Technical bounce faces Fundamental challenge

As the summer season officially draws to an end, we find ourselves entering September with markets in a neutral disposition, and trading volume light. As expected, most risk assets rallied hard last week and SPY has comfortably cleared both the 50-DMA and the $449 R2 level. This week, $449 becomes the new support, and technical focus will be on equities managing (or not) to hold up without breaking it.

Hope that earnings growth will accelerate into 2024 and the Fed will stop hiking rates and the economy will avoid a recession (that is a lot of hope) has the potential to push risk assets to fresh all-time highs as we enter 2024. Both retail and professional money managers are playing “catch up” this year, as their returns have lagged benchmark indexes. While September is a seasonally weak month and may present us with some volatility, bids should come in from under-exposed investors.

We expect dips to be bought as long as a calamity doesn’t hit.

SPY Analysis

Bad News is (still) Good News

On Friday, the BLS has released the employment report, which stated that the economy added 187K jobs and that the unemployment rate rose to 3.8%; the increase in unemployment came above expectations and has fueled bull’s hopes that the Fed is clearly done with rate hikes.

Not only was Friday’s report weaker than expected overall, but downward revisions to previous data (June 209K to 105K and July 187K to 157K) paints a “tighter” economic landscape than previously thought. Overall, since the start of the year, the demand for new workers has been dampened considerably.

All of these sluggish data points have been perceived as bullish by the stock and bond markets. Treasuries have rallied after economic reports bolstered speculation the Federal Reserve will be able to pause its interest-rate hikes in September. Of course, bad economic news is not necessarily good for earnings growth, but that is a concern for a different time.

For now, yields are stable and bonds are managing to hang on to support.

The real risk going forward remains the lag effect of monetary policy. Small and Mid Cap companies (along with a part of consumers), which do not have the necessary liquidity to survive an economic downturn, will need to refinance debt at much higher interest rates than before. This stress may as well “break something” in the economy.

That is the reason behind the huge performance divergence between mega caps and the rest of the market. It is set to continue into 2024, as market behemoths simply do not feel the impact of higher rates to the same extent. The performance disconnect between AAPL, AMZN, META, NVDA, TSLA, GOOG, META (orange) vs the iShares Russell 2000 ETF (IWM - white) remains at a very wide margin.

It’s worth mentioning that the “generals” have returned an eye-popping 59% in the past year (equally weighted), but have barely cleared the break even point on a 2 year horizon. Small Caps are yet to recover to break even after 2 years.

Liquidity is King

The performance of mega cap companies disguises investor’s appetite of hiding where liquidity is highest. As opposed to what others may suggest, this is not risk-seeking behavior, but, in fact, it is the reverse. Using our Stock Screener, we ran a study to see the interest coverage dynamics as they relate to Market-Cap.

Interest coverage is a financial metric that is used to assess a company's ability to meet its interest obligations on its debt. A high interest coverage ratio suggests that the company is generating a significant amount of income relative to its interest expenses, while a low ratio indicates that the company's earnings are not sufficient to cover its interest expenses.

We set limits on interest coverage between -50 and 50, so that outliers are eliminated, then set market cap to various levels, and measured average interest coverage for each cohort. The results are telling:

• Market Cap of 5B and above: 6.05 average interest coverage

• Market Cap between 1B and 5B: 4.02 average interest coverage

• Market Cap between 100M and 1B: 2.45 average interest coverage

The results are clear: as we go lower in the rungs of market-cap, risk rises exponentially, with companies struggling to cover their debt payments from the earnings they produce.

A study done by Albert Edwards and his associate Andrew Lapthorne yields similar results.

“The largest 10% of companies represent 62% of the overall non-financial market cap of the S&P 1500, so from a market perspective, it would appear that interest rates are not yet affecting the balance-sheet stress of the market overall. But lower down the size scale, things are tough and getting tougher. Interest coverage at the bottom 50% of S&P 1500 companies and the smallest quoted companies (as listed in the Russell 2000 index) falling sharply from low levels.”

They continue by comparing the debt schedule of large and small cap companies:

“It stands to reason that smaller quoted companies in the Russell 2000 index, as well as unquoted companies, don’t have as much access to corporate bond issuance so have been unable to lock into the near-zero long-dated fixed borrowings that the larger companies have.”

The coming debt wall in 2024, 2025 and especially in 2026 will hit small caps the hardest, and it’s when the lag effect of the Fed’s tightening will most likely be felt to the fullest extent.

We’d also like to share Albert’s conclusion:

“Contrary to what the mega-cap valuations might suggest, smaller companies remain the beating heart of the US economy – maybe the mega-caps are more like vampires sucking the lifeblood out of other companies. It seems the lights are going out all over the US smaller-cap corporate sector. 

They weren’t able to lock into long-term loans at almost zero interest rates and pile it high in the money markets at variable rates. Ultimately the pain for US small- and mid-cap companies will trigger the recession most economists are now giving up on, and hey, guess what? I think we’ll soon find out that even the large- and mega-cap stocks might not be immune to the indirect recessionary impact of higher interest rates after all.“

Our Trading Strategy

Albert’s bearish fundamental view is in high contrast to current positive technical tailwinds. Portfolio managers must chase risk or they will suffer career risk. In order to reconcile the need to allocate capital to equity markets, but take on as little fundamental risk as possible, it’s no wonder Mega-Caps represent the most crowded trade. The easiest place to allocate cash is where liquidity is highest and bankruptcy risk is lowest.

From a fundamental perspective, we agree that a “soft” or “no landing” scenario is a myth. That is why we are keen to buy treasuries on weakness. When the Fed begins to cut rates in order to “fix the economy”, yields should collapse and bonds should surge. However, we can’t overlook the technical outperformance of the equity market and the need to generate returns for our clients. Therefore, we are maintaining a high risk asset allocation for the moment and watching for further developments.

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