Is Big Tech Back in the Driver’s Seat?

Do you remember when big tech was the ONLY place to invest?

Let’s rewind to the days before half the world closed its doors. From the end of 2018 to the pre-pandemic peak, the S&P 500 Information Technology Sector rose 65%. The Communication Services Sector, which sported 20% weights to both Alphabet and Facebook, jumped 40%. The S&P 500 itself climbed 35%. Not a bad year for investors, right? So long as they had their money in the right place, that is.

Over that 13 month period, every other sector underperformed the index.

Every market historian knows that the bulk of historical index returns are generated by a handful of names (that’s why we focus so much on identifying relative strength). Rarely, though, has that phenomenon been so readily apparent as it was that year, when more than 80% of sectors lagged the index.

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Yellow Rocks Over Falling Stocks

I was talking to a financial advisor awhile back about their firm’s investing philosophy, and they told me they couldn’t imagine giving their clients a significant allocation towards gold. Over the long-term, they assured me, stocks will invariably generate better returns.

Ironically, that shiny yellow metal has outperformed stocks by a pretty handsome margin over the last twenty years, which is probably about when they started investing. In my book, twenty years is a long time.

Don’t get me wrong, for most of the last decade, gold has been a pretty terrible place to be. An investment in gold at its 2011 peak and held until today would have yielded a whopping 3.7% return. For those keeping score at home, that’s 0.31% per year. Yikes.

Over that same period, an investment in the S&P 500 returned 322% – more than 13% per year. Being a gold bug is equally as dangerous as casting the metal aside simply because you don’t believe in its fundamental merits. There’s a time and a place for everything in investing.

More and more, it’s starting to look like the time and place for precious metals has returned.

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Rate Resets, Bank Failures, and an Expansion of New Lows

Were you able to keep up with everything that’s happened over the last week?

If you weren’t, don’t worry. In a year or two, you’ll be able to read all about it in a book that’s number one on the New York Times Bestseller list. And better yet, it’ll probably be riddled with insider accounts of how one of the largest bank failures in history came about.

The week seemed to begin like any other. The most interesting thing on the agenda was Fed Chair Jerome Powell’s semi-annual testimony in front of Congress – an occasion where he’d have the opportunity to adjust expectations for the upcoming FOMC meeting.

For his part, Powell lived up to the hype. In testimony before the Senate Banking Panel, he said that recent economic data would likely require a higher terminal Federal Funds Rate and could force the committee to reaccelerate the pace of interest rate hikes. Powell attempted to walk back those remarks somewhat on Wednesday when he appeared before the House, saying no decisions had been made about the upcoming FOMC meeting. But the damage was already done.

When the week began, the S&P 500 stood near 4050, 2-year Treasury yields were at 4.85%, and markets were pricing in a modest 0.25% hike at the March meeting. By the time Powell finished on Wednesday afternoon, though, stock prices were 2% below their Monday highs, that same 2-year Treasury yield was above 5% for the first time in more than 15 years, and a 50bps hike was fully baked in.

If the week had ended there, it might’ve been among the most eventful of the year. Instead, Powell’s words were a forgotten footnote just two days later.

On Wednesday evening, Silicon Valley Bank surprised investors by announcing plans to sell additional stock. They’d been forced to liquidate some holdings at a loss, and needed additional capital to fill the hole. By Friday morning, SVB was shut down and placed in FDIC receivership – the biggest bank failure since Washington Mutual in 2008.

So what the hell happened?

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Don’t Sleep on the Small Caps

The return of high-flying growth stocks has stolen the show this year.

The NASDAQ Composite, which lagged throughout all of 2022 and ended the year 35% from its all-time highs, has risen more than 11% in 2023. That far outpaces gains in the value-oriented Dow Jones Industrial Average (+0.7%) and the benchmark S&P 500 Index (+5.4).

Slipping under the radar, though, have been small cap stocks. They’ve quietly gained 9.8% to start the year, and that run of outperformance could continue. Compared to the S&P 500, the Russell 2000 bottomed last May.

It’s been all higher highs and higher lows since then.

Last year’s back half outperformance was largely attributable to differences in sector weights. The Russell 2000 has more exposure to Financials, Health Care, Industrials, and Energy, (all areas that outperformed) and is underweight Communication Services and Tech (sectors that lagged).

But that isn’t the story this year. On a like-for-like basis, small caps have simply been better.

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Two Market Themes from February

February is nearing its end, and it’s been a month marked by two themes: failed moves followed by quick reversals and the return of a familiar foe: the US Dollar.

