Wall Street Exclusive - Searching For Diversity

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Two themes (obsessions) dominate the scene: AI and interest rates.The most significant disparity across the growth/value and market cap spectrum is between large-cap growth and small-cap value. Three ...

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The current ideological and regulatory mindset is at odds with the \"transition,\" and that will have to change.There is precedent for the S&P Equal weight index to do well even if mega-cap Tech eventually rolls over. That premise suggests the market can broaden, instead of crash, if/when BIG Tech pauses.Sompong Lekhawattana \"The only constant in the technology industry is change.\" - Marc Benioff THE MACRO VIEW In April, we watched the equity markets sell off due to perceived inflation re-acceleration and economic overheating. That was followed by a period when investors were concerned that the economy was slowing so fast; the Fed had already missed its opportunity for a \"soft landing.\" The bottom line is that very little has changed in the economy this year; it's been slowing consistently with improving inflation since 2022. The issue continues to be the conflicting data prints. The government data skewed \"hotter\" in 1Q and \"softer\" in 2Q from those hotter levels, But year over year it all looks remarkably consistent with steady slowing. The bond market has been whipsawed, with the major equity market impact resulting from investors seemingly giving up on most equities and pouring more and more dollars into fewer and fewer companies, largely impacted by the only substantial and sizable area of economic growth, artificial intelligence. Two themes (obsessions) dominate the scene: AI and Interest rates. Just before the Fed announcement on interest rates, investors were jubilant, cheering the latest inflation data. The Federal Reserve left interest rates unchanged at its latest policy-setting meeting, a decision widely anticipated. However, in the June update of its quarterly Summary of Economic Projections (SEP), the Fed surprisingly increased its expectations for core PCE inflation this year from 2.6% to 2.8% (where it was in April), raised its estimate from 2.2% to 2.3% in 2025, and left unchanged its 2% inflation target for year-end 2026, which is the Fed's terminal objective. Finally, the policymakers downshifted their intent to implement three data-dependent quarter-point cuts this year to one, followed by four cuts each of the next two years. Inflation (FactSet) The two momentum indices (S&P and NASDAQ) didn't seem to care that while CPI is stable, it remains at 3.3%, well above the 2% target. Completely dismissing the Fed's commentary about stubborn inflation, the new high onslaught continued. It seems the DJIA, Russell 2000, Dow Transports, and the average stock paid attention, as many have done nothing lately. The bottom line is that not much has changed regarding the Fed and rates in the MACRO scene. We see how emotion feeds momentum, and momentum can take stocks anywhere they want. (UP or DOWN) It seems the DJIA, Russell 2000, Dow Transports, and the average stock paid attention, as many have done nothing lately. The bottom line is that not much has changed regarding the Fed and rates in the MACRO scene. We see how emotion feeds momentum, and momentum can take stocks anywhere they want. (UP or DOWN) BUT HOW FAR IS FAR ENOUGH? Reflecting economic trends over the past five months, in which the unemployment rate increased, inflation is stable, and the economy slowed, benchmark 10-year Treasury yields appropriately increased from 3.80% last December to 4.70% in April. But with inflation softening over the past seven weeks, bond yields have fallen to 4.25%. Equity investors, however, have looked through this economic and central bank uncertainty and fed the Magnificent Seven's (MAGS) powerful rally. As a result, the S&P 500 surged nearly 33% from last October's oversold trough at 4,103 to Wednesday's overbought intraday record high of 5,447, with stocks up by 14% this year alone. The NASDAQ dwarfs those results with a 40% move off the October lows to the new high at 17,688 and is up 18% YTD. The Fed prides itself on being apolitical. Over the last eight presidential election cycles spanning 32 years, it has been judicious in changing monetary policy during presidential election years to avoid even the appearance of impropriety. To be sure, if policymakers need to raise or lower interest rates or adjust its balance sheet because of the economy, they will. But if it's a close call, and they feel they have the luxury of patience, historically they have tended to abstain from adjusting policy from Labor Day through the election. This year, four remaining FOMC meetings are on the Fed's calendar: July 31, September 18, November 7, and December 18. So, with one or two months of better inflation