In our investment process we utilize both fundamental and technical analysis. Fundamental analysis involves looking at the specific details and valuation of a business. Then based on the analysis, deciding whether an investment is either; overvalued (market price is higher than we think is fundamentally justified), fairly valued (market price is in line with what we think is a reasonable valuation), or undervalued (market price is lower than what we’d consider to be the fair value). This analysis then informs decisions to buy, hold, or sell an investment. Technical analysis involves looking at the price and volume action of any given stock or index – the price action tells us exactly what real investors are doing with real dollars. You can use trends, moving averages, and a variety of other metrics to inform your decisions to either buy, hold, or sell. At MFG, we do our best to marry these two concepts together to inform our investment decision making process. But what happens when the two forms of analysis point in opposite directions? That is where we find ourselves today and why we think the stock market has very recently entered what we would call a bull trap, a false breakout, or head fake.
As you can see on the chart above, the S&P 500 has been trading in a range from roughly 3800 to 4200 for the last 12-13 months or so, with the exception of one pop above the range in August 2022 and a couple of dips below the range in June 2022 and late September/early October 2022. What has just happened in the last week is the S&P 500 has popped its head out of the range to the upside again. From a technical standpoint, that is a good sign as it could point to a new uptrend. However, there also needs to be fundamental support for this to be sustainable and we don’t see there being true fundamental support yet. Which is why we haven’t acted on it.
Let’s go through some of what we are thinking about when we say there doesn’t seem to be fundamental support to follow up on.
- Price to earnings ratio
- Pricing in the Fed cut too early
- Risk Reward tradeoff
- Liquidity Crunch
- Artificial intelligence
- Volatility index
PE Ratio
The price to earnings ratio as Mike mentioned in his last blog video was around 18 at the time and is now closer to 19 or even 20 based on different estimates (Roughly $220/share for 2023). What is happening is called multiple expansion, this happens when asset prices go up, but the underlying earnings aren’t going up at the same rate. Meaning the price to earnings ratio gets bigger and bigger because the price side is outpacing the earnings side. Why does this happen? Because investors are expecting future earnings to improve, essentially catching back up in the future. So, investors front run those expected earnings and the PE multiple would in theory move back down a bit as the earnings picture improves. This is what it means when people say the market is looking 6-12 months ahead of today or even as much as 2 years out from today – investors are pricing in their expectations for the future. This is where our thinking starts to diverge from what the market is currently pricing for.
Pricing in the Federal Reserve
We believe the market is pricing in interest rate cuts from the Federal reserve far too early and may even be missing the mark completely as rates by our estimation, won’t be coming down this year at all and may even be going higher than current levels (unless the economy enters a recession and we have some very negative economic outcomes, at which point we would expect rate cuts, but we don’t think this is priced into the market either). It’s as though Mr. Market is anticipating rate cuts without any economic pain to have caused the rate cuts, very strange in our opinion. If we look at what is happening globally, we think it lends more credence to further rate hikes, than possible rate cuts. In Canada, their central bank paused rate increases only to be forced to resume hiking again at their latest meeting. The same rings true for Australia. The UK 10-year government bond is also now back at the highs seen in October 2022, while these economies are different from the U.S. it does inform what’s possible and even probable to come here. As the U.S. economy continues to stay strong – it would seem the Fed’s job of cooling demand may still have work to be done.
If you look at the chart above, this is the Core CPI (Consumer Price Index) and Core PCE (Personal Consumption Expenditures) price indexes going back the last 3 years. The Fed has indicated that Core PCE is one of its primary focuses in terms of measuring inflation. As you can see the latest year over year readings of Core PCE have been:
January: 4.7%
February: 4.7%
March: 4.6%
April: 4.7%
Powell (the Federal Reserve Chairman) has said many times that he wants to see “clear and convincing evidence that inflation is headed back to their 2% target.” Paraphrasing a little bit there. One Fed official has even indicated they want to see inflation at or below their target for a couple of months before they put rate cuts on the table. There are many ways people can think about inflation and some can make a case that it’ll be at 2% soon by some metrics. But looking at what the Fed has told us is one of their primary focuses – it’s difficult to say with integrity that their job is done if 2% is the target for inflation.
