Chicken Little or Playing Chicken?

“Prepare ship for ludicrous speed! Fasten all seatbelts, seal all entrances and exits, close all shops in the mall, cancel the three-ring circus, secure all animals in the zoo!”?

??????????????????????????????????????????????????????????????????????--Spaceballs

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Can we take off before we land first?

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Key Takeaways:

·????????My variable dimensionality framework is now set to go into a fragile one-dimensional market where the debt limit debate will dominate market direction. The consensus expects a deal will be made, but uncertainty will increase exponentially into Thursday’s recess if the impasse continues.

·????????The House leaves for recess Thursday night and the Senate is already on recess, returning Tuesday May 30. One scenario is a last-minute deal that could come after a market selloff into the middle of the week. The Senate could then approve it before June 1. ?

·????????The market rally is dependent on a handful of stocks driven higher by enthusiasm over artificial intelligence (AI). The spread between the Nasdaq and the small cap Russell 2000 is at the exact high seen just before the tech bubble burst.

·????????The Bear Stearns analog has been fulfilled in terms of time and price. As we are now above 4200 in the S&P 500, this is the time to look for price reversals. Our target is 4300, 2% higher than Friday’s high.

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Noteworthy:

o??Treasury Secretary Yellen has yet to inform congress about the X-date. She had said the announcement could come as late as next Friday. However, the Treasury General Account (TGA) balance was listed as a very slim $57 billion as of Thursday. It fell $11 billion versus Wednesday, the day when the Treasury announced it has $92 billion in borrowing capacity. With the lower TGA balance as of Thursday, it is safe to say that the borrowing capacity of the Treasury to avoid a debt limit breach is currently $80-90 billion.

o??The first two days of June will see more than $130 billion in outflows to Medicare, Medicaid, Social Security, and military pay, among other recipients. There should be slightly more than $40 billion in tax revenues expected to offset that amount. June 15 tax receipts are projected at $80 billion. The market may demand a resolution by Thursday May 25.

o??Dallas Fed President Logan and Fed Governor Jefferson both pointed out that “stubbornly high” services inflation ex-housing displays a lack of progress against inflation, which does not justify a pause. Echoing our warning from last week about a negative feedback loop forming between services inflation and inflation expectations, Logan concluded her speech by discussing the “potential costs of unanchored expectations.”

o??Nomura cut its China GDP forecast to 5.5%, saying its reopening recovery “is rapidly losing steam.”

o??US Defense Secretary Austin said the United States will soon “supply significant military assistance” to Taiwan. This weekend, President Biden’s reversal on allowing F-16 fighter jets into Ukraine and the G-7 statement stressing de-risking from China did nothing to allay rising geopolitical tensions.

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One Decision Dept: The phrase “Nifty 50” was coined in 1972, when 50 large cap stocks--which were considered one-decision stocks to buy and hold forever--drove the bull market of the early 1970s. In 1972 CPI was 3%, on its way to 6% in 1973 and 11% in 1974, and these blue-chip stocks crashed along with all others. The S&P 500 fell over 50% from January 1973 into October 1974.

Many of the Nifty 50 had price-to-earnings (P/E) ratios of 50 before they plummeted. Currently, we now have a Nifty 5 or 10, comprised of mega cap tech stocks that stand to gain the most from the startling arrival of generative AI. Although most of these stocks have a P/E around 30, NVIDIA (NVDA), the darling of the AI theme, is at a cool 180.

Two investors have discussed AI and NVDA this month. Steve Cohen discussed his bullishness, suggesting that AI-related stocks could power the market higher. Similar arguments were made in 1972. Stan Druckenmiller believes that NVDA, one of his large holdings, may not even fall in price if his central view calling for a recession occurs.

Both investors are to be respected, no doubt. However, Stan Druckenmiller, arguably the best macro investor of our times, stumbled in 2000 by going long tech stocks at their highs. One large holding was VeriSign, whose P/E ratio was greater than 6000 at its peak, so 180 for NVDA is relatively cheap. The situation is not as frothy as it was in 2000, but some parallels exist, as seen in this chart of the small cap Russell 2000 relative to the Nasdaq 100:

Last week, IWM/QQQ closed at a level matching the all-time low in August 2000. The Nasdaq fell 80% from August 2000 to October 2002. Just saying…

Carl Icahn was also in the news this week. He also has had a brilliant career, but he announced he took a huge loss betting on a market crash. This is an important anecdote. Frequently, when a large loss is realized by a notable investor, it can mark the time when the trade begins to work. One can go back to December 1994, when Orange County took a stunning $1.6 billion loss on a portfolio of 5-year agency notes as 5-year treasuries shot up to 7.8%. The county closed the position that had anticipated lower rates and declared bankruptcy. However, almost immediately, 5-year rates turned down, dropping in a straight line to 5.1% into February 1996. Most recently, Tiger Global made public that it sold its China equity long position in Q4 2022, and China internet stocks began a rally where the exchange traded fund KWEB doubled over the next three months.

