Stop and Godot

“Nilolai! Tick-tock Tick-tock Tick-tock. Tick tock!”?

??????????????????????? --Tom Hanks Castaway

Stock prices are playing hard-to-get, and it’s working.

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Key Takeaways:

?????????Pauses abound. The Federal Reserve stopped their rate hike campaign. Many investors are shelving their recession forecasts as stock indices avoid an impending profits recession (so far) and the economy ignores leading economic indicators that scream recession. The Treasury paused their extraordinary measures activity as the debt ceiling bill passed. We believe there is a good chance all three will be back in play earlier than expected.

?????????The market looked beyond many risk-averse signs and chased price higher last week. The S&P 500 has overshot our long-standing 4300 and 4360 targets. The enormous pension fund quarter-end rebalance and stretched internals will cause a pullback. The selloff pattern that develops will uncover clues about the market’s direction for the remainder of the year.

Noteworthy:

o??The Federal Reserve’s dot plot revealed that the two most dovish Federal Open Market Committee (FOMC) members are expecting no cuts in Fed funds rates into year-end. Two-thirds of Fed participants forecasted at least two more rate hikes at the remaining four FOMC meetings of 2023. Investors, meanwhile, are not even pricing one full rate hike into either the July 26 or September 20 meetings.

o??Expected single-family home sales have risen throughout 2023, giving hope that the economy has recovered. That datapoint is more than balanced by the continued drop to new lows in the MBA purchase index and the disturbing rise in low-income renters who are being evicted.

o??Building materials, furniture, and appliances also jumped encouragingly, albeit from similar levels as the lows of the global financial crisis. In contrast, if June retail sales are flat relative to May, the quarterly annualized growth rate will enter negative territory.

o??China’s property rates of 4% are the lowest in a decade, yet construction activity is low. This brings into question the value of any additional Chinese government stimulus directed toward the property sector.

o??Initial Claims remain elevated with the 4-week moving average at 247,000, up 30% from the lows. It is at the highest level since November 20, 2021, when it was 249,000 as NASDAQ peaked.?

The Circus May Be Back in Town Dept: Speaker McCarthy agreed to undercut the budget deal caps by $120 billion in a deal to stop ultra-conservatives from blocking the flow of legislation on the House floor. The House Appropriations Committee will be setting 2024 discretionary spending plans at a lower level than its counterpart in the Senate. The Senate will pass the deal agreed to on June 3. Twelve appropriations bills must pass by October 1 to avoid a government shutdown, so there are 12 separate opportunities for ultra-conservatives to effect a shutdown. The potential for an October 1 government shutdown is too far away to worry investors today. However, it looms as a major risk.

A more urgent risk may be that the Treasury accelerates its bill issuance to replenish its general account (TGA) in anticipation of having to resort to extraordinary measures for a second time this year.

In the Weeds

The following is a bit detailed, so bear with me.

As of June 15 the TGA stood at $250 billion, up from $23 billion on Friday June 2.

That $227 billion increase in the TGA could become a severe liquidity drain for the economy unless it is offset by a fall in reverse repurchase agreements (RRP), which would indicate money market funds are purchasing those Treasury bills. RRP balances fell by $55 billion during the first week of this month. The latest H.4.1 report revealed a further drop of $31 billion and ended June 14 with an even lower balance that adds up to a $108 billion RRP decline in June.

Money market fund (MMF) assets rose, meaning the RRP drop was not a function of MMF outflows. Hence, we could see the optimistic case playing out where MMFs are buying the Treasury bills, which is favorable because bank deposits will not drop as individual investors and corporations are not involved.

This situation needs to be monitored over the next few weeks, because other reasons could cause temporary demand from the MMFs, and the RRP balances may not continue to drop. Additionally, the concern by the Treasury over a potential shutdown could result in a ramp-up in issuance, which may require non-bank players to buy bills that would drain bank deposits.

We will need to follow 3-month bill yields to see if they spike up in anticipation of a possible government shutdown after the 2023 Omnibus Appropriations bill expires on September 30. The yield curve around the 3-month area is of heightened importance in the near term.

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With the pause across the Fed, the recession forecast, and the Treasury, it is just a matter of time.

We are faced with:

·???????????????A Federal Reserve that should resume rate hikes at the July meeting, and Chairman Powell’s Wednesday appearance in front of the House Financial Services Committee could ignite that expectation.

·???????????????An economy vulnerable to the influence of interest rate hikes whose impact is in front of us, not behind us.

·???????????????A Treasury that may need to brace for an accelerated Treasury bill issuance schedule to prepare for the possibility of another government shutdown in three months.

