Shut Up and Drive

”You think you’re the last word in crazy? You’re not.”

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In accordance with the Lunar New Year, the equity markets are certainly living in interesting times.

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Key takeaway: While there are arguments for the markets to continue higher, history warns us what happens when the music stops playing. The bull market continuation is based on expected growth, but the Senior Loan Officer Survey reveals banks do not expect to ease lending standards this year; although loan demand may improve, banks are concerned about falling loan collateral value. The drop in NFIB hiring plans and a potential rate rise from New Zealand’s central bank may be two canaries in the coal mine.

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Why 5K versus Y2K Dept: As I mentioned last week, this is a strongly trending market that is reaching rarefied air. The following monthly chart displays the 2000 peak stock price of Cisco Systems in red overlaid with silver futures in green peaking in 1980, and NVDA in black showing its Friday peak at 720. Is this a reason to go massively short NVDA on Monday? No, but it does show the profile of a parabolic market, and while NVDA could continue to power the entire market forward, the example of 2000 shows at the very least to be on alert as the S&P sits at 5K.

The need to be ready is echoed by the valuation chart of semiconductors from 2014:

The lesson from this chart is less an issue of the eye-watering 39 price-to-forward-earnings ratio than the fallout that occurs when you are last to reach the exit as in 2017 and 2021. Being prudent will begin to win out over FOMO.

The market expects the Magnificent 7 to ignore valuation talk and continue to drive the market higher. Year-to-date, NVIDIA gained 46%, Meta is up 31%, Amazon 15%, Microsoft 12%, Google 7%,with Apple down 2% and Tesla down 22%. How much more gas is left in this collective tank?

What is needed is for new capital to come in and buy the rest of the market, which is more favorably valued. For those companies to beat earnings expectations for 2024,

1.??? The labor market needs to at least stay steady to keep consumption strong, and

2.??? Banks need to lead the Fed in easing lending standards, as

3.??? The central bank pushes down a burdensome high real Fed funds rate.

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Labor inconclusive: As suspected, the Employment Trends Index (ETI) was inconclusive (December revised down as January was up slightly). Before we can draw conclusions whether labor demand is back, it requires that we wait for the next payroll report on Friday March 8, along with Monday March 11, when the February ETI is released. The National Federation of Independent Business released its Jobs Report for February, and it shows that small business dropped their hiring plans another 2% to 14% in part due to increased labor costs. While still positive, it is the lowest reading in almost four years. The direction of this series leads the employment report, which puts the recent blowout in nonfarm payrolls into question.

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Tales from Two Central Banks

Banks worry over deteriorating collateral values: The Federal Reserve’s Senior Loan Officer Opinion Survey was released last week. Despite the most recent Federal Open Market Committee (FOMC) statement removing any mention of tighter credit conditions for households and businesses that was depressing economic activity, hiring, and inflation, banks continued to report tighter lending standards and weaker loan demand. The “good” news was that fewer banks tightened even further in Q4 than had tightened in Q3. Still, the central message remains: there were no signs of easing, and the expectation for 2024 is bank lending will continue to be risk averse. The usual suspects remained as reasons for remaining conservative in 2024:

·???????? Less favorable/uncertain economic outlook,

·???????? Deterioration in their current or expected liquidity position.

·???????? Reduced risk tolerance,

·???????? Less aggressive competition from banks and nonbanks, and

·???????? The highest degree of concern at 89.3% was the importance of any deterioration in customers’ collateral values, with 85.1% focused on the potential for weakening commercial real estate credit quality.

On a positive note, banks expect loan demand to improve across all categories, especially for residential real estate and commercial and industrial (C&I) loans. Yet, current demand for C&I loans and mortgages was seen as split between “About the same” to “Moderately weaker”. We would look for insider buying of regional bank stocks that are in uptrends as a signal of a regime shift that banks agree with stock investors’ rosy forecasts.

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Driving in the Wrong Direction Down a One-Way Street? Sliding over to Oceania, the Reserve Bank of New Zealand (RBNZ) meets on February 27 and will publish their quarterly Monetary Policy Statement. ANZ bank is expecting the RBNZ to raise their Official Cash Rate (OCR) by 25 basis points at that meeting, and another 25 basis points in April, taking the OCR to 6%. At their November meeting, the central bank warned that continued inflation pressure would be a trigger to raise rates. Inflation ticked up in December 2023 for the first time since February. Employment was stronger than expected for Q4: even though December unemployment rose to 4%, it was less than the 4.3% consensus.

My problem with this analysis is why not wait to hike because the RBNZ’s position has been—similar to the U.S. Federal Reserve—that their rate hiking campaign is over. To hike again for 25 basis points before cutting in 2025 would seem unlikely, so to commit to 50 basis points in hiking, I would guess that the RBNZ would wait for more convincing data before committing to another 50-basis point increase in the OCR. However, the ANZ economist is in the thick of things, so I will defer to that forecast.

Assuming ANZ bank’s rate hike forecast is correct, it is important because the RBNZ tends to lead global central banks in monetary policy. A rate hike could mean U.S. markets push out their rate cut forecasts and become sensitive to the possibility of renewed rate hikes. Keep a watchful eye on February 27.

The Federal Reserve is already reluctant to cut the high real Fed funds rate which is a weight on economic activity. If the RBNZ reverses direction, there may be even more hesitation on the part of the FOMC. If that happens, and on top of it, fixed income investors temper their rate cut expectations, it is not bullish fully valued risk assets.

