growth. Most of the time, the USD and commodities are they move in opposite directions. Therefore, a weaker USD can lead to an increase in economic activity and in the prices of raw materials, including energy and oil. All of this is important because it is normally inflationary, therefore it could cause a resurgence of inflationary pressure.

Our quantitative analysis still shows the main trend of the 10-year US Treasury yield, bullish. The above explanation could be the reason for the stubborn bullish trend in Treasury yields, all maturities along the curve. Bond and stock prices have similar reactions to the inflationary effect, for different reasons, but similar reactions:

• Low inflation = Lower interest rates and better profit margins (bond and stock prices go up)
• High inflation = Higher interest rates and lower earnings (bond and stock prices fall)

If the US economy is transitioning to a low inflation environment, then the stock market will continue to rally. But then why are Treasury yields rising? Either bond investors are wrong, or if there really is a resurgence of inflation, stock indices should experience another stock sell-off. So the question is when?

There are two reasons why bond yields go up: (i) generally at the beginning of the business cycle when growth accelerates without inflation, which is good for the stock price, and (ii) to combat inflation at the end of the cycle. economic, which is bad news for stocks. Perhaps this is the reason for an inverted yield curve that takes 12 months to live. The curve inversion remains at approximately -100bp, which is double the inversion seen before the Internet bubble burst.

The bond market anticipates events in the real economy around 12 months or longer. Following this rule of thumb, we are only now seeing the effects of the summer 2022 rate increases (June, July, and August) and we are still a long way from experiencing the actual impact of this year’s increases. The stubborn yield curve inversion may be heralding a hard landing for the US economy in the next 12 months or perhaps even longer. In the meantime, the bull market in stocks can continue to rise, and being invested is the only way to participate. But there is a big difference between investing together with a proven risk management strategy to protect capital, or investing while being exposed to the natural volatility (loss) of the market.

The strong momentum and sustained overbought in the stock market are a sign of solvency and are positive for stocks. But you must invest with a clear risk management strategy in case the rotation of capital that began a couple of weeks ago, and which is helping to expand the shareholding, ends up being only a rotation of values ​​from the growth sectors to the most defensive sectors of the economy. This type of turnover is not that of a healthy market. Keep in mind that August and September are generally averse to stocks.

What would need to happen for the inversion of the yield curve to normalize? Remember that the stock market reacts to the yield curve with a lag. Historically, rising unemployment has always signaled that the end of the inverted yield curve is coming to an end, and consequently, a sustainable bull market ensues. For now, unemployment is low and the inverted yield curve persists. Some say the cycle is different this time and the inverted yield curve is unimportant. We will see!