Wall Street Exclusive: 'Mean Reversion'

seekingalpha07-20

Price action confirms one of the biggest risks market analysts see out there - the concentration in the market.The S&P 500 earnings data support the bull market narrative. Pay attention to companies ...

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Pay attention to companies beating estimates and raising guidance.Investors need to turn their attention from the \"Magnificent Seven\" to the \"Magnificent Alternatives.\"Taking the steps to a normalization process that brings stock market equilibrium will be necessary to sustain any BULL market advance. One-sided markets always end badly.   BsWei\"Maintain a firm grasp of the obvious at all times.” – Jeff Bezos The View on Wall Street The stock market was banking on six rate cuts as we started the year, and with it looking like we might see one cut, not many would have predicted the ~18% S&P gain we've recorded this year. This is another example of how the backdrop can drastically change and, more importantly, produce unexpected results. What really happened was the economy stayed more resilient than most \"experts\" thought. Like myself, many underestimated the staying power of the massive stimulus doled out after Covid was under control. Forgiving student loan debt ($167 Billion to date) and spending Billions more on accommodating illegal migrants were never factored into the equation. Therefore, the notion that a recession was right around the corner drifted into the sunset. Unfortunately, that also hampered the Fed's fight against inflation. While the rest of the world has already begun cutting their interest rates, the US has yet to do so. In addition to inflation remaining above target for longer, these are the reasons why the Fed has remained on the sidelines. A better economy is always good for the stock market. Remove the threat of recession, and stocks become a different ballgame. Add in a catalyst like Artificial Intelligence, and it's clear why technology is the best-performing sector. While most stocks have had an up-and-down year, economically sensitive areas like Communications Services (GOOGL, AMZN), Financials, and Energy have added solid gains. Eight of the eleven major market sectors have produced little to no gains since March. While the year-to-date stats are impressive, it's a little shocking to see that only Technology (XLK) and Communication Services (XLC) showed a gain in the second quarter. This past week's recent reversion to the mean trade discussed in the past couple of weeks is starting to change that scene. Looking at the overall economic backdrop, the consumer represents ~70% of the US economy, and the government stimulus has kept that resilient. On the one hand, it's good because the manufacturing data has been abysmal for 2+ years and is still in contraction today. While there is talk about a manufacturing renaissance adding jobs and opportunities, the data doesn't support that rhetoric. Another concern being voiced by some economists is the outsized growth in government employment versus the private sector. Government employment rose by 70,000 in June, higher than the average monthly gain of 49,000 over the prior 12 months. This trend is currently running at a much larger percentage of the overall historical job growth numbers. The economy is about as one-sided as the market. None of this screams recession, but this path does indicate that government spending is increasingly driving job growth. The vast deficits aren't sustainable, and how long the government can sustain the economy is debatable. It's an answer to a question that we may not want to hear. In the future, the consumer will have to find a way to stay resilient, which will depend on the solid job market. For that to occur, Corporate America has to remain strong. Keeping regulations and taxes in check will go a long way to making that happen. With a divided Congress today and a huge budget deficit, any efforts to dole out more handouts will likely be squashed. Inflation has actually been stickier than the world expected, and with a \"higher for longer\" backdrop, the staying power of the consumer comes back into question. The market stats confirm one of the biggest risks market analysts see out there - the concentration in the market. Undoubtedly, our economy is technology-based today, but we are experiencing a period where the pendulum has swung a bit too far. There is nothing unusual about that. It occurs with individual stocks, sectors, and indices all the time. Markets overshoot to the upside and overshoot to the downside. The reversal of those swings makes trading in the markets so difficult. It's impossible to time the exact moment when that occurs. When the initial reversal starts, it's ALWAYS doubted. Investors are of the mindset that the strong trend is just pausing and nothing can go wrong with the fundamental backdrop driving the trend, and