Over the past few weeks, equities have largely moved sideways. But it is not just the past few weeks that have been a wash. Zooming out on the S&P 500 shows that it is now trading at roughly the same level as it was in May of 2021 and May of 2022. In short, US equities have been consolidating over a shorter timeframe and a much longer timeframe… potentially setting up a large move. (Chart 1)

So, this begs the question – what’s next?

With the market going nowhere, it is not a shock that there are conflicting narratives.

The bullish one is rather simple – the Fed could be done raising interest rates. The Fed hiking cycle at least appears to be nearing its end… inflation is moderating, and growth has held up to this point. The market has begun to price in this “soft landing” scenario. Despite being at levels it was two years ago, it has broken a downtrend that started at the beginning of 2022 (see previous chart). Better yet, longer dated bond yields have stopped rising, and Fed fund rate futures are pricing cuts by the end of this year. (Chart 2).

While the bullish narrative appears to be forming, and we suggested this scenario earlier in the year {Feb MIM}, we still believe there are highly plausible factors of the market facing strong downside risk.

Tighter Federal Reserve

The Fed has raised interest rates 500 basis points in a historically short timeframe. The effect of these hikes’ filters through the economy with a lag. And the economy and financial system are already showing cracks. After SVB failure, the Fed injected $400B into the system. As it did this, the “liquidity stars” of the last bull market – META, APPL, MSFT, GOOGL, AMZN, NVDA, TSLA – all soared. Yet, the Fed has now actively withdrawn support and its balance sheet has shrunk by $230B in recent weeks. Even more, it’s not a foregone conclusion interest rate policy has pivoted. A big risk could be hotter than expected inflation prints.

Lack of Breadth

Much of the YTD rally in the major indices has been narrow, confined to the monopolistic tech stocks (up ~61%) previously mentioned. These companies are trading at a 30x PE vs. 17x for the rest of the S&P. There are plenty of headwinds to these valuation multiples and while aberrations can continue for a while, it seems implausible the market can rely on this narrow a group of stocks for much longer. The equal weight S&P 500 index remains flat on the year and narrow rallies are rarely a sign of a healthy market. To illustrate, this chart (chart 3) shows the trailing three-month performance of S&P 500 components on a rolling 50-component basis starting with the 50 largest and moving all the way down to the smallest 50 stocks in the index. While the 50 companies with the largest market caps are up an average of 9.18%, the 50 companies with the smallest market caps are actually down an average of 10.8%.

Debt Ceiling

While many believe that the impending debt ceiling crisis will be averted, if Republicans and Democrats fail to find a compromise solution, it is hard to see this not triggering a risk-off event.

Recession

Recession is the most important domino in all of asset allocation. Recession bells have been ringing for months now, but a combination of fiscal policy and labor market have prevented the 2022 bear market from causing a recession. However, with a deeply inverted yield curve (Chart 3), it is likely a question of when, not If, we enter a recession. 2023 will be defined by the economy and asset markets digesting the lagging effects of the Fed’s aggressive monetary tightening.

Investment Implications

It would be very on brand for stocks to melt up into recession, right before a hard landing. For example, the S&P 500 rallied 11% in the two months after Beat Stearns collapsed in March of 2008. Currently, the S&P 500 is up 7% since the collapse of SVB.

We believe we could continue to see that same phenomenon, but ultimately, we will see more pain in the market and economy, especially before the Fed begins to cut rates. Therefore, our positioning remains relatively neutral, with an eye on downgrading risk assets in the near future. Before this bull market has a firm bottom, we will see more shocks to the system. Tactical management is more important than ever for client portfolios.

Recent Portfolio Changes

No changes this month.

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