data in the bank, the Fed would like to see that trend lengthen sustainably, which suggests a July cut may be premature. If there's no economic crisis, the Fed would like to stay on the sidelines in September, given the proximity to the election. That leaves the November 7th meeting (two days after the election) and December 18 as the Fed's most likely dates to cut interest rates this year. The chances of the economy crumbling and inflation plummeting to 2% by September is a VERY LOW probability and, in my view, should end the discussion about interest rate cuts. A STOCK MARKET VIEW from 30,000 FEET It will be no surprise to anyone that the S&P 500 is getting pretty expensive by conventional valuation measures. Currently, the market trades for 25.5x trailing earnings per share, which, dating back to 1994, is in the 88th percentile of all periods. Only 1994, the tech bubble, a brief period when multiples rose on an economic bottoming in 2002-2003, and the post-COVID stock market boom have had higher multiples. Almost all sectors are similarly positioned at the sector level, with multiples in the top quarter of their historical range or thereabouts. The two major exceptions are Energy, which is valued at less than half the broader market and in the bottom 25% of its historical range, and Real Estate, for which we only have valuation data since 2016 and hence get a skewed picture of the history. As for recent changes, the huge increase in trailing earnings for Tech really stands out. While all sectors have seen multiples rise since the last major low in October, Tech has risen 40% more than the next largest and by far the most of any sector. That doesn't mean investors should abandon it on valuation alone. Consider the tech bubble of the late 1990s: from when Tech hit its current valuation level to the peak for the sector's price, more than two years (and 133% returns) passed, making it a painful period to be entirely sidelined. That adds more confusion about how investors should proceed. The $3 TRILLION CLUB A big deal was made a few years ago when Apple Inc.'s (AAPL) market cap first eclipsed the total market cap of all stocks in the small-cap Russell 2,000. Three stocks individually have bigger market caps than the Russell 2,000! Apple Inc. (AAPL), Microsoft Corporation (MSFT), and NVIDIA Corporation (NVDA) now all have $3+ trillion market caps, while all 2,000 stocks in the Russell 2,000 combine for a market cap of just $2.99 trillion. GROWTH/VALUE Probably the biggest disparity across the growth/value and market cap spectrum is between large-cap growth and small-cap value. Below is a look at the two-year percentage change of two index ETFs that track them. Over the last two years, the large-cap growth ETF, iShares S&P 500 Growth ETF (IVW) has grown by more than 30%, while the small-cap value ETF, iShares S&P Small-Cap 600 Value ETF (IJS) has decreased by more than 10%. Large-cap vs. Small cap (www.bespokepremium.com) As you can see, the two were generally right in line with each other early on in 2023 in the early days of the bull market, but over the last year or so, the gap has widened dramatically, especially so far in 2024. Large-cap growth has soared nearly 23% this year, while small-cap value is down nearly 7%. These two ETFs offer US equity exposure with two very different performance results over two years, showing the importance of choosing the right market area to be in or being diversified enough not to let one theme hurt you too much. With the largest stocks in the US accounting for basically all of the market's gains recently, it's time to look back to the late 1990s and early 2000s to see how the S&P 500 cap-weighted index traded compared to the S&P 500 Equalweight index back then. The last hoorah of the 1990s bull market in late 1999 and early 2000 saw the largest Tech stocks soar, which pushed the cap-weighted S&P higher while the Equalweight index lagged. S&P vs Equalweight index (www.bespokepremium.com) From the start of 1999 through March 2000, the cap-weighted S&P was up 15-25% while the Equalweight index traded flat. But…after the cap-weighted index peaked at the height of the Dot Com Bubble in late March 2000, the Equalweight index began to do very well. In fact, while Tech stocks were crashing in 2000 and 2001, the S&P 500 Equalweight index managed to post double-digit percentage gains. It wasn't until 9/11 that the Equalweight Index rolled over along with the rest of the market. This suggests there's precedent for the S&P Equalweight to do well even if mega-cap Tech eventually rolls over. That premise suggests the market can broaden, instead of crashing, if/when BIG Tech pauses. The Trading Week After a quick move to the upside to start the trading week, the weakening large-cap tech trade was too much for the S&P 500, and it dragged the index to a modest 0.31% loss, closing at 5448. Tech led the way lower, notching a 