MARKET HIGHLIGHTS

• The AI frenzy continues to propel the stock market higher.
• Analysts and market strategists are moving their S&P targets higher.
• The observed rally is driven less by fundamentals and more by concentration in the US benchmark indices, investor flows, and benchmarking.
• Still, the 2024 stock market rally has been more influenced by the average stock in the index than the narrow 2023 market.
• Small cap stocks look poised for a breakout, but interest rates could forestall strength from that market cap tier.
• If the FOMC delays or eliminates rate cuts, some setbacks in the pace of stock appreciation should be expected.
• Historically, with a positive January and February, the forward annual return was higher 27 out of 28 times, and the final ten months were higher 26 out of 28 times.
• Fed fund futures traders are adjusting expectations for rate cuts to align with the Fed’s dot plot of 3 rate cuts in 2024, backloaded to the year’s second half.
• Despite adjusting rate cut expectations and surprise in the January CPI and PCE reports, the bond market does not appear overly concerned.
• Ten-year US treasury yields have retraced all the increase observed at the beginning of the year.
• Real yield curves are no longer inverted, which could carry mixed signals.
• Term premium is positive and will likely remain positive if treasury issuance remains elevated.

The frenzy that continues around AI continues to propel the stock market higher. Most analysts covering AI and the technology sector state we are in the early innings of a multi-year revolution in productivity and profitability. Piper Sandler, UBS, and Barclays have all boosted their S&P 500 targets. Two firms, Goldman Sachs, and UBS have notably increased their targets twice since December. Jonathan Golub, UBS Chief US Equity Strategist, states, “I’ve been doing this strategy job for 20 years, and this is the first time I have ever done something like that.” His second revision to the 2024 year-end S&P target was 5400, tying him with Ed Yardeni.

The other side of the transformative nature of the AI debate is whether generative AI will indeed be a “transformative technology.” AI will have a concrete use case. This fact is not in question; the debate is about the technology’s hyped transformative nature. Productivity has rebounded, but that is from depressed levels and remains below trend levels.

Another argument related to tech spending is a repeat of the CAPEX boom of the late 1990s. While consumers have spent down excess savings, which has bolstered corporate revenues and productivity gains, supporting margins, the duration has been for ~ two years. The build-out of IT equipment and infrastructure took place over eight years.

Current household savings estimates indicate they are exhausted, and the productivity rebound was from very depressed levels. Wildly exponential growth is now being priced into stock market leaders and has likely gotten ahead of itself. Specifically, Nvidia is now priced at 35x sales. A company would need to triple revenues to earn a multiple of 7x. There are examples of what are now mega-cap tech and discretionary stocks that achieved and surpassed such a feat but over 10-15+ year periods. What occurs with these stocks results from speculation, index concentration, passive flows, and rebalancing and benchmarking dynamics instead of fully informed rational investors performing careful discounted cash flow and industry analysis.

At the risk of sounding too bearish on markets, the fundamentals-reliant bears may be missing something from a market technician’s perspective. In 2023, seven stocks drove most of the index’s positive return. However, Apple, Google, and Tesla have been struggling since November. The key takeaway is that a stark difference between 2023 and 2024 is that nearly 70% of stocks are above long-term trend lines. Further, the equal-weighted MSCI ACWI, representing global stocks, outperforms the cap-weighted ACWI.

In addition, a rising percentage of stocks have achieved or are close to new highs. A frequency analysis of forward returns on stocks breaking out from new highs demonstrates a continuous positive bias. The market can and will go much higher than rational expectations. Even in the small caps, there is some evidence of modest improvement in breadth. However, small-cap performance is much more dependent upon lower interest rates. This is because these smaller companies are far more likely to be affected by the cost of borrowing to grow their business. Nonetheless, the Russell 2000 is gaining momentum and may soon break out of the long consolidation phase it entered into in Q2 2022.

Finally, at the start of the year, we made some prognostications about potential strength in financials and healthcare, especially biotech. Despite the bad news around NYCB, financials, and regional banks are hanging in there.

To conclude, we now have a somewhat unique situation where the S&P 500 gained in January and February. While we would still expect one to two setbacks for the year, in the historical occurrence of a positive January and February, the forward annual return was higher 27 out of 28 times, and the final ten months were higher 26 out of 28 times.

Following a stronger-than-expected PCE and CPI report, the market priced out rate cuts and is moving closer to the median year-end dot plot projection of 3 rate cuts in 2024 rather than 6-7.

Overall, the bond market does not seem overly concerned; to that point, the 10Y UST yield retraced nearly all of the increase after the higher-than-expected January report. Worries over banks with significant CRE exposure have likely further contributed to the recent decline in longer-dated yields.

Economic sentiment has improved on both Wall Street and Main Street, as evidenced by Investor Bullish sentiment and the strong PCE report since the Fed’s December FOMC meeting. The February payroll report reflects a healthy beat versus the median economist survey. The “soft landing” narrative seems to have gained acceptance by consensus economists and investors. As measured by TIPS, real yield curves are no longer inverted, which could reflect improved conditions for both the economy and a potential forecast of rising future prices. However, suppose the pick-up in sentiment and growth works against the Fed’s objective of a 2% long-term inflation target. In that case, the policy rate must remain restrictive for longer, increasing the risk of an eventual credit problem, the typical culprit for a recession in previous cycles.

The main difference between the “hard landing” and “no landing” scenarios primarily impacts the fixed income manager’s duration call, in other words, how attractive longer or shorter maturity bonds are to investors.

Finally, US treasury (UST) issuance has grown the fastest in various debt categories since the pandemic. Growth in federal government debt issuance has outpaced households and nonprofits by 5.7% annually, further evidenced by the ballooning federal deficit. The spending bonanza in Washington is not showing any signs of slowing down.

The primary catalyst for yields moving higher at the longer end of the curve beginning in 2021 was inflation and bond market volatility, as measured by the Move Index, for MBS. As inflation peaked and rolled over and bond market volatility settled down, treasury issuance became a new source of agitation for bond markets. This supply of new issuance is likely to be a source of indigestion for the bond market for the foreseeable future. The reason is that the excess return for owning longer-maturity bonds, term premia, rises as the supply increases beyond the market’s ability to absorb that supply. The ten-year term premium is positive and ~25bps, below its longer-term trend. Regardless, it’s more likely that term premiums remain positive, if not above trend, which would prevent yields from falling sustainably back to or below levels seen in the previous decade.