What's Different This Time?

The Ivory Hill RiskSIGNAL? has remained green since December 5th. Our short-term volatility signal is currently green, indicating a bias for higher-beta equities over lower-beta equities in the short term (1 month). However, our medium-term signal has been red since the end of March, indicating a bias for lower-beta equities over higher-beta equities in the medium-term (3 months). This prolonged red signal is unusual and presents us with a critical decision point. It could be a false signal or a warning of an imminent significant market downturn, as the signal typically does not stay red for this long.

Under the Surface

Last week, 5-Year TIPS yields declined from 2.18% to 2.11%, staying comfortably above the early June low of 2.04%. Real rates remain stubbornly high, above 2%, posing a challenge for risk assets and starting to impact various market sectors, including cyclical and consumer stocks. However, "anything AI" seems to remain unaffected. The key level to watch on the downside is last week's low of 2.04%, while the 2024 high of 2.29% is the critical level to monitor on the upside.

In 2024, high-yield credit spreads have dropped by only 19 basis points, whereas the S&P 500 has risen by 13.87%. For context, in 2023, high-yield credit spreads dropped by 142 basis points, from 481 to 339, while the S&P 500 experienced a 24% annual gain. This represents a divergence in correlation between the two, which is over 75% year-over-year.

The Russell 2000 index decisively broke down through the uptrend line established from the late 2023 lows. After retesting the backside of this uptrend line during intraweek trading, it ended the week almost exactly at the key pivot point of 2,000, which has been significant over the past few years. Currently, the small-cap Russell 2000 index is significantly underperforming the broader market, and all indicators suggest further underperformance in the near-to-medium term, especially if the broader market experiences a downturn.

As I've emphasized for the past three years, we won't be in a broadening bull market until small-caps can sustain a breakout over the coming months and quarters. Currently, the market is still primarily driven by the M7 stocks.

Bitcoin experienced a significant shift last week, breaking a long-standing uptrend line, which may signal the beginning of a more substantial pullback in the cryptocurrency market.

Looking ahead, there are several support levels for Bitcoin, starting at $63,430, then $60,830, and finally, the multi-month low of $57,670. If Bitcoin stabilizes and resumes its rally despite the trendline break, initial resistance levels to watch are $67,365 and $71,135.

This development is significant because Bitcoin has typically led stocks by about four weeks over the past six months. Therefore, this breakdown could indicate that stocks might soon experience a similar decline.

We continue to hold our Bitcoin position through the IBIT ETF.

Key Economic Developments

Last week's economic data has rekindled worries about stagflation. The latest Consumer Sentiment report highlighted that rising prices adversely affect financial positions across all income levels, and overall sentiment declined sharply in June. One year ahead, inflation expectations remained steady at 3.3%, slightly above the expected 3.2%. Additionally, initial jobless claims surged to a 10-month high, indicating a weakening labor market, while the downward trend in headline CPI has stabilized. Remember: Economic growth will kill this market, so watch for continued jobless claims to increase along with unemployment.

What’s Different This Time?

The relentless surge in equity markets continued last week and into the start of this week, with the S&P 500 and Nasdaq reaching new record highs. This uptrend has persisted despite increasing bearish signals across various asset classes and deteriorating or negative market internals and indicators.

The current market dynamics strongly mirror those seen before the July 2023 market peak and other market pullbacks, consolidations, or volatility spikes. Notably, the present environment contrasts sharply with the conditions that led to a bullish uptrend last October, which remained in place through the end of Q1'2024. The cautious outlook heading into last summer and the optimistic view established in late October were grounded in extensive cross-asset correlation studies and indicator analysis. Despite numerous warning signs and cautious signals, the equity market rally has shown remarkable resilience, appearing irrationally strong. This prompts the question: What is different this time?

Before diving in, let's review the key market dynamics that led to a more cautious stance on equities starting in Q2 when the S&P 500 was trading just under 4% below its current level:

1. Lack of Confirmation for New Record Highs: The S&P 500, Nasdaq, and multiple leading sectors and styles, including the Mag-7, failed to confirm new record highs based on daily and weekly RSI readings.
2. Overvaluation of the S&P 500: The S&P 500 was overvalued relative to fundamental valuation targets, raising concerns about its sustainability.
3. Underperformance by Cyclically Sensitive Indices: Significant underperformance by the Dow Transports and Russell 2000 indices, as well as consumer-focused sectors like XLY and XLP, indicated a lack of broad market strength.
4. Deterioration in Market Breadth and Investor Sentiment: Despite new records in the S&P 500, there was a noticeable deterioration in market breadth and investor sentiment.
5. Conflicting Fed Policy and Economic Outlook: The market faced a conflicting dynamic with hawkish Federal Reserve policy expectations amid a concerning economic outlook, contributing to an inverted yield curve.
6. Historically Restrictive Real Yields: Real yields holding above 2%, which is historically restrictive, added to the cautionary stance.
7. Widening Credit Spreads: A divergent widening of credit spreads and continued upward trending of junk-rated corporate debt yields suggested increased risk.
8. Upward Trending Dollar: The dollar's upward trend added pressure on equities, particularly for multinational companies.
9. VIX Behavior: The VIX failed to fall to new lows even as the S&P 500 hit new highs, indicating underlying market volatility concerns.
10. Decreasing Trading Volumes: During the latest rally, there was a notable decrease in trading volumes, even in major stocks like the Mag-7, suggesting weakening participation.