2% decline. Breadth was strong, with advancers outnumbering decliners 2 to 1. Energy and Utilities were the best-performing sectors, with gains of 2.7% and 1.2%, respectively. The \"value\" trade rebound continued as the DJIA +0.67% outperformed all the other indices. On Tuesday, it was back to Tech and not much else. The NASDAQ added 1.2%, the Tech ETF, The Technology Select Sector SPDR® Fund ETF (XLK) rose 1.8%, and the Semiconductor ETF, iShares Semiconductor ETF (SOXX) added 1.5%. That was all sparked by a 6.7% bounce for the driver of this bus - NVIDIA Corporation (NVDA). After a five-day 822-point rally, the DJIA gave back 299 points, and the Russell 2000 (-0.42%) was modestly lower. Only two other sectors posted gains: Communications services, The Communication Services Select Sector SPDR® Fund ETF (XLC) (+1.1%) and Energy, The Energy Select Sector SPDR® Fund ETF (XLE) (+0.21%). There wasn't much to write about on Wednesday as the S&P chopped around before adding 8 points to close at 5477. The index has traded in a narrow 37-point trading range in the last four days. It might be coiling for another burst higher, or resistance is now too much to overcome, and the S&P will weaken. In addition to other factors, that adds more confusion to the near-term scene. Breadth was once again negative. Only Consumer Discretionary finished in the green. Otherwise, it was a sea of red. The S&P 500 flipped between gains and losses on Thursday but ultimately extended its winning streak to three, closing up 0.09% at 5482, leaving it just 5 points away from a new high. The NASDAQ also made it three straight days of gains and just missed (by 3 points) forging another new high by adding 0.30%. The DJIA flatlined while the small caps, iShares Russell 2000 ETF (IWM) were the winners, adding 1%. There is a slight improvement in Breadth, with seven of the eleven sectors higher. THE ECONOMY The Ghost Recession Even though the last official US recession was in 2020, 67% of Republicans, 53% of Independents, and 49% of Democrats said the US was currently in a recession in a May Harris Poll of more than 2,000 US adults. (Source: The Guardian). Another reason why the consumer confidence reports are dismal. INFLATION PCE chain price index was unchanged in May, with the core rate up 0.1%, as expected, following respective gains of 0.3% and 0.3%-the May headline rate ties November (and other months) as the slowest since April 2020. The annual rates saw the headline slow to 2.6% y/y from 2.7% y/y. The core decelerated to 2.6% y/y from 2.8% y/y and is the weakest since March 2021. Another report indicates that inflation is slowing, which tells us that the march to the 2% goal will continue to take time. HOUSING U.S. home price indexes reversed their seasonal winter weakness, with the S&P Case Shiller index surging 1.4% in April to a new all-time high. Analysts also saw a 0.2% rise for the FHFA measure to a new all-time high. CONSUMER Consumer confidence declined 0.9 points to 100.4 in June, a little stronger than forecast, after bouncing 3.8 points to 101.3 in May. The weakness was in the expectations component, which fell to 73.0 after rising to 74.9 in May. Consumer Confidence (www.conference-board.org/topics/consumer-confidence) A sideways pattern that is well below pre-pandemic levels. Michigan Consumer sentiment came in at 68.2 in the final June print, improving on the 65.6 preliminary. However, it is still down from May's 69.1 and is the lowest since November. The weakness was in the current conditions index, which was at 65.9, sliding from last month's 69.6. Michigan Sentiment (Charts - Surveys of Consumers) Despite a small bounce in this report. Sentiment remains buried well below pre-pandemic levels. MANUFACTURING The Richmond Fed index fell to -10 from a 7-month high of zero in May. Today's Richmond Fed drop joins a decline for the Philly Fed but gains for the Dallas Fed and Empire State to leave sentiment still fluctuating in contraction territory after falling from lofty peaks in November of 2021 to a trough in January of 2024. Richmond Fed (Federal Reserve Bank of Richmond) Chicago PMI spiked 12.0 points to 47.4 in June, well above forecast, after sliding 2.5 ticks to 35.4. This is the best since November's 55.6, although it is still a seventh straight reading in contraction and off of May's 4-year nadir. The 3-month moving average improved to 40.2 from 38.2. Chicago PMI (United States Chicago PMI) MACROECONOMY This section presents a series of issues that may not necessarily impact the market today but can pose problems for the MACRO scene. The Generative AI BOOM The campaign to phase out fossil fuels is on a collision course with the artificial intelligence revolution. Energy-intensive AI technologies are becoming more dependent on the electrical grid, which is largely powered by coal and natural gas. Oil, gas, and pipeline companies are keys to Silicon Valley's future. Yet