So, It Seems Like I Missed Something  

I’ve often joked that I really should make it a point to buy VIX calls before I go on vacation because the stock market tends to have a bout of volatility when I’m away.  I didn’t go far (Mexico City) and I didn’t go for long (six calendar, four trading days) but I ended up getting a series of phone calls and alerts about the recent swoon in global equity markets.  I wish I’d bought those calls rather than attempting to unplug.  VIX closed at 15.80 when I left and is at 18.59 as I type this. 

While the current swoon can be attributed to the geopolitical tensions in the Middle East, we did raise several notes of caution in recent days.  On April 4^th we pointed out the positive technical trends in oil and offered an early trading lesson that I learned:

become concerned if oil stocks lead the market because it indicates that inflationary pressures are taking root.

Four days later, we questioned whether the stock market’s ability to rise along with bond yields was indeed sustainable.  At that time, just over a week ago, 10-year Treasury yields had risen to 4.42% from 3.88% at the start of the year.  Meanwhile, 2-year Treasury yields had risen from 4.25% to 4.79% over that time span, even as the S&P 500 (SPX) rose 9%.  Since then, SPX is down just over -3%, but rates have increased even further.  They are currently at 4.61% and 4.93% respectively, both down about 6 basis points today.  We can attribute the most recent leg up in rates to a poorly received CPI report on April 10^th, but it is quite clear that bond traders have turned even more negative than before. 

Rates have certainly followed the ebbing expectations for Federal Reserve rate cuts, but it is fascinating to see that rates did not benefit from a “flight to safety” trade.  When crises occur, it is typical for investors to seek safer assets, like US Treasuries.  But as noted above, rates actually rose as global tensions increased.  Some of that could of course be attributed to the fact that tensions involving Iran boost oil prices, which in turn boost inflation fears.  But none of it is friendly for equity investors.  As we cautioned at the time:

The problem of course is determining when equity investors begin to pay attention to rising bond yields.  What we saw last year was that they only did so once stocks began to move sideways during the July-August period.  The year’s early momentum was broken, leaving stocks susceptible when yields spiked higher.  So far this month, we’ve seen stocks’ advance pause, but it is far too soon to say that the uptrend has lost steam, let alone be broken.  That could occur later this month, during earnings season, or next, if “sell in May and go away” takes hold.  Or not.  It’s not a hard and fast relationship.  But when stocks eventually take a sustained break from rising on a daily basis – it’s hard to imagine they won’t, unless you expect a 40% rise in SPX this year – it is difficult to assume that equity investors will continue to ignore rising bond yields.  I can’t say when, or even IF stocks will take notice of rising yields.  But it would be foolhardy to ignore the likelihood that they could.

It’s fine to do some backward-looking analysis, but it is more important to look ahead.  Indeed, SPX is down about -4% so far this month and trading at levels last seen in mid-February, but it is still up over 5% year-to-date and about 20% since the end of October.  By any standards, this is so far a modest pullback amidst some phenomenal gains.  To that end, we re-offer the points we made and strategies we proposed as the new month and quarter began:

To answer the basic question: sure, the momentum can indeed continue?  Paraphrasing Newton’s First Law, “markets in motion tend to stay in motion until acted upon by an external force.”  

But we can’t assume that markets will remain essentially impervious to external forces indefinitely.  What might those external forces be?

• Earnings season begins in a couple of weeks.  Expectations are generally high after last quarter’s performance, but are those reasonable?
• Another factor is seasonality.  Will “sell in May and go away” apply this year?  Seasonality is a fluky thing, but it might behoove investors to consider how to apply more defensive strategies while they still have a month to prepare.
• To that end – dividend paying stocks – specifically those whose cash flows support steady payouts — offer downside protection while still allowing participation in a broadening market.  Think of dividends as providing ballast to one’s portfolio.  While the sexiest investments this quarter have tended to be those with low payouts – like tech stocks – or no payouts — like bitcoin and gold – if we’re considering strategies for a sideways or rocky market, dividends become much more appealing. 
• Think about insurance using options.  Even though it’s never been more expensive to insure your home, it’s rarely been cheaper to insure your portfolio.  With any insurance, you don’t actually want it to pay off!  But you do want to sleep better at night.  I don’t love writing my semi-annual homeowners’ insurance checks, but I’d much rather not put in a claim.   
• Another theme to watch in the coming weeks: Does the Fed really need to cut rates?  Fed Funds futures are questioning that theme after today’s surprise ISM Prices Paid reading of 55.8 (vs. 53 expected and 52.5 last month).  The likelihood for a June rate cut slipped below 50% briefly today, though it is now around 56%.  But I continue to ponder why we need rate cuts if all manner of risk assets are rallying, including foreign stocks and cryptocurrencies.  Credit spreads and credit default swaps show no signs of overt stress, and the FOMC’s Summary of Economic Projections now anticipates 2.1% real GDP growth for 2024.  Do those seem like the conditions that are calling for immediate cuts?

Looking at the points we raised:

• While earnings season has begun, it is still too early to draw conclusions.  But so far, the market has seemed to generally penalize losers more than reward winners.

• Seasonality may have indeed been a factor.  We saw declines in some of last year’s biggest winners that began in the middle of last week, just ahead of when those who successfully traded those names in 2023 would have needed to raise money to pay taxes on those gains.

• Dividend stocks have softened the blow of the recent declines.  With SPX -4% month-to-date through yesterday, the S&P 500 Value Index (SVX) was down only -2.5% while its counterpart, the S&P 500 Growth Index (SGX) was down about -5.5%

• Regarding using options as insurance, we can note that the Cboe Volatility Index (VIX) was at 13.65 when we made the points above.  It is currently 18.77.  Someone decided to hedge.

• On April 1^st, Fed Funds futures showed a 62% chance for rate cut by the June FOMC meeting and 2.68 cuts priced in for all of 2024.  Those figures have declined to 19% and 1.75 respectively.

It is tempting to buy dips, and we see that many traders have been doing so steadily.  But when we see markets so willing to give back gains – especially the phony ones that seem to occur in the 30-60 minutes leading up to the open — that tells us that sentiment has not fully turned.  As a result, I believe that the points we made earlier are still appropriate.