You may have seen some views recently stated by macroeconomic investor Paul Tudor Jones:
He went on to explain in detail what he meant. Basically, the current unsustainable fiscal deficit coupled with recent geopolitical risks at the hands of unstable nuclear regimes doesn’t make a great macro environment.
To be clear, we think his macro views are reasonable. But things have been tough for investors since the start of 2022, especially as the Ukraine war has dragged on and U.S. politics are in flux. Toss in the Israel/Hamas war and it gets even more complicated.
But again, equity markets have been dealing with this for almost two years now. So today we want to peel back the macro surface to reveal underlying data, especially as the S&P 500* has shown positive resilience over the last six trading sessions (as of this writing) not seen since July.
Last week we highlighted the signs of equity seller exhaustion after a steady de-risking that began in late July. The circumstances continue to evolve positively for equities:
- On Wednesday, Oct. 4, and Thursday, Oct. 5, markets opened soft but then closed near highs.
- Friday, Oct. 6, saw the market open lower on an initial read of the “hot” jobs report but reversed higher into the close as more details emerged.
- Monday, Oct. 9, equity markets opened soft on war news, but then reversed higher throughout the afternoon.
- Tuesday, Oct. 10, the equity market breadth continued to expand.
- Wednesday, Oct. 11, equity market breadth expanded even more.
From a macroeconomic perspective, we think there have been two big changes recently that provide support for these equity moves. The first is that interest rates are running out of reasons to relentlessly rise. And the second is how the Federal Reserve has been distinctly dovish, which is a stark reversal from its dominant hawkish tone.
To put this into perspective, at the Sept. 20 Fed meeting, the U.S. 10-year Treasury yield was about 4.31%. After Fed Chair Jerome Powell’s “higher for longer” press conference, the 10-year yield surged to 4.89% in an explosive rise that pressured equities:
But as of this writing, the 10-year yield has fallen to just under 4.6%, which is a 50% retracement from the peak (as we mentioned last week):
Why are rates cooling off?
- The Middle East conflict adds downside risk to consumer confidence and the economy.
- The price of oil pulled back almost 20% from nearly $100 per barrel.
- There are ample signs of a weaker U.S. consumer and drawn down savings.
- The September jobs report showed weakening wage inflation, which is a key Fed measure.
These recent developments spurred “Fed speak” that’s been extraordinarily dovish compared to statements over the past 18 months or so:
Why would such a reversal be bullish for equities?
Remember this rate hiking cycle has been about taming inflation, not breaking the economy. And it’s increasingly clear that inflation was fueled by many supply chain dynamics that have ended or soon will. So, the faster the Fed stops hiking, the faster earnings can recover.
With all due respect to the macro investing community, even with plenty of global uncertainty, it’s extremely encouraging that markets have risen in the last six trading days (as of this writing) in the face of daunting macro news. For now, the market’s “fear gauge,” the CBOE Volatility Index (VIX) sat around 17, which is about average over time.
Let’s now consider forward price-earnings (P/E) ratios. Would you rather own a U.S. 10-year Treasury at an implied forward P/E ratio of 21.5 or high-beta growth stocks (i.e., FANG+) with a forward P/E ratio of 27.2?
To answer that question, let's look back to equity heights. MAPsignals’ Big Money Index (BMI), which is a 25-day moving average of “big money” professional investor buys versus sells, was extraordinarily hot in July and in overbought territory at 83.9%. Fast forward two months and the S&P 500 fell 8% from those oversold levels.
Thankfully though, relative strength in technology and energy stocks helped limit the overall market downside. Still, over the past two weeks, stocks fell hard, and the BMI reached oversold early last week.
We all know Wall Street’s list of worries is a mile long. But remember that all the macro boogiemen have one thing in common: tightened financial conditions. That matters because “pros” became increasingly worried tighter financial conditions would spark a nasty profit-killing recession as the cost of capital surged. But three strong contrarian indicators have converged and that’s bullish.
