Embrace the Bubble

The unstoppable bullish advance has continued in earnest over the past week, as hype around NVIDIA’s earnings has spurred risk-taking in the mega cap growth space. Recession calls have receded as well, with the latest update from the Conference Board no longer pointing to an economic downturn as the base case scenario. Before we update our fundamental assumptions as well (the quarterly report is due for the end of the week), we’ll simply note that a lot of good news is currently being priced in by the equity market, and investors have become overly complacent.

As NVDA blew earnings out of the water on Wednesday night, SPY bounced off the 20-DMA and surged to all-time highs. As shown, the 20-DMA continues to act as crucial short-term support for the market. Until our updated fundamental report is released, it’s hard to identify any kind of actionable technical upside. As for the downside, immediate support should be found at the 20-DMA ($496, -2.32% potential loss) and further below at the R2 level ($486, -4.29% lower). It’s also worthwhile to note that it’s not uncommon for any security to spend some time either above or below the channel trend-lines. These are computed at a 1 standard deviation distance to the mean regression line.

The MACD signal has flipped positive, confirming the bullish trend. However, not all stocks have benefited from the risk-taking apparent in high tech growth names. Small caps have failed to convincingly break out, unlike the larger cap names. IWM is struggling against resistance at $200, after two failed breakout attempts.

Overall market breadth remains uninspiring and continues to indicate a clear divergence. In the past, elevated and overbought price levels, combined with investor complacency (VIX index at 14) and weak market breadth have led to short term corrections.

As is always the case, we never know in advance why such a correction would occur, but at this particular moment, every possible good outcome seems to be expected by the market. With the bulk of earnings season behind us, price action will swing according to economic data, the Fed and geopolitical movements. Of course, prices may act according to technical considerations and profit taking can happen simply because investors are looking for a reason to sell. “Reversion to the mean” is a good enough reason for many.

The unmistakable takeaway form Q4 2023 earnings season is a solid improvement in gross margins for the top 500 US companies. Our composite measure is equally weighted, so this jump should be beneficial for most companies. The recent low point was recorded exactly 1 year ago, as inflation hit companies’ ability to pass on costs to consumers, shrinking gross margins as a result. Using the latest reported data, we can assume this is no longer an issue. Great for equity owners, not so great for anybody actually paying for “stuff”.

Year-on-Year Revenue Growth is the most notable lagging metric, in our Market Fundamentals dashboard. If one chart can show the Fed’s progress in taming inflation, then this is it. However, due to the backward-looking nature of this metric, it’s usually actionable to take the reverse position in portfolios (buy when reported growth is relatively low).

The bump in Gross Margins combined with sluggish Revenue Growth at the top line has been enough to keep reported EPS afloat and above trend. But not enough to push EPS in record territory, as the price action of the S&P 500 would suggest.

Which of course leads to highly elevated valuation levels. The median P/E Ratio for S&P 500 companies (equally weighted) is nearing 2 standard deviation cycle highs. In itself, valuation levels are useless for market timing, but they do betray investor psychology, and the extent to which future growth is being priced in.

For stock investors, the markets are famous for “dragging the last of the holdouts” back into the market just before a correction does indeed occur. More and more participants need to “get onboard the bull train” less they suffer career risk. Analysts need to upgrade price targets, or get left behind feeling behind the curve. Portfolio managers need to allocate to stocks or severely under-perform. And economists face the same pressure, or expect to lose credibility. One can’t keep calling for a recession that does not occur. WSJ noted the recent trend:

“In the latest quarterly survey by The Wall Street Journal, business and academic economists lowered the probability of a recession within the next year, from 54% on average in July to a more optimistic 48%. That is the first time they have put the probability below 50% since the middle of last year.”

As of January, the probability dropped to just 39%. And we’d like to point out that economists have been proven time and time again to be notoriously inaccurate and spectacularly wrong in their assessment, as they fall prey to the same cognitive biases as stock investors. The latest expert body to give up their recession call has been the Conference Board, responsible for publishing the LEI Index.

“While the declining LEI continues to signal headwinds to economic activity, for the first time in the past two years, six out of its 10 components were positive contributors over the past six-month period. As a result, the leading index currently does not signal recession ahead.” – Justyna Zabinska-La Monica, The Conference Board.

As noted, the top contributors to the increase in LEI have been credit growth (no surprise given lower effective interest rates) and the rally in the S&P 500. Should these reverse, the LEI will trend lower yet again. As it stands, a peculiar situation emerges, per the Daily Shot: the number of consecutive monthly declines in the LEI is consistent with the readings that came out of 2008 - we are currently just one month short of that record, at 23 negative months.

With a surging stock market and loosening financial conditions, there are valid reasons to project the avoidance of a recession. Atlanta Fed’s GDPNow estimates a 2.9% growth for Q1 2024, running way ahead of mainstream consensus.

As the Fed’s rate increase campaign takes time to propagate through the economy (around 9-12 months on average), and considering the last hike happened in July 2023, we would expect a recession to take hold in Q2 2024 at the latest. If one fails to manifest until then, odds are there will not be a “landing” at all.

Which brings us to the next point: if economists have abandoned their call for a recession, the bond market has not. The yield spread between the 10-year and 2-year Treasury Bonds remains deeply inverted. And while the inversion itself is not the one that points to trouble ahead, the upcoming un-inversion might bring a nasty surprise. This has been the case ahead for all major economic downturns in recent memory, as the Federal Reserve cuts rates in response to a slowing economy. Only time will tell if “this time is different” or not.

Our Trading Strategy

The market appears to trade as if only blue skies are up ahead. It’s important to recognize that we have transitioned to a momentum driven environment, where maintaining long positions “works” and buying breakouts also leads to favorable outcomes. This comes on the back of improving outlooks for the economy and improving fundamentals for companies. However, for one reason or another, the market always finds a reason to revert to the mean (you can’t have a mean value without readings both above and below it). The odds of a recession are not 0.

We are still going through a phase of contracting liquidity and a reversion in monetary stimulus. Inflation is not yet fully tamed (and this fact is being recognized by Fed officials). Also, the Fed has a very limited reason to cut rates at the moment. And valuations are suggesting investors are not getting a particularly good deal.

Our investment strategy is to “dance until the music stops” and commit to reasonable equity risk until we have a good reason not to do that anymore. We are open to the possibility of avoiding a recession, but we’re not betting the house on that. If we get a buy-able dip, we will increase exposure. If the market violates our technical levels, we will reduce it. In other words, flexibility is the name of the game right now, and allowing the market to “tell” us what comes next.

Our upcoming fundamental review will shed more light on expectations in the medium and longer term.

Signal Sigma PRO members will be notified by Trade Alert of any live portfolio changes (if subscribed). If you’re not on this plan yet, you can get a free trial when you join our Society Forum. If you need any help with your trading strategy (or would like to implement one on your account), feel free to reach out!