US Strategy Weekly: Where is Goldilocks?

Last week in our strategy weekly “A Bubble, or Not a Bubble” (February 7, 2024) we outlined the three possible strategies to employ during a stock market bubble. They are 1.) participate in the bubble and buy stocks displaying the best upside momentum, 2.) add ETFs to your portfolio that mirror the market leadership in order to boost short-term performance, or 3.) continue to invest in good value stocks and weather underperformance in the near term, understanding that value will outperform in the long run and in the event that the bubble bursts. All equity bubbles eventually burst. In line with these strategies, we shifted our sector weightings last week to favor the current momentum seen in communication services, technology, and healthcare.

This week, January’s CPI report is posing the first real threat to the Goldilocks/bubble scenario. January’s inflation data showed headline CPI rising 3.1% YOY, down from December’s 3.4%, but still above the June 2023 level of 3%. This small dip in headline inflation was particularly disappointing because energy costs fell 4.6% on a year-over-year basis. The report was not only a setback to the consensus, but it also challenged the concept that the Fed will make five or more rate cuts this year. Adding to the pain was the fact that the core CPI was unchanged from December’s 3.9% YOY pace. This was distressing for the consensus which was looking for lower CPI numbers to support the view that inflation would fall to, or close to, the 2% level later in the year.

Lower inflation is an important piece of the Goldilocks scenario for several reasons. Not only does it imply a Fed pivot by mid-year, but lower inflation is vital in terms of supporting the high PE multiples seen in the current market. Moreover, stock market rallies and stock market bubbles are driven by liquidity and liquidity does not increase in an environment of rising inflation and rising interest rates. In short, inflation is pivotal to the consensus view.

However, we strenuously disagree with those who believe that owners’ equivalent rent (OER) is the main reason inflation is so high and that without OER the CPI would be growing at a pace closer to 2% YOY. As seen on page 3, owners’ equivalent rent has a 26.8% weighting in the CPI, and it rose 6.2% YOY in January. On the surface, one might conclude that OER is the main reason headline CPI remains so high. But we disagree. The weighting of OER seems appropriate since rent is often 25% to 30% of a person’s monthly income. Moreover, while rents are coming down, so is the trend in OER which was rising 8.8% YOY in March 2023. The 6.2% YOY pace reported in January was substantially down from its peak.

In addition, the calculation for OER is based on a 12-month moving average of rents. This seems fitting since rental agreements are usually renewed on an annual basis and not everyone is getting the advantage of lower rents at present. As a result, the trend in rent expense will move slowly through the CPI and the economy on the way up and on the way down. It has always been this way and only now that inflation and the Fed are major economic issues has this become a major discussion point for the bulls.

And lastly, the OER is not the only issue driving headline inflation. January’s inflation report showed big price increases in tenants’ & household insurance, water & sewer & trash collection, motor vehicle insurance, personal care, and hospital & related services. See page 4. These categories of the CPI represent necessities for most households and the price rises in this list represent a burden on home finances. This explains why the average consumer is not feeling optimistic about the strength in recent GDP and employment data. For those who do not understand why average Americans are not happy with the current economy, we say, “just look at the data” and not just the headlines.

Entrepreneurs are also feeling the pressure. The small business optimism index dropped 2 points in January to 89.9. The significance of this is that it was the 25th consecutive month below the 50-year average of 98, which is typically a sign of a recession. Six of the 10 components decreased in the month; the biggest decline was seen in sales expectations, which fell 12 points to negative 16. Actual earnings changes fell 5 points to negative 30 and hiring plans fell 2 points to 14. See page 5.

It has been an interesting week, and, in our readings, we found these interesting nuggets of information:

The top 10 holdings in the S&P 500 now make up over 32% of the index, the highest concentration seen in data going back to 1980. (https://twitter.com/charliebilello/status/1756721141547196867).

As of February 9^th, the S&P 500 rose for the 14th out of the last 15 consecutive weeks. According to Dow Jones Market Data, the last time this index recorded a comparable stretch of weekly gains was March 10, 1972 (a major market top). This 2024 stretch marked the 13th time it has happened since the index’s inception in 1957.

The current market capitalization of NVIDIA Corp. (NVDS – $721.28) of $1.78 trillion is greater than the GDP of South Korea ($1.71 Trillion – IMF 2023). South Korea is the 13^th largest economy in the world.

In an interview on CNBC earlier this week, Jason Trennert of Strategas, noted that the earnings for the Mag 7 stocks rose 59% YOY in the fourth quarter. The remaining 493 companies in the S&P 500 had an earnings loss of 3%.

Since inflation is in the headlines this week, we would point out that the WTI future (CLC1 – $77.68) might be about to break out above a tight cluster of moving averages. The 50-day moving average is $73.42, the 100-day is at $77.97 and the 200-day moving average is at $77.41. A break above these three moving averages would be bullish and imply higher energy prices, which would not be good for future inflation reports. The next important inflation release will be the PCE deflator scheduled for February 29.

Prior to this week’s pullback, the S&P 500 and the Dow Jones Industrial Average made a series of new record highs. The Nasdaq Composite came close to breaking its November 2021 high of 16,057.44. Still, the Russell 2000 remains the most interesting index as it struggles to better the key 2000 resistance and decisively move out of the 1650 to 2000 range that has contained prices for two years. If the Russell can break above this range successfully, it would be bullish for the overall equity market.  See page 8. The 25-day up/down volume oscillator is at minus 1.14 and neutral this week after a 524.63-point decline in the DJIA on February 13. This indicator has not come close to recording an overbought reading despite the string of record highs in the two main indices in January and February. The last favorable overbought readings of 3.0 or higher took place during 22 of 25 consecutive trading days ending January 5. To confirm the recent string of new highs in the S&P 500 index and Dow Jones Industrial Average, this indicator needs to reach and remain in overbought territory for a minimum of five consecutive trading sessions. This seems unlikely. In short, remain cautious.

Gail Dudack

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