Fed Sparks a New Chapter: Get Ready for the Next Leg of the Rally?

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Thank you for reading this week's edition of Closelook@US Stock Markets, dated August 25, 2024 ??

?? The next update will be published on Sunday, September 1, at 7:00 am ET

?? The next edition of the Closelook@Global Stock Markets newsletter will be published on Saturday, August 31, at 7:00 am ET. I have started a global ETF portfolio. You can find the current edition at https://www.dhirubhai.net/pulse/global-bull-set-continue-new-chapter-may-have-started-look-vyr8e/?trackingId=SHMqxuYZQDuoarxfqO9edg%3D%3D

?? The next edition of the Closelook@Hypergrowth newsletter detailing portfolio changes and the list of hypergrowth stocks I like to buy and avoid will be published on Wednesday, August 28, at 7:00 am ET. You can find the current edition at https://www.dhirubhai.net/pulse/how-long-bull-last-thomas-johannes-look-prhoe/?trackingId=fiNoO%2F30R6C06JDFkvByfQ%3D%3D

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Last week saw the following:

All three major U.S. stock indices concluded the week with gains exceeding 1%, with the S&P 500 now positioned less than 1% away from reaching a new all-time high. The rapid turnaround in the market has been remarkable, bringing the S&P 500 to the brink of record territory.

Market Correction and Recovery

S&P 500 Performance: The S&P 500 narrowly avoided a technical correction, pulling back only 8.5% from its peak. This falls short of the 10% decline typically required to classify as a correction.

Nasdaq's Correction and Rebound: The Nasdaq Composite entered correction territory by declining by more than 10%. What's particularly noteworthy is the speed of its recovery:

• The Nasdaq achieved the fastest 10% rally from a correction low in its history.
• Historically, the index required an average of 32 days to rally 10% after a correction.
• In August, it accomplished this feat in just eight days, setting a new record for the swiftest 10% recovery under these parameters.

This rapid rebound underscores the current market's resilience and the still strong momentum behind tech stocks.

A regime change? Changing tides in market performance

The dominance of the Magnificent 7 stocks has been a prominent market narrative for over a year and with good reason.

These seven companies have significantly outperformed the broader market, delivering returns of 54% compared to the S&P 500's 27% over the past year. However, recent trends suggest a shift in market dynamics.

Magnificent 7 vs. S&P 500

• Past Year: Mag 7 returned 54%, S&P 500 returned 27%
• Current Quarter: S&P 500 outperforming Mag 7

If this trend continues, it will mark the first quarter since Q4 2022, when the Magnificent 7 underperformed the S&P 500.

Broader Market Participation

The current quarter is witnessing increased participation from a wider range of stocks:

• 296 out of 500 stocks in the S&P 500 are outperforming the index
• This is the highest number of outperforming stocks since 2023
• The S&P 493 (excluding the Mag 7) sits at a new ATH, confirming the broadening theme
• Notably, while the R2K index has outperformed the other major US stock indices this quarter, it has yet to entirely recover the losses seen since early August.

Market Breadth Improvement

The recent performance indicates a shift towards broader market participation, challenging the notion that the market's success is solely driven by the Magnificent 7. This trend has been developing for several months.

Equal-Weight S&P 500 Milestone

The equal-weight S&P 500 index has reached a new all-time high. This evolving market landscape suggests a more balanced and diverse rally, moving away from the concentrated gains in a handful of mega-cap tech stocks that characterized much of the previous year.

So what?

The broadening market participation we're currently witnessing in the midst of a bull market is a powerful indicator of robust market fundamentals.

This expansion of market breadth is akin to a bull market flexing its muscles, demonstrating its strength and potential for continued growth. I have not seen any sign of a weakening bull until now.

Market Breadth and the Magnificent 7

The notion that this market rally is solely driven by the Magnificent 7 stocks is becoming increasingly outdated.

Recession Outlook

Recent weeks have seen a significant shift in recession forecasts:

Goldman Sachs Revision

• Previous probability: 25%
• New likelihood: 20%

Goldman Sachs' rationale for this adjustment is straightforward and compelling:

"We have now shaved our [recession] probability from 25% to 20%, mainly because the data for July and early August released since August 2 shows no sign of recession."

Goldman still sees a probability close to 50 % of a recession in 2025.

Expert Consensus

Ed Yardeni has also reinforced this view, predicting that there will be no recession in 2024.

Market Implications

This broadening market participation and decreasing recession probabilities paint a positive picture of the market's short-term outlook.

1. The rally is becoming more sustainable as more sectors and companies support it.
2. Economic fundamentals are more robust than previously anticipated.

Now what?

