If you are focusing on the recent gains in the S&P 500 and the Nasdaq Composite index, you might think a major equity rally is underway. However, with the exception of seven technology stocks, the S&P 500 is unchanged this year as seen by the SPX equal-weighted index which is down 0.35% year-to-date. Viewed another way, the Nasdaq Composite is up 24% year-to-date, while the Dow Jones Industrial Average is down 0.3%. Our favorite index for monitoring the market is the small-cap Russell 2000 index which is up 0.3%, or essentially flat. In short, the 2023 stock market is all icing, no cake.
Most of the recent excitement in the stock market comes down to one stock — Nvidia Corp. (NVDA – $401.11) – up 30% in the last three trading sessions as a result of the billions of dollars expected to be invested in artificial intelligence in coming years. We have no doubt that there will be a lot of investment dollars directed at AI in the years ahead, but a mania seems to be the best description of the action in NVDA this week.
Volmageddon
And there are other interesting market trends that should be noted. A recent Wall Street Journal article titled U.S. Stock Market Stays Calm With Help From Quant Buying, suggests that the equity market remains calm in the face of the debt-ceiling debate due to demand from quant funds. The article states: “At the end of March, quant-focused hedge funds held about $1.13 trillion in assets, according to research firm HFR, hovering just below last year’s record high. That represents about 29% of all hedge-fund assets.”
“It’s rules-based trading,” said Charlie McElligott, a managing director at Nomura Securities International. “There’s no emotion involved.” Data from McElligott shows quants tend to move together quickly when volatility strikes. Take, for example, the stock market selloff of May 2019, when the S&P 500 slid some 7% as investors panicked about U.S.-China trade tensions. McElligott estimates that CTAs unloaded $35 billion worth of equities over the course of a month.”
However, rather than being a calming influence on the equity market, we believe this concentration of quantitative investments could prove to be risky down the road. It is reminiscent of another memorable event in equity history – Volmageddon — which is a blend of the words volatility and Armageddon. Volmageddon refers to the unusual activity that occurred on February 5, 2018. On this day, after about a year of rising stock prices and low stock market price volatility, the CBOE Volatility Index (VIX – 17.46) soared from an opening value of 18.44 to 37.32 at close. Unfortunately, the low volatility that characterized the 2017 stock market had generated huge demand in leveraged short volatility trades, especially in the Velocity Shares Daily Inverse VIX Short-Term note, whose ticker was XIV. The XIV (no longer traded) shrank from $1.9 billion in assets to $63 million in one day due to the jump in the VIX. The SPX only fell 5% on February 5, 2018, but February 5, 2018 proved to be just the beginning of a volatile year that ended in a large December sell-off, a 6.2% decline in the SPX and a 12.2% loss in the Russell 2000 index.
In short, this big increase in quant-based investment can have a calming impact on equity prices today, but if sentiment changes, it can also trigger a lot of volatility, illiquidity, and serious damage to stock prices in the future. In sum, we would not chase this rally and remain focused on recession resistant stocks with predictable earnings streams.
Economics review
After hitting cyclical lows in June or July of 2022 and rebounding to 12-month highs in February 2023, both the University of Michigan and the Conference Board sentiment surveys dropped in the month of May. The declines were across the board including the overall index, present conditions, and future expectations. May employment will be reported on Friday, and it will be interesting to see if these declines in sentiment are a leading indicator of job market weakness. See page 3.
June’s FOMC meeting is only two weeks away. Another month of inflation data will be available in early June, but April’s inflation data could support another rate hike. Both headline and core CPI were relatively unchanged at 4.9% YOY and 5.5%, respectively. Service sector inflation fell from 7.3% to 6.8%, services less rent fell from 6.1% to 5.2%, services less medical care fell from 8% to 7.6%, while other services rose from 4.4% to 4.7%. Nevertheless, all service sector inflation data remains high and well above the Fed’s 2% target. See page 4.
However, small declines in inflation are helping households. April’s personal income rose 5.4% and CPI rose 4.9% which means real personal income is improving. Moreover, disposable income rose nearly 8% as tax payments fell and this produced a 3.4% YOY gain in real disposable income. April became the fourth consecutive monthly gain seen in real personal disposable income. See page 5. Personal consumption expenditures (PCE) rose 6.7% in April. Although expenditures are positive on a year-over-year basis, there are clear signs of deceleration in all categories including durable goods, nondurable goods, and services. See page 6.
Several financial commentators have stated that the current savings rate is “average”, but this is far from accurate. The current savings rate of 4.1% compares to the historical average of 8.8% or the 22-year average of 6.6%. In short, savings are well below average. And while the savings rate did soar to 33.8% in April 2020 as a result of pandemic stimulus checks, that buffer has been depleted. Therefore, it is not surprising that personal consumption expenditures are also decelerating. See page 7.
Retail sales rose a mere 0.15% YOY in April and real retail sales fell 3.2% YOY. Much of this was due to a decline in auto sales which fell 5.8% in the month and 3.4% YOY. However, a lack of motor vehicle inventory has hampered auto sales due to supply chain disruptions; but auto sales face a new hurdle from rising interest rates which will increase the cost of leases and auto loans. See page 8.
Technical Indicators The charts of the S&P 500, DJIA, and Nasdaq Composite are technically positive, but the SPX and DJIA failed to better critical resistance at SPX 4,200 and DJIA 34,500. The Nasdaq bettered the 12,500 resistance, but this was due primarily to Nvidia Corp. (NVDA – $401.11). The Russell 2000 remains our favorite guide for the broader marketplace and it remains well within a defined range with support at 1,650 and resistance at 2000. See page 12. The 10-day average of daily new highs is 94 and new lows are 109, making this combination negative since new highs are below 100 and new lows are above 100. See page 14. With the debt ceiling vote still incomplete, the Russian/Ukraine conflict escalating, Chinese GDP expected to slow from the first quarter’s 4.5%, Friday’s job report, and the FOMC meeting on June 14, there are many ways sentiment could change. Note that there was renewed weakness in crude oil and gasoline prices this week which implies fear of an economic slowdown may be increasing. We remain cautious.
Gail Dudack
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