A very narrow market trading at extremes makes for discomfort.
This week took me to Northern California, with glorious sunshine in wine country. The discussion among advisors and investors was of serious matters, but also with a touch of humor. “I can’t retire here,” agreed the local advisors who complained about state finances, taxes, “I’ll never receive Social Security” and “don’t get me started on politics!” And we laughed—you’d have had to be there. On the plus side, here in the Sacramento Valley, the 119-degree days are at least a “dry heat,” said a Floridian transplant. At a large client event in the Sacramento suburb of Granite Bay, the mostly baby boomer audience loved my Revenge of the Boomers message as a lady complained, “Millennials don’t want to work!” More laughs. No millennial there to defend herself. Had there been, she might have replied, “We may not want to work but we have to—who else is going to pay your Social Security?” She also may have said it’s easy to complain about millennials when boomers’ net worth of $73 trillion represents more than half of total household net worth in the U.S. Social Security, along with Medicare and Medicaid, may represent nearly half of government outlays but were off limits in debt-ceiling talks. As a result, Goldman Sachs estimates the final deal will only cut spending by 0.1-0.2% of GDP y/y in ’24 and ’25 vs. a baseline in which funding grows with inflation. Combined with the current fiscal year’s nearly 10% increase in outlays, overall discretionary spending may end up higher in real terms despite new caps. Meanwhile, the nation’s debt servicing cost keeps rising. It’s closing in on 14% of tax revenue, a level that historically inflicts austerity. Unfortunately, austerity will never happen unless inflicted.
May was another big month for mega-cap tech stocks. The 10 biggest advanced 17%, while the semiconductor names rose almost 16%. But the broad S&P 500 eked out a 0.3% gain and in equal-weighted terms was down 3.8%. The performance spread between the Nasdaq 100 and the Russell 2000 fell into the 99th percentile, as did the outperformance of cyclicals relative to defensives. An even larger outlier—100% of the year’s market gain has come from the 10 largest stocks. Despite this historically narrow market, Wolfe Research has a very tough time seeing value names and equal-weighted indexes catching up and joining the uptrend. A countertrend rally seems inevitable, but timing at the extremes can be very difficult. For now, the 52-week highs are surging in tech, with a net 25% of the sector trading at 52-week highs (though notably, even with the Nasdaq 100 at a new 52-week high, the number of member stocks at new 52-week lows exceeds the number at new highs. That hasn’t happened since Nov. 19, 2021—the exact day of the Nasdaq Composite’s all-time high.) The five largest S&P weights account for over 24% of the index, and both Apple and Microsoft are each greater than 7% weights. That’s never happened. Leuthold Group says it’s never seen anything like this—a bear-market rally that’s survived as long as the current 7½-month upswing, nor a new bull market that’s generated weaker performance in equal-weighted indexes and small caps. Whichever way the market breaks, investors are watching something completely new … or should we say unprecedented!
Should investors just sell in June and go away? History may be on their side. Over the last 15 years, June has been the second-worst month on average for the S&P (only behind September). Global equities look rich, with U.S. sectors 16% overbought based on Piper Sandler’s analysis. If the S&P 5-year normalized P/E multiple were to drop to its highest reading ever during a cyclical bear market low (18.1x in March 2020), the index would sink another 28% to 2,950. Don’t hear anyone calling for it to get that bad. In fact, with Nasdaq and tech growth stocks riding high again and the S&P at this writing well above major resistance at 4,200, a short-covering FOMO rally seems likely. It strikes Strategas Research as odd that the Nasdaq 100 ETF is up 31% YTD without a true scent of herding behavior—it’s experiencing inflows in shorts and outflows in longs. It’s hard to get enthusiastic about an extremely narrow market that is historically rich by virtually every traditional measure. And with the Fed poised to at best skip this month before hiking again, valuations seem problematic barring an AI breakthrough that can manifest itself rapidly. I had a 99th percentile week, staying near San Quentin prison, speaking near Folsom prison and witnessing a bicyclist riding along the inside shoulder of the 7-lane I-80 highway (how did he possibly get out of there?!).
- One reason the Fed may skip, not pause A still hot labor market. May nonfarm payrolls surprised at 339k, the biggest increase in four months. March and April numbers were revised up, too. Also this week, ADP tallied 287k net new private sector jobs, 116k above expectations, and April job openings unexpectedly climbed 358k from March. Buttressed by comments from Fed officers, futures at this writing were pricing a quarter-point hike in July. Odds of a June move also rose but were still 1-in-3, perhaps reflecting May’s weaker household survey, which showed employment shrinking and the jobless rate rising to 3.7%.
- Productive revision Q1 productivity was revised up and unit labor costs were revised down by a large 2.1 percentage points, bringing them closer to average hourly earnings, which have been growing at roughly 4.25% over the past three months. Unit labor costs are now rising slower than prices of nonfarm business output, suggesting that instead of contracting, business margins are expanding.
- Asian factories buck global trends Despite struggles in the U.S. and Europe (more below), China’s Caixin PMI rose for the first time in three months to above breakeven, with new orders expanding a third month out of the last four. India’s factory PMI surged to 31-month high in May, and in Japan, manufacturing new orders advanced to their highest level since spring 2022.
- Manufacturing still struggling May’s ISM fell again, marking the seventh straight month of contraction, as new orders sank to their lowest since January. The good news is the downturn has been relatively modest to date, and employment for the month strengthened. In the Fed’s Beige Book, manufacturing activity was weak across most regional districts. Chicago and Dallas PMIs plunged, copper prices—an indicator of global demand—fell further and the global PMI is stuck in contraction.
- Demand for housing isn’t picking up So says Piper Sandler, citing weekly mortgage applications that moved lower a third straight week and are now slightly above their multi-decade lows of a few months ago. It blames mortgage rates that are rising again, a shortage of inventories as homeowners aren’t willing to give up their low-rate mortgages and stubbornly high prices. The Case-Shiller home price gauge rose a second straight month and is only 2.3% below June ’22’s all-time high. The FHFA index of home prices also increased.
- Sentiment slips Conference Board confidence softened, led again by the expectations component that has been on a choppy downtrend since early ’21 and is now at 10-year lows. Overseas, the euro area sentiment reading fell to a 6-month low, with a broad move down across sectors and countries.
More work for a tight labor market If the U.S. manages to skirt a recession, Yardeni Group says it will be due in large part to capital spending and building related to the massive chip-making, infrastructure and clean energy bills passed the past two years. Capital spending in real GDP terms rose to a record high $3 trillion annualized in Q1, and manufacturing construction that’s underway or ready to break ground jumped 62.3% y/y through March to its latest record high of $147.4 billion. So many manufacturers have locked down locations for new plants in the U.S. that it’s now hard to find shovel-ready “megasites.”
Is it time for small caps for real this time? The S&P 600 is trading at a forward P/E multiple of 12x, 2 standard deviations below the long-term average and at a sharp discount to the S&P 500. While small caps may continue to underperform if a recession hits in the quarters ahead, Wolfe Research thinks it’s time for long-term investors to consider overweighting the asset class.
The consumer reigns supreme Despite April’s decline in confidence, buying plans for autos, homes and appliances improved. And this week, the Transportation Security Administration reported that it screened 9.8 million U.S. airline passengers over the 4-day holiday weekend, 300k above pre-Covid 2019 levels.