Bull Confirmation

Bull market trends are firmly in place. Despite talks of tariff wars, ballooning debt, and inverted yield curves, the market has surged higher. In one of the strongest years of the past century, the S&P has returned around 25% so far. Sometimes it can be difficult to see the true signals through all the noise. But as market participants we welcome the noisy doom-and-gloom crowd because that means we are not in a speculative bubble. The price action we have seen in stocks since the election is likely a reaction to shaking off uncertainty and refocusing on fundamental trends that were already in place. For example, the relative strength in the industrial and financial sectors has been evident for most of the year. This is the lifeblood of the economy. Technology has actually taken a backseat over the last six months and was down in the third quarter when almost every other sector was up. It is true that technology is the leader during bull markets more often than they aren’t. But it is also true that no significant bull market or sustained period of economic expansion can exist in the absence of healthy industrial and financial sectors. The strength in these areas not only reflect good times now but also historically predict positive returns looking out several quarters.

As discussed before, sector rotation is an integral part of a sustained bull market. As a leader falls out of favor it’s necessary for another group to grab the reins and push on. We are seeing exactly that as more and more stocks and sectors participate in the uptrend. Small cap stocks weren’t working before, now they are. Transportation stocks weren’t working before, now they are. Consumer discretionary wasn’t working before, now it is. If you go back and look at previous bull markets, you will notice that the longest running ones take place when underperforming sectors step up and become leaders at some point in the run. Most recently the transportation sector fits the bill perfectly. They have been stuck below their prior cycle highs due to worries of impending economic slowdown or recession. But now (though still lagging on the year) ride sharing companies, railroads, and airlines are all taking off. With so many areas just getting started and breaking above levels not seen in three years, the path of least resistance appears to be higher.

Another confirming piece of evidence of a bull market, and along the same lines of sector rotation, is the rotation into areas that one might think should not be garnering investors’ attention. Solar, for example. When one thinks of Trump, renewable energy does not come to mind. And when he was elected solar stocks tanked, as would be expected. However, over the past few weeks we have seen a trend reversal and buyers taking control. This does not happen in bear markets. In sideways and bear markets laggards get punished, often severely so. Getting solar back to its prior cycle highs would take a monstrous move as the industry as a group is down over 70% from the peak. While we don’t anticipate new all-time highs anytime soon, it is a very welcome sign for the markets as a whole that even solar is finding a way to push higher.

Elections and Seasonal Trends

Readers may recall the market letter from this time last year about seasonality. It discussed average returns during different times of the year and how this period, November through January, is typically the best. Last year the S&P 500 was up nearly 17% over those three months. This year, in addition to normal seasonality we also have the election cycle to overlay, which since 1954 has demonstrated average positive post-election returns of 5.6% over the ensuing 3 months and 8.6% after 6 months. Usually, September and October are challenging for investors and come with “October Surprises” and market sell-offs and even market crashes like in 1907, 1929, 1987, and 2007. Traders have been bracing for a market correction for many weeks now. In September we got a steep but very brief sell-off of around 6%, but the indices managed to fully recover and actually posted gains in both September and October. Objectively, this is a positive development, but it brings with it some anxiety. If stocks didn’t go down during the historically worst period of the year, what will they do when they should be going up, continue to march higher or take a breather?

Historically when markets show strength during otherwise tough times that is a very positive signal. So, bucking the lackluster autumn trend in favor of positive market performance should bode well. There is an old axiom on Wall Street, “buy in October and get yourself sober.” This strategy is referring to both buying during weakness and buying ahead of the year-end rally (i.e. put your worries aside and the bottle down and make some money.) We can’t know for certain what is driving markets higher this time around, but a plausible explanation could be the election. Markets don’t like uncertainty much more than they don’t like any single political party. In fact, the stock market has performed its best when there is a Democratic president and a Republican congress. All spring and summer volatility was relatively low and the markets were chugging along. Then Biden dropped out and volatility spiked to its highest levels of the year. Stocks sold off roughly 10% before bottoming a few weeks later. Calm returned to the markets at roughly the same time polls were showing the Democrats leading in the presidential race. Then in September polling started switching in favor of the Republicans taking the White House and there was another spike in volatility and a sell-off in the markets. Calm returned again and since then the S&P has moved sideways to higher.

