When they make the movie about last week’s stock-market breakout they can call it “The Subtraction of All Fears.” The Federal debt-ceiling was lifted on time, Federal Reserve officials signaled a willingness to forgo another interest-rate hike in mid-June even with the economy holding up nicely and Friday’s employment report showed huge upside in headline payroll growth — but with moderating wage growth, to keep good news from curdling into bad. OK, maybe not all investor concerns were dispatched. There is abiding unease about the precursors of a recession that have been in place for several months, even if the downturn has been slower to materialize than investors were to position for it. The search for new macro worries also quickly found the bad news in the U.S. government deciding to avoid default, pointing out that Treasury will now rush to rebuild its cash balance by selling hundreds of billions in T-bills and thereby siphon scarce cash out of the financial markets. (It’s remarkable how quickly the normally arcane ebb and flow of the Treasury General Account at the Fed became a pervasive talking point, one that fails to note that money market funds have pulled in a cool $750 billion so far this year — with a huge pile of their assets parked at the Fed in so-called reverse repos — and can soak up plenty of that short-term paper). And, sure, many remain uneasy with the rhythm and gait of the S & P 500 ‘s recent advance, a chorus of complaint decrying the outsized impact of just a few huge growth stocks and heavy-breathing A.I. hoopla. .SPX YTD mountain S & P 500 this year Yet with it all, the S & P 500 managed three closes in a week above the 4200 level deemed by most to be the top of its range, before jumping 1.5% Friday to finish at 4282 – just half a percent below its August peak closing value. That’s two straight Fridays with 1%-plus gains, says Bespoke Investment Group, for the first time since November, typically a positive sign for investors’ willingness to assume risk. That August 2022 S & P 500 high was the culmination of a premature effort by the market to price in a Fed pause and potential soft economic landing, and was met by Fed Chair Jerome Powell bluntly promising “pain” to come as much more tightening was to come. S & P 500 poised to break out The trip to 4300 today comes under quite different, and less malign, conditions. For one thing, the level of pain that has ensued in the real economy has been modest, a manufacturing retrenchment for sure but with unemployment remaining below 4%. Inflation then was running near a 9% annual clip and is now below 5% and falling. Back then there was still nearly 300 basis points of Fed tightening ahead of us and earnings forecasts were dropping fast. Even at the August stock-index highs, the CBOE S & P 500 Volatility Index was scarcely able to drop below 20 – typically a floor during bear markets. On Friday the VIX finished at 14.6, its lowest since February 2020. .VIX 5Y mountain CBOE Volatility index, 5 years While this will send off warning flares for some traders as a sign of unmerited calm and hazardous investor complacency, it mainly reflects a stable index with lots of two-way action underneath and is at a level that’s routine throughout history in up-trending markets. (For those who track such things, the VIX never sank below 17 during the extended but ultimately doomed interim rallies during the 2000-2003 bear market.) Too much by the mega-caps? Which is not the same as declaring smooth markets ahead and peace in our time. The ubiquitous angst of the last couple of months about the way a small number of enormous stocks supported the S & P 500 and obscured pronounced weakness across most of the market was not unfounded. Broader market rallies – all else equal – are more durable. But uneven performance and mega-cap dominance can last for a long time, and the indignant commentary about it this time started almost immediately after the trend really took hold in March. As I wrote here in late April : “Most stocks being weaker than the major indexes and non-cyclical growth giants holding up the benchmark means that the rank-and-file names are digesting uncertain fundamental trends, resetting valuations and frustrating their shareholders… “The dominance of the mega-cap favorites would probably be a bigger concern if it were leading investors to grow complacent about the market’s prospects, but most of the sentiment gauges as well as the anecdotal chitchat around the recent action suggests strongly this isn’t happening.” Friday there were some signs that the “unhealthy” narrow breadth could be healed through the market’s own process of homeostasis, with blood flow reaching the suffering precincts of the market to restore some balance. Energy stocks, the equal-weighted consumer discretionary sector and the small-cap Russell 2000 were all up more than 3% on the day, with the Russell 2000 nosing back above its 200-day average. That’s a small portion of the year-to-date underperformance by those groups, but Jeff DeGraaf, founder of Renaissance Macro Research, says through history bad market breadth accompanying an up-trending S & P 500 has been rectified by breadth expanding two-thirds of the time, rather than by the heavyweights buckling to “catch down” to the average stock. This is somewhat encouraging but a lot more mean-reversion action such as we saw Friday will be needed to prove such a benign reconvergence is underway this time. Temporary overheating? The critics of the narrow leadership have a point when they argue that it weakens the case for this being a new bull market born at the October 2022 lows. Having fewer than half of S & P 500 stocks above their 200-day average more than eight months into a new bull market would be rare if not unprecedented. Then again, it’s not been terribly common to go nine months and up 20% from a bear-market low, as the S & P 500 has now just about done, and then give it all back. Let’s recall the other oddities of this cycle. History says stocks should have rallied for months after the Fed began tightening and the indexes tend not to fall much when earnings are at a peak, but last year the market collapsed into the Fed tightening even as profits held up. And perhaps having the most transparent and aggressive Fed in memory hastened an unusually early inversion of the Treasury yield curve? These are somewhat semantic arguments and the virtues of the market are in the eye of the beholder. The market last week simply moved to assign a somewhat higher probability of a softer economic landing than was priced in before. It’s not uncommon for markets to grow impatient waiting for “late cycle” to turn into “end cycle.” In the near term, the S & P 500 looks a bit stretched, the index pushing well above its trend channel – a sign both of respectable strength and temporary overheating. Market celebrations on monthly payroll Fridays have a bit of a history of serving as culminating moments for rallies. And while investor positioning seems far from aggressively bullish, professional investors are not nearly as defensive and under-invested as they were earlier this year. Maybe this is a different breed of bull or simply a hybrid, a wide-swinging market of indeterminate species, at the moment. If the low is in from last October, it was a rather mild downturn relative to most bear markets. That would mean that it set up less excellent, if still solidly positive, forward market returns. Everything has its price.
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