S&P 500 tunnel vision

Stocks are growing increasingly bullish, after strong earnings results for the last quarter, with the S&P 500 closing above 5000 for the first time.

S&P 500

Even small caps are growing increasingly bullish, with the Russell 2000 ETF (IWM) testing resistance at 200. Breakout would signal that the current narrow advance is broadening.

iShares Russell 2000 Small Caps ETF (IWM)

The Price-to-Sales ratio remains elevated, at 2.56, warning of long-term reversion towards the mean at 1.70.

S&P 500 Price-to-Sales

Sales growth improved slightly to 5.2% for the December quarter, compared to December 2022. But this is before inflation; so real growth remains low.

S&P 500 Sales Growth

Operating margins shrunk to 10.7%, with 75.6% of corporations having reported, from earlier estimates of 11.0%.

S&P 500 Operating Margin

Treasury Market

Ten-year Treasury yields are testing resistance at 4.20%. Breakout would offer a target of 4.60% — a bear signal for stocks.

10-Year Treasury Yield

The 2-year Treasury yield — normally a reliable leading indicator of the Fed funds rate — is currently rising, warning that Fed rate cuts are likely to remain on pause for longer.

Fed Funds Rate & 2-Year Treasury Yield

The long-term challenge facing Treasury is the rising projected budget deficits, with debt likely to grow at a faster pace than GDP. CBO projections vastly understate the likely deficit as Brian Riedl explains below:

CBO Projected Deficits

Revised CBO Projected Deficits

Gold & the Dollar

The Dollar Index retraced to test support at 104 but is greatly influenced by the direction of the Fed funds rate and Treasury yields.

Dollar Index

Gold is ranging between $2000 and $2055 per ounce. The lower close at $2024 suggests another test of support at $2000.

Spot Gold

2023 is the first time that the gold price has kept rising while ETF gold holdings are falling. Cause of the divergence is believed to be strong central bank purchases over the past 12 months.

Gold ETF Tonnage

Conclusion

The S&P 500 is vastly overpriced when we compare the current price-to-sales ratio of 2.56 to its long-term average of 1.70. Sales growth is also falling, while operating margins are shrinking. Investors seem to have tunnel vision, focused on rising prices rather than underlying fundamentals.

Long-term yields are rising, with the Fed expected to postpone rate cuts until mid-year, which is bearish for stocks.

Federal deficits are expected to grow to $3.6 trillion by 2034, warning of rising inflationary pressure and higher Treasury yields. The Fed may suppress long-term yields but that is likely to increase inflationary pressure even more.

The short-term outlook for Gold is bearish — if long-term yields rise — but the long-term outlook is strongly bullish because of expected rising inflation and central bank purchases.

Acknowledgements

Australian CPI falls but no rate cuts in sight

Quarterly CPI fell to 4.1% for the 12 months to December, while the trimmed mean is not far behind at 4.2%.

CPI & Trimmed Mean

Household rent increases remain strong, however, boosted by a surge in immigration.

CPI - Rents

Conclusion

Inflation, apart from rents is generally falling as the economy slows. But the RBA is unlikely to cut rates soon unless we see a sharp contraction in household consumption.

Warwick McKibbin

S&P 500 losing touch with reality

The S&P 500 climbed to a new high after breaking resistance at its January ’22 high of 4800. Rising Trend Index troughs warn of strong buying pressure. Pricing seems to be losing touch with reality.

S&P 500

The S&P 500 Price-Earnings ratio climbed to 24.2 on December 31st and is forecast to reach 24.9 at the end of the quarter (based on the current index price and forecast Q1 earnings). The chart below shows the pricing history of the index (and its predecessors) over the past 120 years. We use highest trailing earnings to eliminate distortion caused by sharp falls in earnings during past recessions. Prior to the Dotcom bubble, PE had never exceeded 20 times earnings — even during the heady booms preceding the Black Friday crash in 1929 and Black Monday in 1987. The long-term average PE of 16.5 (since 1973) suggests that the index is currently over-priced by close to 50%.

S&P 500 PE of Highest Trailing Earnings

The price-to-sales ratio of 2.57 shows a similar excess compared to the average of 1.70.

S&P 500 Price-sales Ratio

The operating margin of 11.0% in the December quarter has declined from its 2021 peak at 13.5% but is still above its 10-year average of 10.2%. We expect margins to revert to the mean over the next year or two.

S&P 500 Operating Margins

While margins are still reasonably healthy, annual sales growth plunged to 4.0% in the December quarter. Core PCE inflation of 2.9% in 2023 means that real growth in sales was a paltry 1.1% last year.

