SPY: Is a Correction on the Horizon?

Throughout 2023, the U.S. stock market experienced several micro-cycles. From January to July, the SPDR S&P 500 ETF Trust (SPY), which tracks the performance of the S&P 500 index, advanced over 19% on a total return basis. However, in late October, nearly half that momentum had withered, with the Index briefly plunging into correction territory, indicating a 10% decline from July's peaks.

The rising bond rate between late July and October contributed to the recent correction. The three-month period provided an adequate opportunity for investors to pivot away from stocks. Adding to the investors’ worries was Chair Jerome Powell’s comment: “The question of rate cuts just doesn’t come up.”

October witnessed the weakest performance in the S&P 500 since 2018 – its third successive month of contractions. This decline was perhaps predictable, considering the economic forecast concerns, stubborn inflation rate, prolonged apprehension over Federal Reserve policy rates, and geopolitical turmoil.

The financial picture brightened in November when stocks rallied robustly, nearly restoring the S&P 500 to its July peak. Making an impressive rebound in just 16 sessions, the S&P 500 effectively exited its correction phase, marking the swiftest turnaround since the 1970s.

As evidence of an overheated economy finally began to cool, investor tension eased, and the S&P 500 got a significant boost, surging by 8.5%. This surge brought its progress close to a 20% year-to-date increase, coinciding with the 10-year Treasury rates plunging below 4.5%.

Furthermore, another lower-than-expected inflation reading offers a flicker of hope that the contentious battle against inflation might soon abate.

As the Thanksgiving holiday curtails November's U.S. trading week, investors are waiting to see if this resurgence in the stock market will endure until year’s end.

So, is the pathway clear?

While drawing definite conclusions could be too soon, let’s look at some promising indications suggesting the rally could persist until the close of the year…

After the Fed’s 20 months of stringent monetary policy tightening, it remains unclear to officials if the financial conditions are sufficiently restrictive to control inflation – a rate seen as surpassing the central bank's 2% target.

Despite this uncertainty, the Fed maintains interest rates within the expected range of 5.25%-5.50%. Chairman Jerome Powell has not dismissed the possibility of further monetary tightening, leaving markets to ponder possible future actions of the Fed.

Forthcoming economic indicators will primarily guide decisions regarding future rate hikes. Depending upon inflation trends, there is potential for introducing interest rate cuts during the second quarter of 2024 or the following months.

If the Fed successfully facilitates a "soft landing" for the economy, implementing rate cuts while avoiding a recession, this could potentially set off a stock market rally. Conversely, investors might encounter unexpected skepticism if economic growth continues at its current pace and inflation returns in the following months.

Consumer spending is paid attention to, which, till now, has been crucial for sustaining economic growth amid climbing interest rates that often lead to economic slowdown. Historically, November has proven to be a strong month for the S&P 500, with an average yield of 0.88%, making it the third most lucrative month.

Historically, the S&P 500 recorded positive returns 68% of the time during Thanksgiving week, an achievement exceeding the average week. The sales recorded during Thanksgiving and Black Friday act as a barometer of market sentiment. Strong retail figures may herald the beginning of a robust shopping season, potentially boosting stock prices.

U.S. consumer spending accounts for about 70% of the economy. However, core U.S. retail sales registered a marginal increase of just 0.2% in October as higher borrowing costs and persistent effects of inflation curbed spending, leading to struggles for retail stocks. An uptick in sales could lay the groundwork for a December rally.

Displaying a notable robustness, the U.S. economy has continued to grow at over 2% annualized pace in the first and second quarters of 2023, surging to a 4.9% annualized growth rate in the third quarter. There is additional optimism as the GDPNow forecast for the fourth-quarter GDP has been revised upward to 2.1%.

Favorable economic circumstances like a robust employment market coupled with a resolute trend in consumer spending have contributed significantly to the sustainability of this positive economic momentum. Corporate earnings, too, reflected optimistic trends in the third quarter, a sign that economists regard as propitious.

Analysts are hopeful for a mildly favorable turn in earnings moving forward. While current economic metrics remain somewhat subdued, they do not signal an impending recession. Consequently, the equity market remains a scene of active engagement.

However, should investors be more cautious? Quite likely. Let’s understand why…

This year's most optimistic occurrence was when the small-cap stocks in the Russell 2000 significantly eclipsed the returns of the SPY. Especially notable is the seemingly undervalued status of the small-cap index, which further intensifies with prospective Fed’s interest rate cuts scheduled for the first half of 2024. Historically,  debt-heavy small-caps perform well during Fed-induced rate reductions. Consequently, small-caps could potentially witness a significant boost as investors begin to speculate on the completion of the Fed's interest rate hike cycle.

