Heading Into the Bottom of the 9th
In our opinion, the issues during the Great Financial Crisis were a generational event, just like the Great Depression. The price action of the market in 2008 and 2009 was so severely adverse from historical averages that we should only expect to see this type of weakness once in our lifetime. So, as we celebrate the fifteenth anniversary of the March 2009 bottom and fifteen years of an incredible market run, we are now of the opinion that we are heading toward a more challenging period for stocks.
Expecting a more challenging market does not mean that we are expecting massive losses, bankruptcies, and bailouts associated with the Great Financial Crisis. It means balancing the growing negative evidence that we are seeing in the economy without getting too out of sync with the market. After 25 years in the business, we do not need to seek out attention by making ego-boosting bold market calls, such as calling the next great market top. To us, it is much more important to understand and respect the market environment so that we can better manage the days ahead.
The stock market can undoubtedly continue to move higher, which we expect over the next few months, with more volatility than we have seen recently. But we are now at a point in this extended run where the underlying fundamentals of both the economy and individual companies are starting to negatively diverge. Also, we know the market cannot continue to go up forever, and at some point, the ‘buying the dip’ market mentality that we have become so accustomed to is going to temporarily stop working. As we move forward from here, as a firm, we will become a bit more guarded in our mindset and lean more toward a non-cyclical, defensive exposure in our investments.
Speculation Going Parabolic
Since the short-term market bottom in October of 2023, we have seen several parabolic moves across the market as speculators have continued to pile into certain asset classes. You could have said the artificial intelligence space has been going parabolic for about a year now, but of late “AI” related stocks have kicked into a new gear. There are darling AI-related stocks that investors seem to believe will never go down, no matter how pricey they have become. Most notable of late has been Super Micro Computer (SMCI), which has rocketed by almost 300% through the first ten weeks of 2024. While the company has delivered substantial financial improvements over the past few quarters, the share price has decoupled from the company’s underlying fundamentals, leaving momentum as the key driver for the shares. This type of parabolic price action is consistent with a topping phase in the market and in individual names that typically leads to sharp price reversals once all the buying ends.
Not Tech Bubble 2.0
During the 2nd half of 2022, many market experts were comparing the current pattern of the S&P 500 vs. the pattern of the index in 2007 & 2008. These experts then used the comparison to speculate that the investors should expect to see a significant drawdown in late 2022 and early 2023. While this comparison offered some interesting reading, and we assume it raised the fear level of several individual investors, the comparison crash never appeared. Now as we move into the third month of 2024, we are starting to see the same type of chart comparison, this time comparing the last few months with that of Tech Bubble over the first few months of 2000.
While we cannot deny that when you compare the Nasdaq from early 2000 with its performance over the last few months, the patterns match up well. For most investors, that is about as far as they should read into this comparison. We can present several reasons why the recent market trends do not mirror the Tech Bubble era. One of our primary daily indicators, known as cumulative breadth, readily refutes the notion that the present market will replicate the Tech Bubble phenomenon.
Breadth is the daily number of advancing issues minus declining issues for each index. When these numbers are repeatedly added to the previous day’s breadth data, you develop cumulative breadth. Typically, when a breadth indicator is rising, and the stock index is rising, it shows there is strong participation in the price rise. This means the price rise is more healthy. The same principle applies to a downtrend. But, when the breadth indicator and a stock index diverge, meaning fewer stocks are moving in the stock index's direction. This means the stock index could be setting up to change direction
When we look at it from the cumulative breadth of the NYSE (our favorite breadth indicator) today and compare it against early 2000, these two markets could not be more different. Back during the Tech Bubble, NYSE cumulative breadth presented a massive negative divergence which would have saved many investors from losing capital if they paid attention to it. Today there is no divergence, and the NYSE cumulative breadth made a new all-time high last week. The market usually does not run into much trouble when NYSE cumulative breadth is making all-time highs.
The chart below shows the NYSE cumulative breadth reading between 1997 and 2001, compared to the Nasdaq Composite Index. The NYSE breadth topped out in early April 1998 and then continually declined over the next two years, finally bottoming out in March 2000. As the chart shows, over the same period the Nasdaq Composite Index rose by a massive 275%. So, while the NYSE showed a consistent period of selling for two years, the Nasdaq was in the middle of its greatest run-in history. This was a huge negative divergence at the time which many investors could have benefited from knowing. Today the NYSE cumulative breadth index is at an all-time high, so we do not expect the current market to collapse in a similar fashion to the Tech Bubble over two decades ago.
March Market Expectations
In non-election years, March is usually slightly better than the average month for the market, but for some reason, during election years, the month tends to be one of the weakest months on the calendar. Admittedly, the seasonal performance of March in election years has been affected by the Inflation Crash in March of 1980 and the more recent Covid Crash of 2020. The performance of the S&P 500 in both March of 1980 and March of 2020 are two of the top 10 worst-performing months for the index over the last half-decade. While we are not anticipating a double-digit decline for March 2024, we are expecting volatility to increase over the next few weeks and continue into the first part of April.
One of our timing indicators, which is developed using the commitment of traders’ data for the Secured Overnight Financial Rate (SOFR) - a broad measure of the cost of borrowing cash overnight – is showing that we should expect some market weakness over the coming weeks. This indicator tells us to expect additional market volatility and a negative price bias from the second week of March through the second week of April. Whether we are using the Commitment of Traders data for the SOFR futures or the similar 30-Day Feds Funds futures, the primary key takeaway from these types of indicators is that they provide us with an expectation of market direction and volatility, they do not provide insight into the magnitude of expected moves.
Money Flows
As always, at the top of this list is our Money Flow data which measures institutional buying and capital "flowing" into stocks. While our timing indicators suggest that we should expect some volatility ahead, the simple fact that more than 73% of the stock in the S&P 500 had positive daily money flow at the end of February gives us confidence that any market weakness over the next month should be well-contained and short-lived. Like with the NYSE breadth, money flow is currently not diverging from price action.
From here on out, we do expect volatility to pick up and to see much wider swings in the market than we have seen over the last five months. We also expect the market to begin to pay attention to the underlying weakness we are seeing in the economic data. Our base case assumption is that over the coming months, we could see a final blow-off top in the indices... one of those periods where it feels like the market will go straight up for an extended period. If this should occur, we will declare the exuberance as a signal for a significant turn in this market. Remember that this is our "base case" for the next twelve months. Once we get through our short-term issues, we believe the long-term Tech/AI-driven economy will get back to firing on all cylinders.
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