So, where does that leave us as investors and money allocators? We don’t position our portfolios according to seasonal tendencies alone or simply who will sit in the Oval Office. We have to look at the totality of data points. And the current evidence indicates that we are in a strong and healthy bull market. This is a market that’s solidly up on the year, bucking seasonal trends, expanding breadth (more stocks going up than going down), and booking robust earnings from the dominant market leaders (GOOG, AMZN, AAPL, NVDA, TSLA). The main element that could put a halt to the bull run is the election. There almost certainly will be increased volatility in the coming weeks (as seen today.) One could almost think of the election as a giant earnings report. When a company posts earnings the stock will often move greatly in one direction or the other. Usually, the move is not exactly dependent on whether the report was good or bad but rather if it was unexpectedly good or bad. Traders will also typically “buy the rumor and sell the news.” This means that rumors of some good development or product can cause traders to bid the price higher only to see it fall again once that product is officially announced or actualized. Perhaps this is what we will see with the election. If one candidate winning is already “baked in” to the markets, we could see a sell-off if the expected takes place. Or we could see selling pressure arise from an unexpected or undesirable outcome. Either way we will be cautious over the next several weeks even if we believe this bull market is healthy and still has legs to run.

Fed Normalization

As we enter the fourth quarter in the markets, we do so on the back of a policy shift by the Federal Reserve. September turned out to be a strong month for US equities as the S&P advanced by about 2.5%. The Nasdaq also advanced but the tech-heavy index is still sitting below its highs made in July as uncertainty remains, especially with the looming elections. The broad advancement by stocks was spurred by changes in Fed policy as Chairman Powell announced a 50 basis point (0.5%) interest rate cut and guided for an additional 50bp cut before year-end. The Fed felt that inflation had cooled enough to allow them to focus on the other aspect of their mandate, full employment. Price stability and full employment for the American worker are the two directives given to the Federal Reserve. Powell repeatedly described the policy move as a “recalibration,” noting “slowed” job gains and “confidence that inflation is moving sustainably towards 2%.” This normalization of Fed policy is in contrast to the aggressive rate hikes we saw over the past few years to beat back inflation. A battle that has largely been successful. The markets are now predicting a further 50bp cut (as hinted by the Fed) this year, then a 1% cut in 2025, and a further 50bp cut in 2026. At that point the Fed believes they will have reached “neutrality,” meaning interest rates are neither accelerating nor restricting the economy.

A move toward neutrality is also known as policy normalization. And now that normalization has begun with more rate cuts coming, this should bode well for consumers as borrowing rates come down and access to credit increases. The Fed is in a difficult position because easing rates too aggressively to boost the economy can backfire in two different ways. One is that it can reignite inflation; and secondly it can actually decrease confidence by stoking recession fears. Investors will think something bad must be in the tea leaves if the Fed is trying to juice the economy. This is most likely why in response to the rate decision markets saw mixed price action. Nevertheless, this policy action should bode well for both stocks and bonds giving the steady growth of the economy and lower inflation readings.

A key question for investors is when will industry embrace that we are in an economic expansion and position for higher demand? For the most part, industries other than tech are not beefing up their production capabilities out of a belief that the US consumer is tapped out, or that restrictive tariffs are soon coming. However, if demand does indeed pick up there could be a rush to upgrade production which could drive commodity and material prices higher. So far, commodity prices have remained relatively stable, but we have seen a notable uptick in the performance of industrial and material stock prices. Perhaps there is already a change afoot. This will be something we will be keeping an eye on in the near future.

