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It’s All One Big Trade.

| March 18, 2024

Pick any one of these below and tell me if it is up or down and I can tell you how the rest of the markets are acting.

  • US Dollar
  • Treasury Rates
  • Nasdaq Index
  • Small Cap Index
  • Equal weight (EW) S&P 500 vs Market weight (MW) S&P 500

Pick one, any one. Let’s say you want to pick Nasdaq Index (mostly large cap tech stocks).

Here’s how it works…

If the Nasdaq is up, then the dollar is up, rates are up and small caps are down, and EW S&P are underperforming relative to market-cap S&P. I haven’t looked at all these this morning, so let’s check my thesis.

Nasdaq is UP.

 

Dollar is UP.

Interest rates are UP.

 

Small Caps are DOWN.

Equal-weighted S&P 500 is underperforming the market-weighted S&P 500.

This is how the market is for now. There are days when interest rates are down. On these days you will see this dynamic flipped. Everything that is underperforming will outperform and vice versa.

So, what to do with that? I think there’s two answers.

  • The first is to be diversified. That way you have part of the portfolio invested in all the areas, some are good on any given day, others less so. Overall, you will get a more smoothed out return profile.
  • The other answer is to take a bet one way or the other. You will either be right or wrong. That’s a bet I’m not willing to take. On a daily basis you will be a hero or a goat (and by goat, I am not referring to the overused acronym for “Greatest of all time”).

As you know, we think the markets will gradually broaden out and more companies will participate in the market’s gains. So far this year, that hasn’t so much been the case.

If you break down the S&P 500, you will see that nearly 84% of the gain has come from four stocks and over half has been from one stock. So much for the ‘Magnificent 7’. We’re apparently back to the ‘Fab 4’.

We have said in the past that a narrow market (where only a few stocks account for most of the gains) is unsustainable. That doesn't mean it can’t go on longer than we think, but ultimately the “generals” can’t lead without the “soldiers” coming along. 

If companies that buy “AI” chips from Nvidia aren’t growing, eventually they will be unable to buy more chips. That will lead to less sales for Nvidia.

Also, when there are “excess profits” in an industry, you will find other companies venture into that industry and that should lead to lower profit margins for the prior leader. It has happened for centuries and will likely continue to happen. It’s the nature of capitalism and competition, and I don’t see it going away, short of significant interference in the operation of free markets.

I wanted to discuss one other important piece to this puzzle. Much of the way the market has unfolded this year is because of interest rates backing up because inflation is stickier than the market had previously thought. Hence, the market has removed several rate cuts by the Federal Reserve from its collective forecast.

We have talked about this in many ways over the last few months. If we are to have a “no landing” scenario, there is little reason for the FED to cut rates. After all, why would they cut rates if the economy is doing just fine? They only cut rates when the economy slows down (sometimes called a recession).

Also, we made mention that inflation has averaged between 3% and 3.25% for the past 100 years. Good times and bad, high inflation and low inflation. That’s been the average.

So why is the 2% inflation target in place? Because the “academics” that run the world’s central banks were all educated the same way and suffer from severe ‘group think.’ We’ve talked about this before. It’s an arbitrary number that central banks aspired to when growth and inflation couldn’t get out of its own way after the financial crisis. Does it make sense to ‘anchor’ to that now? I would say no, but that’s just my opinion.

Finally, part of the problem the FED is having is the amount of fiscal spending the government is doing. We know that there is a roughly $2 trillion annual budget deficit and that this is projected to continue for the next 10 years according to the CBO (Congressional Budget Office). Of course, that assumes no recessions in those 10 years either (what’s the chance of that?).

And just in case you missed it, the budget just proposed by President Biden was for $7.3 trillion in spending but only $5.5 trillion in revenue. For a deficit of $1.8T. Included in that proposal was:

 

Everyone knows how expensive houses are and how much demand there is for houses. Here’s a question for you. Do you think that proposal helps more on the demand side or the supply side? I think it’s clear it creates more demand for housing, but does nothing for the supply side. If you already have a demand constraint, you don’t want to feed that with more incentives. You want to make it easier, cheaper, and faster to build more homes. So while the FED is keeping rates high to suppress demand, the federal government is trying to create more demand with incentives.

No wonder inflation is sticky! Supply stays the same but demand goes up. What happens to prices?

That’s it for today, I hope you have a great week. If you have any comments or questions, please feel free to reach out to us.

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