The sign of an assuredly bullish market is the heightened risk appetite, funneling investors toward smaller, growth-oriented companies. This pattern aligns with the traditional long-term advantage of small caps over large caps, an edge not witnessed in recent years.

However, certain risks continue to loom. Most significantly, small-caps' vulnerability to recessions.

Despite Russel 2000’s attractive valuation, large-cap stocks have carried on their ascent while small caps are again underperforming, sparking questions regarding the genuine bullish nature of this market.

SPY’s promising gain offers encouragement. This arises from the fact that it's challenging to maintain a confident bullish stance when all the gains are primarily accruing to the so-called ‘Magnificent 7’, previously known as FAANG. These stocks have mainly driven the market-cap-weight gain in the S&P 500 in recent years, leaving the rest of the stock and bond market on the sidelines.

Over the past year, one prevalent error among investors was underestimating the potential rise in price-to-earnings multiples, particularly for large-cap and mega-cap stocks like those comprising the ‘Magnificent 7.’

Furthermore, the era of viewing stocks as the sole viable investment option has waned. For the past two years, investors have experienced attractive returns through bonds or even by allocating a portion of their portfolio to a money-market fund, with several offering yields exceeding 5%.

Bottom Line

Within just three weeks of November, a significant shift occurred — from initial skepticism about the bull market's validity to witnessing its first correction and ultimately seeing the S&P 500 Index rise to a new historical peak. A swift recovery saw stocks rise again, erasing the memory of the recent correction.

Every sector within the S&P 500 Index closed in positive territory, with more cyclical and economically sensitive industries leading the charges. This demonstrates the enduring expansion and robustness of the bull market, which, up until recently, has primarily been propelled by the strong performances of ‘Magnificent 7.’

With the current bullish trend and the anticipated positive impact of the holiday season, stocks could maintain their rally, even reaching previous high levels.

Bank of America Corporation's strategists suggest that due to U.S. companies' resilience in dealing with higher rates and macroeconomic disturbances, the S&P 500 is on track to reach a fresh peak in 2024. Meanwhile, RBC's projection for the SPY's EPS in 2024 stands at $232, indicating a promising trajectory for additional gains in the coming year.

However, the existing price of the index appears to already factor in the expected recovery in the SPY's forecasted EPS for 2024. Therefore, it may not be sufficient to drive the index's growth at this year's remarkable pace. It should also be noted that potential factors like a recession or emergent political or geopolitical unrest could pose further complications. Therefore, investors should tread with caution.

A Depressing Situation

A year and a half before the election, and a little less than a year before the first primary, the Wall Street Journal is already proclaiming that “Another Biden-Trump Presidential Race in 2024 Looks More Likely.”

Doesn’t that get you excited?

It’s pretty sad that out of more than 260 million adults the best the two parties could come up with is the current president, octogenarian Joe Biden, and his predecessor, Donald Trump, who is 76.

And advanced age isn’t their only drawback: both are, shall we say, not very popular.

Yet only a few people, so far, seem to have the guts to stand up and challenge them—no serious Democrats so far and only a handful of Republicans. But it’s early yet, so let’s not lose hope that others will step into the ring.

As Winston Churchill is credited with saying, “Democracy is the worst form of government, except for all the others.”

There are good reasons why the best and brightest people shun politics and have no desire to be president. Politics played at that level is an ugly sport. Few smart and ambitious people want to put themselves or their families through that. It’s a lot more lucrative and less painful to be CEO of a large corporation than to sully your name in politics. It’s also a lot easier to look yourself in the mirror every morning.

If you are willing to mix it up and eventually succeed into the Oval Office, you often have to do things you may not be proud of. In the spirit of “compromise,” you often have to lie and make empty promises—or worse—in order to get a fraction of what you really wanted. So it’s understandable why the government often botches things—we never get the best people or the best policies, so problems just seem to fester and get worse.

Which brings me to my point and how it applies to the Federal Reserve. Continue reading "A Depressing Situation"

What Happened To Reducing The Fed’s Balance Sheet?

Over the past year the Federal Reserve has driven up interest rates by nearly 500 basis points in its quest to try to tamp down inflation.

