Investment Insights

 — Steve Orr 

Break

Mark it down: the S&P 500 has notched 15 wins in the past 17 weeks. A very rare feat indeed. A lesson learned the hard way: The trend is your friend. All the S&P sectors and the big index are in overbought territory. The advance/decline line continues to move higher, and breadth is averaging 2:1 in favor of advancers most days. Last Thursday’s two standard deviation move in the big index felt like folks rushing to get in. What are the drivers of this Bull cycle, you ask? Lower interest rates, world peace, easy liquidity, falling inflation, the administration deleting a third of all regulations, perhaps? How about none of the above.

Inflation remains sticky in the mid to low 3s, depending on who you talk to. There is a large, but shrinking, group of Wall Street denizens who believe inflation will recede to the Fed’s magic 2% level. The world is getting more dangerous to economic growth by the month; liquidity conditions, if not tightening, are not improving. Interest rates have risen four out of the past five weeks, and, sorry, the regulatory burden only grows.

Although the Magnificent 7 get all the attention, and they deserve a lot, down the stack other stocks are moving. The percentage of stocks above their 200-day moving average is at a strong 77%. Of the 11 S&P sectors, tell us the best performer during earnings season. We would have guessed tech without looking. Since February 9, tech is down 1%. All that “buy the rumor, sell the (earnings) news.” Energy is up 3.8%, tied with Materials at 3.8%. The real economy lives! Yoda might say, “strong is the trend with this Bull,” or something like that. 

Please note

Markets of all types are counting on the Fed to cut short-term interest rates. Thanks to steady economic numbers, the conversation has shifted from “how many cuts” to “when, if any.” Last week’s release of the FOMC’s January meeting minutes drove home the point. Note: Powell has final say on what gets published in the meeting minutes. So, there may be disagreements or alternative views that do not make it to the public eye. The minutes are another tool for the Fed to shape market opinion and outlook. Summary: short-term rate levels are in place at least until June, probably later.

That public service announcement out of the way, committee members did see that the policy rate (5.5%) is likely at its peak. No more increases – that’s good for earnings and consumers. Members were worried about cutting rates too soon. That is a reflex from the early 1980s when the Fed erred on cutting rates before the inflation cycle was over. Volker had to raise rates two more times to finally finish off that cycle. Repeated from the past several meetings is the sentiment that members want to see more progress toward 2% inflation. No argument there.

One highlight from the January inflation data. Owner’s Equivalent Rent is the data series that tries to capture housing costs. The concept is that this is the value a homeowner would see if they rented out their house. Sort of. At any rate, the OER inflation value goes up if your utilities costs go down. At least that is the way the calculations are supposed to work. So please note the glut of natural gas here in the U.S.

During the winter of 2022, cold temps and the Ukraine war vaulted natural gas front futures to almost $10 per MCF. Prices averaged about $3 per MCF the preceding 10 years. Warmer temps and record production this year have inventories above five-year averages in most areas. Henry Hub spot and next month delivery prices are hovering now in the $1.6 range. The drop from the mid-$3 range in mid-November could be pressuring OER higher in the January data and keeping it above where it should be. Anecdotal evidence contrary to OER rising? How about DFW area apartments offering a month’s free rent recently? Summary: inflation levels are going to stick closer to mid 3s than 2% for the coming months. 

Driving meme mad

The market meme of artificial intelligence continues to drive headlines and the Magnificent 7 returns. NVIDIA’s report last Thursday was the last of the Mag 7 for the fourth quarter of 2023. Couple of interesting points about NVIDIA. They are chiefly a chip-maker, focusing on graphics chips for ultra-fast math computations. These chips can process machine learning algorithms faster than traditional processing chips. NVIDIA has added a server products line in which they sell complete systems that resellers and end users can integrate into their networks. This unit is projected to have explosive growth in the coming years by Wall Street. We are curious to see what that growth looks like. After all, the server data-center segment revenue jumped five times over year-ago levels to $18.4 billion. Our favorite data-center tidbit we saw floating around was that if Wall Street’s 2026 estimates were reached, the number of servers sold would consume 1.5 times all of Europe’s energy consumption for last year. That sounds unreachable to us.

What does the company say? They will only forecast the next quarter – a bit unusual in public markets, but their choice. We do favor the NVIDIA concept – sell picks and shovels to the miners. One point is that most, if not all, of the other Magnificent 7 buy chips from NVIDIA, and Google parent Alphabet and Facebook owner Meta both said this season that they are boosting capital spending this year.

We in PWA do agree with the sentiment that AI is in its early innings. The ability to sort through hundreds of thousands of protein combinations to find one that can latch on and kill a tumor is one example. Replacing jobs is another, and I am mindful of the large language models that are learning financial lingo. Is there a welding home study course in my future?

What up

Longer-term interest rates have risen as bets on the Fed cutting rates fall. The 10-year Treasury is 0.46% higher than year-end, and slowly heading higher. This is one market that does make sense at the moment. Interest rate drivers include prospects for economic growth, U.S. dollar, supply of debt, inflation expectations and the Fed.

The Fed is on hold and “ready to cut” someday. We think there is a reasonable probability that the “ready to cut” may be geared to future small bank problems with office building loans. The economy is doing fine, possibly downshifting to first gear in the coming months, but not recession. The dollar is in the middle of its recent range. Supply is an issue. The administration is counting on big capital gains tax revenue this April to keep the deficit around $1 trillion. Color that one doubtful. Inflation expectations are fairly stable at 3%.

Supply, Fed on hold and inflation expectations reasonably account for interest rates drifting higher. We think they are not high enough. Heresy, we know, but hear (read) us out. For the past 200 years or so, the 10-year government bond has hovered around the nominal growth rate of GDP. Nominal GDP growth is decelerating from 6%+ to around 5% in the next quarter. So, at 4.25%, the 10-year Treasury is about three-quarters of a percent expensive.

Most economists think the current real interest rate is around 2.6%. Choose your inflation measure: PCE, CPI, Cleveland trimmed mean, all hovering around 3%. Adding real plus an inflation rate of 3% gets one to at least 5.5%. Again, making Treasury rates relatively expensive. Is there a premium pressing rates down due to geopolitical or election concerns? We think those would also show up in oil and gold prices. Both are moving but inside their recent ranges, so no pressure there or in bonds.