It’s hard to believe the first quarter is already in the books for 2023. We’ve had a much better start to the equities market this year than last, but it hasn’t exactly been a “boom cycle”. After lifting off their October lows, the major stock indices have mostly traded sideways thus far in 2023 along with the fixed income (bond) markets. There have been pockets of strength in some of the underlying sectors, namely the big technology franchises, while there has been some material weakness in other sectors such as the Financials.
It is said that banks are the lifeblood of our economy and right now, they are not all looking so good. The Fed’s unprecedented interest rate hiking campaign to combat inflation has reared its ugly head and the fact that higher interest rates mean lower bond prices has left a mark on some banks balance sheets who didn’t manage that interest rate risk so well. Also impacting this sector, traditionally, banks have made money by borrowing from depositors at lower short-term rates while lending at higher long-term rates. The spread is their profit. But lately, the markets have formed a belief that inflation will moderate in the not-so-distant future and that is keeping longer term interest rates at bay while the Fed keeps raising short term rates. With key long-term rates now lower than short term rates, the banks are facing a major headwind and that has a huge impact on the economy as they tighten up their lending policies.
One could even say this tightening of bank credit is going to do the Fed’s job for them, effectively slowing the economy to fight inflation, and that we might be one step closer to the end of this Fed tightening cycle. This would be perceived as a positive for the markets but leaves the ultimate question to be answered- Will the economy be able to absorb everything being thrown at it and avoid falling into a deep recession?
If you’ve been reading my writings for the past year or so, this really is the same question the markets have been asking all along… Will there be a recession at all, and if so, how severe will it be? Now we can add one more thing- Are the banks in trouble or are the recent failures contained to those with poor leadership and mismanagement? At this point, the latter is most likely. All of this reminds every one of the fallouts of certain banks during the financial crisis and that sentiment, no doubt, puts a cap on the market’s upside right now. I personally can’t help but remember when JP Morgan got Bear Sterns for a mere $10 per share after the firm suffered heavy losses from poor credit management. Bear Sterns was trading hands for $170 per share just one year earlier- nice bargain JP Morgan!!
While the financial media tends to pound any current issue into the heads of investors day after day, it is important to note that Wall Street only discounts the same news once! What I’m saying here is, don’t let the narrative shape your opinion, it’s already been addressed and if the current banking situation doesn’t worsen, the failures are already baked into the current market prices and we move on. What is important, is following the data as it comes out and below is a look at what’s happening.
Key Market Data
Macro: “Improving” The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2023 is 3.2 percent as of March 24, jobless claims are low and remain resilient despite the Federal Reserve’s quantitative tightening and further corporate layoff announcements. Inflation metrics continue trending lower with 5 Year Breakeven Inflation Rates hovering between 2% to 2.5% recently (The Fed is targeting 2%) . The market believes inflation is under control.
Monetary: “Restrictive” The Fed Funds rate has climbed once again to the current level of 4.75 – 5.0%, however, the Fed has changed its language following recent bank failures stating, “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” This softer tone gets us one step closer to a pivot to potentially lower rates at some point in the near future and the housing/mortgage market could sure use that with traditional mortgage rates around 7%.
Fundamentals: “Neutral” – With 2023 earnings estimates of $225 for the S&P 500, markets are trading around 18x earnings. This valuation implies mild optimism and leaves some room to the downside should future data begin to soften yet leaves some room for multiple expansion on the upside. Fundamentals can be tricky as sentiment changes. Note this is exactly the same as my January writing.
Technical: “Improving- Breaking Resistance/Downtrend Lines” – The S&P 500 crossed above the downtrend line that’s been in place since the beginning of 2022 and is currently trading between its 50- and 200-day moving averages (a neutral signal) at a time when the 50 day moving average is above the 200 day moving average (a condition Wall Street calls the Golden Cross as it implies positive long term momentum). A large base has now formed with sideways trading action since last May. Large bases can lead to massive moves once all the weak hands have been removed from the markets and the scramble to get on board takes place!