S&P 500 Annual Sales Growth

Conclusion

The S&P 500 is over-priced relative to earnings and sales growth, with long-term intrinsic value estimated at  3200 — roughly two-thirds of the current price. If the Fed continues to inject liquidity to support financial markets ahead of the November elections, we do not expect a major correction in 2024 — bar a major geopolitical event that impacts on energy prices.

The following year is likely to prove more difficult, however, with the Fed draining liquidity to ease underlying inflationary pressure and Treasury increasing issuance of notes and bonds, driving up long-term yields.

Gold testing $2000 as Dollar edges higher

Ten-year Treasury yields are edging higher, testing short-term resistance at 4.10%, but Trend Index peaks below zero still warn of weakness.

10-Year Treasury Yield

Remarks by Fed governor Waller may have reduced the prospects for an early rate cut in March:

Dollar Index

The Dollar Index broke its descending trendline and resistance at 102.50, suggesting that a base is forming. But another test of 100 remains likely.

Dollar Index

Gold broke below $2025 and is testing support at $2000 per ounce, Trend Index peaks below zero warning of further selling pressure.

Spot Gold

Conclusion

Gold’s direction is largely dictated by the Dollar which is in turn influenced by long-term interest rates. The Fed is still in an easing cycle and we expect further weakness in long-term Treasury yields and the Dollar, fueling demand for Gold.

More signs of US resilience

Real retail sales continue to grow at above trend (dotted line below), showing little impact from higher interest rates.

Real Retail Sales

CSBS community bank survey shows a strong up-turn in business conditions in the second half of last year.

CSBS Financial Conditions Index

The latest Fed Beige Book report is also more upbeat:

The snow may cover the ground, but the signs from the Beige Book suggest the Federal Reserve districts are pretty happy with the economy and remain concerned about inflation. Textual analysis of today’s report showed a clear rise in focus on prices and a positive assessment of the US economy. On the basis of the apparent message from today’s report, expectations of rate cuts in H1 2024 may be wound back. ~ Meyrick Chapman

Conclusion

We no longer expect a recession before the November 2024 presidential elections.

Acknowledgements

Meyrick Chapman, Hedge Analytics Ltd: Beige Book – Inflation & Growth Rise Again

ASX 200 tests support

The ASX 200 retreated from resistance at the high of 7600 and is now testing support at 7400. Breach would warn of a correction to test primary support at 6750.

ASX 200

The Financials Index has similarly retreated from resistance at 6800. Reversal below 6650 would warn of a correction.

ASX 200 Financials

The A-REIT Index would likewise warn of a correction to test 1200 if support at 1440 is breached. The recent rally was in response to falling long-term bond yields.

ASX 200 REITs

The correction in yields is secondary in nature and is unlikely to reverse the long-term up-trend. Further increases in long-term yields are expected to weaken A-REITs.

10-Year AGB Yield

Healthcare also rallied strongly in the past two months but could reverse if long-term bond yields strengthen.

ASX 200 Healthcare

Consumer Staples are in a strong down-trend. Breach of support at 11500 would warn of another decline.

ASX 200 Staples

Discretionary has surprised to the upside, breaking resistance at 3200. A Trend Index trough at zero indicates buying pressure. Retracement that respects the new support level would signal a further advance.

ASX 200 Discretionary

Energy rallied to test resistance at 11000 but a Trend Index peak below zero warns of selling pressure. Another test of primary support at 10000 is likely.

ASX 200 Energy

The All Ordinaries Gold Index fell sharply as the US Dollar strengthened. Follow-through below 6500 would warn of another test of support at 6000.

All Ordinaries Gold Index

The ASX 300 Metals & Mining Index is falling sharply as China’s recovery falters. Another test of primary support at 5600 is likely.

ASX 300 Metals & Mining

China

Rate cuts and measures to stimulate the Chinese economy have been modest as the PBOC is trying to protect the Yuan from further depreciation against the US Dollar.

ASX 200 Discretionary

The result is slowing growth and deflation as weak demand persists.

China & India Inflation

Conclusion

Falling long-term bond yields have boosted Financials, REITs, Health Care and Consumer Discretionary sectors but the correction in yields is secondary and we expect this to reverse in 2024.

The Metals & Mining sector is falling sharply as China struggles to overcome weak demand while at the same time protecting the Yuan from further depreciation against the Dollar.

Our overall outlook for the ASX 200 remains bearish. Breach of support at 7400 would warn of a correction to test primary support from the October 2022 low at 6750.

Santa rally: Monetary easing offsets China woes

China’s economy is struggling despite injection of moderate stimulus and efforts to support a collapsing real estate sector. Shrinking demand from China threatens a global economic contraction. G7 central banks have responded with monetary easing, causing a broad rally in stocks. This is most likely a bear market rally, with far shorter duration than a bull market.

