Santa Claus Rally Nearing 2023 Climax

The benchmark S&P 500 Index just completed its 6th straight week of gains for the first time in 4 years. US Homebuilder stocks are hitting all time records. The German stock market is breaking above its highs again, despite a weak European economy. Oil prices have fallen for 7 straight weeks, for the first time in 5 years, sending interest rates sharply lower. However, the top investment houses, such as JP Morgan and Morgan Stanley, expect a weak economy and lower stock prices in 2024. After 20% gains this year in the S&P and 12% over the past 6 weeks, it would be understandable to expect some reversion to mean in the equity markets, if not for the fact that these esteemed forecasts are similar to their paltry prognostications at this time last year. For 2023, every major wealth management institution had forecasted equity markets to be moderately to severely beneath current levels. The top of their trade strategists have at least dropped the traditional high unemployment recession call from their 2024 outlook but continue to expect a pronounced economic slowing that will restrain business earnings and stock valuations over the next couple of quarters. At some point broken clocks will arrive at the correct timing, but the uninspired proxy indicator analysis used by the majority of the investment elite is frequently fodder for other armchair analysts and pajama traders. Until corporate earnings and the economy (GDP) encounter a couple quarters of contraction, it’s unlikely that these historically torpid fence sitting advisors will change their cautious tone, leaving the due diligence to others that can offer insight. While our own expectations for 2023 in mega capitalization technology stocks have been exceeded and the profits from defensive and small cap have fallen short, we maintain a positive outlook that will witness rotational growth in stocks over the next year, once again. As long as the labor market is relatively tight with only moderately evolving slack, then fully employed consumers will consume at a more normalized pace until economic supply and demand find a long overdue equilibrium. Over the short term, with the SP 500 Index touching 4 month highs, we have entered an expected topping zone in the 4600’s for the month.

As we have illustrated since Q4 2022, home affordability is the worst in modern history. While it hit another record extreme in October and home sales are subdued, the single family and rental housing stocks stay surprisingly healthy. Inventories are low, housing stock valuations are reaching new record highs and residential construction employment is currently at a 16 year peak. We have not participated in this sector, but it has been a profitable, although volatile, area to invest in. Our forecast continues to expect a prosperous housing market until mortgage rates fall to a level with a 4 or 5 handle. This will occur once inflation falls <3%, at which point pent up supply will surge from the voluminous existing home sector that has been locked in due to 23 high mortgage rates. The first half of 2024 should be the final peak for housing stocks for the next year or two.

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Home buyers should not bet on price appreciation over the next few years. 

Outperforming the US equity market, the German stock indices keep running to new record highs this year despite a modest economic contraction in Europe’s premiere economy over the past 12 months. Record equity prices in Germany are mirrored throughout European countries. This appears to be far from the dire Bear market that consensus expected. Like the US, European labor markets are relatively tight, with near record unfilled job openings today in France. This falls a bit short of the foreboding 2023 consensus outlook from last year. Unfortunately, human nature applies to Ivy League analysts whose predictions and advice are imbued by the recency and frequency of past events. To paraphrase famed Morgan Stanley manager Barton Biggs, ‘it’s human nature for investors to be fighting the last war’. Another way of saying, the past is prologue regarding financial forecasts.

Another trend we mentioned where almost every analyst has used lazy analysis has been in the energy sector. Heavy fund flows were flooding to petroleum related stocks in Q3 when Oil prices were $90/barrel and energy stocks were testing record highs. For most it seemed logical that above consensus economic growth in the US, low inventories and OPEC+ production cuts would necessitate higher prices. In our newsletters and interviews at the peak, we said this was the only sector we explicitly advised avoiding until the winter. Our outlook was based upon a combination of seasonality, overbought sentiment and expectations that our economy would begin decelerating. Additionally, the manner in which positive news events were greeted by fleeting shooting star rallies was a tell by the silent majority that Natural Gas and Oil had downside risk. Since our September call, the energy index (XLE) fell 14% while virtually all other stock indices moved higher. While we wouldn’t rule out another dip into the $60’s/barrel in Q1 2024, Oil and Natural Gas should begin a bottoming process in December.