A Tale of Two Companies

All the hype in the markets this past year has focused on Nvidia, culminating with Wednesday’s latest earnings announcement. This was being billed as the most important and anticipated earnings report ever. The CEO was even obliging requests to autograph women’s bosoms. They are a big deal. They provide over 90% of the microchips being purchased today – a clear leader in AI chip design and software. Their earnings have skyrocketed of late, grossing over $30 billion dollars in the last quarter. For perspective, a year and a half ago they were bringing in $5 billion a quarter. On top of that, their profit margins are around 70%, just unheard of for a manufacturer. This is real money, not dot-com hope and expectations. And they are returning that cash to investors in the form of dividends and stock buybacks.

Amazingly, over the last year-plus as the stock has tripled, they have actually gotten cheaper. From a fundamental value perspective, a buyer of Nvidia today is paying less for cash flow and earnings than they would have paid in the past. It trades at about 50 times earnings today, whereas that number was about 150x several quarters ago. It’s impossible to know when the music stops for Nvidia and the earnings multiple comes down, but at least we can count on the earnings to keep increasing on an absolute basis for the next several quarters. The five largest tech companies (Microsoft, Meta, Tesla, Google, and Amazon) plan to spend $200 billion on infrastructure and GPU chips this year and over $250 billion next year. A staggering 40% of all money spent by Microsoft and Meta goes directly to Nvidia. Google pushes 14% of their spending to Nvidia and the CEO recently stated that the risk of underinvesting in AI and processing is greater than overinvesting. So, look for Google to bump up their capital expenditure soon.

Few people predicted that Nvidia would dominate the chip industry in this way. The semiconductor industry is relatively mature with some large and storied competitive players like Intel, Taiwan Semiconductor, Texas Instruments, Qualcomm, Broadcom, and AMD to name a few. Betting on just one company a decade or two ago statistically would not have gone as well as owning all of them. However, skewing towards those that do well by their shareholders is generally a safer bet. Companies have two obligations with their cash, invest in future growth or return it to the shareholders. Nvidia has been doing that for years - even before their meteoric growth. Which takes us to another company that has done this better than anyone for decades.

While all the hype and cameras were on Nvidia and artificial intelligence processors, little old Warren Buffett and his Berkshire Hathaway crossed the trillion-dollar valuation mark with almost no fanfare at all. With Buffett at the helm of Berkshire they have not once issued a dividend. They reinvest all capital. Ostensibly, Berkshire Hathaway is an insurance company. They insure the insurers and collect a healthy premium to do so. With those premiums Buffett first looks to invest in his core businesses to create growth organically or via acquisition, and secondly looks to buy stock in other businesses in the public and private markets that he deems are undervalued (including his own stock). When he can’t find anything that looks fairly priced to him, he will invest in treasury bonds and the S&P 500 index like the rest of us.

There is no one way to make money in the stock market, but there are plenty of ways to lose it. At HWM we know that sticking with companies and funds that take care of the hard-earned cash raised from investors are worthy of investing in and sticking with. We can’t know exactly which direction a stock will go on any given day or quarter but staying away from the ones saddled with debt or poor track records of generating returns on investment, and staying with those growing or returning cash via dividends and stock buybacks has a healthy track record of success.   

Rotation and Volatility

The bull market is steadily moving along but now with renewed volatility. The rotation trade has picked up steam and major indices have experienced turbulence as large market movers give up ground to their smaller or more undervalued counterparts. Summer is often a tamer period for the markets with low volatility as many traders and retail investors go on vacation or are just generally less focused on their finances. For a while it looked like that would be the case this year as well. But over the past few weeks we have seen one of the most epic rotations and swings in market history. Small caps, which have been laggards for years relative to the mega-caps, have come out of the doldrums and raced almost 10% higher this month while the S&P is slightly negative. This included a 12-day span of 13% outperformance, the largest in history. This huge rotation has narrowed the S&P 500’s year-to-date lead over the Russell 2000 (small caps) from a peak of over 16% to less than 4%. And right alongside this reversal has been a shift from growth to value. Another example of why diversification matters.