it will continue indefinitely. Seasoned investors know that to be a myth. Like the wild swings in the pendulum, \"reversion to the mean\" is also part of the investment backdrop. It still might be premature to say we are at that point in time with this market scene, but understand that this is how the market works over time. Make no mistake: taking the steps to a normalization process that brings stock market equilibrium will be necessary to sustain any BULL market advance. One-sided markets always end badly, so this \"change\" is a welcome sign for the BULLS. So unless active investors are day-trading or making quick swing trades, this is a scene where we have to be more selective in the types of companies that we invest in and manage risk according to our unique situations. There are a handful of stocks whose valuations, for deserved reasons, have gone up quite high. Since Nvidia (NVDA) first announced the dawn of Artificial intelligence with their EPS report in May of '23, we’ve seen many companies outside of large-cap tech stocks underperform. Their fundamentals remain solid, but the investing public hasn't reacted positively. This imbalance is actually what opens up a lot of opportunities for us. We need to turn our attention from the \"Magnificent Seven\" to the \"Magnificent Alternatives.\" The backdrop has created a larger valuation gap, which has created opportunities outside that group of large-cap stocks. Lately, it has not been a popular strategy to advise because investors have felt left behind for longer than they wanted to. However, that's exactly what I've recommended. Over time, diversification will turn frowns to smiles when a genuine reversion to the mean does, in fact, take place. I'll repeat for newcomers—that doesn't mean the MAGS contingent should be sold. It means we must put the market in perspective and think beyond tomorrow or next week. While many may not have the luxury of investing for the next 20 years, the goal of remaining diverse in our selections is paramount. I keep getting asked what the catalyst for valuations will be to reconverge and get rewarded for some of the opportunities that are present today. First, the aforementioned \"reversion to the mean, then, ironically, it will be AI itself. Data centers, energy, and those companies that supply power represent MORE value today because of AI. Beneficiaries will be found in Healthcare (XLV), which set a new all-time high this week. Think about how much efficiency we can get out of the healthcare system if we can actually apply AI to research and development projects. It simplifies connections with customers and connects patients to doctors. AI can power industrial profitability. After talking about \"reshoring\" for 2+ years, AI may be the catalyst to reenergize a theme that was started before the COVID crisis. The proper regulatory environment could provide a manufacturing renaissance both in the US and in Europe, opening up growth opportunities. The market might be looking ahead and assigning a higher probability of that and other \"positives\" during anticipated \"change.\"  The Trading Week The shift to a broader market continued as trading opened on Monday, leading to more new highs in the major indices. The S&P 500 rallied 0.31%, closing at 5632 and recording its 38th new high this year. The DJIA joined the new high parade with a rally of 0.53%, while the NASDAQ added 0.40%. The Russell 2000 (IWM) confirmed the money rotation theme, leading the major indices with a 1.8% gain on the day. Entering Tuesday's session, the S&P 500 had posted gains in nine of the last ten sessions. The HOT streak continued with the index rallying 0.62% closing at 5667, its 39th new high. Tech was DOWN, and most everything else was UP. The NASDAQ was flat, while the tech ETF (XLK) was the lone losing sector (-0.56%). The DJIA added 1.9%, recording back-to-back highs. However, Tuesday's session was once again all about the small caps. The Russell 2,000 recorded its fifth straight day with a 1%+ gain. With the IWM's 3.5% gain, it's clear where the new momentum is. We now have a chart that looks like a tech stock. The move sure has the scent of what I've mentioned to members of my service. Hedge funds are unwinding the LONG Tech/SHORT small-cap trade. Wednesday turned into a tech rout. It started with the pre-opening S&P futures and continued throughout the day. The S&P was up 83 points in the prior three sessions and gave back 76 points of that gain, leaving the index virtually flat since last Friday. The index was down 1.3% when the dust settled, closing at 5588. However, it was a completely \"mixed\" picture. The DJIA rose 0.60% to its 3rd record high in a row. After its ~10% 4-day rally, the small caps (IWM) gave back 1%. The NASDAQ was the weakest of all, falling 2.7%. After a failed rally attempt Thursday morning, the S&P 500 dropped for the second day in a row, shedding 0.78%. Small-cap