The myopic analysis by our nation’s leading wealth managers was also exemplified by their adherence to proxy indicators for the economy, earnings per share and the stock market. The Leading Economic Indicator index (LEI) and its technical tool cohorts such as Purchasing Manager (PMI) surveys and Inverted Yield Curves have virtually 100% accuracy foretelling a major economic recession. These provisionary gauges would normally indicate that at this juncture we should be near the nadir of a decline in corporate earnings, stock prices and employment. Yet, today’s stock valuations are robust, business earnings are at record highs, and we have full employment while always waiting for the other proverbial shoe to drop. Mainstream analysts don’t understand the lingering effects of the massive Covid stimulus and that manufacturing surveys expecting contraction merely reflect a reversion to normalcy as production slows to a more sustainable pace. They don’t see the context of the uninverting of a deeply inverted yield curve is due to a deceleration from unsustainable consumption, rather than economic pain. Whenever LEI has been at current levels (see below), we are either months into a recession or at the end of one. The dreaded famous last words of “this time is different” apply here.

There are signs of economic slowing, which can be a good thing, but consumers and businesses in general have yet to exhibit signs of worrisome stress levels or defaults. Credit spreads are an excellent barometer of distress and vulnerability in the economy and the stock market. The lack of hardship today is amazingly positive in this high inflation environment. Perhaps most of the declining credit risk has been factored into investor sentiment near current levels, but until the credit spread downtrend turns decidedly higher, it’s unlikely an economic or stock market collapse is knocking at our door.

A major challenge for investors is knowing where to invest and when the next equity sector rotation will occur. In 2022 mega cap tech stocks like GOOGL, AAPL, MSFT and META fell 30 to 80% at their lows only to recoup all of those losses this year, thanks to Nvidia’s Artificial Intelligence (AI) tailwind.  The valuation gap between most stocks and the handful of large cap companies that dwarf the rest of the stock market has never been greater. This tech outperformance has provided false confidence that Trillion-dollar companies can grow faster than the broader market in an undiversified portfolio forever. Small cap, healthcare and more conservative stocks were threatening new multi-year lows just 6 weeks ago, while the elite members of the technology club have pushed to record highs. The AI boom is in its infancy, so capital inflows in this space dominated by MSFT, NVDA, AMD, ADBE, AMZN, GOOGL … will continue, but these companies are unlikely to elevate their valuation multiples or accelerate earnings at a faster pace than 2023 and rely more upon long term profit trends. Small cap and healthcare however, have room to not only grow earnings but the capacity to increase their price to earnings (PE) multiples to better leverage an overdue profit rebound. They have been cutting costs and suffering during the high interest rate environment of the past 2 years. Now that inflation is 75% of the way to the Fed’s 2% target, long term rates can fall and these stocks should increasingly benefit more than the sectors that have already had a year of stellar growth in profits and expectations. 

We could still be weeks away from a serious correction, but some warning signs are creeping in. Numerous indicators hint that we are in the final push to new 2023 highs in the SP and Nasdaq before the red light flashes for a month long correction. This DeMark Symbolic chart of the Dow is showing signs of froth, while other indices need more time. 

The ExecSpec sentiment chart at the top of the page and daily chart below indicate we are just now entering the “short term” irrational exuberance zone. Longer term we remain Bullish and plan to utilize market pullbacks >4% to buy. While 5.3% risk free money market and municipal tax free Treasuries are valid holdings for 10 to 20% of the average equity investor portfolio, we will use dips to increase diversification into laggard sectors of small cap, healthcare, utilities, and some financials as interest rates should continue on a gradual rollercoaster journey lower in 2024.

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