Broker Check

Supportive of Cutting Rates In 2024?

| August 14, 2023

By know our readers know that August and September are historically less-than-optimal times for investors. Illustrating this again, per our friends at MAPsignals, these two months are the worst of the year for stocks:

As expected, the start to the month was rocky. But if you’ve been paying attention, it shouldn’t really be a surprise. What’s most interesting at this point is the data reflects some significantly outsized moves this month compared to the norm.

That aside, the good news is earnings are working. As of this writing, FactSet reports 84% of the S&P 500* companies have reported results. Of those, 79% beat earnings estimates and 65% beat sales revenue estimates. That’s the macro view.

On a smaller scale, some individual stocks are seeing big moves based on earnings reactions, or in many cases, overreactions. For instance, cybersecurity company Fortinet (FTNT)# beat its earnings estimates, which is good. But discussion of macroeconomic uncertainty lessened the company’s forward guidance, torpedoing the stock by roughly 25% that day. It’s recovered some, but Fortinet is a prime example of earnings (over)reactions being outsized right now.  

A part of these big reactions seems to be gross exposure. Let’s explain. Hedge funds are notorious for using leverage (or “margin debt”) to amplify returns, especially when they’re lagging the market. This leverage has left some of these funds overexposed to potential losses on individual stocks. When such stocks actually do fall, the losses can accumulate and gain speed because that leverage is unwinding.

Make no mistake, the need to recover is there for many hedge funds. Since the market lows of October 2022, markets have been on fire, while many hedge funds are lagging:

To bridge the gap, hedge funds use leverage. In their world, it’s called running a high gross (e.g., gross exposure of 250% or more). Using leverage, hedge funds can deploy 2.5 times as much capital as they have on hand. Absent leverage, normal, run-of-the-mill investors can only deploy a maximum of 100% of their capital.

Digging more, we investigated the debit balances of these types of traders. In short, leverage use has risen lately to the tune of nearly 13% since just December 2022:

The elevated margin use helps explain some of the volatile daily moves in stocks lately. Given the seasonally low liquidity, such moves are amplified and cause turbulence. This may help explain what happened with Fortinet and other recent outsized moves.

Turning to money flows, the Big Money Index (BMI), a 25-day moving average of “big money” investor stock buys and sells from our friends at MAPsignals, recently went overbought. We’re now seeing the BMI begin to drop, coinciding perfectly with the seasonal volatility we expected going into August:

To hammer this point home, you can see the first signs of “big money” selling in a long time:

The good news is that growth sectors continue to remain strong overall. Pullbacks and corrections are part of investing – they’re actually healthy. Markets strengthen due to this “pruning.” And as we’ve stated multiple times, we remain bullish for the fourth quarter due to both improved seasonality and an expected bump from earnings season.

Inflation Data and the Outlook for Stocks

We know the beginning of the month was volatile. But from a historical technical perspective, the timing of all this may be a good thing. We're beginning to lean towards the view that the majority of the aggressive selling this month is likely front loaded:

But the key that we're watching from a technical standpoint is the S&P 500 recapturing the 20-day moving average. That would be supportive from a short-term volatility standpoint.

The July consumer price index (CPI) report, which showed a slight increase in inflation, still came in below expectations. Headline and core inflation rose in line with expectations in July with the latter posting the smallest back-to-back monthly increases in over 2 years. So, as a result of the cooler CPI report, this should be supportive of selling being front-loaded in August.

Also supportive is a recent interview from John C. Williams, who is president of the Federal Reserve Bank of New York:

This is probably the first time anyone from the Fed has verbally discussed the possibility of interest rates being cut next year if inflation continues to fall. To be clear, Mr. Williams is considered neutral, not dovish. His interview is interesting because it could be the start of a changing narrative overall.  

As our readers know, we think the Fed is slightly behind on its inflation data. It’s why we’re constructive in our belief that inflation will continue to fall significantly. That’s especially true if you look at lagging data.

Check out the falling gas prices:

Prices fell for eight months before showing a decline on a year-to-year basis.

The same is happening in used vehicles:

Prices declined steeply – 11.6% year-over-year – accelerating to the downside. And the CPI was again behind.

Perhaps most importantly, it’s happening too in shelter costs, one of longest lagging metrics feeding inflation data:

A recent San Francisco Fed paper suggests that housing will show negative year-over-year declines in 2024. The next few months will be telling in terms of where this trend is headed. You know we’ll be watching.

If all this data continues to play out, would it be supportive of a strong Q4 2023 and subsequent cutting interest rates in 2024? We think so. Should the Fed cut rates, it would be positive and hugely significant for stocks as we look out over the longer term. And then (once again) staying invested will likely prove to be smart.

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* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

# Daniel Milan owns FTNT personally. Cornerstone owns FTNT in some managed client accounts.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.