outperformance was nowhere to be found, as the Russell 2,000 dropped 1.85% on the session. The only sector higher on the day was Energy, with a 0.33% gain. Every other sector was lower, with over 1% declines in Materials, Financials, and Consumer Discretionary. The worst performer was Health Care, which fell 2.3%. Gold, Silver, and Uranium all fell. Bottom Line: There was nowhere to hide. There was no respite from the selling on Friday. Every index closed in the red, with the DJIA leading the way down, losing 0.93%. Only Healthcare and Utilities posted gains for the day. The two-week winning streak for the S&P was broken, as was NASDAQ's six-week winning skein. On the flip side, the DJIA extended its weekly winning streak to three, and the Russell 2000 (IWM) made it back-to-back weeks with gains. So, for the moment, the script has been flipped, keeping investors wondering what comes next.  The Economy The Empire State index slipped to -6.6 in July from -6.0, remaining in negative territory since last December.   NY Fed (www.tradingeconomics.com)The components also moderated. The Philly Fed Manufacturing report has been the outlier in the manufacturing story in 2024, and it continues with the latest report. The Philly Fed index surged to 13.9 in July from a 5-month low of 1.3. The ISM-adjusted Philly Fed rose sharply to a 26-month high of 55.4 from 47.6 in June.   Philly Fed (www.tradingeconomics.com)This week's Philly Fed rise joins an Empire State drop, leaving sentiment overall likely ticking up to a neutral reading from slight contraction territory. The Leading Index dipped 0.2% to 101.1 in June. That follows the 0.4% decline to 101.3 in May and the 0.6% drop to 101.7 in April. Today's print is the lowest level since April 2020. The LEI has been negative in 20 of the last 21 months.   LEI (www.conference-board.org/topics/us-leading-indicators)The components were mixed, with four contributing negatively and six positively. Consumer sentiment, new orders, yield spread, and unemployment insurance claims led to June’s LEI decline. June retail sales ex-vehicles were up 0.4% vs. last month, compared to the consensus of 0.1%. Ex-autos and Gas, total sales were up 0.9%, which was 0.7% better than the consensus forecast. Nonstore retail (online) saw the largest increase, as sales jumped 1.9% on top of May's increase of 1.1%. NAHB Homebuilder sentiment fell 1 point to 42, its lowest level of the year and the lowest since August 2020. Elevated interest rates weighed on sales and kept construction financing costs high. The Global Scene China Data: Q2 GDP rose 4.7% less than expected, slower than the 5.3% year-on-year increase in the first quarter. While Industrial production rose at a solid pace, retail sales hit the worst monthly growth rate since the end of 2022 (and remember, these are not inflation-adjusted). ECB: After cutting rates for the first time at its last meeting on June 6th, the European Central Bank left rates unchanged as expected at today’s rate decision. Its policy statement was consistent with prior communications, but economic commentary was dovish; “Most inflation measures were stable or edged down in June” and the inflationary impact of wage growth is being buffered by profits”. Political Scene While many like to exclude \"politics\" from the investment equation, the market tells us differently through its price action. Media outlets and research firm analysts have been discussing a \"Trump trade\" since the \"debate,\" Biden's mounting opposition to step down increases the odds of a Trump win. Vice President Harris would be considered the frontrunner for the nomination, but other nominees could emerge – potentially impacting the race odds and market impact. The upcoming election is certainly part of the investing conversation, whether one wants to admit it or not. Be that as it may, the market does not like uncertainty, and what we have on the Democratic side is a boatload of uncertainty. While all will eventually be worked out, it can easily add to the volatility that has recently surfaced. Getting back to what is being called a \"Trump trade,\" my feeling is that these \"fads\" usually have little staying power, as it's pure speculation to call the outcome of an election that is months away. Savvy investors will have plenty of time to assemble a game plan after the results are in. In the meantime, we'll be inundated with reports on all of the \"what ifs\" that this election may hold. Here are excerpts from a recent Federated Research analysis;  Let’s put our emotions aside for the moment and compare Biden and Trump regarding policies and the potential investment implications. Assuming divided government, which might arguably be the case even if there’s a “slim” sweep, one would expect Trump to extend the tax cuts and drop corporate tax rates to 15-20%. Biden, by contrast, would limit the tax cuts to individuals making $400K per year