When bull markets end, they seldom go gentle into the night. As the market turns down, sharp rallies can occur, inflicting enormous pain on anyone underweight or short the declining asset class. Every decade or so, markets get carried higher by a structural theme which triggers an enormous re-rating of the favored asset class. Examples include Energy in the 1970’s after fears of “peak oil”, Japanese equities in the late 1980s, Internet stocks at the turn of the century, and most recently, US mega-cap tech stocks on the belief that “software eats the world”.

That brings us to 2023. This year, we have had a sharp rally in all thing’s tech, and especially in the “Magnificent Seven” stocks that have driven so much of US and global equity market performance in 2023. So, was the 40% gain in the Nasdaq between early January and July a typical post-bull-market surge? Or is this rally a continuation of the US growth stock bull market that started in 2011? Or is it the start of an altogether new bull market? (Chart 1).

While the answers to those questions will only come with time, since the beginning of August, it has looked as if the tech rally has run out of steam. Major equity indices are off their peaks, and the technical backdrop has become less clear. The S&P 500 and Nasdaq have both dipped below their 50-day moving average, and for the most part, the “Magnificent Seven” mega caps are showing cracks.

US long-dated bonds have not been sending the same message as stocks this year. Treasuries have rolled over, and yields have taken out highs from October 2022. Equity multiple expansion and yields, which have recently moved in tandem, have meaningfully decoupled. (Chart 2).

The discrepancy in the performance of US equities and long-dated bonds defies easy explanation. The invention of ChatGPT and AI wave is certainly a catalyst… as is the resiliency of the US economy this year. However, ultimately, declining inflationary pressures have helped strength beget strength in the stock market.

The re-emergence of inflation remains the key risk to portfolios.

So, which asset class is right? Is the inflation genie really back in the bottle?

Is There Still Inflation Risk?

Many of the tailwinds that have pushed inflation lower this year have either receded or flipped. Higher energy prices, higher food prices, a weaker dollar, and fiscal loosening all set the stage for another bout of inflation. And falling inflation could even sow the seeds of its own demise. Consumption and real income growth are highly correlated. If inflation continues to fall, real wages will rise further. If that were to happen, the resulting increase in consumption could cause inflation to reaccelerate. As previously mentioned earlier in the year (Feb MIM), we discussed deflationary pressures for 2023 and that inflation is following a similar path to the 1970’s, where we saw a second surge of inflation. There are other structural forces like aging demographics providing tailwinds.

Therefore, we believe there is uncertainty over how quickly inflation will fall, and if it does fall, whether it will stay down. This against a backdrop of equities discounting a return to a “2% world”. We believe the US is not out of the woods when it comes to inflation, which means that it is too early to conclude that the Fed can stop raising rates. Any further increase in inflation risk would prompt us to turn more cautious on stocks. (Chart 3).

Is There Still Recession Risk?

Given the normal range of “long and variable lags” between tightening financial conditions and recession ensuing, the US economy is not out of the woods. The yield curve inverted 300 days ago. On average, it has taken 589 calendar days for a recession to arrive after the curve first inverts. (Chart 4).

Rarely do overshoots lead to soft landings. While recession has been pushed out, it is probably a question of when not if.

Past performance is no guarantee of future results. Performance prior to January 1, 2018 was earned on accounts managed at a predecessor firm, JAForlines Global. The person primarily responsible for achieving that performance continues to manage accounts at Donoghue Forlines in a substantially similar manner. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. The investment descriptions and other information contained in this Markets in Motion are based on data calculated by Donoghue Forlines LLC and other sources including Morningstar Direct. This summary does not constitute an offer to sell or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities. The views expressed are current as of the date of publication and are subject to change without notice. There can be no assurance that markets, sectors or regions will perform as expected. These views are not intended as investment, legal or tax advice. Investment advice should be customized to individual investors objectives and circumstances. Legal and tax advice should be sought from qualified attorneys and tax advisers as appropriate. The calculation and presentation of performance has not been approved or reviewed by the SEC or its staff.

The Donoghue Forlines Global Tactical Allocation Portfolio composite was created July 1, 2009. The Donoghue Forlines Global Tactical Income Portfolio composite was created August 1, 2014. The Donoghue Forlines Global Tactical Growth Portfolio composite was created April 1, 2016. The Donoghue Forlines Global Tactical Conservative Portfolio composite was created January 1, 2018.

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