Fed on Track to Deliver Rate Cuts

Last week, we've been discussing a market which remains firmly bullish, but capped by limited upside and a degree of risk stemming from bad technical breadth. On Wednesday, inflation was reported below expectations both at the headline and at the core level. Furthermore, in the aftermath of this data, the FOMC delivered a pleasing consensus view, which excluded rate hikes, while anticipating at least one cut for 2024.

Stocks surged to all time highs on surprisingly weak breadth and volume. For now, the bullish trend remains intact both on a medium and short term timespan, but vulnerabilities are building up below the surface. SPY is well supported at the 20-DMA and R1 level, near $536, while upside remains unconstrained to $575. Higher highs beget higher highs for now.

Below the index level surface, trouble is brewing. So far in 2024, the Equally Weighted S&P500 ETF (RSP) is up a feeble +3.24%. Meanwhile, SPY is higher by 14.84% in the same timespan, generating a relative chart (RSP / SPY) that is downright atrocious. This is happening because gains are occuring only in a handful of stocks, while most of the other issues are struggling to keep up. While a “crash” or crisis event is not necessarily the outcome of such a discrepancy, it does suggest that the rally is weaker than indexes suggest.

Another corollary of weak breadth is that investors are required to hold the same basket of stocks or risk severe underperformance. Whenever the trend changes for those stocks (NVDA especially), the unwinding of so many concentrated bets will be ugly.

We can clearly visualize the exceptionally weak breadth by noting the number of stocks closing above their 50-Day Moving Averages. This has been trending lower ever since the start of the year, while SPY has been notching fresh all-time-highs. Such a divergence has often preceded short to intermediate term corrective action.

Sentimentrader has put together a graph describing the market breadth issue on a longer timeframe (59 years). It shows the S&P 500 hitting new highs while simultaneously:

• More NYSE stocks are hitting 52-week lows than highs

• More NYSE decliners than advancers

• More NYSE volume flowing into losers than winners

This particular confluence of indicators is rare, as it has only occurred in 1995, then a couple of times in 1999, and finally in 2022 and today. We might as well be looking at a false alarm, as in 1995. However, it could also be a more meaningful signal that the market will be headed lower in the intermediate term.

The main narrative currently driving the market are rate cuts delivered by the Fed in the context of an expanding economy. On Wednesday, the May inflation print came in cooler than expected, sending stock and bond prices higher. This comes as no surprise for ourselves, since a litany of indicators have been printing lower, well ahead of the official inflation figures.

As can be seen in the table below, by far the most impactful figure in the inflation calculation is housing. Officially known as Homeowners Equivalent Rent (OER), housing comprises 44.6% weight of the index. Other components only matter at the margin, as the change in OER dwarfs their impact by comparison.

OER was measured at 13.5% in the latest inflation reading, and is lagging the US National Rent index by about 5 months. OER will decline gradually for the next 18 months as it catches up to real-time rents, even as the latter increases (graph courtesy of ZeroHedge).

“A 0.2% monthly core CPI reading should be the base case for the balance of the year, especially as it looks more and more like the long-awaited slowdown in shelter costs will hit as soon as the next report.” – Inflation Insights

While inflation remains far more “sticky” than expected, the trend is still lower and we believe the Fed will eventually achieve its target of 2%. The only question that remains is weather we’ll get a recession along the way. In either case, bonds are very attractively priced.

TLT has completed a breakout above its S2 level and the 200-DMA. Pricing has “stuck” by the end of the week, and “higher lows” have technically been achieved. This setup is very bullish for bonds, as fundamentals align with technicals. TLT is overbought in the short term, so a bit of consolidation would be expected here.

This week, markets will be closed on Wednesday, 19 June (Juneteenth National Independence Day). The economic and earnings calendar is light, with very little in the way of market moving data.

As a result, we believe technicals will dictate market movements more than anything.

Our Trading Strategy

We would like to increase our bonds exposure on a consolidation in TLT. Short term corrective price action may occur in the equity market as well, and we will be looking for any indication that market breadth is improving. In theory, oversold sectors (XLE) and factors (IWM) should catch a bid on a rotation trade from large cap growth tech stocks (XLK, IVW).

Our usual Portfolio Rebalancing processes will occur, as we monitor risk and reward metrics for each position.

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