access to cheap, reliable, and abundant electricity powered by fossil fuels will soon pose a major risk to such businesses as Apple, Amazon, Google, Microsoft, and, yes, the supplier of the AI chips, Nvidia. The irony is that Big Tech helped give life to climate catastrophism and has advocated a net-zero energy transition. For years, Silicon Valley ideologies have financed the political and cultural movement against the extraction, refinement, and transportation of fossil fuels. Now, the brilliant minds that brought us semiconductor chips, iPhones, the internet, and Generative AI will have to make up their minds and decide between ideals and reality to fuel their latest innovations. The dilemma offers Big Tech an opportunity to deal with reality and get serious about the need for American-produced fossil fuels, energy efficiency, and nuclear energy innovations. Silicon Valley must start supporting permitting reform, pipeline construction, and the approval of new chemicals and nuclear options that will drive AI to new heights. As we will see later, the collision can be averted, but there's no time to waste. When it comes to solving problems, history has shown how private enterprise typically comes to the rescue. To put the size of the \"Power\" problem into perspective, McKinsey Research wrote that a hyperscaler's data center could use as much power as 80,000 households do. In the same article, McKinsey forecasted that the power needed to facilitate US data centers is set to double from 17 gigawatts (GW) in 2022 to 35 GW by 2030. These hyperscale data centers consume a whopping four times more power than cloud servers, and Microsoft appears to be preparing for this increased demand by powering them with nuclear power. This decision will not come without challenges; regulatory changes will be needed for this new technology to reach its full potential. Not to mention the tremendous upfront investment required. Therein lies another hurdle that could take time to overcome. Terrapower (non-public) and NuScale Power Corporation (SMR) are companies actively developing SMR Nuclear Technology. Another more diversified way to play the nuclear energy scene is the Global X Uranium ETF (URA), which has been in the playbook for over two years. There is another natural resource that the AI revolution is going to impact. The AI data centers of China may soon need more water than is consumed by all of South Korea. So much energy is used in data centers that enormous quantities of water are required to cool the machinery involved. By 2030, China may need 792 billion gallons. China's not alone. Google acknowledged using 5.6 billion gallons of water in 2022. California's water issues have been and will continue to pose a problem, and the added AI burden will exacerbate the problem. The AI boom may produce many technological advances, but the power and water issues will require plenty of ingenuity to keep the hot transition pace going. The current ideological and regulatory mindset is at odds with the 'transition\", and that will have to change. Aspirations for and benefits from the AI transition are high, but so are the hurdles to make it all work. I think Nuclear Power will eventually have to become a viable option. It's doubtful that Silicon Valley's mindset will change toward fossil fuels, so the ONLY VIABLE option is to embrace nuclear power. Microsoft's venture into SMR Technology looks to be a solid first step. The Daily chart of the S&P 500 (NYSEARCA:SPY) The S&P 500 traded in a narrow range all week until Friday when it sprinted to make new intraday all-time highs (5523). That high did not hold, as the index again suffered a \"reversal,\" closing down 20 points at 5462. S&P 500 (www.freestockcharts.com) We've seen these turnarounds occur before, and so far, they haven't deterred the S&P's upward path. We'll see if this time is different. Trading was choppy, with all the indices moving between modest gains and losses all week. Breadth remained somewhat improved, but there is a long way to go before the situation can be deemed normal. A pullback to initial support can occur anytime and can't be ruled out. FINAL THOUGHTS THANKS to all the readers who contribute to this forum to make these articles a better experience. These FREE articles help support the SA platform. They provide information that speaks to both the macro and the short-term situation. With a diverse audience, authors cannot get specific unless they're simply highlighting ONE stock, ETF, etc. Therefore, detailed analysis, advice, and recommendations are reserved for members of my service offering on the platform. The information provided here is verified by SA; in most cases, links are provided as supporting documentation. If anyone can point out a comment in any article I put forth and demonstrate that it is factually INCORRECT - I will REMOVE it.  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