The Market Mosaic 3.3.24
S&P 500: Room to run?
Welcome back to The Market Mosaic, where I gauge the stock market’s next move by looking at macro, technicals, and market internals. I’ll also highlight trade ideas using this analysis.
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Now for this week’s issue…
Despite the most restrictive monetary policy in over 20 years, risk assets like stocks and cryptocurrencies are charging higher.
Last week’s PCE inflation report for the month of January showed a year-over-year increase of 2.4%, continuing a trend of moderating inflation levels among the Federal Reserve’s preferred inflation gauge.
But despite progress on the inflation front, investors are quickly dialing back expectations for interest rate cuts. The first rate cut is not expected until June, and that means the fed funds rate (red line) will stay well above PCE (blue line) for the foreseeable future. Right now, the spread between fed funds and PCE is the largest since 2007 as you can see in the chart below.
But despite restrictive monetary policy, low volatility levels in other areas of the capital markets are driving loose financial conditions overall. For example, the CBOE Volatility Index (VIX) that tracks implied volatility in the S&P 500 has stayed in an extremely low vol regime since November. At the same time, interest rate spreads on high yield debt are hovering near historical lows (chart below), indicating easy lending conditions even for low quality companies.
So despite the level of fed funds, overall financial conditions are holding near the loosest levels in at least two years as you can see in the chart below from the Chicago Fed (above zero indicates tighter than average conditions and vice versa). And those loose conditions are helping drive the S&P 500 to new highs. After tacking on another 5.2% in February, the index is now up 7.7% on the year.
But loose conditions aren’t just boosting the S&P 500, with other segments of the capital markets catching fire recently. And it’s one that has important implications for the stock market’s next move.
Speculative Growth Breakouts
Despite the challenges posed by restrictive monetary policy, loose financial conditions are helping propel speculative growth areas of the capital markets higher.
While bearish-minded investors will point to excessive risk taking as yet another sign of frothy sentiment, there are important base breakouts underway…meaning that new uptrends are still in their early stages as opposed to signaling a top in my opinion.
And when you look back historically, emerging periods of strong speculative growth performance has marked some of the best trading environments over the past decade.
Bitcoin and the gains in other cryptocurrencies grabbed the most attention this past week. After a slight undercut of the 50-day moving average (MA – arrow at the black line in the chart below), Bitcoin went on a huge rally in February and gained 23% last week alone. The crypto is now trading just below the prior all-time high near the $70,000 level.
But it wasn’t just crypto on the move last week. I’ve written recently about small-cap stocks and the growing signs that smalls can emerge from a bottoming base by clearing resistance stretching back to early 2022. That includes the IWO small-cap growth exchange-traded fund (ETF). You can see in the chart below that IWO moved above the key $260 level last week.
Small-cap growth companies tend to be more speculative since a bulk of their profit potential is in the future. That makes their valuations especially sensitive to rising interest rates (where higher rates makes future profits worth less in today’s terms). With rates on both the short- and long-end of the yield curve holding near relatively high levels, that makes the rally in small growth shares notable while also highlighting the impact of easier financial conditions overall.
The pressure from high interest rates is also making the move in biotechnology stocks stand out. The XBI biotech ETF also features many companies whose profits exist far in the future. But XBI is breaking out over the $95 level this past week, which is confirming a new uptrend in place.
I also want to highlight the recent breakout in an ETF tracking retailing stocks with XRT. The fund holds companies like Abercrombie & Fitch (ANF) and Carvana (CVNA). Given the importance of a strong economy and consumer spending to their sales and earnings, the breakout from this bottoming base going back two years is notable as well.
Since early September, I’ve been showing how the right sectors were leading the way for the stock market, which would lead to new highs for the S&P 500. Back then, it was sectors like homebuilders and semiconductor stocks. This next round of base breakouts in ETFs tracking sectors like small growth and biotech signals ongoing improvement in risk-taking sentiment.
Now What…
While the S&P 500’s breakout to new highs is leading to a hot start for 2024, the rally could still be in its early stages. That’s especially the case when over a year passes since the S&P hits an all-time high, indicating a consolidation phase for the index.
The S&P last topped out at the start of 2022 and then fell into a bear market, marking two years since a fresh all-time high. The chart below shows the average forward gains for the S&P when hitting a fresh new high in over a year, with the index about 15% higher 12 months later on average.
It’s also worth considering that the average bull market in the S&P 500 has lasted 694 days on average since 1940. The current bull market is 506 days old, and along with emerging uptrends in areas like small-cap growth and biotech, I believe there’s still room to run.
I also continue to believe the sustainability of the rally will come down to the earnings picture, with an ongoing recovery needed to support share prices. Forward earnings estimates for the S&P 500 moved to new highs before price ever broke out. And now the rate of change in small-cap earnings is inflecting higher as well for the first time in a year as you can see below (h/t to
for the chart).
With improving risk sentiment, I’m paying more attention to small-cap growth stocks with a strong earnings and sales profile that are setting up favorable chart patterns. That includes several Brazilian fintech companies, like with Inter (INTR).
The last three quarters have seen year-over-year sales growth at 40% or better, while earnings growth in the most recent quarter came in at 400% (albeit off an easier comparison). The stock is basing since November just below the prior highs near the $6 level. I’m now watching for a breakout to new highs, while the MACD turns higher from the zero line.
That’s all for this week. The macro calendar gets heavier in the week ahead, with Fed chair Jerome Powell delivering remarks to Congress and the February jobs report coming out on Friday. But with more sectors seeing base breakouts, I’ll watching for positive follow through and a positive impact on market breadth.
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Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this report.
Nice insights on small caps, thanks!
Could you please elaborate on how the low volatility is "driving" loose financial conditions?