In previous discussions we have written about the great run large cap growth and specifically tech have had since the Great Recession. And just a few weeks ago the ratio of Growth to Value on a total return basis hit its highest level since the dot-com bubble. Since then however, we have seen an 11% outperformance by value. The current small cap and value rotation is being led by regional banks, homebuilders, and energy companies. Regional banks for example were up nearly 20% for the month while Nvidia and semiconductors were down roughly 15% until the big rally today as the Fed kept rates unchanged. It’s important to keep in mind that swings and rotation are normal in a healthy bull market. It is not healthy to see one pocket of the market dominate forever. Also, regional banks doing well is a very good indicator that small businesses and consumers are in good shape. As we noted last month, consumer sentiment is low but that is a reflection of the impact inflation has had on the average household. People’s investment accounts and 401(k)s have been growing but at the same time the savings rate has decreased slightly over the past year. Even though the inflation rate has come down dramatically from over 9% a couple years ago to below 3% today, prices are still much higher, and many paychecks are not keeping up with the increases. Retail sales rose just 1.9% from a year ago and adjusting for inflation that is actually a decrease in spending of 1% from last year. Consumers are definitely tightening their belts.

The recent rotation out of the Magnificent 7 (Microsoft, Apple, Google, Nvidia, Amazon, Meta, and Tesla) and into other areas has contributed to what’s called “breadth thrust,” another measure of a healthy market. The stock market is a “market of stocks” after all and the more stocks that are participating (or larger breadth) and doing well, the better the overall market. There’s an indicator called the “Advance-Decline line” that measures the difference between advancing stocks and declining ones. It has just reached a new 52-week high, the highest level of the current bull market and close to the highest level in history. So long as market internals like these remain positive, we will remain optimistic about future returns.

Market High Sentiment Low

The major indices are solidly higher this year and that seems to be making pundits nervous. The clamor is getting louder for a market correction. Maybe it’s the election cycle or maybe the summer heat, but whatever it is the news media are frustrated with the market exuberance. What often fails to be mentioned though is that we sort of already had a correction. The median stock is down this year, small cap stocks are also down, and consumer discretionary has been a laggard for months. Industrials broke out to new highs at the end of last year but have now been flat since March - as have financials. We’ve experienced a correction and now we are getting a rotation.

As discussed before, rotation is vital to a healthy bull market. And right now while sentiment is low, investors seem to be taking the guesswork out of it and simply pouring money back into the tech titans. Microsoft, Apple, Google, Nvidia, and Meta are all at or near all-time highs. While this bodes well for the bull market overall that might not be the case in the near-term. The Nasdaq, on a technical analysis basis, is nearing “extremely overbought” levels. It sounds scary, but in the past it hasn’t paid to bet against this signal. Extreme readings such as this are often followed by short-term weakness, but then continue their long-term uptrend. If we do see a near-term pullback in the indices and further sentiment deterioration, it will likely just be a continuation of the rotation process. This time out of tech and into other areas.

A potential winner of the next rotation are commodities. A few months ago, we saw cocoa scream higher, now orange juice is near highs, gold is hitting all-time highs, and copper is on the verge of a historic 13-year breakout. If commodities continue to show strength, the beneficiaries would likely be industrials, materials, and energy companies. A rotation out of the mega-cap leaders and into some of these smaller conglomerates may not be enough to drive the indices up at the same pace we have seen over the past year, but on the other hand last week we saw both Nvidia and Apple stumble and yet the S&P still closed higher for the third straight week, advancing 0.61%.

In a recent survey of investors, over 60% responded that they’re expecting a major market top sometime over the next three months. For those of us that have been through several market cycles, this is music to our ears. Seldom do markets top when people expect them to.

Tech Resilience

After a rough April and despite the tough close to end the month, tech stocks came clawing back and left industrials, small caps, and many other stocks in the dust during May. Non-tech stocks made their attempts but ultimately failed to recapture their former highs from March. And yet just few weeks ago Dow bulls were taking a victory lap as the index crossed the 40,000 mark for the first time in history. Since then, we have seen the Dow fall about 4.25%. The same can be said for other indices like the Russell 2000 (down 3.5%) and midcap index (down 3.25%). This is a normal fluctuation seen during a bull market, but we know market technicians will be keeping a keen eye on those March levels. Tech-heavy indices like the Nasdaq and S&P 500 are showing strength while industrials are failing to break above their former highs. For some industries, like energy, those former highs go all the way back to 2014, and a break above those levels could lead to pretty significant outperformance. But over the last few weeks, investors returned to favoring what has worked for them over the last decade, and that’s tech.

