Made In China
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Monday morning, we all wake up to serious shockwaves in the markets due to the new AI development out of China, DeepSeek. No one is to know if it is real or just something that is the next reason for creation of market turbulence. What we do know is that it kicked many of the tech leaders in the shins and we can only wait to see if the threat is real. I find it a bit strange that there have been few whispers of this technology and instead, a Sunday bomb drop. Hence, the title, Black Swan. Nobody knows that there is one till it is here. To give perspective on market volatility, I find it tremendously interesting to know what markets do. As can be seen below, large corrections seldom happen, but small ones happen 2-4 times a year. Take some time and digest this chart, very important!
What we do know is that in this final week of January we quite a lot of noise to add to the “jumpy” nature of the markets:
·??????? Fed meeting on Wednesday and Thursday. This will provide insights into the future course of interest rates under a new administration. Fed Chair Jerome Powell seems unlikely to disrupt a good situation when the central bank meets today and tomorrow.
·??????? 4 of the 7 Magnificent 7 companies declare earnings Wednesday and Thursday. This is sure to create some significant repositioning. So far 80% of all S&P 500 companies that have reported as of the end of last week surprised to the upside by 7.3%.
·??????? Q4 Gross Domestic Product number is released, this is a report card on the productivity of the country.
·??????? Friday represents the last day of trading for January. Just like I gave statistics on the first five days of January, the full month of January has some pretty compelling statistical importance as well. If the full month is positive (closes Friday above 5881.63 on the S&P 500) then there is a high probability of a positive return for the year and an average of 19% up for the year!
Hodgepodge
A common question I get from new clients or even new employees is, “how do you come up with ideas every week?” Actually, the problem is quite the opposite. There are no shortages of ideas. The challenge is to ascertain what is most important to relay to my readers, whether I can provide a practical, unique insight, and if I can communicate it clearly. The struggle is especially real today, with the new administration, uncertain Fed policy, near-record valuations and sentiment, and Q4 earnings season, just to name a few.
In that vein, today’s report tackles three topics:
·??????? The strong dollar- most correlate the word “strong” with “good.” But in the case of global trade, strong is not good as it makes our goods and services more expensive outside the US. So, we want a stable dollar, and at times a slightly declining one.
·??????? Investor Sentiment- what investors overall are thinking is important from the perspective of a continuum. A measure, known as the AAII Sentiment Index (you can Google this and read up on it if you would like). When it becomes important is when it is at extremes. And, before the run up we saw last week in the equity markets, it was truly at an extreme (connotation, is to buy if it is within a longer term uptrend of markets). According to Jason Goepfert of Sentiment Trader, the ratio of bullish respondents in the AAII survey plunged below 40% for the week ended January 15th, only the second time that has occurred since May 2023. The S&P has been higher 72% of the time in the six months following such declines and 79% of the time 12 months later.? This is what we are seeing right now:
·??????? As can be seen next, the action of the S&P 500 flipped positive for the first time since October 2023 from the kind of extreme we just saw;
Taking it even further back, here is where we are going back to 2017. This shows an even more graphic extreme that we are currently turning up from:?
·??????? Valuations- besides breadth, this is the number one arrow in the quill of negative market prognosticators. Basically, if one were to look at the prices of all companies relative to their historical high and low valuations, we are at a relatively high point. Not good, but not necessarily bad. I say this because if we were to simply remove the Magnificent 7 large technology companies, then the market is really quite fairly valued or in an average valuation place.
Our conclusions are that the recent surge in the dollar is not bearish by itself. In light of near-record P/E ratios and earnings growth, the symptoms of dollar strength are a risk to the bull market, even if they are misdiagnosing the root cause. On a positive note, December’s breadth divergences are clearing up. The weight of the evidence remains positive for now, although our concerns about the second half of the year have not been alleviated.
Dollar effect
The U.S. Dollar Index has surged to a 26-month high. For the S&P 500 Index, investors have tended to look past swings in the dollar. Bears cite a rising dollar’s negative impact on earnings. They are not wrong. A strong currency, as I bulleted above, makes exports more expensive and overseas profits smaller when translated into dollars. S&P 500 EPS growth has been flat when the dollar has been up over the past year versus +14.6% when it has been down. The net result is that S&P 500 returns have been only marginally lower when the year/year change in the dollar has been positive (7.8%) than when the year/ year change in the dollar has been negative (10.9%). Perhaps it is because currencies tend to smooth out over time, or perhaps it is because the U.S. is more insulated than other economies, or perhaps it is because dollar oscillations impact investor sentiment in other ways; whatever the reason, fears over the bearish impact of a strong dollar have generally not been realized. Instead, as a US person, I would look at what the dollar does to interest rates. If it is stronger, then it infers that foreign capital is rushing in to benefit from higher interest rates here and a better exchange for them when they bring their money home. Currently, rates are staying pretty stable (10-year maturity between 4.6 and 5%).
P/E extremes (high valuations), better known a high P/Es, applies to the study to today is that valuations are near all-time highs. The only times P/Es have been higher were around the dotcom bubble in the late 1990s and early 2000s, during the financial crisis in 2009 (when earnings were depressed), and during the pandemic in 2020. The current reading of 25.2 is in the top 12% of operating P/Es since 1983. As can be seen below, the S&P has spent the period from mid-December through January digesting a pretty solid upward move and then breaking this downtrend at the end of last week only to get smacked back down by the DeepSeek shock on Monday:
At Davos last week, the sage, Peter Druckenmiller, was interviewed. As can be seen below, after a 49-year history of investing, Druckenmiller feels that the new administration pro-business agenda could release “animal spirits” into the markets.
In the end, we need to stay on top of whether we are to continue the uptrend we have been in, or to start new move lower. I believe that it is most important to pay attention to the “quality” of the current rally and keep a close eye on this. Friday the S&P 500 reached a marginal new high and then got swatted on Monday. We continue to balance what we see as below-average market-top risk with longer-term performance studies that indicate the S&P is likely to moderate this year vs. last but still continue to advance. For S&P levels, support starts at the 50-day average (5,980) and the December peak (6,100) marks resistance.
I will continue to provide valid statistics for you and my honest opinion if deploying money into the markets or sitting on the sidelines makes more sense. At present, this is the current bird’s eye view analysis as illustrated by Ned Davis Research: If inflation as measured by the Consumer Price Index (CPI) is lower than its 5-year average, stocks are better than bonds, cash and commodities. When this changes we will let you know.
The wild card today seems to be centered around newly elected President Trump and his global policies. On the positive side, his deregulatory push would see industries under previous tight restrictions get a boost, on the negative side is the commotion that is caused by changing international situations like the Panama Canal. I say negative in that quantifying the ultimate outcome is very hard to handicap. As always, we will be diligent at discussing what we feel should be top of mind for portfolio allocation and management.
Ken South, Tower 68 Financial Advisors, Newport Beach
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Kenneth H South CA Insurance Lic # 0A75043. State of domicile is CA and principal place of business is 610 Newport Center Drive, Suite 1520, Newport Beach, CA.