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Markets:

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Equity Market: Stretched

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Weekly Trend: Bullish

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The stock market did what markets do in strong uptrends, and that is exceed normal resistance levels. I mentioned last week that the topping view allowed for a move as high as 5000-5025 in the S&P 500. The index hit 5030 and closed at 5026 Friday. I did not mention that 5000-5025 range randomly. Using a magnifying glass, let’s examine the hourly chart of the S&P 500.

?The black arrows show the first and second wave, and from there a final target can be calculated. The normal projection was at 4955 – 4983, which is why I had written two weeks ago that the S&P could reach as high as 4950-4980, and it was no coincidence that the prior Friday it stopped at 4975. In strongly trending markets, it can extend as high as the 2.618 extension, which is shown in the chart and is at 5029.75.

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For those who choose to sell into strength to cut exposure: The 5030 level is significant, and I have a strong confluence of resistance at 5036. Above there, I can’t rule out a run to 5100. Therefore, lightening up on net exposure with those two pivots in mind is not unreasonable.

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Again, this is not a market where it has paid to sell into strength. It is more prudent to look for failed support levels. A break of 4970 is an early sign to consider a trend change, with last week’s low of 4918 important. On a larger timeframe, the first signal of a trend change comes on a close below 4800, the odds of which increase on a break below 4850.

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Watch the Russell: The Russell historically has already fallen 5% from its peak when the S&P hits its final high. It had dropped almost 9% from its December 27th high into a low on Jan 17, but as of Friday’s S&P record high, the Russell drawdown is 3%. So, the divergence exists, which for me is close enough, but doesn’t perfectly fit for data mining purposes. Perhaps this means there could be one drop and yet another attempt at a high in the S&P.

Below is a monthly chart of the technology stock ETF XLK relative to IWM, the Russell 2000 ETF. The data started in May 2000, two months after the March 2000 tech top, and two months before the IWM high. The ratio peaked in July and August 2000, and it is now just 1% from that level. Since this is a monthly chart, I added another horizontal line depicting the highest daily close, and that is 3% higher from Friday’s close.

Notably, on November 10, 2023, the ratio exceeded the prior 2000 monthly high, and approached the 2000 daily high, hitting 1.06. The XLK’s top 3 holdings are AAPL, MSFT and NVDA, which comprise 50% of the ETF’s weight. I will be watching this ratio closely, and on any breakdown, the direction of the IWM will determine if we enter a sustainable selloff.

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Fixed Income: Great auction results, lousy price action

Weekly Trend: Bond Bearish

The 3-year, 10-year, and 30-year auctions were a success, but the outcome was poor in that yields ended the week higher. The anticipated CPI revisions released Friday were slightly positive for the bond market, but it failed to generate a bid from investors. The weekly 10-year bond model closed on a sell signal (higher yields above the filter line and positive on the trend model):

?We have been referencing the bond ETF TLT, and it needs a 2-point rally to close above 95.80 to signal a bullish reversal with confirmation above 96.25.

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The next CPI report out Tuesday is important to see if a lower inflation number can push equities and bonds higher. Market tone will be important.

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Stagflation?

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Investors have been warming to a revived growth forecast coupled with falling inflation. Meanwhile, the following chart warns of slowing growth based on daily copper prices in red, which have fallen since the beginning of February.

?The blue overlay is the 7–10-year Treasury note ETF, and the red arrow on the right shows the drop in prices during the auctions last week. Bond and copper prices have been positively correlated since the October 2022 equity market bottom. Often it is the opposite. If inflation is falling, bond prices will rise, and if that is happening with slowing growth, copper prices will fall. If inflation is rising, bond prices will fall, and if that is accompanied by an overheating economy, copper prices will again go in the opposite direction to fixed income, and rise.

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The only way fixed income and copper move together are under the following circumstances:

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·???????? Stagflation is negative for both: inflation rising, pushing bond prices lower, with declining business conditions, decreasing the demand for copper, or

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·???????? Deflationary growth is positive for both: Inflation falling, pushing bond prices higher, with improving business conditions, increasing the demand for copper.

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During? the first three quarters of 2023, the copper and bond markets moved lower in a stagflation dynamic but reversed at the October 2023 equity low in a display of deflationary growth. However, since the beginning of this year, both bonds and copper are acting as though we are back into a stagflationary environment. One could argue that China weakness has pressured copper lower, and debt supply concerns have depressed bond prices distorting the relationship, but copper rallied with fixed income throughout Q4 2023 and both those overhangs existed then.

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The message from the bond and copper markets is consistent with the following chart of the S&P 500 non-tech equities relative to tech stocks from Bloomberg:

This shows that S&P tech stocks contained in the S&P 500 are priced at a record high premium relative to non-tech stocks, even more so than during the tech bubble. This reflects concern about economic growth compared to the pristine prospects of technology shares.

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Crude Oil: Well, well…

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Weekly Trend: Bullish

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Hedge funds pushed into Brent and WTI crude longs at the end of January. They logged their? biggest Brent crude net longs in four months and net WTI longs moved to their highest level in three months in anticipation of the OPEC+ Joint Ministerial Monitoring Committee (JMMC) meeting on February 1. The selloff came afterwards, on disappointment on the news of no decision at that meeting. Because the production cuts from the last OPEC+ meeting expire March 31, there is a growing expectation that those cuts will be extended a few weeks prior to the deadline. The JMMC meets again on April 3, and the next OPEC+ meeting is slated for June 1.

Crude has been bullish on my weekly trend model (blue bar) for the past three weeks:

The $78-$80 resistance level needs to be cleared before any upside volatility will come into this market, although supportive signs are starting to appear.

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Peter Corey

PavePro Team

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