Strategy & Positioning 

 — Steve Orr 

Resilience 

Are we post- anything yet? Post-shutdowns, post-inflation, now post-banking crisis? We opt for none of the above. The Bulls among us insist that stocks bottomed in a Bear cycle low last October and the rally is on. The Fed is almost done and will soon lower rates. They point out that the NASDAQ and S&P 500 have steadily worked their way higher since last month’s bank failures. Both have returned to their early February highs. Positive tape action is good for your statement and peace of mind. 

Bears assert that the economy is slowing, dragging company earnings lower. They may agree that the Fed’s interest rate “Higher for Longer” mantra was dented by March’s bank failures. Their retort is now the Fed will have to “Pause for Longer.” The big indices have shown some resilience climbing walls of worry recently. Can the rally continue? Let’s assess the fundamentals and technicals. 

Coincident fundamentals suggest the economy remains on the border of Okay to Blah. Those are economist terms for +1% to flat growth this year. Jobless claims have risen for seven weeks but remain at low levels and WARN layoff notices are rising. Personal income is holding steady. Industrial production and manufacturing output are trending lower. 

Lagging indicators like the prime rate, labor costs, and personal credit as a percentage of income are in uptrends. That personal credit data also shows up in increased credit card use. The stimulus savings from Congress are clearly gone. The consumer price index headline number has been falling since last summer’s peak. Unfortunately, the Conference Board’s lagging index uses CPI for services, which remains close to its high of 6.5% last fall. 

Not to harp too much on Leading indicators, but the index year-over-year value has decreased for eight months straight. According to the Conference Board it tends to lead turns in the business cycle by around seven months. By that measure, the slowdown is just in front of us. The fundamental backdrop is slowing manufacturing, a steady service sector, and slowing job growth. Interest rate readings across the board suggest the Fed has gone far enough and needs to pause its rate increases. Yield curve inversions are off their worst readings, consistent with an imminent slowdown. 

Tech Geek

Bears here at home point to weak volume and narrow leadership in the indices. We mentioned a couple of weeks ago how the big eight tech stocks were dragging the S&P 500 higher. For a rally to have “legs,” one needs rising volume and/or participation by more stocks. Participation, or market breadth, is measured in a variety of ways. 

One method is new highs minus new lows. New daily highs minus new daily lows should sit above zero. Both the NYSE and S&P 500 have struggled to hang around zero, sitting mostly below. When the index rises and new lows exceed new highs, that is a sign that just a few names are pulling the index higher. Weak volume and just a few leaders usually mean a trend is running out of steam. The last 10 trading days S&P and NASDAQ relative strength and their advance-decline line measures have flatlined. That builds a Bear case that traders are beginning to stand aside and wait for the Fed and earnings. 

Overseas the story is slightly different. European continental stocks sit at their highest level in over a year. Euro and Asian banking structures are different than ours, so they have not experienced our bank failures. Credit Suisse was taken over in an arranged marriage, but CS had a host of well-documented troubles long before this interest rate cycle began. Like the U.S., most of Europe’s inflation rates peaked last year. Recent data suggests their slowdown may be waning. Our international indicators flashed on these trends late last year and we increased international exposure in January. 

Positioning

Another warning sign with volume and breadth is positioning. Think of traders in a boat on a rough ocean. Fear and greed drive the fast money to one side or the other. Markets tend to snap the opposite direction when too many players load up in one sector or theme, washing them with a wave of losses. Winter’s conventional wisdom of “Higher for Longer” sent hedge funds and other fast money into defensives like consumer staples and utilities. These sectors tend to lead when the two-year Treasury yield falls back below Fed Funds, as it did in early March. 

Two positives in positioning are investor sentiment and futures contracts. Sentiment and S&P 500 futures are bearish, again all to one side of the boat. Futures contracts are net short, the largest short position since 2011. Clearly some traders are going into earnings season set up for bad news. Be alert for a good earnings report or two in the coming weeks sparking a couple of percents rally. It may just be shorts covering their positions and not the bell ringing a new Bull cycle. 

Yep, still here

Inflation remains a concern. Last week’s consumer price report showed March prices 5% higher than a year ago. The 1% drop from February’s 6% reading was a nice headline but reflected temporary drops in gasoline and used cars. Next month’s reading will likely be higher as recent used car auctions have trended higher, and summer blend gasoline is arriving at gas stations. Housing prices and apartment rents falling year-over-year should help CPI drift lower by late summer. In prior rate cycles the Fed has continued to raise short-term rates until they were above the CPI reading. We do think the Fed will raise another quarter point in May and then pause over the summer. 

The next brick in the market’s Wall of Worry is the looming refinancing of commercial real estate loans. Most are held by mid- and smaller banks and institutions. Office building occupancy has not returned to pre-shutdown levels, especially on the coasts. We would note that year-over-year bankruptcies are trending higher. The full damage of rate increases is still to come.