The Fed Keeps The Party Going

Last week (and in fact for the past several weeks) we have argued for a technical correction in the stock market, given the current extended and overbought environment. Our expectations appeared to play out as expected up until Wednesday’s FOMC meeting announcement. While the meeting itself did not provide for any surprise, the outcome was perceived as “dovish”, and a good reason for the markets to rally. Mr. Powell re-affirmed that the Fed was on track to deliver 3 rate cuts in 2024, as projected in December 2023. There was a slight difference for 2025, as Zerohedge notes:

“While The Fed kept its median dot at 3 cuts for 2024, beyond that the dots signal considerably less aggressive Fed rate-cutting. We also note that while the median 2024 dot remained the same, 8 Fed voters were for 50bps or less in Dec, now it’s 9. The Fed now expects one less rate-cut in 2025 and 2026… and the so-called ‘neutral’ rate has also been increased.“ – Zerohedge

The dot plot comparison above reveals a marginally more hawkish Federal Reserve, with a higher implied target rate for the years ahead. While that’s not particularly bullish for bonds, overall financial conditions remain exceptionally loose. In fact, according to Bloomberg, financial conditions in the US are now as loose as in 2021, after the post pandemic boom, despite 5.5% benchmark rates.

It’s no surprise then, that the stock market has surged to all-time-highs, reversing the recent weakness in momentum and bouncing from the 20-DMA.

As the editor of this newsletter, I need to confess that I’m bored out of my skull doing the same technical analysis over and over for the past 2 months - but this is the market that we currently have - Andrei

SPY is now perched at the top of a clearly defined trend channel that has run from mid-December. The high trend-line from this short-term channel eventually leads to upside of about $534 - $536, where it intersects with the long-term high trend-line. This would represent an additional gain of +2.45%. Downside has been very well defined during this period as well, with the 20-DMA acting as support for every moment of weakness. Currently, we can expect dip-buying algos to kick in at around $510 (-2.15% potential loss). A violation of this level would be a warning that the current rally phase of the market is over.

The MACD signal has now turned positive again, powered by the latest rally. The following tweet from Simon Ree describes investor’s current mindset perfectly:

The bout of mind-numbing volatility that we are experiencing right now will, at some point, reverse itself. What triggers such a reversal is unknown until after the fact, and algos that have been buying the dip will switch to selling the rip once fear pervades market psychology.

Yet more valuation signals are pointing to the fact that pockets of the market live in “bubble territory”. BofA’s recent update of a history of market bubbles chart is telling for the fact that the A.I. hype is at least as big as housing was in 2007. During the course of history, there have been even bigger bubbles than A.I. (gold in the late 70’s, the tech bubble in 2000, China and Bitcoin), but the optimism is now too great to ignore.

F.O.M.O. is obvious when looking at our own Market Fundamentals median P/E ratio for S&P 500 companies, now pushing into 2 standard deviation territory. This simply means that based on previous year earnings, stocks are getting very expensive and investors are getting a bad deal if deploying capital indiscriminately.

The common belief for every period of extreme exuberance is a shared belief that “this time is different”. On this topic, Goldman Sachs recently noted:

“The recent rally has driven the market cap share in stocks with extremely high valuations to levels similar to those reached during the euphoria of 2021.

However, the prevalence of extreme valuations today looks far less widespread than in 2021 after adjusting for market concentration. The number of stocks with elevated EV/sales ratios has declined sharply from the peak in 2021. Unlike the broad-based “growth at any cost” in 2021, investors mostly pay high valuations for the largest growth stocks in the index. This dynamic more closely resembles the Tech Bubble than 2021. However, in contrast with the late ’90s, we believe their fundamentals currently support the valuation of the Magnificent 7.

There’s some truth to Goldman’s conclusion about the concentration of extreme valuations, but it does not apply within the S&P 500. If we exclude the top 10% of stocks by market cap from the S&P 500 and compute the average P/E Ratio, we still get a figure north of 25x.

We ran a screener to prove this (excluding the top 50 stocks by market cap from the top 500). The average P/E comes down to 25.43x.

In order to get much more decent valuations for stocks, we need to go a lot lower in terms of market cap. The iShares Russell 2000 ETF (IWM) offers a better proposition than SPY when accounting for valuation discounts. We see a buyable dip in IWM in the $196 - $200 range, as a range breakout finally seems to stick for the broad market tracking ETF.

The most leveraged play for a breakout in IWM can be accomplished using the regional banks space (KRE). This ETF has a 0.81 correlation to IWM and its constituents probably enjoy the highest discount to fair value courtesy of the commercial real estate loans issue.

KRE has been able to maintain support near the S1 level at $47. This ETF reach a +27% upside by year end if the Fed continues to support regional banks, as they’ve done so until now via the Bank Term Funding Program (BTFP). Our target is $61, a level consistent with pre-crisis valuations.

In the past year, the Federal Reserve established the Bank Term Funding Program (BTFP) aimed at assisting banks holding undervalued securities. Through this initiative, banks were able to collateralize undervalued Treasury assets with the Federal Reserve. As a result, the Federal Reserve provided these banks with loans equivalent to the face value of the bonds, despite their below-par market prices. This program has now technically ended, but the Fed is rumoured to employ a new scheme, with a different name but similar results.

Under this new program, regulators could eliminate the need for banks to hold capital against Treasury securities. Under such a regime, the banks could buy Treasury notes and fund them via the new BTFP. If the borrowing rate is less than the bond yield, they make money and, therefore, should be very willing to participate, as there is potentially no downside. The complicated and technical nature of such a structure could be an easy sell to the public, as inflationary pressures are not immediately obvious.

Conclusion: this is bullish for banks.

We’ll end today’s newsletter on a great quote from Howard Marks:

“We can infer psychology from investor behavior. That allows us to understand how risky the market is, even though the direction in which it will head can never be known for certain. By understanding what’s going on, we can infer the ‘temperature’ of the market. 

We must remember to buy more when attitudes toward the market are cool and less when heated. For example, the ability to do inherently unsafe deals in quantity suggests a dearth of skepticism among investors. Likewise, when every new fund is oversubscribed, you know there’s eagerness.“

By our Sentiment metric, the temperature of the market is certainly high, but could get even hotter. Currently at 65 / 100, sentiment is not yet “Extreme”. We’d need readings of >76 to achieve that.

There’s not much short covering left to be done either, as bears are nowhere to be found. Short interest in SPY and QQQ is at record low levels since 2018 as JP Morgan notes:

Our Trading Strategy

With pockets of extreme valuations now prevalent, one can’t simply expect to throw money at the markets and get great results. We need to be very picky with our exposure. If A.I. stocks are benefiting from extreme bullishness at the moment, the same can’t be said about the banking sector or energy companies at the moment.

Our approach has worked well so far, and we plan to maintain it. The point of our portfolio positioning is to not get “burnt” by an eventual reversal in the fortunes of high growth tech stocks. However, it’s not the time to be exceedingly defensive either. That is why we maintain an equity exposure almost at target and prefer sectors such as Energy, Financials and Industrials for new positions. Only if the trend is broken, shall we start to reduce exposure.

We are also fighting hard to avoid the “herd mentality” sucking investors in the bull run. Prices in the stock market currently don’t make sense when compared to owning bonds for example. This bullish episode won’t last forever and we’ll get a better chance to buy stocks at some point later in 2024. The larger the deviation from the mean, the greater the eventual reversion. Bearing this in mind, we invest accordingly.

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