As of market close June 9, 2023. Returns in percent.

 Investment Insights

 — Steve Orr 

Summer Swim

Mid-June and summer is upon us. Over the weekend temps touched one hundred degrees. The broader stock market finally got hot, too. We spent most of the spring lamenting at the narrow leadership in the S&P 500. The seven or eight biggest stocks, think Apple, Nvidia, Google, Meta, etc. have carried the load this year. The S&P 500 through last Friday was up 12% year-to-date. The seven biggest stocks contributed 11% of that 12%. The other 493 — barely helping. Since the debt deal was signed, big tech returns the last few days have flattened out and Mid-Cap and Small have run at least 6% higher. More stocks in the rally pool is a sign of a healthy market.  

Small Cap has been trapped in a roughly 11% up and down range since last November. June’s move higher has traversed two-thirds of that range in short order. More stocks participating in the rally helped the S&P 500 peak over the 4,300 mark briefly and the 20% gain from the low on October 12 got the TV crowd talking about a new Bull market. Hold on to your horns.  

Rotate or rally?

Stocks may not obey gravity — coming down or going up when we think they should — but they do obey some laws of physics. Inertia says that once a body is in motion it tends to stay in motion. Like my hand reaching in the bag of chips. There are 14 cases since World War II when the S&P 500 has rallied 20% off a low, marking the end of a cyclical Bear. According to Bespoke Research, over the next month performance was uneven at best. Six months down the road in 10 of the 14 cases, the index was at least 4% higher. 

A 16% return would be a very nice Christmas present. More important for our portfolios, twelve months later 12 of 14 cases showed a gain averaging 16%. Looking at the time to reach a 20% return, this rally would rank as the third slowest, at 164 days. This is not surprising given the Fed’s interest rate increases and the resulting banking difficulties. 

Last week we wrote that this market would have to prove to us the rally is real. For those scoring at home, here is a checklist to get started: 

• S&P 500 staying above 4,300 
• Small Cap (Russell 2000) breaking out of its trading range
• Banking sector stocks participating 

With the big tech rally moderating last week, we are turning our attention to the second and third bullets. Despite its 7% rally this month, the Russell 2000 index remains 22% below its all-time high set in November of 2021. The KRE regional bank ETF sits 44% below its all-time high and 26% below 2022’s year-end. Banks have a lot of ground to make up and that begins with restoring loan growth and cleaning out bond portfolio losses. New rules on the horizon requiring banks to hold more capital could constrain loan growth and will certainly cut stock buybacks. 

Not Wednesday

The Fed’s next steps in its battle against inflation are a key component of all the market’s issues above. Fed speakers communicated “pause” for this Wednesday’s press release and markets have adjusted accordingly. Since they went into speech blackout, employment and services numbers paint a steady economy. In response, traders have moved up the odds for a July rate increase of one quarter of a percent to just over 50%. 

We expect this is not the “pause” markets were hoping for, but rather a “skip.” Strong job numbers through the summer would spur the Fed to keep raising rates. The press conference Wednesday afternoon could prove interesting. Several members stated before the blackout that more increases were necessary to attack inflation. Chairman Powell was guiding the markets toward a pause in rate hikes. He will have to weave around bank stress, the year or so lag in rate hike impacts, and differing members’ views to explain why the Committee decided not to raise at this meeting. This meeting will also feature the quarterly update of members’ and staff’s economic projections. With the economy chugging along in second gear, we expect the members’ 2023 year-end interest rate projection to be higher than March’s 5.125%.  

Just rotate

Stock and Bond markets have a number of drivers. Fear & Greed play a short-term role. Longer term drivers are earnings, inflation and money supply. The only economic bright spot on our indicator board is employment. Remember employment usually does not turn lower until the recession has started. 

Manufacturing turned lower months ago. Consumer spending is keeping GDP above water at the moment. Together they mean company earnings at best may be bottoming in the next quarter or two. Inflation is not going away anytime soon. The real question is whether the Fed gives up on its goal of 2% inflation and decides 3% or even 4% is okay. They are continuing to wind down their balance sheet by letting their Treasury and mortgage bonds mature. This pulls money out of the banking system, altering the money supply. 

When the government is pushing money into the banking system, like they did with Covid Stimulus, it’s easier for hedge and fast money traders to borrow and buy stocks. Since January when the government could not borrow, the Treasury has been pushing money out of their checking account to pay bills, Social Security, etc. More money aids NASDAQ and a growth stock rally.

Now that Congress has raised the debt ceiling, the Treasury can borrow again. At one point around June 2 or 3, the Treasury’s General Account fell below $30B. Their goal is to issue enough T-Bills and Notes this month to finish June at just over $400B and close to $600B over the next eight weeks. A larger supply of debt should push rates higher, and they have been creeping up over the last week. That will also pull money out of the banking system. Our sense is that the reduction in liquidity will aid Small Cap and Value sectors at the expense of the recent NASDAQ and growth rally.