Does This Mean We Are About to Crash?

No, but it does line up exactly with what I was predicting in my March 12 commentary “F is for FDIC” when I wrote: “We expect the FDIC takeover of Silicon Valley Bank will put investors’ minds at ease. Because this has happened before. On a Thursday in March, Bear Stearns discovered that it did not have sufficient liquidity to open its doors Friday (sound familiar?)…Markets reversed on a dime, and over the ensuing two months, the S&P rallied almost 15% before experiencing a much larger decline later that year…The main lesson from this week is that historically investors are all too eager to give the all-clear signal...the same problem can come back bigger in the future.”

Regarding the last point about the problem coming back bigger in the future, it was notable that CNN reported that Janet Yellen warned of more bank mergers (read: more bank runs, more bank bankruptcies).

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The Crisis That Gets No Respect

With the Senate already on recess, and the House leaving after Thursday May 25, the timing for a deal is getting critical. The market is clearly not worried, despite the dwindling reserves at the TGA, which have fallen from $238 billion to start the month, to the most recent reading this Thursday of $57 billion. Risk-off selling will be a nonlinear process, meaning the market will decline in an accelerating manner if we approach Thursday May 25 without a deal.

If I could lay out a scenario, perhaps the risk-off sentiment builds into Wednesday, and a last-minute deal is struck that helps markets recover into month-end.

Hopefully, the consensus will be proven correct, and a deal will be reached. I am expecting the process to take until Thursday because movement to the middle has been insufficient during the past few days. Although the market is not expecting it, the fact that President Biden is still pushing for tax hikes could be one negative final-hour surprise coming out of the talks. It is unlikely, but the demographics of the Republican Party have changed a great deal, although the big donor pool has not.

In the case of a compromise, investors will be facing heightened odds of a rate hike at the June Federal Open Market Committee meeting, and the harsh reality of the Treasury General Account being replenished, meaning liquidity will be removed from the economy. Stocks were enjoying the added liquidity as the TGA balance was wound down since January to pay government bills. The process would have to be unwound on a budget deal.

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Regarding the markets, the persistent bid of the Nifty 5-10, and especially the AI-related mega-caps, is the key to the overall market direction. From my perspective, the risk-return begins to flatten out above 4200 for the S&P 500 and turns increasingly negative as we approach our 4300 target. As the market rises, the chances of a reversal increase, not decrease, so hedges can be layered in for trading accounts below 4150, 4100, and the more significant 4050 closing level in the S&P.

From the bullish side, if the Bear Stearns analog was to play out to its full conclusion, an equivalent rally from the recent S&P low of 3800 on March 17 stretches to 4360. Certainly, this is a possibility, but we underline that caution is increasing as we move higher in price, and so should cash levels.

Because Steve Cohen is the preeminent stock trader of our time, why don’t we track the accuracy of his bullish market prediction with Microsoft (MSFT), the company that kicked off this AI feeding frenzy. Ironically, the stock did not take off on the announcement of the ChatGPT acquisition. MSFT kicked into high gear following its Q1 earnings announcement, gapping up above its August 2022 high (see highlight in blue in the chart below). I had a price pattern target of 319, which was met on Thursday’s high. I also have two reinforcing targets at 320-322. If the general market indices are going to continue higher in ludicrous plus mode, then MSFT should blow through 322 on its way to an all-time high of 350. The AI-forever theme would be deflated on a drop below 292, the low price traded after its Q1 earnings release.?

Extrapolating a move in one stock to forecast the direction of the entire market is normally not advisable. However, given the similarities to the Nifty 50 environment, and Microsoft’s astonishing 6.7% weighting in the S&P 500, it is worthy of us following it closely.

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Oil has been finding a bid around the Strategic Petroleum Reserve (SPR) $70 WTI floor, but what it is not finding is enthusiastic demand. Although I cannot rule out a move as high as $78, the bounce after the announcement that the U.S. can buy oil back into the SPR was uninspired. Futures closed the week at $71.70. UAE stockpiles of oil products at their ports hit a five-month high last week. I continue to look for new lows this year.

Bond Note

The 10-year yield chart gave a decisive sell signal this week, as yields rose. This could signal some jitters over the debt ceiling talks falling through, although the move is muted given the potential aftershock of a negative outcome. The lack of major selling in treasuries reflects a strong degree of complacency that the current gridlock is not a game of chicken where the economy and markets will go over a cliff. Fixed income investors are not as joyous as equity investors are, but they are looking at the concern about financial Armageddon as a Chicken Little event. Let’s hope the consensus is correct.

On the news of a positive debt resolution this week, keep an eye on whether trendline support holds at 3.50%. Fixed income turns bullish on a break below.

Dollar Note

The Dollar Index continued to rise last week toward the important resistance level of 103.75. The prospects for an immediate move higher will be based on a breakout above 103.75 on any positive budget news.

We maintain a positive long-term stance on the dollar if the Dollar Index stays above 100.

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Peter Corey

PavePro Team

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