·???????????????A stock market facing a weakening consumer and the specter of enormous rebalancing flows out of stocks and into bonds.

That last point is crucial. Given the recent MSCI World equity index outperformance versus the Global Aggregate bond index of almost 700 basis points, JP Morgan estimates a potential asset allocation swing of $300 billion: $150 billion in stocks sold and $150 billion in bonds purchased to rebalance portfolios. The rebalance would occur across defined benefit pension funds and balanced mutual funds in the U.S., the Norwegian oil fund, the Swiss National Bank, and the Japanese Government Pension Fund (GPIF).

The total U.S. amount is calculated at $185 billion, but JP Morgan expects approximately $60 billion in equity selling and proceeds invested in the bond market to occur at quarter end.

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Regarding the markets, our targets were exceeded, and we were wrong last week when we wrote: “Any spike high into that 4360 region should generate a strong reversal lower. Given the very strong bullish readings from the American Association of Independent Investors (AAII) and CNN’s Fear & Greed Index, it would be unusual not to see at least a pullback, if not an outright trend reversal.”

That did not happen, and AAII bullishness and the Fear & Greed index pushed to further extremes. The latter reading hit 82 on Thursday and Friday, the highest level of the past year, and the same reading that timed the February S&P top.

We did mention the following caveat last week:

“Because the sentiment backdrop is overly confident, if we do not witness a market turn next week, the price action is reflecting something far more optimistic than I am forecasting and must be respected. “

Therefore, despite the onslaught of quarter-end supply and heavily overbought indices, if there is no drop below 4260 in the S&P 500, we may need to change our view. For now, our stance is unaltered—we continue to believe that above our 4300 targets, the risk-return is unfavorable.

We repeat that stocks will not have a meaningful decline until the top five tech stocks (Apple, Amazon, Google, Meta, and Microsoft) plus the two high-flyer, high P/E stocks (Nvidia and Tesla) begin to underperform the NASDAQ.

The following weekly chart starting in 2012 of an equal-weighted portfolio of those seven stocks relative to QQQs shows that the outperformance continues at a sharp rate. Importantly, note that the outperformance of these top stocks has been a decade-long phenomenon:

I mentioned that Microsoft (MSFT) kicked off the rally, but it started after it announced the ChatGPT purchase. It was the company’s surprisingly favorable earnings call that started the frenzy. I also mentioned that if MSFT broke above the 320 area, it would signal a runaway move in the AI-related stock group, and target 350. On Friday, MSFT hit a high of 351.50 before selling off 3% to close at 342. Keep Friday’s 351.50 high in mind as we trade this week.

The VIX volatility index is back at recent lows. Seasonally, volatility is entering the window marking its low for the year, which could bring in selling from volatility-balanced funds. This supply would be on top of the pension fund rebalance and has the potential to have an accelerated negative impact on prices.

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China is seeing its first H1 decline in floorspace under construction since data started being collected in 2000. Hopes are hanging on recent fiscal incentives, but we expect the Chinese stimulus to have difficulty gaining economic traction, which should depress crude oil demand. From the supply side, Saudi Arabia is open to OPEC+ production increases for those investing in oil infrastructure. This could mean the Saudis feel the need to appease African producers who felt shut out at the recent meeting that granted the UAE production increases. We anticipate new lows this year in WTI.

Bond Note

At the risk of sounding repetitive, the 10-year Treasury note is on a sell signal, and trading within a trendless zone. It has not moved outside of its tight 85-basis point range since December.

Chi Yin pointed out the drop in Italian Government Bond (BTP) yields to German Government Bonds (Bunds). The BTP/Bund yield spread is a widely followed risk indicator, and it has narrowed impressively, falling from 250 basis points (bp) over the past three quarters:

I highlighted in yellow the widening spread from 100 bp in Q3 2021 (as stocks were peaking) to 250 bp in Q3 2022 (as stocks hit their lows). The 150 bp level is important. We can utilize this chart for clues in managing stock exposure: break below 150 bp, and maintain longs, or reverse higher above 150 bp, and become defensive.

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Dollar Note/Bitcoin

The Dollar Index pushed below our first support at 102.85, but so far remains above the key 100 support. Expectations are for other central banks to raise rates more this year, and for the Fed to cut more than those central banks next year. That forecast is adding downward pressure on the dollar. For the near term, the index needs to rise from its current 102.50 to above 102.85, and then above 103.40 to recover its bullish tone.

Bitcoin continues to be on its sell signal, but it held a key support level last week. If there are consecutive closes above 27,000, this signal could be a whipsaw and the model will flip back to positive. Despite Bitcoin’s volatility, quick reversals after a trading signal are rare. For now, the model is short.

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Peter Corey

PavePro Team

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