These dynamics collectively contributed to a more cautious market outlook despite the apparent strength in equity indices.

So What is Different This Time?

In 2024, a small group of mega-cap tech stocks created an unusual concentration in the S&P 500's year-to-date gains. This exuberance has led to an outsized impact, with NVIDIA (NVDA) alone contributing over one-third of the S&P 500’s nearly 14% gain. Essentially, one stock out of 503 is responsible for almost 5% of the rally, a scenario rarely seen since the early 2000s tech bubble.

This trend is driven by investors chasing substantial gains, including enthusiastic retail investors and underperforming institutional investors who had reduced their long positions due to perceived rising market risks in Q2. Instead of focusing on broader indexes, these investors are concentrating on a few key tech stocks. The use of single-leg, long call options on these "Mag-7" stocks has further amplified the rally. This is evident from the drop in implied correlations between S&P 500 stocks, as options dealers buy back uncovered calls or hedge their risk by purchasing the underlying stocks. Supporting evidence includes CBOE charts below, a spike in the SKEW index, and a drop in the Put/Call ratio, which suggest a self-fulfilling bullish trend that is not sustainable indefinitely. The underlying market risks I've monitored since early April continue to linger.

The top chart shows the CBOE’s 6-Month Implied Correlation Index, which uses options market data to predict whether stocks will move in high correlation (indicating strong market breadth and wide participation in a rally) or low correlation (indicating weak market breadth and thin participation in a rally). This indicator recently dropped to an all-time low, similar to what was seen in January 2018 and July last year—both periods that preceded market volatility.

The lower chart presents the CBOE’s Short VIX Futures Index, which tracks the performance of the "short-volatility" trade. This index reached an all-time high in January 2018 and hit 52-week highs in January 2020 and summer 2023, all of which were periods that also preceded increased market volatility.

The SKEW Index spiked back to the familiar 155 area last week after experiencing a sharp drop the previous week. This indicates one or both of the following scenarios:

1. Bullish Momentum and FOMO: Despite numerous caution signals, bullish momentum and a fear of missing out (FOMO) are driving sophisticated money managers back into the market. This results in a significant rise in equity hedging as these "smart money" managers aim to protect their solid year-to-date gains.
2. Institutional Trading Strategies: Institutional traders are opting to chase the market using long call options rather than establishing new long equity positions. This strategy allows them to capitalize on the limited downside risk and low cost due to the current low implied volatility conditions.

The drop in the Put/Call Ratio last week supports the notion that institutional traders are favoring long call options as a means of participating in the market rally.

In essence, despite the technical details, the current market melt-up is driven by enthusiasm for AI technology and FOMO (Fear of Missing Out) on related stocks like NVDA. However, this trend will eventually face a catalyst that disrupts the uptrend and triggers volatility. The further the market climbs, the more significant the subsequent volatility will be. Key warning signs to watch include uptrend breaks in any M7 stocks, an upside violation of the VIX downtrend dating back to April highs, and a Put/Call ratio reversal. These indicators, especially from the options market, will likely provide the earliest signals of a change. Until then, growth stocks and mega-cap tech are expected to continue leading the bullish trend as we approach mid-2024.

There are some signs of potential exhaustion in the M7 rally. These include encountering resistance in relative strength and a sluggish RSI reading compared to earlier this year, which are areas of concern. However, the overall trend in outright price remains bullish. As long as the 2023-2024 uptrend is maintained, this group of mega-cap tech stocks is likely to continue moving higher.

This week, the long-standing downtrend line from the April highs in the VIX has been broken, indicating a potential warning for the stock market rally's sustainability and increasing the likelihood of impending volatility. The May closing high of 14.47 is a crucial resistance level to monitor. The VIX could easily move towards 17 or higher if it is breached. On the downside, the key support level is 11.86, the lowest close from 2024. A move below this level would alleviate concerns about rising volatility and the possibility of a significant pullback in stocks.

At this moment, a risk management strategy is more crucial than ever to protect your hard-earned capital from a major market crash.

As long as our long-term signal remains green and the VIX stays below 20, we are focused on buying dips in stocks that align with the current cycle. If our long-term signal breaks down, we will not hesitate to raise our cash levels.

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And remember - The one fact pertaining to all conditions is that they will change.

Feel free to use me as a sounding board.

Best regards,

-Kurt

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Kurt S. Altrichter, CRPS?

Fiduciary Advisor | President

Email:?[email protected] ?|?ivoryhill.com