Investors may benefit from looking beyond the Magnificent 7 for potential opportunities. They may also benefit from looking for stocks beyond the Nasdaq 100 index.

The S&P 500 and the DJIA have nearly recovered all their losses seen in the flash crash in late July/early August. Nasdaq 100 has retraced about 78.6 %, a significant Fibonacci level, and has shown some relative weaknesses- both on the way down and up.

The SP 500 Growth index has lagged recently. Smallcap and midcap stocks have shown better performance than growth stocks but lagged the overall SP 500.

The PHLX housing index has shown excellent sector strength. The same applies to utilities and gold/silver.

Oil services have performed miserably, and semis have not done well either. The commodity indices have performed poorly, and so has the dollar.

SP 500 Value stocks have outperformed SP 500 Growth stocks. The S&P 500 Equal Weight Index has seen an ATH.

Financials and Health Care stocks have done well. The SP 500 info tech sector has lagged considerably. The same applies to Communication Services.

Consumer Staples outperformed Consumer Discretionary and recorded a new High. Industrials, real estate, and materials were strong, too.

The Dow Jones Transportation Index lagged the performance of the DJIA index. According to the Dow theory, this may soon flash a sell signal.

The last time we had a similar performance was in the fourth quarter of 2023. This only lasted a very few months. With the fading of the interet hopes, investors returned to the Mag-7 and megacp stocks quickly.

Wave count and technical analysis

The bull trend is still intact. The market touched the lower trend channel line and bounced quickly.

I still await a second leg down in the Nasdaq 100 index. A catalyst may be disappointing Nvidia results this week (August 28, 2024).

Soft landing or hard landing

Fed chair Powell made it clear in his Jackson Hole speech that the time has come to cut interest rates. He said the following.

"The time has come for policy to adjust."

"It seems unlikely that the labor market will be a source of inflation any time soon."

"We do not seek or welcome further cooling in labor market conditions."

The only question is whether it will be a 25- or 50-bps cut at the next FED meeting. That answer will come next month. All eyes will be on the labor market and how quickly it is weakening - if at all.

This will also decide how best to invest and position in the months ahead.

Soft landing scenario

I am a buyer of stocks in the following sectors:

1. Financials
2. Housing/real estate
3. Unprofitable (low profits), swiftly growing tech
4. Health care.

Hard landing scenario

I am a buyer of T-Bills and short-term treasury notes, and a net seller of stocks in all sectors. Usually, there is no way to properly hide in the very early stage of a recession-induced bear market.

I am watching for the performance of the R2K index and the SP 500 housing, materials, and financials sectors. In a soft landing scenario, all four will rise substantially. In a hard landing scenario, they will crater.

I will also watch the performance of the TLT ETF. If it rises quickly and substantially towards 110 USD now, a recession may be unfolding.

Why? This would not match a yield curve that goes flat and then moves to normal when inflation hovers between 2 and 2.5 percent (Normalization of rates in a soft landing scenario).

The first resistance level is around 100. The next major one is around 110, with little in-between.

The Portfolio

I still need to start the derivatives portfolio, as mentioned last week. I plan to begin after Wednesday's Nvidia earnings are out, and I will enter the first positions this week.

I will detail the concept in a special edition during the week. The suggested minimum starting value is 500.000 USD (higher than the other two portfolios, but both parts can be applied separately).

The portfolio is separated into two parts. One is a growth stock derivatives option play. The second is an index play.

In the first one, I will sell puts deep in the money on selected growth stocks. In the second one, I will apply several options strategies, such as spreads, strangles, straddles, etc., to a specified number of indices and ETFs tracking these indices.

While for the first one, I think I know the long-term (not the short-term) direction of the stocks, the second one is based on the notion that forecasting where a market or index is heading is unnecessary to make profits (the stock market is not a forecasting problem it is a decision problem).

It is enough to know where the specific market is probably not heading and apply the appropriate options strategy - usually on the hedged selling side.

Example part 1 - Nvidia: If you think that Nvidia will continue to double and triple in the years ahead, you may want to sell long-term puts deep in the money instead of buying short-term calls, such as the put expiring in December 2026 with a strike price of 250, and see what happens :-))

I will explain why I like this strategy more than buying calls this week.

Example part 2 - Interest rates: If you are sure that short-term and long-term rates will not rise from this level in the months ahead but are unsure how much they will decline, you may continuously sell puts on the TLT and IEF ETFs instead of buying calls.

I will explain why I like this strategy more than buying calls this week.

Final words

Never fight the FED, and the market climbs a wall of worries. These are the two phrases I usually follow.

Unless there is evidence of a recession, I like to keep it this way and stay in the bull camp.

However, the bull may see a set of new favorite stocks in the short term.