China’s Shanghai Composite Index is testing primary support at 2900, warning of an economic contraction. The Trend Index peak near zero confirms selling pressure.

Shanghai Composite

Copper, however, has penetrated its descending trendline. Follow-through above 8500 would test resistance at $8750 per metric ton, threatening a wide double-bottom reversal with a target of $9500. Breakout above $8750 would signal global economic recovery, while reversal below $7800 would warn of a global recession.

Copper

US Stocks

The S&P 500 is testing it 2022 high at 4800, buoyed by injections of liquidity into financial markets.

S&P 500

The equal-weighted S&P 500 broke resistance at 6300, suggesting a broader rally than just the top 7 stocks. Retracement that respects the new support level would confirm the target at 6665.

S&P 500 Equal-Weighted Index ($IQX)

The Russell 2000 small caps ETF (IWM) threatens a similar breakout above 200, offering a target of 240. Breakout would confirm that investors are growing more aggressive (risk-on) and downplaying risks.

Russell 2000 Small Caps ETF (IWM)

Interest Rates

Ten-year Treasury yields are retracing to test resistance at 3.9% or 4.0%; respect is likely and would confirm the target of 3.5%.

10-Year Treasury Yield
An increase in supply of Treasury Notes will test bulls’ conviction next week:

A raft of fresh, post-Christmas government bond supply will put that comprehensive bullishness to the test. Next week, Treasury will auction $57 billion, $58 billion and $40 billion in two-, five- and seven-year notes, respectively. That’s up 20%, 15% and 7% from their average sizes over the past four monthly auctions. (Grant’s Current Yield)

The 2-year Treasury yield (purple below) is falling in anticipation of Fed rate cuts next year. A peak in the 2-year tends to lead the first rate cuts by 6 to 9 months. The signal misfired with the SVB banks crisis in March but the October peak warns of Fed rate cuts in Q2 or Q3 of 2024.
Fed Funds Rate Minimum Target & 2-Year Treasury Yield

International Stocks

The FTSE 100 is testing resistance at 7700, with a Trend Index trough at zero signaling buying pressure.

FTSE 100

The DJ Stoxx Euro 600 — reflecting the top 600 stocks in Europe — broke resistance at 470. Follow-through above 480 would test the 2022 high of 494.

DJ Euro Stoxx 600

Japan’s Nikkei 225 is testing long-term resistance at 33750. Breakout would signal a fresh primary advance but declining Trend Index peaks show a lack of commitment from buyers.

Nikkei 225 Index

The ASX 200 is testing resistance at 7600, buoyed by strong iron ore prices and falling long-term bond yields. A sharp rise in the Trend Index indicates buying pressure but reversal below 7400 would warn of a correction to test support at 7000.

ASX 200

Gold & the Dollar

The US Dollar Index respected resistance at 102.50, confirming the target at 100. Trend Index peaks below zero signal strong selling pressure.

Dollar Index

Gold broke through resistance at $2050, closing at $2053 per ounce. Expect retracement to test the new support level; respect would confirm another attempt at $2100. A falling Dollar and increased bullion demand from central banks is expected to maintain upward pressure on Gold prices.

Spot Gold

Conclusion

Stocks are rallying in response to falling long-term Treasury yields and in anticipation of Fed rate cuts next year. But falling LT Treasury yields is a medium-term rally in a long-term bear market, with LT yields expected to rise in 2025. Fed rate cuts are also a bearish sign, normally preceding a recession by several quarters — falling earnings are definitely not bullish for stocks.

Investors will need to be agile, to take advantage of the current bullishness in stocks while guarding against:

  • a trend reversal in long-term yields; and
  • signs that the broad economy is falling into recession.

Vacation

This is our last newsletter of the year as we close our office for two weeks over Christmas and the New Year.

We wish all our readers peace and goodwill over the festive season and hope for a less tumultuous year ahead.

The Magpie by Claude Monet

The Magpie by Claude Monet

Dovish Fed, Dollar falls, Gold climbs

Long-term Treasury yields plunged in response to a dovish Fed meeting which kept rates on hold, with a target range of 5.25% – 5.00%. Ten-year Treasury yields are now testing our target at 4.0%.

10-Year Treasury Yield

Declining inflation and signs of labor market easing moved the FOMC to discard the additional rate hike and increase projected rate cuts to 75 basis points next year. Their dot plot now shows 2024 ending with a target range of 4.5% – 4.75%.

