The Stock Market Is Vulnerable, But On Solid Footing

Short-term headwinds for stocks

I have written a few times recently on the short-term headwinds arising for the stock market following two consecutive quarters of positive price action and what has been a terrific six months for risk assets. Pull-backs and even 10-15% corrections are a normal part of bull markets, and when sentiment and positioning across all risk assets become as extreme as it has in recent weeks, markets generally need to go lower before they can go higher.

For the most part, investors have been underweight stocks to a fair degree since mid-2022 and it appears only now we are seeing capitulation to the upside. All of a sudden, sentiment and positioning are no longer wholly supportive of the stock market.

Sentiment gauges such as the AAII Bull-Bear spread and NAAIM Exposure index have recently reached cycle highs.

While speculative positioning across all major stock market indices (inverse of commercial hedger positioning below) has recently spiked to its highest level since early 2022.

Speculative furore across the board has risen notably of late as everyone has been piling into the market. This has seen S&P 500 margin debt grow to its highest levels since 2021. Such rapid growth in margin debt to such levels generally marks short-term tops in markets.

While the outlook for the business cycle remains relatively robust and supportive of corporate earnings (as we shall see shortly), it is important to remember the broad stock market indices (notably the S&P 500 and Nasdaq) have already priced-in much of this favourable outlook.

We can see this dynamic again below when looking at the outlook for EPS growth. The outlook for earnings growth remains fairly positive (and should continue to be so as lending standards ease), but much of this is already in the price.

What’s more, we have seen some stagflation-like data come in of late. This leaves the markets vulnerable to a repricing to the downside, if only minor. My various short-term growth versus inflation asset allocation quadrants are currently flagging a stagflation environment, which is generally less favourable for the stock market. I suspect we will fluctuate between reflation and stagflation for the rest of 2024.

Another important support to risk assets over the past 12-18 months has been liquidity. Both global M2 and net liquidity bottomed in late 2022/early 2023 and have been growing since. However, we now appear to be reaching a point where the major equity markets in the S&P 500 and Nasdaq which are most sensitive to liquidity have become somewhat overextended relative to the actual underlying expansion in liquidity, as we can see below.

What is perhaps more worrisome from a liquidity perspective over the coming few months is chaining debt issuance dynamics announced via the Treasury’s Quarterly Refunding Announcement (QRA) this week. Without going into too much detail, when the Fed is undertaking QT and the US Treasury issues a greater level of longer duration bonds relative to shorter dated bills to fund their deficits, it’s generally unfavourable for markets as it sucks liquidity out of the financial system by reducing commercial bank reserves as the longer dated bond issuance cannot be met from the Reverse Repo facility. This is exactly what the Treasury intends to do over the coming quarter or two, thus the Fed’s Reverse Repo Facility is unlikely to be used to offset these negative debt issuance dynamics like it has done over the past year.

As such, this is headwind markets must navigate over the coming few months, at least until we see the Treasury General Account drawn down (likely to occur later this year as we approach the election) such that it offsets these less favourable issuance dynamics. This QRA dynamic also has the potential to be a headwind for longer dated bonds, as we will see an increase in the supply of duration.

In addition, we are also entering what is generally a less favourable period of the year for the stock market. The June options expiration cycle in particular looms as a window of vulnerability to which the market could pull-back or consolidate.

For the rest of 2024, the outlook for stocks remains positive

While it’s clear there are some shorter-term headwinds facing risk assets over the coming few months. It is true the market remains on solid footing from a growth and liquidity perspective over the medium term. This is very much what my longer-term stock market indicators are signalling. As such, there is every chance markets continue to march higher into mid-year and beyond in the face of these short-term headwinds.

Central to this supportive backdrop from stocks is the robust outlook for the business cycle. My work suggests the cycle bottomed sometime between late 2022 and late 2023, with growth reaccelerating to the upside for much of the past year. The leading indicators of the business cycle continue suggest the rest of 2024 should see some upside economic growth. It may just be a case growth does not accelerate to the same degree it has done over the past six months.

The primary longer-term risks to markets in which we are slowly starting to see show up in the data is a re-acceleration in inflation. I have been suggesting for some time now inflation would likely bottom in late 2023 (at least on a headline basis). The data has been very supporting of this thesis thus far in 2024. And, as we can see below, we should continue to see upside inflationary pressures show up from a goods and food perspective.

But we must also be cognisant of the outlook for services inflation, particularly from a wage growth and Owners’ Equivalent Rent perspective. We should see both continue to decline over the next three to six months.

A key driver of this dynamic will be continued wage growth deceleration, which looks increasingly likely for the rest of 2024.

All my leading indicators of wage growth are pointing to further declaration from here, just at a slower pace than what we have seen in recent months.

As a result, I don’t see inflation moving materially to the upside until much later in 2024. What we will see though is Headline CPI bottom at a structurally higher level than anything we have seen in recent decades. As such, the growth and inflation outlook for the rest of the year should be relatively supportive of markets, just to a lesser extent than they were in 2024. The real risks around stagflation are probably more of a story for 2025.

This relatively favourable outlook for wage growth should also give the Fed scope to maintain the dovish stance it so badly wants to take. I don’t see a path to more than one or two rate cuts, but I think it’s fair to say rate hikes are out of the question for the foreseeable future. Again, that is probably a story for later in 2025 than it is 2024. The acceleration in employment growth we are likely to see as we progress through 2024 lends some credence this notion, but is not anything policy makers need to worry about right now.

Another dynamic which could offer reprieve for risk assets globally is the potential for cyclical dollar weakness. I have been a dollar bull since mid-2021 for a number of reasons but am now beginning to turn bearish toward the greenback over the medium-term.

Recent dollar strength has been a notable headwind for stocks, and will probably continue in the short-term should the market correct.

But we are approaching the end of QT and reaching a point where foreign central banks (i.e. the BOJ) are looking to intervene in order to stop their currencies depreciating. In conjunction with these dynamics, the potential we see global growth start to outpace US growth suggest the fundamentals could start to swing the other way for the dollar. Dollar positioning is also beginning to turn somewhat unfavourable, meaning sustainable dollar upside is likely to be difficult from here.

Putting it all together. We are a situation where a number of short-term headwinds are present for the stock market. Stretched positioning and a liquidity air-pocket could see markets undergo a few months of consolidation, or even a pull back like we saw in August through October last year.

For the rest of 2024, the market remains on solid footing, with robust economic growth likely to support risk assets. But investors should be cognisant of what markets have already priced in, and realise that much of the easy money has probably been made for this cycle, so looking to allocate capital to quality sectors and businesses whose backdrop is supported by solid fundamentals should reap rewards for the foreseeable future. The outlook for commodities relative to growth stocks continues to also look appealing.

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