By the middle of January, the US Dollar Index was down than 10% from its September peak. The move pushed the index below its 2016 and 2020 peaks for the first time in nearly a year – a heartening development for equity market bulls, who watched Dollar strength wreak havoc on returns in 2022. The downtrend continued as we moved into the second month of the year, and the first trading day of February brought with it new lows for the index. All seemed well.

Then a month of declines were erased in the next 72 hours.

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The Real Market Leaders

In case you haven’t been paying attention, it’s the tech-like names that have led to start 2023. Communication Services, Consumer Discretionary, and, of course, Information Technology. Those sectors were the undisputed champs of the raging bull market of the 2010s, and they’re at the front of the pack again in 2023.

Just don’t let a few weeks of outperformance distract you from who the real leaders of this market are.

The Industrials are still showing relative strength.

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Inflation Matters to Mr. Market

Whether we like it or not, economic data matters to the markets. Not every report will move prices, but each one has its place in building the macroeconomic puzzle. This week’s inflation update could be particularly important. Equity prices for the last year have mirrored changes in interest rates and foreign exchange rates. Rates and currencies are being impacted by central bank policy. And central banks are being forced to act in response to high inflation. Let’s break it all down.

Those who’ve followed this blog know that interest rates and currencies were the big drivers of equity price action in 2022. Check out how closely the three moved together:

Those relationships seem natural – a stronger dollar negatively impacts corporate earnings, and higher interest rates increase the cost of capital and decrease the present value of future cash flows. Still, the correlations typically aren’t that strong. Last year was nearly unprecedented.

So if interest rates and currencies are what’s driving the stock market, what’s driving interest rates and currencies? The most obvious answer is central bank policy. The US Federal Reserve began using forward guidance to tighten financial conditions in the summer of 2021, and then began hiking short-term rates last March.

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Precious Metals Have a Problem

Everything seemed to be working in January. US stock prices jumped 6%. International stocks were up even more. The bond market rallied, cryptocurrencies ripped higher, and gold prices soared. Even Bed, Bath & Beyond, a company on the verge of bankruptcy filing, managed to turn in a positive performance. No matter where you put your money, you probably had a good month.

Unless you put that money in silver.

It’s not like silver had a bad January. Prices for the popular precious metal fell less than 1%, a fraction December’s 8% gain. But in a month where just about everything else was in rally mode, silver was notably absent from the party.

It was a sign that not all was right in the world of precious metals.

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A Broad Look at Market Breadth

Stocks are surging to start the year, leading many to believe the bear market lows are in. This week, we’re taking a broad look at market internals to gauge the health of this advance.

The reason we watch breadth is pretty simple: the more stocks that participate in a trend, the stronger that trend is. A handful of large stocks can drive cap-weighted index prices higher (or lower) by themselves. Sometimes they can do it for longer than people expect. But they can’t do it forever. Monitoring stock market participation is one way to monitor the durability of a trend.

The cumulative advance-decline line might be the most well-known of breadth indicators. Its calculation is fairly simple: an index is created by cumulatively adding or subtracting the net of rising vs. falling issues for each trading day. If a greater number of stocks are rising than falling, the advance-decline line rises, and vice versa. No indicator is infallible, but the NYSE Advance-Decline line has reliably diverged from prices before several major stock market selloffs. Its track record is less reliable during bear market recoveries, but that’s not a reason to ignore the A/D line entirely – it can still offer useful information.

Right now, the A/D line for the NYSE is at its highest level since last August, and it’s broken the downtrend line from the 2021 highs. At the very least, that’s evidence of the downtrend in advances weakening.

Similarly, the A/D line for the NASDAQ Composite is at multi-month highs and just below the lows from last spring. For A/D lines like this, we don’t view prior lows or highs as areas of support or resistance, per se. This isn’t a tradable index, so there’s little reason to treat it as such. But conceptually, it makes sense that if this line recovers above those former turning points, breadth must be stronger than it was back then.

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A Changing of the Guard? Growth vs. Value

2022 was the year that Value made a comeback. For more than a decade, ‘Value Investor’ was synonymous with ‘Serial Underperformer’. From the lows in 2007 to the highs in 2021, the S&P 500 Growth Index outgained its Value counterpart by a whopping 170%. Last year, it gave up a third of those relative gains.

Now the S&P 500 Growth/Value ratio is nearing a pretty important level: the internet bubble highs. I’ve spoken at length on this blog about the significance of historical turning points, even ones from 20 years ago. Wouldn’t it make sense to see prices react as we approach those former peaks? If they do, that’ll pave the way for growth to outperform over the near and intermediate term.

It’s not just the S&P 500 flavor of growth/value that’s at a key level.

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