The price action over the past several months has left many investors scratching their heads. Despite an uncertain macro environment and soft fundamental trends, equities (SPX) are up 16% since August 2019. The standard explanation for the rally is central bank easing and dissipation of some macro overhangs. The Fed responded to stress in the short term lending market in the summer by buying T-bills and consequently increasing its balance sheet from $3.8T to $4.3T. This is in stark contrast with the start of 2019 when investors were debating where Chairman Powell would raise rates despite the wobbly economy. Currently the futures market is pricing that the Fed will hold rates steady through at least September.
Breakout In Equities Coincides With Fed Balance Sheet Expansion
The crux of the bull argument is that equity valuation multiples can continue to expand because rates are low, central banks are dovish and economic growth can last longer than in previous cycles, albeit at a lower level. On the flip side, a growing number of concerns like stretched valuations, anemic global growth and political uncertainty are likely to cap the upside ahead for equities. The opportunity over the next 12 months is not deciding on the direction of equities but on the rotations and relative value trends in the market.
Growth outlook remains soft despite a stabilization in some macro indicators
Broad economic indicators like PMI rebounded slightly in the US and Europe after a steady decline over the past two years. Given the cyclicality of these indicators, it was natural to get a bounce from trough levels. However it’s unlikely this is the start of a new sustained growth cycle, and the most likely path for the economy is low-growth muddle through.
Economic Activity In US And Europe Has Stabilized
Importantly, market-based growth indicators are signaling a patch of weak growth ahead. The copper/gold ratio (HG1/CL1) historically tracks US ISM closely. Over the past several weeks, the copper/gold ratio had two weekly declines greater than 5%. This is among the biggest weekly drops in the last 3 years.
Copper / Gold Ratio Suggests Downside For ISM
Other real time indicators confirm that the market’s implied growth view has not increased nearly as much as the rally in equities. Many growthy trades have traded sideways or down including small-caps vs. large caps, 5Y Treasury yields, AUDUSD and Industorials sector vs. SPY. These instruments are a good approximation of the medium-term macro growth expected by the market. Accordingly, they are suggesting that growth is unlikely to rebound meaningfully in the near term.
“Growthy” Trades Are Trending Down
SPY Inflows Remain Muted And Bearish Positioning Near Lows
The equity rally over the past 3 months occured in the context of muted inflows into equities. For example, investors have pulled out around $11B from SPY over the past 4 weeks. Stretched equity valuations, narrow stock leadership and macro uncertainty are some of the reasons retail investors are staying on the sideline.
SPY Flows Have Not Kept Pace With Higher Prices
Additionally, the 12.7% short interest in the SPY is near its low (h/t @DelphiCapitalSD) which suggests investor positioning is skewed bullishly. Bullish positioning wouldn’t itself cause the market to decline. However, any macro, political, or fundamental hiccup will cause positioning to reverse and equity prices to fall. This setup last happened in 2018 when SPY short interest fell to a record-low 11.9%, and exacerbated the decline in the SPY which peak-to-trough fell 10%.
Short Interest % in SPY Near Record Low
Sector performance shows surprising trends
The Tech sector (XLK) has been the clear leader in the equity market — up 6% in January YTD (about 3x the SPY return of 2%). Within tech, the strength is broad based with strong performance in internet, semiconductors, hardware, and software. The earnings season has been mixed with Apple beating expectations, while Facebook and AMD surprising to the downside.
Utilities sector (XLU) is the second best performing sector, with a 5.8% return YTD. The sector has performed well because Treasury yields have declined, supporting multiple expansion. Additionally the sector benefited from natural gas collapsing to $1.90, which is a cost input for many utility companies. Energy (XLE) and Materials (XLB) are the worst performing sector YTD, down 6% and 3%, respectively.
Sector Performance YTD in 2020
Another big winner YTD is the homebuilders sector (ITB ETF), which is benefiting from low unemployment and low interest rates. The sector is up 10% YTD and many of the stocks in the ETF are up 20% including Pulte (PHM), Lennar (LEN). Given that rates across the board have started to decline, these stocks will likely continue to outperform.
Homebuilders ETF (ITB) Constituents
Equities are near all-time highs after several macro risks have receded. However, stretched valuation, extreme positioning, and political uncertainty and macro risks will likely make the next six months more challenging relative to the last six months.
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