or less and married couples making $450K or less while increasing corporate taxes from 21% to perhaps 28%. The Inflation Reduction Act is likely to survive a Trump win, though the GOP might pare it back. Immigration would likely slow under Trump, but it could be that the labor market is already weak enough that this would fail to stoke inflation. As for tariffs under Trump, the 10% global tariff he has proposed seems less likely to go into force than the 60% tariff on Chinese imports. Certain sectors and industries would fare better depending on which candidate wins. If Trump, expect India to benefit from China tariffs. Other areas that could benefit from Trump: Financials, liquid natural gas, Medicare Advantage and for-profit education. As for Tech, Biden might be softer on export controls of semiconductor firms but firmer on regulation of big tech here and abroad. The reverse is true for Trump. A trade war, more likely under Trump, would hurt Industrials. In election years, we normally see Energy trade sideways or lower from this point until the election but then look for a jump afterwards. Finally, there are certain issues either candidate will face. We’ll bump up against the debt ceiling in the summer of 2025. Trump’s individual tax cuts sunset at the end of 2025 as do ObamaCare subsidies. Certain features of both presidencies seem likely to remain: high deficits, skepticism towards China, protectionism and industrial policy. The populist phenomenon in the U.S. and globally suggests further issuance of debt to be paid at some indeterminate time in the future – as we continue to kick the can down the road.  It is a very \"fair \" assessment of the political environment. I've simplified the situation for clients and members of my service. One candidate proposes raising taxes, and one proposes keeping the low tax backdrop in place. For the record, I have a bias towards low taxes and a pro-business backdrop. That has always been my focus since I started investing decades ago. When I turn the office lights on in the morning, I want to work in a positive, low-tax, and regulatory environment because that can offset many other ills and issues the US economy faces. In essence, I'm rowing with the tide, not against it. Bottom Line: It is WAY TOO EARLY to begin thinking about or, worse yet, positioning for ANY perceived election outcome. As mentioned in earlier reports, what happens with the makeup of Congress is more important because they can control what might or might not get put into law. Earnings Earnings reports ramp up significantly over the next two weeks, with a total market cap of $12.3 trillion in S&P 1500 members (359 stocks) hitting the tape next week and another $21.6 trillion (555 stocks) the following week. Alphabet (GOOLG) will be the first mega-cap to report on Tuesday (7/23), along with Tesla (TSLA), followed by Amazon (AMZN) next Thursday (7/25). The next mega caps will not be for another week when Microsoft (MSFT) will come out with results on Tuesday (7/30), followed by Meta (META) that Wednesday (7/31) and Apple (AAPL) the day after (8/1). The following week, there will be a big drop in large-cap stocks reporting, but the slate will still have many stocks (over 300), including the next closest names to entering the trillion-dollar market cap club. The last of the mega caps, NVIDIA (NVDA), won’t report until late August. Macroeconomy This section presents a series of issues that may not necessarily impact the market today but can pose problems for the MACRO scene. Green Energy Debacle There has been a lot of investment and hype, but the green energy transition from fossil fuels isn’t happening. Achieving a meaningful shift with current policies has already been shown to be too costly. Globally, we've seen $2 trillion tossed at this issue in 2023 alone to try to force an energy transition. Over the past decade, solar and wind energy use has soared to record levels. But that hasn’t reduced fossil-fuel use, which increased even more over the same period. It's the argument that was brought forth at the beginning of this failed experiment. Alternatives are just that, at best, backups to abundant and, more importantly, reliable energy sources. Now that we have entered the first phase of the AI transition, the argument to continue using fossil fuels is enhanced. Studies show that when countries add more renewable energy, they do little to replace coal, gas, or oil. It simply adds to energy consumption. Research shows that less than one unit of every six units of green energy displaces fossil-fuel energy. The administration's EIA (Energy Information Administration) concludes that renewable energy sources worldwide will dramatically increase by 2050, but that won’t be enough even to begin replacing fossil fuels—oil, gas, and coal will all keep rising, too. The writing has been on the wall, but many global policymakers have refused to read it. The world has an unquenchable thirst for affordable energy. In the past 50 years, oil and coal use has doubled, hydropower use has tripled, and gas use has quadrupled. The use of nuclear, solar, and wind power has surged. Other than the last two mentioned, ALL are reliable PRIMARY energy sources. Solar and wind fail on both counts. They aren’t better because, unlike fossil fuels, which can produce electricity whenever we need it, they can produce energy only according to the vagaries of daylight and weather. At best, they are cheaper only when the sun is shining or the wind is blowing at just the right speed. The rest of the time, they are expensive and mostly useless.   