First is the Goldman Sachs’ U.S. Financial Conditions Index, which rolls up all that spooky macro input into a single measure. Notice in the chart below that as the index begins spiking, equities started falling:
Similarly, investor sentiment is quite negative currently, per the American Association of Individual Investors Weekly Sentiment Poll. “Big money” investors watch this bulls-minus-bear spread closely. Negative readings mean more bears than bulls. The latest reading is -11.5, well below 40-year average of 6.5:
But it's always darkest before dawn and when there's “blood in the streets,” we buy. That can be emotionally tough. But when there is extreme bearishness everywhere, we lean on history. As you can see, the S&P 500 has posted above-average 6% returns in the six-month period following bottom-quartile bullish sentiment readings, like the most recent one:
Now let's dig one level deeper and see if we're getting the same bullish contrarianism from the BMI. Readings less than 30% are rare and indicate stocks are near or at oversold levels (i.e., a reversion signal). Well, right in line with the macro data above, the BMI bottomed out on Monday, Oct. 9, at 22.3%, officially going oversold:
This came after what appears to be final washout of capitulation selling from Oct. 2-6:
Historically, rips off oversold BMI levels tend to be powerful and last for months:
Independently, Fundstrat’s Chief Technical Analyst Mark Newton sees the same expected rip moving forward:
Even through all this carnage, the top performing sectors are still energy and technology. But most importantly, while they’ve outperformed comparatively, neither are overbought. The recent panicky profit taking amid all the macro handwringing means that energy and tech are still on sale.
In previous posts, we’ve discussed what’s driven tech and energy buying over the last 18 months or so. But now we want to introduce a new angle: as interest rates rise, the huge piles of cash on the books of mega-cap tech and oil firms have increasingly attracted institutional money. That's because the corporate cash is earning 5.5% on Treasury bills and serving as a healthy shock absorber to cushion earnings in uncertain macro headwinds.
The biggest 13 mega cap companies (i.e., FANG+ and oil) are collectively sitting on $807 billion. They own 30% of the total cash held by S&P 500 companies:
Those 13 companies will earn roughly $42 billion on just that money alone over the next 12 months.
So, knowing all this, we’ll ask again: based on current forward P/E ratios would you rather own a 10-year bond or the stocks of huge, growing companies sitting on enormous piles of cash?
We should point out that real estate and utilities are still lagging badly. That’s because those sectors are almost considered bond proxies with their “high” dividend yields. Both sectors have been slammed as risk-free 5% bond yields make their 4% payouts significantly less attractive while higher interest rates increase financing costs, threatening future profits. Defensive, countercyclical sectors like staples and health care are experiencing similar pain as their dividend yields are also undermined by higher interest rates.
The good news is all these lagging sectors are extremely oversold and ripe for a rebound. On a forward-looking basis, higher beta cyclicals like technology and energy offer the best “bang for your buck” in this current environment.
To summarize, we have a clear emerging picture: all the negativity finally drove panic selling, which means all the doom and gloom is already priced into depressed stocks. Everybody who wants to sell has done so. This is causing the BMI to dive. Stocks and exchange-traded funds have reached levels of extreme selling and virtually all sectors are oversold.
History says that when this takes place, markets are materially higher in the weeks and months afterwards. Combine that with markets entering their historically best time of the year, and there’s evidence that the bottom is near (or here). If investors can remove macro emotion from the process and let data be the guide, history suggests they’ll do well over time.
The great poet Oscar Wilde framed the situation perfectly when he said, “The optimist sees the donut, the pessimist sees the hole.”
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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.
*Cornerstone owns AAPL, GOOG, MSFT, AMZN, META, CVX, CSCO, TSLA, IBM, NVDA and CRM in managed client accounts.
*Daniel Milan owns AAPL, MSFT, AMZN, META and NVDA personally.
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