Technology companies have been outperforming essentially since the Great Financial Crisis of 2008. At that time energy made up the majority of the weighting in the S&P 500 but then started to steadily lose favor to computer companies and pharmaceuticals, including biotech. Over time, tech companies of all kinds continued to plod away and take a larger investor allocation percentage at the expense of other industries. However, the run we have seen in semiconductors in particular over the last few years has been anything but plodding. Semis are the backbone of the tech industry, and they are now on the verge of becoming the most dominant sector in the S&P, overtaking software. Nvidia is up more than 1,150% in the last 20 months and now makes up almost 6% of the S&P 500. The only two companies that are larger are Apple and Microsoft.

The strength and resilience we have seen in technology is not only lifting US markets like the Nasdaq and S&P, but also markets abroad. Historically, investors and money managers would allocate funds to emerging markets in order to increase their commodity exposure and potentially capture larger gains while taking on more risk in developing countries. Once a safe bet to beef up your oil and mining portfolio, now you getting about 22% technology in emerging market funds due to the growth of companies like Taiwan Semiconductor, Alibaba, and Samsung. In some regards this is great, but it also means things are getting more correlated. The rising tide of tech is currently lifting all ships, but it’s best to remain diversified. As Warren Buffett has said, when the tide goes out, you get to see who’s been swimming naked.

Price Trends

Each month we try to highlight the largest or most significant trend that is driving the markets. This can be a challenge as there is a lot of noise out there and plenty of signals for us to sort through. Last month we discussed the ongoing rotation into commodities and materials companies at the expense of technology companies. We are continuing to see this trend although it does appear pretty subtle at the moment. The overall markets along with the tech-heavy Nasdaq were down about 3% for the month whereas energy and broader commodity-based companies were up about 2%. This is something that we will continue to keep an eye on because often commodity prices will go in super-cycles that last many years.

The bond and currency markets seem to agree that “things” along with commodities are getting pricier and will remain pricier. When commodity prices increase, inflation increases. It is up for debate which causes which, but regardless we are starting to see currencies losing value to all sorts of things, while at the same time bond markets are pricing in higher inflation and interest rates. Ten-year and 30-year Treasury yields are approaching 6-month highs and Inflation Protected Treasuries (TIPs) are at 52-week highs relative to nominal yielding treasuries. The commodity index looks similar, approaching 52-week highs, and companies in the business of mining copper are hitting all-time highs.

The Japanese Yen is dropping to levels not seen in over 30 years as it loses value relative to everything else. But this is not just a Japanese thing, we are seeing weakness in currencies all over the place. Assets, especially hard assets, have been making new all-time highs when priced in these currencies. Gold has been making new all-time highs even when priced in dollars. Copper, as mentioned above, is doing the same and crude oil is coming right behind it. In an environment where currencies are declining, of course we are going to see prices go up. And historically speaking, it’s more accurate to think of these price trends not as “How high will they go?” but more as “How long will it last?”

We are still in a bull market and believe there is plenty of room to run for all sectors, but at the same time we are interested in increasing our exposure to sectors that tend to do well in higher inflation, higher interest rate, and higher commodity price environments. For example, if crude oil does get to and remains above $100 or even goes to $200 in the next several years, it wouldn’t be the worst thing to own a few companies or funds in that space.

Rotation

With the S&P closing higher for the month of March, this marks the 5th consecutive month of market gains. When this happens, future gains 12 months down the road are actually quite normal.  Almost 93% of the time the market is higher, with an average return of 12.5%. But market returns are not equally distributed. The current bull market was led by tech last year, which advanced around 40%, but we are starting to see technology companies take a back seat to companies with hard assets. Companies that produce oil, materials, and other commodities have moved into favor as inflation and interest rates remain stubbornly high. Over the last month, as money has rotated into the energy, utilities, and materials sectors, market gains in those areas have greatly outpaced gains in technology, healthcare, and consumer discretionary funds.