Risk Reward Tradeoff
The risk-reward tradeoff between stocks and bonds is also nearing what has marked near-term tops in November and February. If we use the current estimates for 2024 S&P 500 earnings which are in the ballpark of $240/share. That puts the current earnings yield at roughly 5.6% using the current price of around $4,300. Right now, the 10-year US Treasury Bond is just above 3.75% putting the spread between the two at just 1.85%. Meaning the expected reward for taking on market risk is fairly narrow at current prices. This isn’t an authoritative indicator, but it does at least rhyme with indicators that mark near term market tops.
Liquidity and Artificial Intelligence
So what has created this bull trap? Will think Artificial Intelligence (AI) and excess liquidity due to the debt ceiling issues. There is a lot of hype around AI and its capabilities which have actually been around and under development for years, however, with Chat GPT it has become mainstream and well known by all. This is creating a lot of hype around new possible products, and the possibilities of new efficiencies that businesses can capture. There are some very real aspects of these new opportunities, but in a market where there is little to no growth – investors are piling into the one shiny object available right now. This chart below highlights the contrast between about 490 companies relative to the other 10 companies in the S&P 500. As you can see Communication Services (think META, GOOGL, NFLX) Technology (think AAPL, MSFT, NVDA), and Consumer Discretionary (think AMZN and TSLA) these 8 stocks and there are a few others have done almost all of the heavy lifting for the indexes year to date. As you can see the other sectors are basically flat or down on the year so far. So that’s one piece of the bull trap in our opinion.
The other is the debt ceiling issues. Because the US Government reached the limit of how much debt it can hold, it was no longer issuing treasury bonds while at the same time it was spending down its cash reserves. To give some numbers as a reference point – The US Gov. usually holds around $500 Billion in cash reserves and by the end of May it had spent those down until there was roughly $35 billion remaining. This going to zero is what was being referenced as the timing for when the US would default on its debt. What is just starting and will happen over the coming weeks is likely $1 Trillion+ of treasury bond issuance. That is being done to refill the coffers of the US Government. That doesn’t mean $1 Trillion worth of value is going to disappear from the S&P 500, but it does mean the liquidity that has been floating around in the last month or two is going to be under pressure. Couple that with the Fed’s continued quantitative tightening and that alone is reason enough to be skeptical of the recent price action in the market in our opinion.
Volatility Index (The VIX)
The last item we wanted to highlight for you is the VIX (volatility index). Today the VIX touched down at 13.5 which is a level we haven’t seen since February 2020 – pre-pandemic. The VIX gives a feel for the level of fear within the market. When it gets low, say below the 15-16 level that would indicate there is very little fear within the market. That doesn’t mean whenever the VIX is below 15, it’s time to sell stocks. But it’s important to keep an eye on because there are two emotions that drive stocks in our opinion – fear and greed. And when there isn’t any fear in the market, investors tend to get complacent and that sets up for possible downside in the near term. You’ll also notice on the chart below – the VIX never got above the 35-36 level all last year. To mark the end of a bear market, you’d often see the VIX shoot above at least 40 and in some cases well above that level – seen in March 2020. This is an aside from what we wanted to highlight in this blog, but it’s something that has concerned us for a while, we didn’t see the final washout in the market where the violence really accelerates and typically would mark the final phase of a bear market. A concern for us is this final washout phase may be yet to come.
We hope this blog has helped with understanding where we are right now in terms of our thinking and investment strategy. We recognize that this concept has not yet played out, however, the data hasn’t changed other than equities have actually extended and become more expensive on a relative basis. We want to assure you of our continued effort in evaluating our positioning within the market and our goal to manage well through cycles that can be quite volatile. This has been a tough season – yet history encourages us to remember that a valuation reset is often a necessary part of the setup for a more healthy market long term.
Authored by: Michael McCracken CFP®, ChFC and Jeffrey Gardner, Financial Advisor The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.