Sector Rotation: “Confusing”- Signs of a move to “Risk On” were prevailing but with the banking crisis, that has changed rapidly. Our proprietary “Essentials” (Defensive) index has stopped losing ground relative to our Non-Essentials Index which has fallen considerably while our Pro Technology & Cyclicals Index has been an outperformer. High beta stocks which were leading gave back their outperformance relative to the low volatility complex and smaller companies are gave back their gains relative to the blue chips recently. It appears investors appetite for risk has abated for the time being.
Market Internals: “Weakening”- Measures of market Breadth (or participation) are weakening recently with both NYSE and NASDQ advance decline lines and their associated volume metrics Losing ground. New 52-week lows are beginning to outpace new 52 week highs once again which is grounds for some concern. Think of market internals as a canary in a coal mine… Weak internals foretell that the “average stock” is losing ground while just a select few big manes are holding up the indexes.
Sentiment: “Poor” Investor sentiment is in the tank with some of the lowest readings ever being registered by the American Association of Individual Investors. Readings this low often lead to a market bottom. Active money managers have dialed back their stock allocations to very low levels leaving plenty of “dry powder” (cash) on the sidelines. When all this money comes back, look out above!
Seasonal: “Bullish” – April is the final month of the “Best Six Months” strategy and Wall Street’s famous saying- “Sell In May and Walk away”. Recent 21-year market performance in April and pre-election years since 1950, shows the month has been nearly perfect with gains steadily building from the first trading day to the last with only the occasional and minor blip along the way. Keep in mind that Pre-Election years have a history of solid returns as well.
Charts of interest:
- The downtrend line that formed during the bear market of 2022 has been broken, however, stocks continue to grind sideways in a trading range. A breakout above recent highs would create a series of higher highs and higher lows which is how we define an uptrend. For now, the trend is neutral.
- Longer term Interest Rates appear to be stuck in a trading range just under recent highs with false breakout in the past couple of weeks on both sides.
- Not much can really be gleaned from recent activity other than this is one volatile market for now.
- What appeared to be a rising bond market gave back positive trend attributes and is stuck in a sideways trading pattern as rates gyrate.
- Upward pressure on the US Dollar has finally given way as the uptrend has been broken.
- The Dollar Index below 105 is a healthy sign for earnings and trade in my opinion.
- The recent volatility in our currency is unprecedented.
- Industrial metals broke out of the large base and looked like they were off to the moon but that’s all reversed.
- China’s reopening has improved demand.
- Another trading range…
- With the softening dollar and the pullback in longer term yields, Gold has surged some 20% off its recent lows.
- Gold may be looking to test prior highs given all the uncertainties and positive macro set up for the precious metals.
Summary/Strategy Notes:
Recent market activity has once again suggested a rotation back to defense and as such, we have exited our positions taken late last year in High Beta, Consumer Discretionary, and small companies. We’ve also taken profits from our longer-term position in industrial stocks, all of which has significantly raised our cash balances over the past month. Lower Volatility Blue Chips, Utilities, Healthcare and Staples remain as core holdings along with last year’s addition of mega-cap Tech stocks as they are viewed as bellwethers in this environment while we maintain a hedged/neutral stance with regards to our fixed income holdings and are enjoying much higher interest rates from these securities without price sensitivity to interest rates.
I am very comfortable sleeping at night with our current allocations and the environment we are navigating. I truly believe the current narrative could improve substantially in the near future, but feel it proper to respect the headwinds we are facing at the present time with a defensive tilt. Should the banking issues prove to be just a few “bad apples” and we begin to see financial policies ease while the economy keeps chugging along, I see no reason 2023 won’t turn out to be a good year. These things take time to work themselves out and it feels like it’s been doom and gloom forever (It’s been a little over a year!), but I can assure you we are much closer to the end of this rout than the beginning.
Should you wish to discuss the current markets, our strategy, or just touch base to see how things are going, please don’t hesitate to reach out to our office @ 843-651-2030. Also, feel free to share these newsletters with your friends and family via email and visit us on our website at www.sabowealth.com or www.facebook.com/sabowealth.
Important Disclosures: Past performance is not a guarantee of future results. The statements contained herein are solely based upon the opinions of Edward J. Sabo and the data available at the time of publication of this report, and there is no assurance that any predicted or implied results will actually occur. Information was obtained from third-party sources, which are believed to be reliable, but are not guaranteed as to their accuracy or completeness.