Costly Renewables (www.lazard.com/research-insights/levelized-cost-of-energyplus/)The proponents of green energy never want to recognize that when the cost of just four hours of storage is factored in, wind and solar energy solutions become uncompetitive with fossil fuels. The notion that the current green energy plan, which promotes heavily subsidized renewables, will magically make fossil fuels disappear is deeply flawed. The problem has been the same since day one of this green push: COST with little or no RESULT: This spending splurge WILL continue to slow economic growth, making the actual cost balloon to absurd proportions. Renewables will become a viable solution as technology improves, but that isn't the case today. Spending money on what is already deemed an inadequate substitute for global energy needs is a folly that has to end. A Recession Looming?  Last month's jobs report showed another uptick in the unemployment rate to 4.1%, up from a low of 3.5%. We’re getting very close to tripping the Sahm rule in the next couple of months, which has a perfect record of calling recessions since 1960 (we’ve always had a recession when the 3-month moving average of the unemployment rate increases by 0.5% in less than a year; we are at 0.4% today). Will this be another indicator that will fail economists, or will the SAHM rule continue its perfect record? Overreaching Regulation Another climate change lawsuit is overturned. Baltimore was suing fossil-fuel producers for causing a public nuisance with their emissions and misleading consumers about their contributions to climate change. The city demanded that the companies pay damages for sundry climate harms allegedly resulting from their emissions. It's another example of the insanity that has gripped a faction of the US. Most, if not all, of these frivolous attempts to \"control\" society have already been struck down by the Supreme Court in many rulings against the administration and its regulatory agencies.  The real harm is the waste of taxpayer money that could be used to lift the city out of poverty. Entitlements keep increasing.  Critics called Obamacare the non-affordable care act and were roundly criticized. Unfortunately for the American taxpayer, they were right. The Congressional Budget Office estimated in its revised 10-year budget forecast last month that ObamaCare subsidies would cost $1.3 trillion over the next decade. The law’s Medicaid expansion for healthy adults earning below 138% of the poverty line is projected to cost another $1.4 trillion. The original 10-year cost estimate for ObamaCare, made in 2010, was $940 billion. Food stamps are another program that increases during times of economic stress, but they never seem to retreat when the economy recovers. According to the administration's experts, the economy is doing just fine. So, one has to wonder why 42 million, or 12.4% of the US population, are getting food stamp benefits today. The cost of the food stamps program for 2023 was $112.9 billion. As with any handout, there are numerous reasons why the true cost is far greater than originally proposed. The primary reason is that entitlements always cost more than originally estimated, and Congress always expands them. That’s how the U.S. has ended up with entitlements that the country can’t afford, but the politicians are too afraid to reform. There was a time when the US could absorb waste. With a multi-trillion debt load, that time is slowly slipping away.  The Daily chart of the S&P 500 (SPY) The S&P 500 closed the week on a three-day losing streak. That gave us a look at the first \"crack\" in the rally off the April lows. The index closed below the initial support trendline for the first time since May 30th. S&P 500 (www.freestockcharts.com)Unless the BULLS can gather enough buying power to retake that trendline, the S&P appears to be heading down to test secondary support. It would equal the 5%—6% April setback if that occurs. A break below would enhance the probabilities for the S&P's largest pullback since last October. 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, there is no way for any author to 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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