Consumers are still feeling the strain of high housing and food costs and are less willing to spring for new gadgets as they were a couple of years ago. With high inflation comes high commodity prices (and vice versa), and the effect can be seen and felt all over the place. The main pressure point for people is at the gas pump, but anyone that’s had to fix a fence or get a new one feels it too as lumber prices have nearly doubled. And now cocoa prices have gone parabolic. Last year a metric ton of cocoa cost about $2,400 and today it’s around $10,000. Some say all this is the fallout from the fiscal stimulus during Covid, but whatever the driver is money is on the move.

Apple has been the darling of the market for a decade, but over the last 4 months it has quietly lost over half a trillion dollars in value as investors have rotated out of the tech giant and into other areas. Half a trillion. For perspective, there are only 13 companies in the world worth over half a trillion dollars. Sure, Apple can make a comeback, in fact we have no doubt that it will. But when something of this size takes place, it catches your attention and begs to question why. The bottom line is that this is 2024 and things that worked great in the past may not work as well in the near future. Sector rotation is a perfectly normal and healthy part of a bull market and correct positioning can help augment gains and dampen losses. The entire market may rise boosting portfolio gains, but catching the niche that is moving the fastest and highest is always the objective, especially if there is a larger secular trend afoot.

It is much too early to tell, but commodities and commodity companies may be poised for much greater gains relative to the overall market in the years to come. At different times in history different types of companies make up the largest stocks. Just ten years ago the value of the Nasdaq 100 companies (mainly technology) were equal in value to all of the energy, materials, and other commodities companies. Today, the ratio is $22 trillion for the Nasdaq companies to $3 trillion for the commodities companies. If we are indeed at the beginning of an AI and technological revolution, then we are going to need a lot more and a lot better energy and materials to fuel it. And companies doing just that should be well positioned for the future.

Bull Marches On Part 2

Once again, we have another winning month in the stock market. The broad markets advanced roughly 2% in February as the bull market continues. However, we are still seeing signs of waning momentum outside of a few red-hot sectors. Fewer and fewer stocks are going up in price, but the indices were still able to muster gains as behemoths such as Nvidia lifted entire markets after their monster quarterly results were released. We are cautious, but not yet bearish because the Dow continues advancing. An old saying on Wall Street is, “Don’t fight Papa Dow.” Until we see more strength from previous market leaders, we will remain cautious but still expect to see positive market returns.

Apple, Google, and Microsoft were all unable to post gains for the month, taking a breather after outsized returns over the past year. Google had the toughest month down more than 10%, but much of that was due to backlash over some of the content coming out of their generative AI tech, Gemini. It will be hard to see significant moves higher in the Nasdaq and S&P without these big three participating. In fact, it has been impressive watching diversified portfolios holding so strong and advancing with such few numbers of stocks making new highs. However, some of those new highs have been very high indeed, and that has helped. Semiconductors have been ripping higher as have drug manufacturers and biotech. Nvidia has advanced more than 230% in just this last year, and not to be outdone, chip manufacturer, Super Micro Computer has jumped a whopping 700% in that time. The AI revolution in computation is truly upon us and data centers the world over will have to upgrade their chips. In other industries, drug manufacturers are once again having their day in the sun as weight loss and diabetes drugs are taking the world by storm. Profits have been soaring as many consumers believe the holy grail of lifestyle drugs is upon us: the do nothing, eat whatever you want, and remain healthy drug.

It's true we are only seeing a handful of stocks making new highs, but there is something we are not seeing that tells us the bull has permission to march on – new lows. Mathematically, it is impossible for us to have a stock market correction without stock prices falling. So, for any bears out there, or stock market naysayers saying the top is here and the bubble is bursting, they might be right at some point but just not quite yet. Volatility is bound to pick up and the economy might get messier, but until we see more stocks falling and making new lows relative to where they were a week or month or year ago, we will remain cautiously optimistic that the bull market will continue.