From a range of 0.25%-0.50% back on March 17, 2022, the Fed since then has steadily raised its target for its benchmark federal funds rate to 4.75%-5.00%, with the possibility of more to come. Over that time the Fed has raised rates nine times—four times by 75 basis points, twice by 50 bps, and three times by 25 bps.

At its two most recent meetings, in February and March, the Fed raised rates by only 25 bps each, possibly because it saw fit to take a slight pause and measure the effect of all these rate increases to see if they are having the desired effect of slowing the economy in order to bring down inflation.

Of course, as we know, the rate hikes haven’t done a whole lot in reining in inflation.

Rather, they created a panic among some fairly large regional banks that has unsettled the entire banking industry, the effect of which has done more to slow the economy than raising rates has done.

Should the Fed then say that the ends justify the means, even if the means—creating the panic—were totally accidental? Should the Fed now brand its “policy normalization” program a success even if a couple of banks failed in the process? Let’s hope not.

This fiasco does call attention to the other prong of that normalization process, namely a reduction in the Fed’s massive balance sheet, which was supposed to help raise long-term interest rates gradually and lessen the Fed’s presence in the U.S. economy.

On that score, there has been negligible progress.

Back in the good old days, before the 2008 financial crisis, the Fed’s balance sheet never totaled more than $1 trillion, a figure that now looks fairly quaint, yet it was a mere 15 years ago. Continue reading "What Happened To Reducing The Fed’s Balance Sheet?"

Opportunity To Get Ahead Of The Curve?

At the end of March, interest rates now sit at 6.32% average across the country for a 30-year fixed rate mortgage. While this is lower than a few weeks ago, they are still much higher than a year ago.

The cause is that the Federal Reserve has been raising rates aggressively over the last year to fight persistently high inflation. The Fed's goal of raising rates is to slow the economy and bring inflation back down to a normalized level or target goal of 2%.

Raising rates makes large capital expenditures for businesses or individual households more expensive, thus creating a situation where it is no longer affordable or makes good business sense to make those investments.

Fewer large investments or fewer new homes being built because the financing costs of making those purchases are too high will eventually slow the economy and thus bring inflation down.

While we all want inflation to come down quickly, it takes time for high-interest rates to flow through the system and change business leaders' and households' decision-making.

Furthermore, there is a rather big delay with the economic data that tells us how the economy is performing and whether or not large investments, home purchases, and overall spending is slowing.

This all means that when we realize business leaders-consumers have changed their minds about what investments and purchases are worth making, the economy is already slipping.

If we now look strictly at the household side of the equation, it seems clear that this group is heading toward tough times in the not-so-distant future, thus making the idea of a new home purchase much less likely.

First, we have high inflation. This is making everything across the board more expensive. Consumers' average cost of living is increasing, whether it be groceries, child care, transportation, or clothing. Continue reading "Opportunity To Get Ahead Of The Curve?"

Did The Fed "Pull A Homer"?

In an early episode of The Simpsons, “Homer Defined,” Homer saves the nuclear plant from meltdown by randomly pushing a button on the control panel. Soon “to pull a Homer,” meaning to “succeed despite idiocy," becomes a popular catchphrase.

Is that what happened last week? Did Jerome Powell and the Federal Reserve inadvertently “pull a Homer” by helping to create a bank panic that actually might accelerate their desire to slow down the economy? That might not have been their intention, but it sure looks like it.

At least it does to former White House adviser and Goldman Sachs President Gary Cohn (although he didn’t reference The Simpsons).

"We're almost getting to a point right now where he's outsourcing monetary policy," Cohn told CNBC, referring to Powell. “I don't believe they [the banks] are going to loan money, or as much money, and therefore we're going to see a natural contraction in the economy.”

Minneapolis Fed president Neel Kashkari said basically the same thing on CBS’s Face the Nation Sunday.

"It definitely brings us closer [to recession]," Kashkari said. "What's unclear for us is how much of these banking stresses are leading to a widespread credit crunch. That credit crunch ... would then slow down the economy.”

Now, I sincerely doubt that the Fed deliberately phonied up a banking panic in order to put the brakes on the economy.

Just the same, though, it certainly did play a major role in creating one not just through monetary policy — by raising interest rates so high and so fast — but also through neglect.

Just as it did in the road leading up to the global financial crisis, the Fed allowed problems at several banks it regulated to reach the point that generated an electronic run on deposits and the banks’ eventual failure. Continue reading "Did The Fed "Pull A Homer"?"