10-Year Treasury Yield

Unemployment is forecast to rise to 4.1%, from 3.8% at the end of 2023, but still close to full employment. PCE inflation is projected to slow from 2.8% at the end of ’23 to 2.4% by the end of ’24, with real GDP growth slowing from 2.6% in 2023 to 1.4% next year.

QT continues unchanged at the rate of $95 billion per month: $60 billion Treasuries and $35 billion MBS.

The S&P 500 closed at 4707, headed for a test of its previous high at 4800. Breakout would signal a primary advance, with a target of 5500.

S&P 500

The equal-weighted S&P 500 ($IQX) also rallied strongly, testing medium-term resistance at 6300, compared to the early 2022 high of 6665.

S&P 500 Equal-Weighted Index

Large caps show plenty of buyer interest but the Russell 2000 small caps ETF lags far behind. Normally small caps lead in the first stage of a bull market, so this warns that investors are more risk-averse than in a typical bull market.

Russell 2000 Small Caps ETF (IWM)

Gold & the Dollar

The Dollar weakened, as no doubt intended. Breach of support at 102.50 would offer a target of 100.

Dollar Index

Gold jumped to $2031 per troy ounce. Recovery above $2000 signals another test of resistance at the earlier close of $2070. Dollar Index breach of support at 102.50 would be likely to push Gold above $2070, confirming the medium-term target of $2250 per ounce.

Spot Gold

Conclusion

The bull-trend in stocks, bonds and Gold continues. Breakout to new highs on the S&P 500 and Gold are likely. But beware that the bullish outlook is built on an unstable foundation, with commodities warning of a global recession and record-high federal debt-to-GDP limiting Fed options if the Treasury market is threatened by large outflows.

Acknowledgements

10-Year Treasury yields rally, Dollar surges

Ten-year Treasury yields tested support at 4.25% yesterday before rallying to 4.35%. Breakout above 4.35% would suggest a stronger move to test 4.50%.

10-Year Treasury Yield

The Dollar index surged in response and is likely to test resistance at 103.

Dollar Index

Gold weakened slightly, to $2040 per ounce.

Spot Gold

Long-term View

Jim Bianco thinks we are headed for 5.5% yield on 10-Year Treasuries by mid-2024. He says that the 10-year yield should match nominal GDP growth:

  • No recession next year
  • Inflation bottoms around 3%
  • Real growth of 2% to 3%
  • That gives nominal growth of 5.0% to 6.0%.

Growth

Nominal GDP growth ticked up to 6.3% for the 12 months to September, but the long-term trend is downward.

Nominal GDP Growth

Growth in Aggregate weekly hours worked declined to 1.1% for the 12 months to October — a good indicator of real growth.

Estimated Aggregate Non-Farm Weekly Hours Worked

Continued unemployment claims are climbing, suggesting that (real) growth will slow further in the months ahead.

Continued Claims

Inflation

The other component of nominal GDP growth is inflation, where five-year consumer expectations (from the University of Michigan survey) have climbed to above 3.0%.

University of Michigan Inflation Expectations 5-Year

However, core PCE inflation (orange) and trimmed mean PCE (red) are both trending lower.

Core PCE & Trimmed Mean PCE Inflation

Services PCE inflation (brown below) is also trending lower but likely to prove more difficult to subdue.

PCE Services Inflation

Real Interest Rate

Jim Bianco suggests that nominal GDP growth will fall to between 5.0% and 6.0% in 2024 — a good approximate of return on new investment  — while the 10-year yield will rise to a similar level. This represents a neutral rate of interest  that is unlikely to fuel further inflation.

10-Year Treasury Yield & Nominal GDP Growth

Inflation builds when the 10-year yield exceeds GDP growth by a wide margin. The long-term chart below shows how PCE inflation (red) climbs when 10-year Treasury yields minus GDP growth (purple) fall near -5.0%. Inflation also falls sharply when the purple line rises above 5.0%, normally during a recession when GDP growth is negative.

10-Year Treasury Yield minus Nominal GDP Growth & PCE Inflation

Conclusion

Jim Bianco’s premise of 10-year yields at 5.5% is based on the expectation that the Fed will maintain neutral real interest rates in order to tame inflation. Whether the Fed will be able to achieve this is questionable.

Japan and China have stopped investing in Treasuries, commercial banks are net sellers, and the private sector does not have the capacity to absorb growing Treasury issuance to fund federal deficits. That leaves the Fed as buyer of last resort.

The Fed may be forced to intervene in the Treasury market, keeping a lid on long-term yields while expanding the money supply. The likely result will be higher inflation and a weaker Dollar, both of which are bullish for Gold.

Acknowledgements

  • CNBC/Jim Bianco: 10-Year Treasury yield to rebound to 5.5%