Wrapping up a Stellar Q1

We hope you had (or are still having) a blessed Easter holiday!

Q1 2024 is now in the history books, and it was one of the largest beginning-of-the-year rally, with the S&P 500 up +10.79%. While not unprecedented, the surge in the equity market has now notched the 5’th consecutive month of gains, and has left many individual stocks and sectors in highly overbought territory. Exuberant markets can certainly stay that way for a while due to underlying momentum. But when it comes to increasing exposure levels from here on out, the risk / reward equation becomes problematic.

When we study the history of such advances, we can draw a couple of conclusions. As was the case in 2019, the S&P 500 posted positive returns during all three months of the first quarter. Such has occurred on 9 other occasions in the past 30 years.

In 7 out of 9 cases, April was a positive month as well, with an average advance of +0.89% and +1.22% median.

In all 9 cases, the entire calendar year was positive, with an average return of +22.4% and +26.31% median. This leaves an average of +12% extra performance to be realized until year end, and would take the S&P 500 to 5.880 in the following 9 months, if historical performance is repeated.

While undeniably bullish, this kind of price action is typical of periods in the market following recessionary periods (1991, 2012, 2013), or just leading up to major bubble formations (1998, 2006). Based on valuations, we believe we are currently in the latter case and not the former, but more on this later.

The market has posted 5 months of positive performance, not just 3. Looking at previous instances of 5 month consecutive gains, we can also glean some important takeaways.

1. All periods of positive performance come to an end sooner or later;

2. The odds of further positive performance decrease, as the winning streak increases (they are inversely correlated);

Since 1871, there have only been 21 occurrences of 5-month stretches of positive returns before a negative month appeared. The odds of the 6’th month being positive as well is 4.82%, as only 12 instances of 6-month positive streaks exist in the entire history of the stock market.

Sometimes, the end of a winning streak is mild, other times it’s a more brutal correction. But as long as exuberance exceeds logic, buyers will keep bidding up the market in order to get allocated into the positions they want, regardless of price.

For SPY, this is how the full technical analysis currently looks like:

• Upside sits at the High Trend-Line - $536, +2.47%

• Key Short-Term Support is at the 20-DMA and the R2 level - $514, -1.73%

• If the 20-DMA is breached, our first correction target is R1 - $490, -6.32%

• If the R1 level is also breached, key support should come in at the M-Trend level - $470, -10.14%

While a 6-10% correction will seem much worse than it is, such can always happen in any given year simply as a function of profit taking. Psychology works in both directions, and we must be aware that we are approaching “Extreme Greed” levels now. In the longer term, we would argue that such a drawdown would be healthy and would represent a much better opportunity to increase exposure into.

When buyers keep buying irrespective of price, their exit strategy becomes “the greater fool theory”. As all trades become one sided and investors start chasing returns, our indicators turn to “Extreme Greed”, which is also labeled as the “SELL ZONE” in our Market Internals / Sentiment indicator:

There is still some overhead available to our sentiment indicator, but we are getting very close to our own exits (you may be aware we’ve been reluctant to aggressively sell up until now).

While the technical setup for an eventual reversion seems to be in place (the powder keg), what is lacking is the right catalyst that sparks a correction (the fuse). Last Friday’s inflation data was mostly pleasing, so that’s not it:

• Core PCE prices in the (which exclude food and energy) rose by 0.3% from the previous month, consistent with market expectations;

• Personal income rose by +0.3% from the previous month, slightly below market expectations of a +0.4% growth;

• Personal spending rose +0.8% month-over-month, the biggest gain since January 2023 and above 0.2% in January, and expectations of 0.5%; this could prove problematic for inflation, but a net positive for corporate profits;

We could speculate that the coming Q1 earnings season will disappoint a market which is starting to become egregiously overvalued. In the upper panel of the chart below, you can find the P/E ratio of S&P 500 companies, as measured by our Market Fundamentals instrument. This valuation measure correlates rather well with analyst’s price target upgrades as a percent of all estimate changes.

It makes sense: when the future looks more rosy (higher percent of price target upgrades), valuations get more expensive.

Conversely, when a lot of downgrades occur, valuations contract for the entire market. This relationship has held up remarkably well for almost the entire market cycle up until now. Since August 2023, valuations have increased, without proportionate analyst price target upgrades. In fact, the trends for the two series are entirely divergent, a situation we would call “unsustainable”.

The author of the lower panel chart notes the point in time when Chat GPT was released. AI is certainly responsible for a part of the S&P 500’s valuation increase in the last 6 months. For infrastructure providers like NVDA, AMD and MSFT, this phenomenon will certainly translate to the bottom line. But what about everyone else?

The [support for the] 33% rally is that the AI revolution will drive corporate profits sharply higher. That may be entirely plausible but let us look at what is actually happening with the data. Our preferred measure to gauge earnings momentum is the percentage of analysts’ eps estimate changes that are upgrades.”

“You will immediately note above (and below) how erratic the monthly data is but that a six-month moving average draws out a clear trend – one that has been falling in recent months. The same downtrend is apparent for the tech heavy Nasdaq 100 index – the 12m mav has also topped out.”

- Albert Edwards, Societe Generale

“A clear change in direction in analyst optimism is usually a good cyclical ‘straw in the wind’ of a change in fortune for an economy. On that basis the closely watched manufacturing ISM index, which typically moves in step with analyst optimism, is now at risk of a surprise downturn.”

Such is precisely why reversions to the mean eventually occur. While “stocks are not the economy”, it is economic activity which eventually creates corporate profits which are reflected in stock prices. The driver of economic activity in the past couple of years have been unprecedented stimulus and extraordinary liquidity measures (reflected in the money supply).

There is also a loose correlation between the year on year change in M2 Money supply and corporate revenue growth rates. As more money exists in the system, companies are able to grow their top line, as they capture this excess form of liquidity.

But when the growth of M2 falters, we would expect a reversion to a slow growth environment with a risk of recession. With no artificial stimulus to support demand going forward, we would expect the “pull of consumption from the future” to become a drag on demand. Inventory levels have now normalized, after the huge pressure on supply chains seen in 2020 - 2022, helping drive inflation lower. Less inflation means less pricing power for corporations.

Our Trading Strategy

Whichever way we look at it, technical or fundamental, the market remains at risk of at least a shallow drawdown in Q2 of 2024. The only thing that’s needed is the right catalyst. Until then, we’ll maintain our long allocation intact, with the plan of taking profits and eventually selling when the first cracks of a correction appear. It is not a question of “if” but of “when” and “how large of a correction will we get”.

In the longer term, a drawdown will offer a much better entry point for equity risk exposure than we are currently getting right now. When risk suddenly appears via an “unexpected” event, the supply and demand for stocks will translate into selling pressure. The trick is to not get overly “taxed” by this event in our own portfolio.

We’d rather miss out on some temporary extra gains right now than spend a lot of time “getting back to even” later on. Remember:

“Opportunities are made up far easier than lost capital.” – Todd Harrison

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